Regulating a Carbon Market: Issues Raised By the European Carbon and U.S. Sulfur Dioxide Allowance Markets
Regulating a Carbon Market: Issues Raised By the
European Carbon and U.S. Sulfur Dioxide
April 30, 2008
Specialist in Financial Economics
Government and Finance Division
Specialist in Energy and Environmental Policy
Resources, Science, and Industry Division
Regulating a Carbon Market: Issues Raised by the
European Carbon and U.S. Sulfur Dioxide Allowance
Both the European Union’s Emissions Trading Scheme (EU-ETS) and the U.S.
Title IV sulfur dioxide (SO2) program provide insights into regulatory issues that may
face any future U.S. carbon market. From the initial operations of the EU-ETS, the
2006 price crash raised questions about the adequacy of market regulation. In
particular, some suspect that information about allocations leaked before official
publication, and that certain traders profited from this knowledge.
Title IV’s longer trading history reveals two important trends: (1) an increasing
trend toward diverse and non-traditional participants that is likely to continue under
a carbon market; (2), an increasing use of financial instruments to manage allowance
price risk that is likely to expand under a carbon market as a hedge against price
uncertainty. Indeed, a carbon market may look more like other energy markets, such
as natural gas and oil, than the somewhat sedate SO2 allowance market.
Regulation of emissions trading would have to consider two kinds of fraud and
manipulation: fraud by traders or intermediaries against other investors, and sustained
price manipulation. Four agencies could have roles in the regulation of an emissions
market, each with its own attributes that may contribute to effective regulation.
The Commodities Futures Trading Commission (CFTC) currently oversees the
Title IV program and its current mission most closely resembles what a regulator of
a future carbon market would do, including experience in market surveillance to
prevent or detect fraud and manipulation. The major failing of the CFTC, according
to some, is that it lacks the resources and the statutory mandate to do its job.
The Securities and Exchange Commission (SEC) is much larger than the CFTC,
and its enforcement programs are considered more effective than the CFTC’s. While
the CO2 market will resemble commodities markets more closely than securities,
SEC has some appropriate regulatory tools applicable to an emissions market.
The Environmental Protection Agency (EPA) would likely be responsible for
the primary market in allowances. However, EPA lacks experience comparable to
that of the CFTC and SEC in regulating trading markets, although the data it gathered
in the primary market could be critical to oversight of the secondary market.
Federal Energy Regulatory Commission (FERC) was granted oversight authority
over bulk electricity and interstate natural gas markets in 2005. Its experience with
market surveillance and enforcement is thus limited in comparison to the SEC and
CFTC, and it does not play an active role in overseeing the Title IV market.
It is possible that no single regulator would have clear jurisdiction, as is the case
in the Title IV program. This kind of regulatory fragmentation has not always worked
well. An umbrella group to monitor markets and provide a forum for regulatory
coordination might help to prevent regulatory gaps or conflicts in the market.
In troduction ......................................................1
The European Emissions Trading System (ETS)..........................3
What Is Regulated.............................................4
How Exchanges Are Regulated...................................6
Lessons from the ETS..........................................7
The U.S. Sulfur Dioxide Trading Program (Title IV)......................8
Administering the Program: The Environmental Protection Agency
Interface with Electricity Regulation: The Federal Energy
Regulatory Commission (FERC) and State Public Utility
FERC Allowance Accounting...............................13
State Public Utility Commissions............................14
Over the Counter: Cash Market, Futures and Options.............16
Regulation of Allowances as an Exempt Commodity: Commodity
Futures Trading Commission (CFTC).........................20
Regulation of Trading Venues...............................21
Lessons and Observations from Title IV Program....................26
Implications for a Future U.S. Carbon Market: Regulatory Issues...........27
An Efficient Trading and Pricing Mechanism.......................28
Fraud and Manipulation........................................30
Transparency Versus Confidentiality .............................35
Appendix: Regulation of EU Emissions Exchanges......................39
European Climate Exchange (ECX)..............................39
European Energy Exchange (EEX)...............................40
Table 1. Information Recorded by EPA’s Allowance Tracking System.......10
Table 2. EPA Official Allowance Transfers and Transactions: 1994-2003....16
Table 3. EPA 2007 Auction Results..................................17
Table 4. SO2 Futures Contract Specifications...........................19
Table 5. Summary of Trading Venues for Exempt Commodities
Under the Commodity Exchange Act (CEA)........................22
Regulating a Carbon Market: Issues Raised
by the European Carbon and the U.S. Sulfur
Dioxide Allowance Markets
A number of congressional proposals to advance programs that reduce
greenhouse gases have been introduced in the 110th Congress. Proposals receiving
particular attention would create market-based greenhouse gas reduction programs
along the lines of the trading provisions of the current sulfur dioxide (acid rain)
reduction program established by Title IV of the 1990 Clean Air Act Amendments.1
These “cap-and-trade” schemes would impose a ceiling (cap) on total annual
emissions of greenhouse gases and establish a market in pollution rights, called
allowances, between affected entities. An allowance would be a limited authorization
by the government to emit one metric ton of carbon dioxide equivalent (CO2e), and
could be bought and sold (traded) or held (banked) by participating parties.
These domestic proposals have parallels with the programs being implemented
in Europe to meet its obligations under the Kyoto Protocol. Specifically, the
European Union (EU) has decided to implement a cap-and-trade program, along with
other market-oriented mechanisms permitted under the Kyoto Protocol, to help it
achieve compliance at least cost.2 The EU’s decision to use emission trading to
implement the Kyoto Protocol is at least partly based on the successful emissions
trading program used by the United States to implement its acid rain control program.
These two operating cap-and-trade programs — the U.S.’s acid rain program
and the EU’s climate change program — may provide insights for the design of a
domestic greenhouse gas reduction scheme.3 However, while the experiences of the
EU system directly relate to the greenhouse gas reduction initiative of the domestic
legislative proposals, it has operated only a short time (see text box). The acid rain
control program has a longer operating history, although the control scheme differs
1 P.L. 101-549, Title IV (November 15, 1990).
2 Norway, a non-EU country, also has instituted a CO2 trading system linked to the EU-ETS.
Various other countries and a state-sponsored regional initiative located in the northeastern
United States involving several states are developing mandatory cap-and-trade system
programs, but are not operating at the current time. For a review of these emerging
programs, along with other voluntary efforts, see International Energy Agency, Act Locally,
Trade Globally (2005).
3 Other U.S. cap-and trade programs exist — most notably the nitrogen oxide program
developed by EPA in the late 1990s.
in some important ways — e.g., it is internal to one nation and involves fewer types
Among the lessons that Phase 1 ofThe EU’s Emissions Trading
the European Trading System may haveSystem (ETS) covers more than 12,000
for a similar U.S. program is thatenergy intensive facilities across the 27
allowance prices are linked to the priceEU Member countries, including oil
of other energy commodities.4 Analysisrefineries, powerplants over 20 megawatts
of ETS allowance prices during Phase 1(MW) in capacity, coke ovens, and iron
suggests the most important variables inand steel plants, along with cement, glass,
determining allowance price changeslime, brick, ceramics, and pulp and paper
have been oil and natural gas priceinstallations. Covered entities emit about
changes.5 For example, when natural45% of the EU’s carbon dioxideemissions. The trading program covers
gas, the cleaner fuel, becomes moreneither CO emissions from the
expensive relative to oil, industrial2transportation sector, which account for
users may switch to oil, creatingabout 25% of the EU’s total greenhouse
increased demand for allowances. Thisgas emissions, nor emissions of non-CO2
suggests that traders will pursuegreenhouse gases, which account for about
arbitrage strategies involving20% of the EU’s total greenhouse gas
simultaneous transactions in allowancesemissions. A “Phase 1” trading period ran
and oil and gas contracts. For example,from 2005 through 2007. A second, Phase
a trader anticipating a rise in the price2, trading period began in 2008, covering
of oil might take a position inthe period of the Kyoto Protocol, with athird one planned for 2013. (For further
allowances in the expectation that thebackground on the ETS, see CRS Report
two prices would move in tandem.RL34150, Climate Change: The EU’s
Since there is widespread suspicion thatEmissions Trading System (ETS) Enters
excessive speculation by hedge fundsKyoto Compliance Phase, by Larry Parker.
and others has affected energy prices inRelevant directives on the EU-ETS are
recent years,6 the possibility that theavailable at [http://ec.europa.eu/environ
price of allowances could also bement/climat/emission.htm#brochure].)
subject to distortion or manipulation
will be a policy concern.
This report examines the ETS and Title IV sulfur dioxide cap-and-trade
program, with a focus on the market activity and the current regulatory overlay.
From that discussion, observations are drawn about implications for regulating a
future greenhouse gas trading scheme in the United States. No current U.S. cap-and-
trade proposal has specific provisions with respect to carbon allowance financial
instruments or who would regulate such a market or its participants.
4 For more on the EU-ETS, see CRS Report RL34150, Climate Change: The EU Emissions
Trading Scheme (ETS) Gets Ready for Kyoto, by Larry Parker.
5 Maria Mansanet-Bataller, Angel Pardo, and Enric Valor, “CO2 Prices, Energy and
Weather,” 28 The Energy Journal 3 (2007), pp. 73-92. Powernext (a French energy
exchange) has described CO2 prices as the cornerstone of relative energy prices for
generating electricity. See Jean-Francois CONIL-LACOSTE, Chief Executive Officer,
Powernext SA, Market Based Mechanisms to Fight Climate Change (2006).
6 See, e.g., Senate Permanent Subcommittee on Investigations, “Excessive Speculation in
the Natural Gas Market” (Staff Report), June 2007, 135 p.
