The Senate's Role in Getting Carbon Market Regulation Right

As the Senate begins to weigh in on the climate debate with its own version of climate bill, the issue of carbon market oversight still remains a major concern to many members.

The final bill that passed through the House created many important restrictions on trading that should ensure the carbon markets will meet with their primary environmental objectives, but more can still be done on the Senate side to ensure that the rules will not benefit speculators over time.

The following is a brief description of what the ACES bill said (including the managers amendments), what issues are left to be resolved, and where the Senate can improve on the good work done in the House ACES bill: 

What the ACES climate bill said about carbon market regulation:

1. The Federal Energy and Regulatory Commission (FERC) has been put in charge of regulating the emission allowance, offset credit, and Federal renewable electricity credit markets. FERC will establish rules to 1) provide effective and comprehensive market oversight, 2) prohibit fraud and market manipulation, 3) ensure transparency, 4) create position limits and margin requirements (as necessary), 5) create a fair, orderly, and liquid national market system for these allowances, 6) limit or eliminate counterparty risk, market power concentration risk, and other risks associated with "trading regulated allowances outside of trading facilities" and 7) create a series of enforcement provisions to ensure the integrity of the new markets, including fines and jail time for offenders.
2. The Commodity Futures and Trading Commission (CFTC) has been put in charge of regulating the derivatives markets for emission allowances, offset credits, and Federal renewable energy credits. While the guidelines for determining the regulations for the derivatives markets are similar to those for the cash markets under the FERC, these carbon derivatives are to be regulated by the CFTC under the Commodity Exchange Act (CEA). Under CEA regulatory guidelines, the carbon market derivatives must be traded over a contract market designated by or registered with the Commission (effectively banning OTC trading). The CEA would also require any foreign board of trade to have the approval of the Commission before establishing a similar product.
3. The ACES bill also includes rules that would require the CFTC to create position limits, reporting requirements, and market oversight provisions for the oil, natural gas, coal, and electricity markets. SEC. 351 would also essentially ban OTC trading for these commodities, ensuring that these markets are less volatile and less subject to price spikes. A new section (SEC. 358) has been added, however, that could make these provisions null and void if over-arching derivatives reform is passed into law.  
4. While the 10% default position limits on carbon derivatives have now been deleted from the ACES bill, regulation under the CEA should establish position limits that are far more aggressive with respect to speculation (see table below):

 What issues should the Senate focus on?

1) Oversight Enforcement

While the CEA does have aggressive position limits in place, some have recently argued that these position limits are being (politely) ignored by the markets and not well policed by the CFTC historically.

The new Chairman of the CFTC Gary Gensler has now acknowledged that speculators played a role in last years spike in commodities prices but more needs to be done than just saying we will try harder next time. Enforcement is a critical component of regulation and the Senate can help ensure that this becomes a higher priority for the CFTC in drafting their version of the climate bill.   

ACTION ITEM -Make Enforcement a Priority for the CFTC

2) Closing the Loophole for Avoiding Energy Market Oversight

The House bill included a last minute null and void clause in the energy market regulation section of the bill which deserves further scrutiny in the Senate. Under SEC. 358, Effect of Derivatives Regulatory Reform Legislation, several important sections dealing with market oversight of the energy markets in the ACES bill (the most significant of which is SEC. 351) would be deleted if derivatives regulatory reform is passed into law.

While over-arching legislation that reforms the derivatives markets should take priority over the provisions in the bill, the term "reform" is clearly subject to interpretation. If the Senate chooses to leave this section in place it should at least try to include a definition of "reform" that serves to provide a minimum amount of conditionality to repealing these important sections of the bill.

ACTION ITEM - Require That Only Meaningful Energy Market Reforms Would Make Climate Bill Provisions Null and Void

3) Resolving Issues with respect to Over-the-Counter Trading

Over-the-counter trading is an issue that is far from being resolved as these types of transactions have various degrees of buy-in from emitters, the banks, and offset providers alike.

Unregulated OTC derivatives contracts not only increase market volatility, but they also create a significant amount of counter-party risk that can paralyze the markets as evidenced during the collapse of Enron, AIG, and Lehman Brothers.

Ideally the Senate will choose to leave the OTC ban on carbon derivatives in place, but without assurances on how OTC trading will be dealt with for other energy derivatives, it is not clear that the issue can be settled as simply as that.

According to a recent report from Goldman Sachs, the carbon markets could become the third largest trading market in the world over the next several decades. While the US market is only expected to account for roughly a quarter of this global market, the rules written today by Congress will most certainly affect how this trillion dollar market will evolve over time and how it will interact with the other energy markets going forward. As a result, the Senate should focus on both short and long term concerns with respect to how the OTC market will evolve and impact the carbon markets.

While banks are likely to tell the Senate that OTC trading is cheaper for their customers-as their customers can post less collateral for these transactions than they would at exchanges-there are two fallacies with this argument. One is that insufficient collateral is the reason we got into ourselves into this credit crisis in the first place, so saying we should do it again (this time with taxpayer money at stake) is a bit ridiculous. The second is that what the banks are really saying is that OTC is a lot cheaper for them because they don't normally post collateral against these transactions. The Senate needs to see through the thin veneer of these arguments and at a very minimum require all OTC energy and carbon trades to be cleared through market exchanges (as is done in the coal markets today).

ACTION ITEM - Write the OTC Rules for a Growing Carbon Market  

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