By Tom Fowler

Houston Chronicle

Pending U.S. climate change laws could create a market for carbon dioxide emissions much like the risky mortgage-backed derivatives market that contributed to the global recession, according to a recent report.

The so-called cap-and-trade systems at the heart of most proposed climate laws are expected to create a market for permits to emit carbon dioxide and other greenhouse gases that may eventually rival existing oil markets. Research firm Point Carbon has estimated the market could reach $3 trillion by 2020.

But that market could take on the same characteristics as the mortgage derivatives market if investors are allowed to securitize emissions credits without strong regulatory oversight and enforcement, said Michelle Chan, a senior policy analyst with the group Friends of the Earth and the author of the report.

"If we aren't careful, we could end up creating a massive, poorly regulated derivatives market that not only poses risks to the broader financial markets, but also undermines efforts to save the climate," Chan said.

Most climate change bills being considered by industry and Congress aim to lower emissions by putting progressively lower caps on the amount of CO2 or other greenhouse gases facilities can emit per year. Companies that are able to lower their emissions below the cap could trade their excess emissions credits to firms exceeding their quota.

Existing laws appear to be sufficient for many of the emission credits that would arise from a cap-and-trade system, said Craig Pirrong, a finance professor at the University of Houston who specializes in commodity markets.

"Those plain vanilla kinds of forward contracts should fit well into the existing framework," Pirrong said.

But secondary markets that will likely arise around carbon markets may be trickier. This includes a market for offsets - carbon credits awarded for projects that reduce emissions.

These might include capturing greenhouse gases through such means as planting trees that absorb CO2 or gathering methane produced by landfills.

Offsets would increase the number of carbon credits available for trading, and are seen as a way to keep compliance costs down while encouraging greenhouse gas reduction projects in industries or nations outside of the regulated markets.

"I'm not quite convinced lawmakers are fully aware of the thicket of issues that will arise in this context," Pirrong said.

The systems for validating offsets so far have a poor track record.

For example, factories that manufacture refrigerants known as HFCs are granted offset credits when they destroy a byproduct of the manufacturing instead of releasing it into the atmosphere. They then sell the offset credit in the existing carbon market in Europe.

But in some cases the lure of the offsets actually encouraged plants to increase production of the byproduct just so it could be destroyed for the credit, Stanford University researchers found.

Studies also have found problems with offsets in some existing voluntary carbon markets, where companies have banded together to reduce emissions as an effort to gain "green" credibility with consumers and to gain experience in such markets and perhaps generate credits that may be valuable in future markets.

The offsets are supposed to be created just for the purpose of the credit and not as part of an existing "business as usual" practice.

But in some cases landfill pro-jects that had been capturing methane for years are also getting offset credits for those projects.

Offsets could become a form of "subprime" carbon credits because of their dubious credibility and the prospect that they might not actually lead to the emissions reductions they claim, Chan says in the report.

The report recommends lawmakers include carbon trading in the ongoing discussions about financial market reforms, prohibit the use of offsets and use a wide range of programs other than carbon trading to tackle emissions reduction targets.