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Risky business

Lessons in risk management for an international greenhouse gas emissions market

Identifies risk-management principles pertinent to the international market for greenhouse gas emissions rights and fashions recommendations for each.

Executive Summary

The devastating impacts of the Asian financial crisis of 1997-98 serve as only the most recent reminder that all liberalized financial markets critically depend on regulatory frameworks that incorporate sound risk-management principles. An international market for greenhouse gas emissions rights will be no exception. Risky Business identifies three risk-management principles as particularly pertinent to this emerging market, and fashions recommendations for each:

1. Establishing transparency and disclosure rules. Sound information is the lifeblood of financial markets. Countries will need to build on the existing monitoring, reporting, and review provisions included in the Kyoto Protocol, and the IPCC "good practices" on estimating emissions inventories.

2. Properly sequencing regulatory policies. If there is any lesson learned from the Asian financial crisis, it is that regulatory safeguards must be in place before large-scale international capital flows begin. To ensure this, designers of the international emissions trading system should impose legally binding eligibility requirements on all countries before they are allowed to participate in international emissions trading.

3. Avoiding perverse incentives that result in excessive risk taking. Misaligned incentives in an international emissions trading system will result in an environmental train wreck. To avoid this, market framers should design a "liability rule" that properly aligns risks and rewards--possibly an "escrow reserve" option, which the paper proposes.

Building a credible international regulatory framework until now has had few, if any, guideposts. Fortunately, the high-stakes, unprecedented policy experiment of international emissions trading can learn from the hard-fought experiences of international financial markets. So, even though trading advocates' constant refrain of "learning by doing"; is good advice, the international greenhouse gas emissions market need not undergo the tumultuous times known from crises in more traditional financial markets. Indeed, in shaping specific rules, the time-tested lessons of financial risk-management principles offer an opportunity for "learning by not doing"

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