The European Emissions Trading System (ETS)
The European Emissions Trading System (ETS) is by far the largest market for
greenhouse gas emissions allowances. Trading began in 2005, when allowances
were issued by the 27 member states of the European Union to about 12,000 electric
utility and industrial sources of CO2. In 2007, allowances for 1.6 billion metric tons
of carbon emissions changed hands, with a financial value of nearly $41 billion.7
Secondary market trading involves not only companies to whom allowances are
originally allocated, but also a range of brokers and intermediaries. Trading occurs
in the form of bilateral agreements and on over-the-counter (OTC) markets, both of
which are essentially unregulated (other than an obligation to report all transactions
to the national registry). Trading also takes place on financial exchanges, which are
subject to various forms and degrees of regulation. The leading exchange market is
the European Climate Exchange (ECX) in London, which handles about 75% of
exchange-traded volume. The other exchanges with significant trading volumes are
BlueNext (formerly Powernext), based in Paris, with about a 14% market share; Nord
Pool, a Scandinavian electrical power exchange, which handles about 8%; and the
European Energy Exchange (EEX), in Leipzig, Germany, with about 4% of volume.8
The basic unit of trading is the European Union Allowance (EUA), which
permits the holder to emit one metric ton of CO2. Allowances themselves are bought
and sold in the spot market, but there are several additional forms of emissions
!Term contracts call for a specified number of deliveries of
allowances to take place over a period of time.
!Forward contracts are sales where delivery is to be made at a future
date, but at today’s price.
!Futures contracts, which are traded only on exchanges, give holders
the right to buy or sell allowances over the term of the contract at the
price that prevailed when the contract was made. They gain or lose
value as the market price of the underlying allowance fluctuates, and
they allow financial speculators who do not deal in physical CO2
themselves to participate in the market.
!Swaps are economically equivalent to futures, but are traded over-
the-counter rather than on an exchange. The value of a swap is
linked to the price of the underlying allowance. The two
7 “Global Carbon Market Grows 80 Percent in 2007,” Business Wire, January 18, 2008.
(The source of the figures is Point Carbon, a brokerage firm.)
8 Kjetil Roine and Henrik Hasselknippe, “Emissions Trading in Europe,” Futures Industry,
May/June 2007. Figures are for 2006.
counterparties may structure the contract any way they like, but the
essence is that one will pay the other if the price rises, and vice
!Spreads are two or more transactions that take place simultaneously.
For instance, a firm with a surplus of 2008 EUAs that anticipates a
shortage in 2009 might sell the former and buy the latter. The price
would be expressed as the differential between the two contract
prices at the time the trade was made.
In addition to the market in EUAs, there is a related market in certified emission
reductions (CERs). A CER represents a reduction of CO2 emissions by one ton
outside the EU, generally in the developing world. CERs are created under the
United Nations Kyoto Protocol. The United Nations, through its Clean Development
Mechanism, verifies that the reductions have in fact taken place, and issues the
corresponding CERs, which may be submitted by EU CO2 emitters in place of EUAs
within certain limits.10 To EU market participants, CERs and EUAs are close
substitutes. Trading in CERs takes the same forms: regulated or unregulated spot
markets and forwards, futures, and other derivative instruments.
What Is Regulated
Implementation of the ETS proceeded without a formal directive or
specification as to secondary trading venues or regulation:
The legal framework of the ETS does not lay down how and where trading in
allowances should take place. Companies and other participants in the market
may trade directly with each other or buy and sell via a broker, exchange, or any
type of market intermediary that may spring up to take advantage of a new11
market of significant size.
The decision was to let trading be shaped by market forces. As a result, the act
of buying and selling allowances does not in itself subject one to regulation, or make
one a regulated entity. This is not to say, however, that the EU envisioned a
completely unregulated market. Instead, allowance traders come under regulation
when they engage in financial practices that are regulated regardless of the nature of
the underlying interest or instrument. Similarly, when transactions take place on
9 The EUA swap market has been slow to develop for two reasons. First, there is no
standard contract documentation — several private trade associations have competing
versions, which make it difficult for a trader with many individual contracts to calculate his
overall position in the market. Second, there is no standard, universally accepted price
source to use to calculate a swap’s value. Several investment banks, brokers, and markets
offer competing prices and indices.
10 In 2007, the secondary market in CERs amounted to 350 million metric tons, or $8.3
billion. “Global Carbon Market Grows 80 Percent in 2007,” Business Wire, January 18,
11 European Commission, EU Emissions Trading: An Open Scheme Promoting Global
Innovation to Combat Climate Change, Brussels, EU, 2005, p. 14.
regulated markets, emissions trading is regulated in the same way as other
transactions executed on those markets. The degree of regulation depends on two
things: (1) does the instrument being traded meet the definition of a financial
instrument or product, and (2) is the trade taking place on a regulated market?
Although financial regulation has been harmonized in the EU to a significant degree,
there remains some variation in these definitions and in market regulation among EU
On the first key point — what is being traded — there appears to be general
agreement among national laws. The simple sale of an allowance by one party to
another does not subject either party to regulation.12 A firm may sell its EUAs the
way it sells any other piece of property.
If, however, what is being transferred is not an EUA itself, but rather a financial
contract that conveys rights to an EUA, or that is based on future delivery or the
future price of an allowance, the trade meets the definition of a financial transaction
or instrument in many countries and may be regulated. A person arranging or
participating in such a transaction may come under the jurisdiction of banking or
securities laws and be required to register as an intermediary or broker.13 Certain
forms of trades, like futures contracts, may be restricted to regulated futures
Trades that are otherwise unregulated may come under government oversight
if they occur on a regulated market. Several of the European emissions exchanges
provide a platform for spot market trades, as well as financial contracts. These spot
trades are subject to the same types of market surveillance as the financial contracts
(some of which could not be legally executed off-exchange), and the same
registration and reporting requirements apply. In addition, if an unregulated over-the-
counter (OTC) trade, such as a swap or forward contract, is processed and guaranteed
by a regulated clearing house, that trade is also open to the scrutiny of financial
regu lators. 14
12 The exception, as always, is that trades must be reported to the national registries, which
are linked electronically to a central EU facility. An ownership registry is necessary
because all firms must surrender at the end of each year a quantity of allowances sufficient
to cover their emissions (or else pay cash to cover the excess pollution).
13 The website of the International Emissions Trading Association (IETA) has brief
summaries of Polish, German, Dutch, and Czech laws on this point. See
[http://www.ieta.org/ieta/www/pages/index.php?IdSitePage=152], visited February 27,
14 A derivatives clearing house guarantees that all contracts will be paid, even if an
individual counterparty defaults. Clearing houses are a traditional feature of the futures
exchanges: the guarantees they provide permit rapid trading to occur by eliminating the need
for traders to assess the opposite party’s creditworthiness. In recent years, clearing houses
have begun to accept off-exchange, or over-the-counter (OTC), trades as well.
LCH.Clearnet, a British clearing house, announced that it would provide clearing services
for OTC emissions trades beginning on February 29, 2008. See LCH.Clearnet, Press
Release, February 25, 2008.
How Exchanges Are Regulated
National regulations vary within the EU. The differences, however, continue
to diminish as a result of both EU harmonization directives and the globalization of
markets, which is most visible in the numerous cross-border mergers that continue
to occur among securities and futures exchanges. Many of the differences that remain
are matters of terminology rather than substance.
In general, the exchanges where emissions and emissions derivatives are traded
are subject to a regulatory scheme broadly comparable to the regulation of the futures
exchanges in the United States by the Commodity Futures Trading Commission
(CFTC).15 The exchange itself must satisfy numerous conditions of registration,
which include market surveillance to deter fraud and manipulation, various reporting
requirements including publication of trade and price data, and so on. Exchange
rules are generally subject to regulatory oversight or approval.
Access to the trading mechanisms is generally limited to exchange members;
others must trade as customers of a member intermediary. Exchange members may
be required to register with a regulatory agency and in all cases are subject to
exchange rules and financial standards. (Apart from their exchange memberships,
brokerage firms may also be subject to registration and regulation by financial
authorities because of the nature of their business.) Some features of the regulatory
environments of the four largest EU emissions exchanges are set out in an appendix
to this report.
Clearing houses may be part of an exchange or stand-alone entities. They are
also subject to registration requirements, generally administered by the exchange
regulator. In addition, because they represent a concentration of financial risk, they
may be subject to central bank safety and soundness regulation.
The fact that a given market organization may be international in scope may
require it to report to multiple national regulators.16 This does not appear to have
been a barrier to the development of the market, or a source of market fragmentation.
As noted above, London has become the trading center, with about three-quarters of
all secondary derivatives trading. (In commodity markets, trading tends to gravitate
to the single market providing most liquidity. Before the EU drive for a single
financial market, this impulse was blocked by laws and regulations in several
European countries intended to preserve a monopoly for local exchange and traders.)
15 CFTC regulation, in many aspects, is modeled on Securities and Exchange Commission
(SEC) regulation of the stock markets.
16 For example, due to local legal provisions, LCH.Clearnet SA reports to French, Dutch,
Belgium and Portuguese regulators as follows: Banque de France, Autorité des Marchés
Financiers, Comité des Etablissements de Crédit et des Entreprises d’Investissement,
Commission Bancaire; Commission Bancaire, Financière et des Assurances, Banque
Nationale de Belgique ; and De Nederlandsche Bank, Autoriteit Financiële Markten.
[http://www.lchclearnet.com/rules_and_regulations/sa/], visited February 26, 2008.
Lessons from the ETS
The fact that the ETS was implemented without a formal, government-devised
blueprint for secondary trading does not appear to have caused significant problems
in the market. According to one study, “This apparent confidence in market
ingenuity has proved well-founded.”17 Trading volumes are growing rapidly,
suggesting that investors do not view the market as being rigged against them or
subject to manipulation by insiders.
This does not mean that the first phase of the ETS (from 2005 through 2007)
was an unqualified success. In fact, many regard it as a disaster. The major problem,
however, did not come from the secondary market but rather from the primary market
process of allocating and issuing EUAs.
