America needs strong climate policy that will boost the economy and reduce dangerous global warming pollution. A key piece of successful climate legislation will be a "cap and invest" system that allows non-polluting companies to trade carbon credits on the energy market. But unregulated or self-regulated trading can lead to a series of market risks. Climate policy should mandate that the carbon market instead be regulated to ensure success.

Risks of Self-Regulated Energy Markets

Past attempts at self-regulating energy markets can teach us what not to do. Four key risks of self-regulated markets, as well as examples of their failure, are outlined below.

Risk 1: Spot Price Manipulation  - A primary concern is the ability of individual market participants to control sufficient trading volumes to manipulate commodity prices. This is especially true for the carbon markets as the supply of carbon is constrained over time, creating issues of scarcity. 

Example:During the five years leading up to the collapse of the unregulated electricity markets in California, Enron and others had been able to use market manipulation to create "false shortages" or scarcity in the electricity markets, resulting in $23 billion in additional energy costs to the consumer, $8 billion of losses for California's largest utilities, and an end to California's foray into unregulated electricity markets.

Lesson: Unregulated commodity spot markets can be manipulated through the exercise of market power by individual market participants and/or through collusive behavior. Carbon markets will be best served by limiting the exposure of any one participant in a given commodity to a level that would not prove disruptive during times of market stress.

This level of exposure should be limited to not more than 5% of open interest in the futures contract, given the inherent issues of scarcity that a declining supply of available carbon emissions creates.

Risk 2: Future Price Manipulation  - Another concern is the ability of market participants to manipulate the future prices of a commodity. While trading volumes for short-term futures contracts for any given commodity are generally high enough to make market manipulation difficult, the same cannot be said for futures contracts that have longer terms before they expire. Long-dated futures contracts are useful since they allow market participants to hedge their future cash flows; however, they are not as commonly traded, giving rise to potential market manipulation.

Example:The hedge fund Amaranth made large bets on longer-dated natural gas contracts, which was extremely disruptive to suppliers and consumers of natural gas looking to hedge their future costs. Amaranth's "arbitrage" strategy was to use as much capital as necessary to push around the natural gas forward contracts, forcing smaller market players to ultimately buy the forward contracts back from Amaranth at higher prices. Amaranth was employing this strategy in late 2005 when they spent billions of dollars in contract value to help drive the price of the February 2006 natural gas contract trade nearly $3 higher than the price of the current December 2005 contract ($12/MMBtu vs. $9/MMBtu). This ultimately led to Amaranth's downfall when the price of natural gas fell to $6/MMBtu in the spot market, making a $3/MMBtu premium for the February 2006 contract unsustainable despite their market manipulation efforts. Amaranth suddenly lost $6 billion of capital and consequently had to shut down their operations. In a regulated market, Amaranth would not be allowed to own such a high percentage of these forward contracts. But since natural gas was an unregulated market under Federal Energy Regulatory Commission (FERC), Amaranth was repeatedly successful in forcing forward prices higher.

Lesson: Unregulated commodity futures markets can be manipulated through the exercise of market power by individual market participants away from spot prices and regulation is needed to ensure stable forward markets as well. Carbon markets should also include regulations to restrict derivatives positions in the longer term contracts to avoid disruptive and misleading future prices of carbon.

Risk 3: Investment Class Risk - As commodities have become an investment class in their own right, there is now considerable risk of market activity that has nothing to do with current supply/demand considerations for a given commodity. For example, investments by pension funds, endowments, and index funds that are betting on the long-term out-performance of commodities as an asset class can be disruptive to the market.

Example: Leading up to the oil price spike this past summer, large off-balance-sheet trades were taking place in the unregulated derivative markets for commodities, adding upward momentum to oil prices. Using something known as the "Enron Loophole," large investors such as pensions and endowments were able to purchase exposure to oil futures contracts from investment banks via swap agreements without the knowledge of the regulators of the New York Mercantile Exchange (NYMEX). These large positions could be as big as $1 billion in size and had a significant impact on the price of crude. As a result, the loophole prevented the exchange from having the authority to contain speculation in the oil market because large trader positions were not being effectively monitored.  By some estimates, these Enron loophole contracts, known as "total return swaps," had a market value equal to more than 150 percent of the open interest in the underlying commodities that make up the Goldman Sachs Commodities Index, forcing oil prices to rise an additional $20-$30/barrel on the way up and then pushing prices over $50/barrel on the way down as oil prices fell. The upward pressure on oil prices cost participants in the oil markets between $100-150bln in increased oil costs during this time frame and ultimately lead to a $4 price on gasoline in the US. In a regulated market that eliminated such Enron Loophole trading activity, investors would be forced to limit their activity to a permissible size and be subject to the regulatory oversight of the exchange.

Lesson: Market manipulation can occur through off-balance-sheet trades and should be prohibited to ensure a stable transparent carbon market. Carbon markets should be developed to exclude banks from using the "Enron loophole" to increase unregulated investor access to the carbon markets.

Risk 4:Counter party Risk- Counter party risk is defined as the risk of the bank or business that you enter into a contract with defaulting on their obligation prior to the expiry date of the contract, leaving their liability unanswered for. The current case of the credit default swap (CDS) market highlights the importance of counter party risk in un-regulated markets.  

There is approximately $55 trillion worth of these credit derivatives in the markets today, designed to offer insurance against a corporation defaulting on its debt. As there is currently no exchange to trade these CDS derivatives on where margin requirements would limit an investor's exposure to default, the loss of a large player to bankruptcy can prove disastrous for the entire interlocking system of commitments.

Example:The default of Lehman Brothers shows how counter party risk in un-regulated markets can affect the smooth settlement of contracts. Of the $400 billion in Credit Default Swaps outstanding on Lehman, nearly 2 percent of the total ($8 billion) is expected to be left unpaid due to Lehman's inability to meet is obligations. Regulated markets avoid this kind of uncertainty due to its use of margin requirements and as of this writing an exchange traded Credit Default Market is being created to replace the old way of trading these derivatives. Once the Credit Default Market is launched and the counter parties risk is netted at the exchange, it is estimated that the total number of outstanding CDS trades will shrink from $55trln today to around $3-5trln due to the netting of risk exposures, dramatically reducing potential losses from default.

Lesson: Effective commodity market regulation requires consistent application of margin requirements commensurate with counter party risk exposure levels.  Carbon markets should require that meaningful margin requirements are established all exchanges for carbon trading to help avoid losses from the failure of its participants to meet their financial obligations.

Carbon Markets Should Be Regulated to Avoid Unnecessary Risks

A successful carbon market will have four features:

• 1) Contract limits in the spot market that must be set down as mandatory requirements, not just "where necessary and appropriate." These contract limits should include a firm's total exposure and failure to stay within these limits should be met with significant penalties.
• 2) Margin requirements sufficient to discourage price manipulation by potential speculators.
• 3) Prohibition of off-balance-sheet "Enron Loophole" style trades that allow investors anonymity from the regulatory oversight of the exchange.
• 4) Well staffed regulatory oversight is needed to monitor trading under either the Commodity Futures Trading Commission (CFTC ) or the Federal Energy Regulatory Committee.  The US Treasury bond futures market offers a very good example of how a large futures market can be successfully overseen under well defined regulatory guidelines to ensure that the market will function in a stable and efficient manner so as to avoid harm to the programs environmental objectives .