Energy Reforms Critical for Assuring Carbon Markets
Posted August 12, 2009
A new report to be released later this month by the U.S. Commodity Futures Trading Commission (CFTC) is expected to reveal that contrary to their previous findings, speculators were in fact to blame for generating a "significant" amount of the price volatility in the oil markets last summer. In response to these new findings, the CFTC's new Chairman Gary Gensler has concluded that the CFTC needs to institute a series of reforms designed to reign in this kind of speculative activity. While Mr. Gensler's solution of creating position limits for exchange traded energy futures looks like a step in the right direction, the CFTC needs the authority to go farther.
Indeed, Congress needs to pass legislation that would allow the CFTC to expand its authority by setting position limits and reporting requirements for all trading that takes place in the energy markets. Oversight provisions that would effectively ban the "dark" or non-reported trading practices that have allowed speculators to ply their trade from the shadows without detection for far too long.
Congress could accomplish this by passing the ACES climate bill, which already includes a series of energy market reforms that would allow the CFTC to set strict position limits and requires all "dark" trading to come into the light. Reforms that would also help provide lower price volatility in the carbon markets and provide the kind of long-term market assurances needed to keep a cap and trade program viable over the long term.
The following is a check list for Congress to consider in creating meaningful position limits for the energy markets:
1. Position Limits need to be Inclusive
The CFTC's proposal to create position limits in the energy markets need to include trades that take place in both the exchanged traded as well as over-the-counter (OTC) traded markets. Creating position limits only for exchange based trades would only encourage more trading to take place in the "dark" markets and leave the regulator more in the dark themselves as to what's going on.
By requiring position limits to be inclusive of both OTC and exchange trading markets, participants would be forced to comply with aggregate position limits rather than simply switching their trading to the OTC swap market to avoid compliance like the U.S. Natural Gas Fund did earlier this year.
2. Position Limits need to be Enforceable
Even if the CFTC agrees to create aggregate position limit for the energy markets, it does not have the authority to enforce them. OTC trades in the energy market are exempted from regulatory oversight and these exemptions would need to be repealed if the CFTC is going to be able to require that trades are reported into the regulator to help them track aggregate position limits.
Congress can help the CFTC fight "dark trading" in the energy markets by passing legislation similar to the energy reforms suggested in the ACES climate bill. These provisions would set strict reporting requirements for all participants in the energy markets and provide a number of other regulatory reforms that would help put speculators on notice that their days of running rough shod over the energy markets through "dark trading" are numbered.
3. Position Limits need to be set at an Appropriate Level
Another important requirement to be considered is the level of the position limit itself. As a rule, position limits should reflect the amount of time needed to unwind a given position without becoming disruptive to the markets. Under normal market assumptions (which of course are rare), a position size of say 5% would generally require 10 days to unwind without becoming disruptive to the markets - a position size of 10% would require roughly three to four weeks and a position size of 15% or more would require one to two months and would not be able to be unwound without having a material impact on market prices.
It is in this context that a relatively low position limit is favored for the energy markets. The CFTC already has experience setting low position limits for the agricultural commodities and similar limits are encouraged to be developed for the energy markets as well. The carbon markets under the ACES bill for example would carry the same speculative position limit as an agricultural commodity like wheat, which has a speculative limit of roughly 2% of the markets open interest.
4. Strict Reporting Requirements Would Ban "Dark Trading"/ Reduce Credit Risks
By creating strict reporting requirements for all energy transactions, Congress would effectively be banning "dark trading" as it is currently being conducted today. Speculators would no longer be able to rely on the anonymity of the OTC markets to disguise their trades, making their games less effective in pushing around prices in these markets.
These requirements could be enhanced by requiring all transactions to be cleared through a registered exchange. In this way, the CFTC would be able to almost eliminate credit risk from energy trading and lower price volatility in these markets even further.
In sum, the US consumer has paid a high enough penalty for poor market oversight in the energy markets. The CFTC has acknowledged that more needs to be done to reign in speculation but their suggestion of position limits should only be considered a half-measure as it is currently proposed. Position limits need to be inclusive, enforceable, and appropriate to the markets and Congress can ensure that these requirements are met and that "dark" trading is banned by passing energy market reform provisions similar to what are already included as part of the ACES climate bill.