When phase one began in 2005, trading commenced before the formal
allocations had been made. Thus, prices were initially based on traders’ expectations
of the number of EUAs that would be issued.18 Allocations were not made at the EU
level, but were left to the discretion of individual countries. When the allocations
were finally made, it became apparent that some countries had been very generous
and that the total supply of EUAs was going to be much higher than the market
anticipated. As a result, the market crashed in the spring of 2006: the price per EUA
dropped in a few weeks from over €31 to less than €11 (and by the end of phase one,
in 2007, fell below one euro).19
The price crash, by weakening the financial incentive to reduce pollution,
undermined the basic rationale for the ETS. Although the problem did not originate
in the secondary market, it did raise questions about the adequacy of market
regulation. In particular, many observers suspect that information about the size of
allocations leaked before official publication, and that certain traders profited from
this knowledge. Traders with nonpublic information on certified emissions data —
which gives an indication of future demand for allowances — may also have
Unauthorized leaks of verified emission data for 2005 in several countries
created information asymmetries and undue opportunities for some businesses
market participants. This has highlighted the need for strict rules and procedures
for handling of price-sensitive information along the lines that is common in20
more mature financial markets.
17 Liz Bossley, Emissions Trading and the City of London, London, City of London, 2006,
18 Additionally, trading in EUAs began before the national registries were operational. As
a result, all early trades were forward contracts, because immediate delivery was impossible.
19 Alex Scott, “Europe’s CO2 Permit Prices Dive; Further Turbulence is Expected,”
Chemical Week, vol. 168, May 17, 2006, p. 15.
20 Statement of Per-Otto Wold, in U.S. Congress. Senate. Committee on Energy and Natural
Resources, EU Emissions, Hearing, 110th Cong., 1st sess., March 26, 2007, p. 11.
A number of theoretical studies have raised the possibility of price manipulation
by a dominant firm or by a few large firms acting in collusion — while thousands of
pollution sources receive EUAs, a few large power generators account for a
disproportionate share.21 Some observers have raised the possibility that such
manipulation may have occurred during the price crash:
The fact that knowledge about excess allowances has gradually become known
without the market reacting immediately was seen by some analysts as a sign that
there might have been collusion of the big power companies, which in essence
are the major buyers and equally benefit by a high allowance price through22
higher power prices.
It is likely, however, that any undue market power accruing to a few large
consumers of allowances — in the EU or the United States — will diminish as
emissions trading becomes global in scope, particularly if markets are linked
It should be noted that EU regulators have not brought any enforcement actions
based on manipulation of emissions prices (in public, at least). On balance, the
secondary market in emissions allowances that has evolved without central direction,
and in a combination of regulated and unregulated venues, appears to have
functioned well. For the most part, the incentives of market participants and
regulators are in alignment: both want an efficient and transparent price discovery
mechanism, and a financially-sound market free of manipulation and fraud.
The U.S. Sulfur Dioxide Trading Program (Title IV)
Title IV of the 1990 Clean Air Act Amendments supplements the sulfur dioxide
(SO2) command-and-control system of the Clean Air Act (CAA) by limiting total SO2
emissions from electric generating facilities to 8.95 million tons annually, beginning
21 See, e.g., Robert Godby, “Market Power in Laboratory Emission Permit Markets,”
Environmental and Resource Economics, vol. 23, November 2002, p. 279; Akira Maeda,
“The Emergence of Market Power in Emission Rights Markets: The Role of Initial Permit
Distribution,” Journal of Regulatory Economics, vol. 24, November 2003, p. 293; and Matti
Liski and Juan-Pablo Montero, “A Note on Market Power in an Emission Permits Market
with Banking,” Environmental and Resource Economics, vol. 31, June 2005, p. 159.
22 Christian Egenhofer, “The Making of the EU Emissions Trading Scheme,” European
Management Journal, vol. 25, December 2007, p. 455. This scenario is the opposite of what
was suggested above: instead of trading ahead of the publication of price-sensitive
information, the putative manipulators fail to trade on such information, maintaining an
artificially high price. In another hypothetical scenario, large traders with inside information
could prop up the price in the spot market to give them time to take short positions in the
derivatives market that would become profitable when the spot price eventually fell.
in the year 2000.23 Title IV essentially caps SO2 emissions at individual utility
sources operating before enactment of the CAA in 1990 (known as “existing
sources”) through a tonnage limitation, and at those plants beginning operation after
enactment (known as “new sources”) through an emissions offset requirement. SO2
emissions from most existing sources are capped at a specified emission rate times
a historical average fuel consumption level. Beginning January 1, 2000, SO2
emissions from new plants commencing operation after enactment must be offset —
in effect, the emissions cap for new sources is zero. Their allowances come from
emissions reductions at existing facilities. The program was implemented through
a two-phase process with the final phase beginning in 2000.
To implement the SO2 reduction program, the law creates a comprehensive
permit and emissions allowance system (cap-and-trade program). An allowance is
a limited authorization to emit a ton of SO2 during or after a specified year. Issued
by EPA, the allowances are allocated to existing power plant units in accordance with
formulas delineated in the law. The owner of the facility receives the allowances for
a given plant regardless of the actual operation of the plant. For example, an owner
may choose to shut down an existing power plant and use those allowances to offset
emissions from two newer, cleaner facilities. As noted, generally, a power plant that
commences operation after enactment receives no allowances, requiring new units
to obtain allowances from those with allowances, or purchase them at an EPA-
sponsored auction, in order to operate after 2000. An owner may trade allowances
nationally as well as bank allowances for future use or sale.
If an affected unit does not have sufficient allowances to cover its emissions for
a given year, it is subject to an emission penalty of $2,000 (1990$, indexed to
inflation) per ton of excess SO2 , and it submits to EPA a plan for offsetting those
excess emissions in the next year (or longer if EPA approves). Further, EPA must
deduct allowances equal to the excess tonnage from the source’s allocation for the
Another EPA responsibility is to provide for allowance auctions. For the post-
Anyone may participate in these auctions as a buyer or seller, and those selling
allowances may specify a minimum sale price. EPA may delegate or contract the
conduct of the auctions to other agencies, such as to the Department of the Treasury,
or even to nongovernmental groups or organizations. Two streams of allowances are
sold in the auctions. The first stream represents “spot sales” of allowances that must
either be used in the year they are sold or banked for use in a later year. The second
stream represents “advance sales” of allowances that must either be used in the
seventh year after the year they are first offered for sale or be banked for use in a later
year. For 2000 and thereafter, Title IV provides that 125,000 allowances be set-aside
annually for spot sales, and 125,000 for advance sales.
23 Clean Air Act Amendments of 1999, P.L. 101-549, Title IV. For a more detail discussion
of the title, see Larry B. Parker, Robert D. Poling, and John L. Moore, “Clean Air Act
Allowance Trading,” 21 Environmental Law 2021-2068 (1991).
Administering the Program: The Environmental Protection
It is EPA’s responsibility to administer the trading, banking, and auctioning of
Allowance Accounting. EPA has developed an integrated system to track
allowances (the Allowance Tracking System — ATS)24; to verify and record SO2
emissions from affected units (the Emission Tracking System — ETS); and to
reconcile (true-up) allowances and emissions at the end of the year. The Allowance
Tracking System is the official record of allowance transfers and balances used for
compliance purposes. Each participant in the system has an ATS account, and each
account has an identification number.
Table 1 identifies what the ATS tracks and does not track with respect to
allowance activity. As suggested, EPA primarily gathers information to ensure
compliance with the emission limitations of Title IV — the ATS is not a trading
platform. Participants are not required to record all transfers with EPA until the
affected allowances are to be used for compliance. Participants must notify EPA to
have any transfers recorded in the ATS. When parties agree on a transaction that
they want recorded on the ATS, they provide information on the buyer and seller and
the serial numbers of the affected allowances to the ATS which records the transfer.
Table 1. Information Recorded by EPA’s Allowance Tracking
ATS RecordsATS Does Not Record
Allowances issuedAllowance prices
Allowances held in each accountOption trades
Allowances held in various EPA reservesAny allowance transaction not officially
reported to EPA
Allowances surrendered for compliance
Allowances transferred between accounts
To facilitate its primary compliance responsibility, EPA assigns each allowance
allocated a unique 12-digit serial number that incorporates the first year it can be used
for compliance purposes. These allowances may be held in one of two types of ATS
accounts. First, there are Unit Accounts where allowances provided under Title IV
allocation formulas are deposited and where allowances are removed by EPA for
compliance purposes. Second, there are General Accounts that may be created by
24 EPA has renamed the ATS the Allowance Management System (AMS), but ATS remains
the commonly used term and will be used in this report.
EPA for anyone wishing to hold, trade, or retire allowances. Participating entities
with General Accounts include (1) utilities who keep a pooled reserve of allowances
not needed immediately for compliance (i.e., an allowance bank); (2) brokers who
need a holding account for allowances in the process of being bought or sold; (3)
investors holding allowances for future sale; and (4) environmental and other groups
holding allowances they wish to remove from the market (i.e., retire).
Allowance Auctions.A key provision of Title IV to ensure liquidity in the
SO2 markets for new entrants is the EPA allowance auction. As noted above, the
EPA is required to auction 250,000 allowances annually in two streams, spot and
advance. The auctions began in 1993 and are held annually — usually on the last
Monday in March. Sealed bids entailing the number, type, and price, along with
payment, are sent to EPA no later than three business days before the auctions.
The auctions sell the allowances according to bid price, starting with the highest
bid and continuing down until all allowances are sold or there are no more bids.
Unlike allowances offered by private holders for auction, these EPA allowances do
not have a minimum price.
For the first 13 years, the auctions were conducted by the Chicago Board of
Trade (CBOT) for EPA. CBOT received no compensation for the service, nor was
it allowed to charge fees. Beginning in March 2006, CBOT decided to stop
administering the auctions; EPA now conducts them directly.
Interface with Electricity Regulation: The Federal Energy
Regulatory Commission (FERC) and State Public Utility
Background. The 1990 Clean Air Act Amendments were enacted during a
time of transition in the electric utility industry. There are three components to
electric power delivery: generation, transmission, and distribution. Historically,
electricity service was defined as a natural monopoly, meaning that the industry had
(1) an inherent tendency toward declining long-term costs, (2) high threshold
investment, and (3) technological conditions that limited the number of potential
entrants. In addition, many regulators considered unified control of generation,
transmission, and distribution the most efficient means of providing service. As a
result, most people (about 75%) were served by vertically integrated, investor-owned
The Public Utility Holding Company Act (PUHCA)25 and the Federal Power
Act (FPA) of 1935 (Title I and Title II of the Public Utility Act)26 established a
regime for regulating electric utilities that gave specific and separate powers to the
states and the federal government. Essentially, a regulatory bargain was made
between the government and utilities. Under this bargain, utilities must provide
electricity to all users at reasonable, regulated rates in exchange for an exclusive
25 15 U.S.C. 79 et seq.
