Climate change legislation remains on schedule to be out of Committee by Memorial Day and brought before the House for a floor vote this summer. The 648 page discussion draft sponsored by Chairman of the House Energy and Commerce Committee Waxman and Representative Markey covers a lot of ground, as would be expected from any bill that aims to create a multi-decade market-based program, and is headed in the right direction on a wide variety of fronts.

Indeed, the section on regulating carbon trading looks particularly encouraging. While many shudder at creating a new trading market for anything these days, carbon trading is in fact needed to allow the market to determine the true price for carbon allowance values over time. Since investors in low carbon technology need to know what the price of carbon is expected to be well into the future (in order to justify these investments to their finance departments, bankers, and shareholders) the ability for the market to set the price of carbon is critical to get these investments green lighted.  

While it is impossible to argue that the Waxman-Markey bill fully addresses every issue relevant to carbon trading, it can be said that it has made some very encouraging first steps to ensure that the carbon market is set up in the most transparent manner possible.  The following is a quick summary of what the bill says, what the bill prevents, and what the bill still has yet to determine:

What the Bill Says

• Carbon trading will be open to all participants and will be overseen by the Federal Energy Regulatory Commission (FERC).
• Banking of allowances is permitted and an emitter may also borrow allowances from future vintages at an interest rate of 8% per year.
• No participant may purchase more than 20% of the allowances from any one quarterly auction.
• A regulated derivatives market is to be established with the regulator given the same authority as the Commodity Futures Trading Corporation (CFTC) to enforce compliance with any contract, agreement, or transaction under the regulators authority.
• Regulations are to be established to prohibit fraud, discourage market manipulation or excess speculation, create position limits and margin requirements, limit or eliminate counter party risk in over the counter transactions, increase transparency, and create the proper record keeping procedures.
• As a default rule an individual market participant shall not control more than 10% of any class of regulated carbon allowances to limit market manipulative behavior.

What the Bill Prevents

• Excess speculation and market manipulation are limited by a combination of position limits and fines that can run as high as $25mln depending on the severity of the act.
• Fraud is held in check by well defined guidelines for record keeping and compliance obligations already established by the CFTC.
• Market power will be limited by suitable margin requirements. By requiring substantial good faith deposits to an exchange, even large hedge funds will struggle to find the capital needed to push around a trillion dollar market.

What has still yet to be Determined

• The agency selected to regulate the derivatives market is a tricky one given committee jurisdictional issues in the Congress, but whichever agency is given the nod, rest assured that there are plenty of highly qualified investment bankers available to fill the 100 to 150 positions needed to fully staff such an agency.
• While a default position limit of 10% is encouraging, the regulatory authority has up to six months to review this recommendation. I would recommend that this be reduced to 5% given the unique characteristics of the carbon markets. Unlike other markets, the carbon market has a fixed and declining supply of allowances. This makes it different in many ways from a commodity like oil which operates under normal supply/demand dynamics and can adjust to increase its supply over time.
• Derivative trades that take place away from regulated exchanges appear to be discouraged but more clarity needs to be given to how  regulators will deal with these transactions. It is hoped that if these transactions are permitted at all that deals larger than $10mln would have a reporting requirement into the regulator. This would allow the commission in charge of market oversight to keep track of larger transactions that would prevent participants from surreptitiously exceeding their carbon market position limits.  

In sum, the Waxman-Markey bill addresses many important concerns with respect to carbon trading. It is hoped that this process will continue to promote guidelines that will ensure the long term integrity of the cap and trade program and allow cap and trade policy to serve as an important platform for accelerated low carbon investment.