While the Senate does appear to support the scientific and environmental need to put a cap on our carbon emissions, some Senators remain fearful that the “trading” portion of the cap and trade bill will just be creating another derivatives market for speculators to “sink their teeth into”. As a result they feel that only emitters should be allowed to trade carbon allowances and Wall Street should be left out the market entirely.

On the face of it, this approach seems fairly sensible given what a mess Wall Street has made of the energy, mortgage, and credit default swaps markets over the past few years. Instead of creating a “trading” market for carbon allowances, we would instead create an “emitters only” market for carbon allowances where the emitters could just trade between themselves. Then we wouldn’t have to worry about creating another derivatives market and the program could focus less on trading and more on ways to ensure the integrity of the cap over time.  

Although this solution sounds like the most straightforward approach, if we are actually looking to design a carbon program that will keep transaction costs down, accelerate the deployment of low carbon technologies, bridge the credit gap, lower overall program costs to the consumer and best ensure we meet the environmental objectives of the program a “trading” market approach where non-emitters can participate will deliver far better results than a “emitter only” market for carbon.

The following is a list of five reasons why the “trading” market detailed in the ACES bill would be more effective than an “emitter only” market:

1. Trading Markets Lower Transactions Costs / Improve Market Liquidity 

A well regulated, exchange based carbon “trading” market like the one described in the ACES bill would have very low transaction costs relative to an “emitter only” market. Market makers and speculators would compete on an exchange to narrow bid/offer spreads and reduce overall trading costs for market participants under a “trading” program. This would compare favorably to an “emitter only” program that would tend to have wider spreads and higher transactions costs as emitters would only tend trade sporadically and be less focused on providing liquidity to the overall market.

2. Emitter Only Trading is Not Immune from Volatile Price Swings

An “emitter only” program would tend to be more volatile than a "trading" market when market fundamentals have changed. This is due to the fact that an "emitter only" market would have too few sellers of allowances when the economy was strong and have too few buyers of allowances when the economy was weak, as emitters would be all looking to trade in more or less the same direction.  A “trading” market on the other hand would have several different kinds of actors involved in the market on a day-to-day basis and as a result would be more balanced and less prone to this kind of unwanted market volatility. 

3. Emitter Only Trading is Not Immune from Market Manipulation

While it can be argued that an “emitter only” program would tend to be less volatile due to the lack of speculators in the marketplace, this would not mean that an “emitter only” market would be immune from market manipulation. In fact, the presence of several large emitters, whose compliance obligations would be larger on a percentage basis than the speculative limits allowed under the ACES bill, would have the ability to meaningfully influence carbon prices leaving the market prone to the same “games” played by speculators in other markets.

4. Trading Markets Accelerate Low Carbon Investments

Like them or not at the moment we need the banks to provide the trillions of dollars of loans needed to fund our transition to a low carbon economy. One way for the banks to start lending again is to provide loans to emitters for low carbon investments backed by the collateral value of their carbon allowance allocations. This kind of lending is desperately needed to accelerate low carbon investments and can only effectively take place in a market that allows “trading”. An “emitters only” market would not provide enough flexibility to use carbon allowance values as collateral as the banks would not be able to sell the allowances in the market if the covenants of the loan were to be broken.  As a result, many economic investments under a "trading" market program would be delayed under a "emitter only" market program due to the inability to finance these kinds of projects without using carbon allowances as a form of collateral.

5. Trading Bridges the Credit Gap / Lowers Overall Program Costs

In a credit constrained world, the ability to tap the collateral value of allowances lowers an emitter’s borrowing costs, allowing them to accelerate investments in the low carbon technologies needed to meet our environmental objectives. In this way “trading” not only helps bridge the credit gap faced by emitters but also helps to lower program costs overall by enabling these technologies to scale up faster. A more rapid deployment of these technologies will allow us to more easily keep pace with the declining cap on carbon emissions and keep carbon costs low.

While the benefits of a “trading” market approach may be persuasive, recent comments on the Senate floor that trading “makes no sense” would still be valid if the ACES climate bill simply outlined a plan to create another unregulated playground for the banks and hedge funds to play in.

Fortunately the 400 pages of carbon market assurance regulations written in the ACES bill moves us 180 degrees away from creating another one of these “dark” markets where speculative traders thrives in the shadows.  Unlike these markets, the carbon derivatives regulation under the bill would  1) require all trading to take place on exchanges, 2) prohibit over-the-counter (OTC) trading, 3) limit speculative activity, and 4) severely restrict overseas allowance trading. Additionally, if the Senate carbon market oversight provisions were also to be incorporated into the bill, carbon would be regulated under an independent Carbon Markets Oversight Committee that would be responsible for ensuring that carbon trading is conducted in a way that is in keeping with the programs long-term environmental objectives. 

Furthermore, the ACES bill would also repeal many of the regulatory exemptions granted to the energy markets under the Commodity Futures Modernization Act of 2000. By banning OTC trading, introducing position limits, and increasing reporting requirements for oil and natural gas market participants, the bill would help ensure that market price volatility would fall in these markets and that the “rollercoaster ride” we experienced last summer at the pump would be shut down and no longer open for business.

In sum, carbon "trading" markets have benefits that cannot be replicated by an "emitters only" market.  Like it or not at the moment, we need the banks to be involved in the carbon markets as they are expected to provide trillions of dollars in financing for the deployment of the low carbon technologies needed to cost effectively acheive our climate goals. Lastly, while fears that we are creating another "speculative orgy" are not well founded with respect to the carbon markets, it is important that the Senate remain vigilant with respect to the energy market reform provisions in the ACES bill. These provisions will greatly improve the ability of the carbon trading markets to do their job and put speculators on notice that the energy commodity markets are coming back into the light.