26 16 U.S.C. 791 et seq.
franchise service territory. State regulatory commissions address intrastate utility
activities, including wholesale and retail rate-making. Authorities of these
commissions tend to be as broad and varied as the states are diverse. At the least, a
state public utility commission will have authority over retail rates, and often over
investment and debt. At the other end of the spectrum, the state regulatory body will
oversee many facets of utility operation. Despite this diversity, the essential mission
of the PUC is the establishment of retail electric prices. This is accomplished
through an adversarial hearing process complete with attorneys, briefs, witnesses, etc.
The central issues in such cases are the total amount of money the utility will be
permitted to collect (revenue requirement) and how the burden of the revenue
requirement will be distributed among the various customer classes (rate structure).27
This is commonly known as “rate of return” (ROR) regulation.
Under the regime set up by the Federal Power Act (FPA), federal economic
regulation addresses wholesale transactions and rates for electric power flowing in
interstate commerce. Historically, federal regulation followed state regulation and
is premised on the need to fill the regulatory vacuum resulting from the constitutional
inability of states to regulate interstate commerce. In this bifurcation of regulatory
jurisdiction, federal regulation is limited and conceived to supplement state
regulation. The Federal Energy Regulatory Commission (FERC) has the principal
functions at the federal level for the economic regulation of the electricity utility
industry, including financial transactions, wholesale rate regulation, transactions
involving transmission of unbundled retail electricity, interconnection and wheeling
of wholesale electricity, and ensuring adequate and reliable service. In addition, until
passage of the 2005 Energy Policy Act (EPACT05),28 the Securities and Exchange
Commission (SEC) regulated utilities’ corporate structure and business ventures
under PUHCA to prevent a recurrence of the abusive practices of the 1920s (e.g.,
cross-subsidization, self-dealing, pyramiding, etc.).
This comprehensive, cost-based approached to regulation began to undergo
change in the 1970s and 1980s as passage of the Public Utility Regulatory Policies
Act of 1978 (PURPA)29 and the Fuel Use Act of 1978 (FUA)30 helped establish
independent electricity generators — electricity producers who sold at wholesale and
had no exclusive franchise area. Building on the perceived success of these
independent generators under PURPA, the Energy Policy Act of 1992 (EPACT92)
created a new category of wholesale electric generators called Exempt Wholesale
Generators (EWGs) that are not considered utilities and not regulated under
PUHCA.31 EWGs, also referred to as merchant generators, were intended to create
27 For a comprehensive discussion of state and federal regulation, see Robert Poling, et. al.,
Electricity: A New Regulatory Order? Report for the Committee on Energy and Commerce,
House of Representative (June 1991), committee print.
28 P.L. 109-58.
29 P.L. 95-617, 16 U.S.C. 2601.
30 P.L. 95-620.
31 Exempt Wholesale Generators may sell electricity only at wholesale. EWGs may be
located anywhere, including foreign countries. Before enactment of EPACT05, utility
a competitive wholesale electric generation sector. EPACT92 effectively initiated
deregulated wholesale generation by creating a class of generators that were able to
locate beyond a typical service territory with open access to the existing transmission
system. EPACT05 continued this process by adding provisions to address system
reliability, repeal PUHCA, and modify PURPA.32
The current status of these initiatives and resulting state responses is a mixture
of states with traditional, comprehensive ROR regulation of electricity and those with
a restructured industry with segmented generation, transmission, and distribution
components. Over the past 20 years, some States have truncated their ROR regulation
to the extent they have chosen to restructure their industry in response to Federal
initiatives. In states that have not restructured, the system operates as it has since
enactment of the Federal Power Act, with retail consumers paying one price that
includes transmission, distribution, and generation. This is referred to as a bundled
transaction. In states that have restructured, consumers are billed for separate
transmission, distribution, and generation charges. This is referred to as unbundled
electricity service. In those states, retail consumers are allowed to choose their retail
generation supplier; however, few states actually have competitive markets for retail
choice (exceptions include Texas and Massachusetts). FERC regulates all
transmission, including unbundled retail transactions.33
FERC Allowance Accounting. With the restructuring of the electric utility
industry, FERC generally does not set cost-based rates for electricity generation
under its jurisdiction. Rather, FERC conducts a two-pronged horizontal and vertical
generators were limited by the Public Utility Holding Company Act of 1935 (PUHCA) to
operate within one state.
32 In repealing PUHCA, EPACT05 provides that FERC and state regulatory bodies must be
given access to utility books and records. Also, FERC is given approval authority over the
acquisition of securities and the merger, sale, lease, or disposition of facilities under FERC’s
jurisdiction with a value in excess of $10 million. With respect to PURPA, EPACT05
repeals the PURPA mandatory purchase requirement for new contracts if FERC finds that
a competitive electricity market exists and a qualifying facility has adequate access to
wholesale markets. Among its provisions to address reliability, FERC is authorized to certify
a national electric reliability organization (ERO) to enforce mandatory reliability standards
for the bulk power system. For more information on EPACT05, see CRS Report RL33248,
Energy Policy Act of 2005, P.L. 109-58, Electricity Provisions, by Amy Abel.
33 On October 3, 2001, the U.S. Supreme Court heard arguments in a case (New York et al.
v. Federal Energy Regulatory Commission) that challenged FERC’s authority to regulate
transmission for retail sales if a utility unbundles transmission from other retail charges. In
states that have opened their generation market to competition, unbundling occurs when
customers are charged separately for generation, transmission, and distribution. Nine states,
led by New York, filed suit, arguing that the Federal Power Act gives FERC jurisdiction
over wholesale sales and interstate transmission and leaves all retail issues up to the state
utility commissions. Enron in an amicus brief argued that FERC clearly has jurisdiction
over all transmission and FERC is obligated to prevent transmission owners from
discriminating against those wishing to use the transmission lines. On March 4, 2002, the
U.S. Supreme Court ruled in favor of FERC and held that FERC has jurisdiction over
transmission, including unbundled retail transactions.
market power analysis to determine an entity’s eligibility for “market-based”
wholesale rates.34 If eligible, the entity may set its wholesale prices according to
market demand, not according to production costs.
Because of the market-based nature of FERC wholesale rates, allowances are
an accounting issue, not a ratemaking issue for FERC. Electric public utilities and
licensees within FERC jurisdiction are required to maintain their books and records
in accordance with FERC’s Uniform System of Accounts (USofA).35 The USofA
guides the jurisdictional entity in understanding the information it needs to report on
various FERC forms. Included in the USofA are instructions on how to account for
allowances allocated to the entity under the 1990 Clean Air Act, or acquired by the
entity for speculative purposes. Allowances owned for other than speculative
purposes are accounted for at cost in either Account 158.1 (Allowance Inventory),
or Account 158.2 (Allowances Withheld) as appropriate. Allowances acquired for
speculative purposes are accounted for in Account 124 (Other Investments).36
By defining allowance value in terms of historic costs, allowances allocated by
EPA to entities are valued at zero. FERC does require that the records supporting
Account 158.1 and 158.2 be maintained “in sufficient detail so as to provide the
number of allowances and the related cost by vintage year.” Likewise, the Uniform
System of Accounts also provides instruction on accounting for gains and losses from
It should be noted that the Internal Revenue Service (IRS) also values
allowances allocated by EPA to an entity on a zero-cost basis.37
State Public Utility Commissions. In states with bundled rates, the valuing
and disposition of allowances is more than an accounting issue, it is also a
ratemaking issue. During and after passage of Title IV, there was substantial debate
and studies were done on the role of the PUCs in facilitating (or hindering) allowance38
trading. In Title IV, the regulatory treatment of allowances is left to the appropriate
state and federal regulatory bodies. Title IV contains no mandated requirements
regarding the treatment of allowance transactions in state utility rate proceedings.
34 FERC Order 697, Market-Based Rates for Wholesale Sales of Electric Energy, Capacity
and Ancillary Services by Public Utilities, Docket No. RM04-7-000, Final Rule (issued June
35 Code of Federal Regulations, Title 18, Conservation of Power and Water Resources, Part
36 Code of Federal Regulations, Title 18, Conservation of Power and Water Resources, Part
37 Treatment of emission allowances under the Federal income tax is spelled out in Rev. Rul.
Internal Revenue Bulletin, No. 1992-46, November 16, 1992-13, p. 32-33. See also,
Announcement 92-50, Internal Revenue bulletin, No. 1992-12, March 30, 1992, p. 32.
38 For example, see Kenneth Rose, et. al., Public Utility Implementation of The Clean Air
Act’s Allowance Trading Program, National Regulatory Research Institute, May 1992.
Basically, Congress chose to leave the state commissions free to apply any rate
treatment they deem reasonable and appropriate.
The states responded in a diverse manner, some states issuing broad guidelines
on treatment of allowance transactions while others decided such events on a case-
by-case basis. An analysis of the interaction between PUCs and the allowance
system made three general observations about the resulting PUC treatment of
allowances: (1) regulations tend to require 100% of both expenses and revenues from
allowances to be returned to ratepayers with net gains (losses) incurred used to offset
(or increase) fuel costs; (2) a few states have allowed utilities to retain some of the
profits as an incentive to sell excess allowances; (3) state regulations tend to be
tailored to a state’s specific circumstance — “allowance rich” states have regulations
encouraging sales, “allowance poor” states have regulations encouraging purchases.39
The focus of PUC decisions has not been to encourage allowance transactions, but
generally to ensure ratepayers and not shareholders receive the benefits of the
allowances. In some cases, PUCs have also used their authority to encourage utilities
to protect high-sulfur coal production, even if it is not the most cost-effective control
Internal Transfers. When the 1990 Clean Air Act Amendments were enacted,
about 75% of the allowances were allocated to vertically integrated, ROR regulated
entities. Today, that percentage has shifted with more allowances allocated to
independent generating entities as some utilities have divested themselves of their
generating assets. This diversification of ownership is reflected to some degree in the
ATS statistics on official transfers and transactions.41 As indicated by Table 2, in the
first two years of trading, transfers between economically unrelated entities were a
small percentage of total transfers. More recent data suggest that transfers between
unrelated entities account for about 50% of total transfers. However, it is clear that
internal transfers remain a major part of the allowance market, even in a restructured
industry, and that the total number of official transactions occurring is quite modest.
