Green bubble
Illustration: Shane Busato

The green bubble cometh

There has been a lot of discussion in the media about the 2008 housing bubble that we have just gone through. Economic bubbles are nothing new and have been around for a very long time. We can look back the 17th century and the Dutch tulip bulb bubble where everyone was trading tulip bulbs in a market were people thought that the prices would increase forever making everyone rich. This same process has been repeated throughout history with cycles of boom and bust. Which brings me to the next potential bubble, get your wallets out and open them up as it is time to “go green.” “Going Green” is one of the latest buzzwords to hit the street these days and just like in the late 1990s when the “Internet” was the latest buzzword this has all the makings of the initial hype that is needed to start off any bubble. Indeed for any bubble to happen the first thing that is needed is support. So do we have the support yet to start the process off?

In this article I will take a look at the support needed to create the conditions for the next bubble and then talk about how this bubble might develop. Just a note, I hope that I am proven wrong and that there are no more bubbles with their boom and bust cycles but that sustainable economic growth will become the norm. Well one can only dream!

We need to see support from three main areas:

•Citizens need to buy in to the concept.
•The government needs to support the concept through legislation.
•A high enough level of demand needs to arise to justify supplying the financial products allowing people to participate in the market to allow the bubble to form.

Over the past several years there has been a slow but gradual increase in awareness of environmental issues in society. This has been building for the past 30 years and it has reached the critical mass needed to really effect change. Government policies in turn reflect the moods of the society that support them.

We have had the Kyoto protocol around for several years but the United States has still not ratified this treaty yet and has been dragging its heels for years, casting doubt on what the US's policy really is. In addition, most of the signatory nations have not met their emissions reduction targets anyway. From this point of view it, looks like the protocol has been a failure. However in spite of that there is still a commitment to do something even if everyone can not agree on what exactly should be done. The recent G8 meeting and the announcement to reduce carbon emissions by half is a promising development even though it is not clear how this will be accomplished yet. In December of this year we have the United Nations Climate Change Conference 2009, which will take place in Copenhagen, to look forward to. All these are promising. But perhaps the biggest single development so far though, is the American Clean Energy and Security Act of 2009. This act has several key components which I see as key to helping provide support for the coming bubble. The first is the cap and trade program which provides emissions allowances in the form of carbon credits to industries. These credits, however, will be gradually reduced year on year. Secondly, it sets clear emission targets to be met, for the first time the world’s largest economy is setting up mandatory limits on the emissions of greenhouse gases. Carbon credit trading between institutional investors has been around for several years in various forms. But it is about to get far more meaningful and far more valuable in the US now that there are clear targets to be met. Now that the world’s largest economy has this system in place, this can only spur other nations like Japan to in-turn develop their own systems. Japan currently has a trial carbon trading system that, in place since October 2008, but it is based on voluntary targets. There is however the desire to move to a more formal system with mandatory carbon emission reduction targets.

Corporations will create the initial demand but corporate demand alone is not enough to create a bubble. Just like the tech bubble of 2000 and the housing bubble of 2008 it is up to the individual consumer to provide final “gas” needed to inflate the bubble. In 2000 it was the retail investors who really pushed the bubble over the top with their endless demand for the next tech stock. The same thing happened in 2008, it was the individual consumer that played the housing market game and provided the critical mass of demand needed. In both bubbles, the sky was the limit and people thought that “this time it is different.” So how will this turn into the green bubble then? Where will the demand come from?

Money will move to where it is expected a profit can be made and the American Clean Energy and Security Act of 2009 appears to support this. As mentioned there is a year-on-year reduction in the amount of credits issued. This is a unique situation as normally supply and demand forces interact together to determine prices. But in this system, the supply of carbon credits is “fixed” regardless of the demand. This will provide at least automatic support for prices and should encourage price inflation, all things being equal. Given this, companies are now pressured to reduce their carbon footprint. So it only makes sense that there will be a boom in new environmental technologies. Just like in the tech bubble of 2000, we can expect all manner of start-ups to develop the technologies needed. It will not be long before the retail investor gets interested and attempts to seek alpha in this area.

So we have the combination of government legislation which will spur the initial corporate demand. Follow this on with consumer demand and we have the support needed to start the bubble off. All we need now is that last piece of the puzzle to fall into place. Now it is time to provide the “supply”.

Providing “supply” would come in the form of new financial products geared toward fulfilling this demand. After all this is a perfectly natural market reaction, where there is demand someone will come along to provide supply.

It will not be long before I can envision a whole host of new financial products available on the market to cater to the retail investor’s interest in carbon trading. I can foresee the development of a couple of new indices to measure the value of carbon credits or emission rights. Then there will be options and futures products based on these indices and the value of a credit. We will also see the development of exchange traded funds and other mutual funds based on the new carbon credit index or based on a basket of environmentally related companies that will be seen as the new “growth” companies.

Yes this is where the real fun starts once the general public gets caught up in it and once again everyone will get involved and want a piece just like with the Dutch tulip bulb bubble of the 17th century.

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