Carbon Trading Regulation Needs to be Made Explicit under a Climate Bill

Congress is drafting legislation that will create a multi-trillion dollar market for carbon allowances is expected to attract a great deal of attention as the climate policy debate begins to unfold.  We have the tools to make sure that carbon trading is free of fraud and manipulation.

Given what has gone on recently in some other trading markets, many Americans probably would prefer not to see investment bankers anywhere near climate legislation and to leave all the trading to companies that emit the pollution.  As logical as that may sound, the reality is that we need the banks to be involved in the carbon markets for two important reasons.

The first is that investors and other market participants will be required to help provide the "liquidity" or depth of market needed by emitters to "hedge" or fix the price of some of their longer term climate obligations.  With lots of companies that emit pollution looking to buy emission allowances, market makers and speculators are needed to provide a selling price in the markets to give the emitters confidence that they can hedge their carbon portfolio risk day in and day out through the year.

The second reason is that the banks are needed to help extend the trillions of dollars of loans required to transform our twentieth century high carbon energy economy into a twenty first century low carbon energy economy. In order for the banks to lend money to emitting companies they will need a full understanding of their carbon exposure and may be asked to use carbon allowance revenues as a form of collateral against these loans in the early years. Without access to the carbon markets, the banks would be unable to access this collateral if the loan went sour and as a result the banks would be less willing to make these kinds of loans for low carbon technology investments.

So given that blocking out the traders is probably off the table, the American people still have a right to demand that rules for regulating carbon trading be clear, transparent and faithful to the fundamental non-financial objective of a cap and trade program: curbing carbon pollution. This means that the rules must be written in a way that best facilitates the American peoples' long term environmental objectives and not the short term financial objectives of speculative traders.

Regulation of the carbon markets offers unique challenges that have never been addressed by a US regulator before.  For other commodities, such as oil, supplies can rise or fall based on the amount of investment put into exploration and production.  In contrast, the supply of carbon emission allowances is deliberately constrained and will decline dramatically over time. The draft climate legislation authored by House Energy and Commerce Chairman Waxman and Representative Markey calls for an 83% reduction in the supply of emission permits between the years 2012 and 2050.  Carbon permit prices will tend to rise as their supply declines, unless innovation in clean energy technology keeps up.  As a result, the challenge of limiting the impacts of this market bias needs to be explicitly addressed by Congress in the climate legislation as the risks involved are seen as potentially destabilizing to the program's long term integrity.

Here are the safeguards that need to be made explicit in a climate bill.

•1)     Contract Limits

Congress should set a "position limit" on carbon trading positions that would limit the size of a participant's exposure to the carbon trading market above their emissions compliance level. This position limit should be set no higher than 5% of the total size of the derivatives markets. By establishing a position limit of 5%, no one market participant will have the market power needed to meaningfully influence prices. Furthermore, this  position limit will also insure that the troubles or bankruptcy of any individual player (for whatever reason) does not disrupt the market.      

•2)     Regulatory Oversight that Encourages Trading on Exchanges

Congress should weigh the benefits and costs of allowing unregulated transactions between two participants, known as over-the-counter (OTC) transactions, to take place in the carbon markets. While OTC trades are currently used by banks, investors, and large companies in other markets to tailor their trading positions, the question still remains whether OTC trades would be needed in the carbon markets.

Given the fact that regulated carbon futures with multiple year vintages are expected to be trading in the carbon market, the fundamental argument that OTC transactions are needed to provide liquidity in later years for hedging and investing falls short in the carbon markets. Unlike oil where the depth of the market is very thin past 2 years, carbon allowances are expected to be liquid enough for up to 10 years, encouraging market participants to prefer to trade on the exchange.

Another advantage to discouraging OTC trading is the benefit gained from dramatically reducing the "counterparty" or credit risk involved from these transactions. This problem, which has become a major concern in the markets following the collapse of Lehman Brothers, would not be a significant issue if trading was limited to a well run exchange as the exchange would be able to require daily market to market and margin requirements on all positions.

In respect to determining whether OTC trading is needed at all, there are two positive points that should be considered before concluding on this issue. The first is that from the emitter's perspective, OTC trading is useful as a way to structure hedging programs that meet their individual needs. The second is that there is an issue of tax treatment. Emitters would prefer to keep their hedge positions matched against their costs in order to allow for more favorable tax treatment of these programs on their income statements.

If Congress and the emitting entities determined that these benefits are worth preserving, an OTC market could be allowed to exist in a way that would discourage speculators but keep emitters happy. Congress could do this by explicitly including a provision that non-standardized trades with a nominal value above $10mln have a reporting requirement into the regulator.  Not only would this actively discourage speculative trades in the OTC market as these trades would still be under the purview of the regulator, but they would allow the regulator to keep track of large trades and outstanding counterparty risks in the marketplace.

•3)     Regulatory Oversight Provisions that Address US Carbon Allowance Trading Overseas

A multi-trillion dollar carbon market is expected to attract interest from overseas exchanges looking to facilitate trades during non-US market hours. These exchanges will tend to have their own reporting criteria that may or may not be accessible to US regulators. This leaves open the risk that market players could side step position limits on carbon trades by holding some or all of these allowances offshore. In an effort to address this carbon leakage issue, Congress should look to establish a working group to address the issue as it relates to overseas exchanges looking to set up look alike US carbon contracts.