Internal transfers (i.e., transfers within or between economically related entities)
tend to be transacted in accordance with agreements that the utility and/or holding42
company has filed with the appropriate state PUC, or FERC, or both.
39 Elizabeth M Bailey, Allowance Trading Activity and State Regulatory Rulings: Evidence
from the U.S. Acid Rain Program, MIT, March 1998, pp. 9-10.
40 See Ken-Ichi Mizobuchi, The Movements of PUC Regulation Effects in the SO2 Emission
Allowance Market, Kobe University, May 2004.
41 “Official” here means that the transfer has been recorded by the ATS. The actual transfer
of ownership may have occurred earlier. As noted earlier, parties are not required to notify
the ATS of any transfer within a specific time period and may choose for some reason to
delay informing the ATS of a transfer.
42 For example, see the now terminated agreement AEP System Interim Allowance
Agreement filed with the FERC on August 30, 1996 in Docket No ER96-2213-000
Table 2. EPA Official Allowance Transfers and Transactions: 1994-2003
TotalbetweeneconomicallyPercent ofTotalTransactionsbetweenPercent of
YearTransfers(millions ofdistinctTotalNumber ofeconomicallyTotal
2004 15.3 7.5 49.0% 20,000 n/a n/a
2005 19.9 10.0 50.3% 5,700 n/a n/a
Source: U.S. Environmental Protection Agency, 2007.
Over the Counter: Cash Market, Futures and Options. Beyond
restructuring, other entities are emerging as participants in the allowance markets.
This increased diversity of interest in the allowance market is reflected in the most
recent (2007) EPA allowance auction. As indicated by Table 3, several brokerages
have created positions in the allowance market, both for themselves and their clients.
This may suggest an increasing importance of intermediaries to the functioning of the
allowance market, the development of a more liquid market, and to the maturing of
designated as Appalachian Power Company Supplement No. 9 to Rate Schedule FPC No.
Indiana Michigan Power Company Supplement No. 10 to Rate Schedule FPC No. 17;
Kentucky Power Company Supplement No. 6 to Rate Schedule FPC No. 11; and, Ohio
Power Company Supplement No. 9 to Rate Schedule FPC No. 23. Agreement terminated
by FERC, effective January 1, 2002, in accordance with the mutual consent of the parties
Table 3. EPA 2007 Auction Results
(Winners of more than 20 allowances)
Percent of Total
Spot Market Bid WinnersQuantityAllowances offered
Saracen Energy LP15,00012.00%
Transalta Energy Marketing U.S. 9,9007.92%
South Carolina Public Service Authority7,5006.00%
Constellation Energy Commodities Group,2,5002.00%
Merrill Lynch Commodities Inc.2,5002.00%
The Detroit Edison Company2,0001.60%
TOTAL SPOT 124,97599.98%
Percent of Total
7 Year Advance Bid WinnersQuantityAllowances offered
American Electric Power80,00064.00%
Cantor Fitzgerald Brokerage10,0008.00%
Source: Environmental Protection Agency, 2007
The basic market for allowance trading is the Over-The-Counter (OTC) market.
The most common trading structure involves spot sales with immediate settlement
accounting and delivery into EPA’s Allowance Tracking System (ATS) with43
payment by wire transfer in three business days. Daily spot trading volumes for
immediate settlement are estimated in the 10,000 to 25,000 ton range.44 Forward
43 Peter Zaborowsky, The Trailblazers of Emissions Trading, Evolution Markets Inc. (April
44 Ibid. In September 2007, the monthly volume was estimated at 175,000-200,000 by
Evolution Markets Inc., who termed it low volume. Evolution Markets Inc., SO2 Markets
settlement transactions are less common and are fairly short-dated — 6 to 18 months
out. Vintage swaps also occur in both markets with the difference in value usually
paid in additional allowances rather than cash.45 This preference for allowances
reflects regulated entities’ desire to keep these transactions non-taxable under current
IRS regulations. Cash market transactions are facilitated in some cases through
available electronic trading platforms, such as Intercontinental Exchange, Inc. (ICE)
and TradeSpark (CantorCO2e), and by the emergence of a number of allowance
brokers. Currently, EPA lists 14 allowance brokers on its website.46 A similar list
is available from the Environmental Markets Association — a trade association.47
Brokers tend to be registered with the SEC and one or more Self-Regulatory
Organizations, such as FINRA; but participation in this market would not in itself
make a firm subject to SEC regulation. Four brokers — Cantor Fitzgerald,
Evolution, ICAP Energy, and TFS Energy — form the basis of the Platts emission
price index. Argus AIR Daily also produces price indices through daily phone
surveys of active brokers.
Two exchanges provide SO2 future contracts as well as clearing services: New
York Mercantile Exchange (NYMEX) and Chicago Climate Futures Exchange
(CCFE). The availability of exchanges as a trading platform for allowances or to
clear transactions was cheered by traders when established in late 2004 and 2005.
As stated by the Environmental Markets Association with respect to NYMEX’s
decision: “NYMEX does offer information on power, and any time you have them
expanding into our market, that’s going to create opportunities for people who may
be using other products to take a second look at emissions.”48 Both exchanges offer
standardized and cleared futures contracts, along with clearing services for off-
exchange transactions. As reported by Platts, futures volume on both exchanges
have expanded greatly over the past year. SO2 futures trading on the CCFE was
nearly 1.9 million allowances in the first half of 2007, compared with about 500,000
during the same time in 2006. For the NYMEX, volumes in the first half of 2007
was 665,000 allowances — a more than three-fold increase over the first half of
— September 2007 at [http://www.evomarkets.com/assets/mmu/mmu_so2_sep_07.pdf].
45 The first year an allowance may be used for compliance is called its “vintage.” This
situation can result in entities engaging in a “vintage swap.” For example, a “vintage swap”
may occur because one entity has excess allowances in the upcoming year (2008) but
anticipates it will have insufficient allowances in 2009. Another entity may be in the
opposite position because of planning future emission reductions. The two entities agree
to “swap” allowances to improve their allowance streams over these years.
46 EPA Website: [http://www.epa.gov/airmarkets/trading/buying.html].
47 EMA Website: [http://www.environmentalmarkets.org/page.ww?section=About+
Us &name=Company+Di rectory] .
48 Comment of Matt Most, Emissions Market Association, as reported in Platts Emissions
Daily, “Emissions market hails NYMEX move,” February 15, 2005, p. 1.
49 Platts Emissions Daily, “Emissions exchanges continue to grow SO2, NOx futures
markets,” August 10, 2007, p. 1.
Table 4. SO2 Futures Contract Specifications
Clearing Organization NYMEX ClearPortThe Clearing Corporation
Self RegulatoryNYMEX and NationalNational Futures
OrganizationFutures AssociationAssociation (NFA)
CFTC Regulatory StatusDesignated ContractDesignated Contract
Contract size100 SO2 allowances25 SO2 allowances
Minimum Price$25 per contract$2.50 per contract
SettlementPhysical through EPA’sPhysical through EPA’s
Source: NYMEX and CCFE.
In April, 2007, the CCFE began offering SO2 options.50 For October 2007, the51
CCFE offered European-style options on its futures contracts for expiration on the
October 2007, November 2007, December 2007, April 2008, and December 200852
futures contracts. As with the futures market, participants are required to settle their
delivery obligations via the ATS. Volume remains light with the CCFE reporting
in July, 2007 that there were 200 calls on July contracts, 5,315 calls and 411 puts on
August 2007 contracts, 740 calls and 46 puts on September 2007 contracts, and 44053
calls on the December 2007 contracts. The spike in calls and puts in the August
2007 and future uncertainty about allowance price direction over the summer. The
NYMEX does not offer SO2 options.
50 Chicago Climate Futures Exchange, Chicago Climate Futures Exchange to Launch
Options market on Sulfur Financial Instrument Futures Contracts, Chicago, April 5, 2007.
51 An option that can only be exercised for a short, specified period of time just prior to its
expiration, usually a single day. “American” options, however, may be exercised at any time
52 For current options market data, see [http://www.ccfe.com/mktdata_ccfe/sfi_options.jsf].
53 CCFE Market Report, CCFE SFI Options, (July 2007), p. 3, table 4.
54 Traditional Financial Services (a brokerage firm) noted the peak in allowance prices in
July because of higher than expected storage in the natural gas markets. See TFS, Global
Environmental Markets, August 2007, available at [http://www.tfsbrokers.com/pdf/
Regulation of Allowances as an Exempt Commodity:
Commodity Futures Trading Commission (CFTC)
Definition. The Commodity Exchange Act provides the basis for federal
regulation of “derivative” transactions in contracts based on commodity prices.
Pursuant to the act, the Commodity Futures Trading Commission (CFTC) regulates
the futures exchanges, such as NYMEX, and certain other derivative transactions that
occur off-exchange. The CFTC’s authority varies according to the identities of the
market participants and the nature of the underlying commodity. In general, the
CFTC does not regulate spot (or cash) trades in commodities, or forward contracts
that will be settled by delivery of the physical commodity (which are also considered
In terms of allowances, the CFTC’s jurisdiction is confined to trades that take
place on those markets it regulates. It has no jurisdiction over spot trades in
allowances, full jurisdiction over futures and options trades on regulated exchanges,
and limited jurisdiction over derivatives trades on certain other markets subject to
lighter regulation than the exchanges.
