On climate, we need a global carbon market with its own ‘federal reserve’

Predictably, the November round of UN climate talks generated nothing but hot air and cold comfort. Representatives of 189 countries spent two weeks in Warsaw negotiating the shakiest of timetables for meeting the lamest of environmental goals. No emission cuts were agreed and zero funding was pledged to the Green Climate Fund.

Time and again, these diplomatic pow-wows have demonstrated global governments’ inability to mitigate man-made climate change with top-down solutions, or to price environmental costs and risks with any sense of urgency. UN climate talk participants seemed unaware that an effective top-down climate deal is impossible to contemplate until China, India and other developing economies accounting for most of the future growth in emissions agree to binding cuts and contribute hard cash in adaptation funding to smaller developing countries. The UN climate talks will continue to limp into a future where they won’t make much difference.

Immediate action at scale is more than ever dependent on channeling private sector hunger into overcoming climate change. The task at hand is relatively modest: We need to channel $1 trillion a year to effect a global low-emissions transition, a modest sum compared to a global GDP of $70 trillion. We already know the most effective way to crystallize private sector funding while correctly pricing environmental costs and risks. By creating a marketplace where permits to emit carbon can be traded openly - ideally at as high a price as possible - we can give companies a tangible economic incentive to make their operations greener. Carbon markets make polluting pricey while enabling a clean energy transformation, and generate revenues for cash-strapped Governments who through carbon permits, print and regulate a new sovereign currency.

These markets are set to play a major role in efforts to confront climate change because they are on pace to cover about 3 billion people and the lion’s share of the world’s economy by 2015. Yet as of now, the current patchwork approach is less than ideal because it creates a system riddled with loopholes and perverse incentives, leading to dysfunctional and highly volatile carbon markets (in particular, the global carbon markets and those of Europe).

Why does volatility matter? Dramatic price swings have a chilling effect on climate ambition because policymakers can’t compute how much climate action will cost their economy—often adding to their reluctance to act, or to their confusion (witness murmurings last week that British Chancellor George Osborne may scrap the UK’s national carbon price, demonstrating how confused this particular policymaker is). In addition, extreme volatility and uncertainty can have a chilling effect on economies experimenting with the early stages of carbon pricing, while also dampening clean energy innovation by undermining investor confidence.

This price instability comes from a fundamental supply and demand imbalance caused by nations’ lack of climate policy ambition. The potential buyers of carbon credits from clean energy investments simply aren’t buying. If countries ramp up their ambition (as they should), they will look to the global market to contain costs. Point Carbon analysis suggests that by 2030, prices could reach €66 per ton in the EU’s Emissions Trading Scheme.

New analysis from the US think tank the Brookings Institution shows how the price crisis shaking the global carbon market presents an opportunity. The study urges leading multilateral organizations to buy up dirt-cheap carbon securities to capitalize a global “carbon market reserve” that would have the authority and mandate to adjust the supply of global carbon credits.

Reserves are accounts set aside to offset any unexpected fluctuations in supply and demand of a given asset (the US Federal Reserve, for example manages global supply and demand of dollars). Reserves can be filled with assets at regular intervals, or all at one time. Once filled, they make additional assets available for purchase or for sale when prices reach a certain level or when decision makers otherwise decree. Reserves can thus be used to control price in a given market by releasing or holding the asset. While they do not eliminate price volatility, they can be useful in preventing spikes above or below a given level.

With carbon prices at almost rock-bottom, there’ll never be a better time to invest in such a reserve, and doing so would both stabilize market prices and boost investor confidence.

A carbon market reserve is not a new idea. In fact, almost every carbon market in the world has some form of reserve or price stabilization policy – with the exception of the European and of the global markets who stand alone when it comes to lacking price stabilization tools, with disastrous results.

It’s time to fix that. Given the vast oversupply of carbon securities in the market today, we have a unique opportunity to begin to capitalize a carbon market reserve now at low cost, placing us on a path toward stronger carbon markets tomorrow while, as a secondary benefit, also helping to shore up today’s carbon markets by reducing excess supply.

A carbon market reserve, established now with cheap credits, would smooth out variability and play a key role in allowing the private sector to drive investments of $1 trillion or more into our transition to a low-emissions world.