Allowances are regulated by the CFTC as exempt commodities under the
Commodity Futures Modernization Act of 2000.56 The Commodity Exchange Act
defines an exempt commodity as any commodity other than an excluded commodity
(e.g., financial indices, etc.) or an agricultural commodity. Examples include energy
commodities and metals. Emission allowances are related to energy production. This
designation has been supported by other federal entities. In a 2005 Interpretive Letter
approving physically settled emission derivatives transactions, the Office of the
Comptroller of the Currency, Administrator of National Banks, states that physical
settlement of emission allowances do not pose the same risk as other physical
The proposed emissions derivatives transactions [e.g., futures, forwards, options,
swaps, caps, and floors] will be linked to three emission allowance markets: the
U.S. SO2 (Sulfur Dioxide) and NOx (Nitrogen Oxide) markets and the European
Union’s CO2 (carbon dioxide) market. These emissions markets are volatile and
price fluctuates considerably. Market participants manage price risk through the
use of derivative structures, such as forwards, futures, options, caps and floors.
These derivatives are generally physically settled, because the current emissions
market is primarily physical in nature....
The OCC has previously concluded in a variety of contexts that national banks
may engage in customer-driven commodity transactions and hedges that are
physically settled, cash-settled and settled by transitory title transfer.... Similarly,
the OCC permitted a national bank to make and take physical delivery of
55 The CFTC has occasionally brought enforcement actions for fraud in the spot market, but
these are rare. The legislative history does not suggest that Congress meant the CFTC to be
a regulator of cash commodity markets.
56 See CFTC approval of CCFE application for designation as a Contract Market: Order of
Designation: In the Matter of the Application of the Chicago Climate Futures Exchange,
LLC for Designation as a Contract Market, November 9, 2004.
commodities in connection with transactions to hedge commodity price risk in
commodity linked transactions....
In these decisions, the approved activities were subject to a number of conditions
due to risks associated with physical transactions in certain commodities. Those
risks included storage (e.g., storage tanks, pipelines), transportation (e.g., tankers,
barges, pipelines), environmental (e.g., pollution, fumigation, leakage,
contamination) and insurance (e.g., damage to persons and property, contract
breach, spillage). Physical settlement of emissions derivatives and hedging with
physicals would not pose those risks, however. Emission allowances are not
tangible physical commodities, such as electricity or natural gas. Rather, they are
intangible rights or authorizations. They can be bought and sold like other57
commodities, but they exist only as a book entry in an emissions account.
The Federal Reserve also considers emission allowances as commodities for
purposes of trading.58
Regulation of Trading Venues. The CFTC identifies four venues for
trading exempt commodities under the Commodity Exchange Act: (1) Designated
Contract Markets (DCM), (2) Commercial Derivatives Transaction Execution
Facilities [none currently in operation], (3) Exempt Commercial Markets (ECM), and
(4) Over-the-Counter (OTC) — not on a trading facility.59 As suggested by the
discussion above, allowances are traded on three of these venues. Futures contracts
and clearing services are provided by NYMEX and CCFE — both DCMs — with
options also available on the CCFE. ICE and TradeSpark — both ECMs — are used
by brokers and principals for allowance transactions. Finally, principal-to-principal
transactions and broker-assisted transactions are occurring OTC without the use of
a trading facility. Table 5 summarizes these venues and their regulation under the
Commodity Exchange Act.
For the three trading venues set out in Table 5, the degree of regulation varies,
most significantly according to the identities of the participants. Small public
investors are allowed to trade only on regulated exchanges (DCMs); these are subject
to extensive self-regulation and CFTC oversight. Electronic trading facilities, where
small traders are not present, are subject to much less regulation, because traders are
assumed to be capable of protecting themselves from fraud. However, if an
electronic trading facility plays a significant price discovery role (that is, if the prices
it generates are used as reference points by the cash market or other derivatives
markets), the CFTC may require disclosure of certain information about trading
volumes, prices, etc. Where trades are purely bilateral, negotiated, and executed
57 Comptroller of the Currency, Administrator of National Banks, Interpretive Letter #1040:
Emissions Derivatives Proposal, September 15, 2005.
58 Board of Governors, Federal Reserve System, JPMorgan Chase & C. New York, New
York: Order Approving Notice to Engage in Activities Complementary to a Financial
Activity, November 18, 2005.
59 See table entitled: Venues for the Trading of Exempt Commodities under the Commodity
Exchange Act (CEA), available on the CFTC website at [http://www.cftc.gov/stellent/
gr oups/public/@news room/documents/file/exemptcommoditiesvenues_091207.pdf].
between principals, the transaction is said to occur in the OTC market, which is
entirely exempt from CFTC regulation, with the exception of certain provisions
dealing with fraud manipulation.
Table 5. Summary of Trading Venues for Exempt Commodities
Under the Commodity Exchange Act (CEA)
DesignatedExemptCommercialOTC — Not on aTrading Facility
Contract MarketsMarkets (CEA(CEA Sec. 2(h)(1)-
(CEA Sec. 5)Sec. 2(h)(3)-(5))(2))
Permittedcommodities (e.g.,commodities (e.g.,
energy metals,energy metals,
allowances, etc.)allowances, etc.)
Method of TradingTrading can takeElectronic multi-Non-multi-lateral
place on anlateral trading (i.e.,trading (e.g., dealer
facility or by openplatforms) individually-
NoticeMust apply to andYes; simple noticeNone; exemption is
Requirementreceive priorcontaining contactself-executing
approval frominformation and
CFTC; must satisfydescription of
and core principles
ParticipantsNo limitationsEligibleEligible Contract
Entities only — institutions, finds,
subset of Eligibleand wealthy,
Participants; indivi duals)
IntermediationPermittedNone; principal-to-Limited; only if
principal tradingdone through
DesignatedExemptCommercialOTC — Not on aTrading Facility
Contract MarketsMarkets (CEA(CEA Sec. 2(h)(1)-
(CEA Sec. 5)Sec. 2(h)(3)-(5))(2))
Types ofFutures andDerivatives,Derivatives,
Transactionsoptions including swaps,including swaps,
futures and optionsfutures, and
(Note: ECMs oftenoptions
also trade products
including spot and
StandardizedYesYes, terms set byUsually yes when
Products?the entityexecuted on a
Usually no, when
Cleared?Transactions mustClearing notCan be if a
be cleared throughmandatory; ifstandardized
a Derivativesoffered, it must becontract; many
Clearingthrough an SEC-traders choose to
Organizationregistered clearingclear trades at
(DCO) approvedagency or a DCONYMEX or LCH
by the CFTC(many ICE
cleared at LCH;
other ECMs offer
or The Clearing
TransactionSubject to allOnly anti-Only anti-
Prohibitionsprovisions of themanipulation andmanipulation and
anti-fraud rules do
not apply to
DesignatedExemptCommercialOTC — Not on aTrading Facility
Contract MarketsMarkets (CEA(CEA Sec. 2(h)(1)-
(CEA Sec. 5)Sec. 2(h)(3)-(5))(2))
Self-regulatoryYes, significantMinimal and theyNone
responsibilities;that goes to the
must comply on aintegrity of trading.
ongoing basis withResponsibilities
8 designationinclude a reporting
criteria and 18 corerequirement for
principles. Mustcontracts over a
have complianceminimum volume
and surveillancethreshold; ensuring
Responsibility toComply withProvide notice ofNone
CFTCdesignation criteriaoperation and
and core principlesweekly transaction
data for high-
provide access to
records of activity
DesignatedExemptCommercialOTC — Not on aTrading Facility
Contract MarketsMarkets (CEA(CEA Sec. 2(h)(1)-
(CEA Sec. 5)Sec. 2(h)(3)-(5))(2))
CFTC OversightUnlimited,Limited (specialNone
Authorityincludingcalls); Sec 8a(9)
ongoing marketauthority does not
programs, ability to
markets (e.g., force
ons of position,
large trader reports
programs via rule
Source: Venues for the Trading of Exempt Commodities under the Commodity Exchange Act (CEA),
available on the CFTC website at [http://www.cftc.gov/stellent/groups/public/@newsroom/documents/
Although allowances are regulated like any other commodity by the CFTC, it
should be noted that it is not a deep liquid cash market. As noted by emissions
broker Evolution Markets LLC, the affected source base for SO2 allowances is about
500 companies. The broker also estimated in 2005 that about 20 companies
represented the bulk of trading activities.60 In recommending CFTC approval of the
CCFE as a DCM, the Staff memorandum noted the following:
In futures markets generally, the existence of a liquid market for a particular
contract and the ability of an FCM to liquidate positions therein which it may
inherit from a defaulting customer are important to the financial integrity of such
an FCM and, in turn, its ability to fulfill its obligations to other customers and
to the clearing system. The EPA will facilitate the delivery process of these
contracts in a manner that makes cash positions known and compensates for any
current lack of a developed deep liquid cash market for the contracts as compared
to other futures contracts. Collectively CCorp, NFA, and EPA will carry out
financial surveillance, monitor situations, and provide information the effect of
60 Evolution Markets LLC, “An Overview of Trading Activity and Structures in the U.S.
Emissions Markets,” NYMEX Emissions Futures Seminar, July 28, 2005.
which should counterbalance any disparate effects on financial integrity, which61
might be imposed by the initial lack of trading history and prices.
Lessons and Observations from Title IV Program
Despite the tendency to view the Title IV program as a model for a future
greenhouse gas reduction scheme, there are several important differences. For
example, the Title IV program involves up to 3,000 new and existing electric
generating facilities that contribute two-thirds of the country’s SO2 and one-third of
its nitrogen oxide (NOx) emissions (the two primary precursors of acid rain). This
concentration of sources makes the logistics of allowance trading administratively
manageable and enforceable with continuous emissions monitors (CEMs) providing
real time data. However, greenhouse gas emissions are not so concentrated. In 2005,
the electric power industry accounted for about 33% of the country’s GHG
emissions, while the transportation section accounted for about 28%, industrial use
about 19%, agriculture about 8%, commercial use about 6%, and residential use
about 5%.62 Thus, small dispersed sources in transportation, residential/commercial
and agricultural sectors, along with industry, are far more important in controlling
GHG emissions than they are in controlling SO2 emissions. This diversity multiplies
as the global nature of the climate change issue is considered, along with the multiple
GHGs involved.63 Thus, a carbon market is like to involve far greater numbers of
affected parties from diverse industries than the current Title IV program.
It will also involve far greater numbers of tradeable allowances than the current
Title IV program. Under the current program, about 9 million allowances are
allocated to participating entities annually. In contrast, a domestic greenhouse gas
program that capped emissions in the electric power, transportation, and industry
sectors at their 1990 levels at some point in the future would be allocating about 4.85
billion allowances annually. This is a two and a half orders-of-magnitude increase
over the Title IV program and double the Phase 2 allocations under the ETS. Trading
activities under Title IV has been increasing since 2005; however, the volumes don’t
approach those anticipated if a greenhouse gas cap-and-trade program were
Finally, the economic value of a future carbon market is likely to be
substantially greater than the Title IV program. With EPA’s pending implementation
of the Clean Air Interstate Rule (CAIR), the price of a Title IV allowance has
61 The Division of Market Oversight and The Division of Clearing and Intermediary
Oversight, CFTC, DCM Designation Memorandum: Application of Chicago Climate
Futures Exchange, LLC (“CCFE”) for Designation as a Contract Market pursuant to
Sections 5 and 6(a) of the Commodity Exchange Act (“Act” or “CEA”) and Part 38 of
Commission regulations, November 3, 2004.
62 U.S. territories account for the remaining 1%. Data from EPA, Inventory of U.S.
Greenhouse Gas Emissions and Sinks: 1990-2005, April 15, 2007, p. ES-14.
63 The EU addresses this issue by having the ETS cover only 45% of its emissions and no
non-carbon dioxide emissions, as noted earlier. Still, it has 11,500 entities to oversee.
increased to about $500.64 Thus, the annual allocation of SO2 allowances has a
market value of about $4.5 billion. Using estimates of $15 to $25 an allowance, the
annual allocation of 4.85 billion allowances posited above for a greenhouse gas
program would have a market value of $72.8 billion to $121.3 billion.65 Unlike the
Title IV market, a carbon market may be quite liquid, particularly as the market
Despite these differences in scope and magnitude, there are trends in Title IV
trading that are likely to continue in a carbon market.
First, there is a trend toward more diverse, non-traditional participants in the
Title IV market. Like the Title IV market, the economic importance of a carbon
market will likely draw in entities not directly affected by the reduction requirements,
such as financial institutions. The motivations of these entities may be equally
diverse, including facilitating projects involving the need for allowances, portfolio
balancing, and profits earned through intermediary fees or proprietary trading.
Second, there is trend in the Title IV market toward using financial instruments
to manage allowance price risk. This trend is partly the result of the regulatory
uncertainty introduced in the allowance market by CAIR. Given the greater
economic stakes involved in a carbon market, this trend toward more sophisticated
financial instruments is likely to emerge early as a hedge against price uncertainty.
The emergence of entities well-versed in the use of these instruments may reinforce
the trend and make options, collars, strangles, and other structures as common in the
allowance market as they are in other commodity markets. With a more liquid and
dynamic market, a carbon market may look more like other energy markets, such as
natural gas and oil, than the somewhat sedate SO2 allowance market.
Implications for a Future U.S. Carbon Market:
If the United States adopts a cap-and-trade system based on CO2 allowances, the
resulting trading market would be large. As noted above, between four and five
billion allowances might be issued each year, with a market value of around $70 to
$120 billion. Judging by the interest already expressed by major Wall Street firms,
the value of secondary market trading might be several times that figure.
Since thousands of businesses would be affected by a mandatory emissions
trading system, there is a strong public interest in ensuring that (1) the market
functions smoothly and efficiently, generating prices that accurately reflect supply
and demand for emissions permits, (2) the market is free from fraud and
64 Based on data from Cantor Fitzgerald, October 2007.
65 Range based on EPA estimates for reducing emissions to 1990 levels by 2020 as required
under S. 280. See EPA, Analysis of The Climate Stewardship and Innovation Act of 2007,
July 16, 2007. For reference, a Phase 2 ETS allowance currently sells for about 20-25 euro.
Data from the European Climate Exchange, [http://www.ecxeurope.com/default_flash.asp].
manipulation, which could potentially arise from a number of sources, including
market power in the hands of a few firms and the abuse of nonpublic, price-sensitive
information, and (3) market participants’ and regulators’ need for transparency is
balanced against legitimate business concerns about the release of confidential,
An Efficient Trading and Pricing Mechanism
A generation ago, only a few large, established exchanges would have had the
capacity to handle the trading volumes anticipated for a U.S. CO2 market. That is no
longer the case: thanks to cheap computing power and telecommunications, small
firms with a few dozen employees can handle much of the volume of the major stock
exchanges, which employ thousands. Thus, we can expect trading mechanisms to
emerge quickly once U.S. carbon trading is authorized, with no need for government
A number of organizations and groups have been preparing for the advent of
emissions trading. The Chicago Climate Exchange (CCX) already operates a
voluntary greenhouse gas emissions market, featuring both spot and futures trading.66
Cantor Fitzgerald, a securities firm that operates a secondary trading platform for
U.S. Treasury securities, has formed a subsidiary, CantorCO2e, which offers “an
integrated set of services — transaction, financing, technology and consultancy —
to bring environmental commodities to market and to assist clients across the world
in managing the financial aspects of energy and environmental choices.”67 In
December 2007, the New York Mercantile Exchange (Nymex), the leading U.S.
energy futures market, announced the formation of the Green Exchange, in a joint
venture with several major investment banks. The Green Exchange will offer
environmental futures, options, and swaps, and expects to register with the
Commodity Futures Trading Commission (CFTC) as a futures exchange in 2009.68
IntercontinentalExchange (ICE) already owns and operates a CFTC-regulated futures
exchange (the former New York Board of Trade), which specializes in sugar, cotton,
and other agricultural commodities but could easily offer emissions-related contracts
as well. Any of these entities would have little difficulty in hosting large-scale
trading of emissions allowances.
Since start-up costs are relatively low, it is likely that a number of competing
trading venues would emerge to handle U.S. emissions trading if the United States
followed the EU’s example and did not mandate a particular trading mechanism or
structure. Competition would favor markets with low trading costs, easy access, and
fast and reliable execution systems. The usual pattern in trading markets is for
66 The CCX created the ECX in 2005. Since 2006, CCX and ECX have been owned by
Climate Exchange PLC, a publicly traded company listed on the AIM division of the
London Stock Exchange.
67 [http://www.cantor.com/brokerage_services/co2e], visited February 29, 2008.
68 “Nymex and Other Major Market Participants to Form the Green Exchange,” PR
Newswire, December 12, 2007.
volume to gravitate to a single market, to enhance liquidity.69 This suggests that the
less successful competitors might be relegated to niche markets, that a number of
trading mechanisms could be linked electronically to form a single market, or that
mergers and acquisitions would reduce the number of trading venues.
It is of little public interest which firm or firms emerges as the market leader.
What is important, however, is that there be an authoritative source of price
information, since the price of emissions will guide firms considering investment in
pollution abatement. Price discovery mechanisms are most efficient in liquid
markets, where many traders bring information to the price-setting process by their
buying and selling decisions.
In general, the functioning of the price mechanism has not been a concern of
financial regulators.70 The Securities and Exchange Commission (SEC) and the
CFTC both rely on self-regulation by the exchanges in this area, reflecting the fact
that the exchanges predate the federal regulators by decades or centuries. Both
agencies have broad authority to intervene if they determine that prices do not
accurately reflect the underlying forces of supply and demand.
If patterned after the Title IV program and the EPA maintained the registry of
allowance ownership, that agency might play a role in price dissemination in a future
carbon market. Reports to the EPA that a trade has occurred could be required to
include price information, which could be published electronically. In practice,
however, the EPA might not be the best source of price data. Since the EPA would
presumably receive only spot market trade data, and since most proposals follow the
Title IV procedure that specifies that each transaction report to the EPA must include
a written certification of the transfer, signed by a responsible official of each party,
the question arises whether prices generated by the EPA registry would be outdated
by the time they were published. In practice, many commodity spot markets look to
the futures exchanges for current prices; new prices are generated there second-by-
second, recorded, and transmitted almost instantaneously. If substantial numbers of
spot transactions took place on exchanges, as they do in Europe, current information
on spot prices might also be available.
Regulators might have a role to play in ensuring that the exchanges did not
charge excessive fees for access to real-time price data. Both the SEC and CFTC
have grappled with this issue — customers tend to view the exchanges as public
utilities, and prices as common goods, but the exchanges naturally look upon price
data as their private property, to be sold for what the market will bear.
The availability of price information also depends on the regulatory status of the
source market. Exchanges regulated by the SEC or CFTC are required to disclose
69 In a liquid market, there are many buyers and sellers, and traders have less reason to fear
that their order to sell will cause the price to drop before the order can be filled (or vice
versa). For large traders in particular, the impact of their trade orders on the market price
is a major component of total transaction costs.
70 With the exception, of course, of the rare occasions when price manipulation is suspected,
as discussed below.
price and volume data. (The proprietary issue mentioned above refers only to intra-
day or real-time prices.) These rules do not apply with the same force to over-the-
counter (OTC) markets, which are a significant presence in financial and energy
derivatives markets, but which are largely exempt from CFTC regulation.71 Under
current law, the CFTC has very limited authority to require OTC markets to disclose
trading data. Legislation before the 110th Congress would require such disclosure by
exempt markets that were determined by the CFTC to play a significant role in the
price discovery process.72
Fraud and Manipulation
Regulation of secondary emissions trading would have to consider two kinds of
fraud and manipulation: fraud by traders or intermediaries against other investors,
and sustained price manipulation, which is harmful not only to market participants,
but potentially to consumers and the economy.73
Investor Fraud. Both CFTC and SEC have extensive experience with
numerous programs designed to prevent and punish fraud. Much anti-fraud
regulation takes place in a self-regulatory framework: regulated exchanges are
required to establish and enforce rules to promote fair trading. To choose two
examples from a very long list of investor protection rules, securities brokers are
bound by a duty of best execution — they are required to obtain the best terms
reasonably available to fill a customer’s order — while futures commission
merchants are prohibited from trading for their own accounts when they have an
unfilled customer order in hand. Many similar protections would apply to trades in
emissions allowances or derivatives executed on a regulated exchange, whether
futures or securities. Both types of markets require professional traders to maintain
accurate records of all transactions. There is no strong reason to think that CFTC or
SEC regulation would be superior in protecting small traders: either should be
In addition to federal statutes and regulations and the rules of self-regulating
securities and futures exchanges, state laws provide protections against crooked
dealings. Brokers, investment advisers, and other intermediaries are regulated at the
state level in their transactions with customers, to prevent them from taking
advantage of public investors with less knowledge of current market conditions.
The degree to which fraud on the unwary could be a problem depends on how
many and what kinds of traders are attracted to the market. In the SO2 market, it is
not a significant problem. SO2 emissions are primarily generated by relatively few
71 See CRS Report RS21401, Regulation of Energy Derivatives, by Mark Jickling, for a
discussion of issues associated with unregulated OTC trading.
72 The Senate-passed version of H.R. 2419 (the Farm Bill) and an unnumbered bill to
reauthorize the CFTC marked up and approved by the House Agriculture Committee in
73 This report does not address fraud outside the secondary markets, such as falsification of
emissions data. The EPA would be the appropriate agency to oversee and verify emissions
power utilities, each of which has roughly the same information as the others. All see
the same weather forecasts and energy price data. In such a market, it is difficult for
one party to defraud another.
The CO2 market would be different: there would be thousands of firms in the
market, and potentially millions if the program were to cover transportation
emissions. Assuming that significant information asymmetries exist between small
firms in the market and large ones, the latter are likely to be in a position to take
advantage of the former. Either SEC or CFTC regulation could be appropriate,
depending on whether emissions allowances and derivatives came to be traded on
securities or futures exchanges.
In OTC derivatives markets, where only sophisticated investors and institutions
are allowed to trade,74 participants are assumed to have the incentive and capacity to
protect themselves from fraud.75 This is the general rationale for exempting certain
markets from regulation: if public customers are not present, there is thought to be
no public interest in providing investor protection at the taxpayers’ expense.
Spot market trades, which would not come under regulation under current
securities or commodities law, are another area where abuses could arise from
information asymmetries between large, sophisticated traders and smaller firms that
rarely use the market. The potential for abuse, however, would be greatly reduced
if current price data were easily available to all market participants.
Inside Information. The European experience suggests that there may be
opportunities to trade on inside, non-public information. Even sophisticated market
participants are vulnerable to this type of fraud. The concepts of insider trading,
however, are not the same in securities and futures markets.
Under securities law, insider trading involves the use of nonpublic information
about a single firm. Corporate insiders in possession of nonpublic information that
is material — that is, that would affect a reasonable investor’s decision to buy or sell
— are prohibited from buying or selling the company’s shares until the information
is disclosed to the public. All trades by certain executives, officers, and directors in
their own company’s shares must be disclosed within two business days. The
definition of who is an “insider” has been expanded by legislation and court decisions
in recent decades, so that under certain circumstances investment bankers,
journalists, and various fiduciaries may be encompassed.76
74 OTC traders must be “eligible contract participants,” defined in the Commodity Exchange
Act as financial institutions, market professionals, corporations with a net worth greater than
$1 million, or individuals with assets over $1 million, or income over $200,000.
75 Both derivatives and securities are traded in private, less-regulated markets. Under federal
securities law, companies may sell stocks or bonds to a limited number of institutional
investors or wealthy individuals without having to register with the SEC.
76 For a brief overview of the law, see CRS Report RS21127, Federal Securities Law:
Insider Trading, by Michael V. Seitzinger.
In futures markets, there is no equivalent to inside information about a single
corporation’s prospects. Contracts are based on homogenous commodities that
thousands of people produce, trade, and consume. Certainly some traders — large
producers or industrial users of commodities — have information that others do not
have, but the price discovery process depends on that information being incorporated
into the price.77
The Commodity Exchange Act and CFTC regulations bar exchange employees
(or governing board or committee members) from trading on material nonpublic
information obtained through their positions, or from “tipping” others to trade on
such information.78 This prohibition does not extend to everyone who trades in the
Because of the variance between futures and securities concepts of insider
trading, if, hypothetically, the CEO of ExxonMobil were to buy stock knowing that
the discovery of a major new oil field would be announced the next day, the
transaction would be clearly illegal under the securities laws. If, however, in the
same circumstances he sold crude oil futures contracts, expecting that the
announcement would lower the price of oil, it would not necessarily be unlawful.
Thus, it is not certain that either the CFTC or the SEC approach to insider
trading would be adequate to protect the market from the kind of abuse suspected in
Europe before the allowance price crashed in 2006 (where traders may have used pre-
publication data regarding emissions levels and allowance allocations). What may
be required is a hybrid of securities and commodities law, imposing disclosure
requirements on certain firms in possession of material nonpublic information.
Market Manipulation. Investor protection is not the only goal of anti-fraud
regulation. Even though sophisticated investors in unregulated, private markets have
the incentive and means to protect themselves against fraud by those with superior
information, these markets may be just as vulnerable to price manipulation as the
public markets. In recent years, there has been widespread concern in Congress and
elsewhere that excessive speculation in energy derivatives may have caused the
prices of oil and natural gas to be higher than the fundamentals of supply and demand79
77 There is a large theoretical literature, on both stock and futures markets, that argues that
any restriction of insider trading is undesirable because it makes pricing less efficient.
78 The “tippees” are likewise prohibited from trading on that information. See 17 CFR
§159. (The definition of “material nonpublic information” is essentially the same as in
79 See U.S. Senate Permanent Subcommittee on Investigations, Excessive Speculation in the
Natural Gas Market, staff report, June 2007. The argument that manipulation has occurred
is not universally accepted. See Written Testimony of Acting CFTC Chairman Walter
Lukken and Commissioner Michael Dunn before the Permanent Subcommittee on
Investigations, Senate Committee on Homeland Security and Governmental Affairs, July 9,
[ h t t p : / / www.cf t c .gov/ s t e l l e nt / gr oups/ publ i c / @newsr oom/ document s / s p eechandtestimony
Allowance price manipulation would resemble the kind of manipulation that the
CFTC is equipped and accustomed to prevent, detect, or punish. Allowance prices
would be subject to corners and squeezes to the same extent as any commodity
contract, assuming that allowances were issued in advance, as they are in Europe, and
that the supply could not be expanded before the beginning of the next allocation
cycle. To corner the market, a manipulator would amass a large inventory of
allowances while simultaneously taking futures or forward positions that required
others to make delivery to it. When a squeeze is successful, traders with delivery
obligations have no choice but to buy from the manipulator at prices it can dictate,
and then sell those same allowances back to the manipulator at the lower prices
specified in the futures and forward contracts.
To prevent manipulations of this type, which can cause prices of the underlying
commodity (emissions, in this case) to rise far above fundamental levels for extended
periods of time, the CFTC has a number of surveillance programs that apply to both
the spot and futures markets. First, the CFTC maintains a large trader reporting
system: anyone controlling more than a specified number of contracts must report the
position daily. This information is not made public, but it allows the CFTC to
observe the accumulation of large positions that could serve as the basis for
manipulation. CFTC is able to aggregate positions held by a single trader with
various brokerage firms. Second, the CFTC monitors the deliverable supply of
commodities, particularly as the expiration date of the futures contract draws near.
If unusual shortages in deliverable supply emerge, the CFTC can take certain
remedial steps.80 However, the CFTC does not have the capacity (nor a clear
statutory mandate) for comprehensive monitoring of spot trading in all the
commodities upon which futures contracts are based.
The futures exchanges and clearing houses have strong incentives to prevent
manipulation — since futures trading is a “zero-sum” game,81 victims of manipulated
prices will almost certainly include many exchange members. Clearing houses,
which guarantee payment on all contracts, face the risk that a squeeze or corner may
cause many traders to default on their obligations.
To deter manipulation, the exchanges impose position size limits on certain
contracts, but these apply only to speculators. Hedgers, those who produce or deal
in the underlying commodity, are generally exempt. In the allowance market, as
noted above, a concern is that a single large emitter, or a group acting in concert,
could have enough market power to influence prices. If concentration in the
allowance market is significantly greater than in other commodities, a system of
position limits that applies to hedgers might be useful.
/opalukken-26.pdf], visited March 3, 2008.
80 For an overview of the CFTC’s anti-manipulation tools, see “Written Testimony of Acting
CFTC Chairman Walter Lukken and Commissioner Michael Dunn before the Permanent
Subcommittee on Investigations,” July 9, 2007.
81 All futures contracts are bilateral, and any given price movement causes equal but
opposite gains and losses to the two sides.
SEC anti-manipulation efforts, on the other hand, are generally not aimed at
manipulations of an entire market, but at the schemes to distort the price of a single
stock, or group of stocks. Many such manipulations deal with misuse of inside
information or spreading false information. There is no general equivalent to the
CFTC’s large trader reporting system, although buyers of more than 5% of a public
company’s shares must disclose their ownership and state whether the investment is
passive or whether control of the company is sought.
The Energy Policy Act of 2005 (P.L. 109-58) significantly expanded the
authority of the Federal Energy Regulatory Commission (FERC), giving the agency
a new role in regulating energy markets. The act expanded the jurisdictional reach
of FERC, authorizing it to address any manipulative device and any entity
participating in or affecting FERC’s jurisdictional markets (primarily bulk electricity
and interstate natural gas). FERC also received new civil authority to impose
penalties of up to one million dollars per violation per day. FERC oversees power
markets that involve extensive administrative adjustments to regional markets
through market monitors, but not markets that would be characterized as exchanges.
Even before the 2005 Act, beginning in 2002, FERC had built a new analytic
capability to examine markets and look for anomalies in response to the Enron and
California electricity crises. FERC established a Market Oversight unit, which grew
to approximately 50 staff. To comply with its new regulatory mission under the 2005
Act, resources were shifted to emphasize enforcement and audit activities. As a
result, the market oversight unit lost staff and has continued to shrink, to perhaps a
dozen full time professionals at this time.
Though it is relatively inexperienced as a regulator of secondary markets, FERC
might play a key role in coordination with another agency (or agencies). Since the
prices of natural gas and wholesale electricity would be affected by emissions costs
(and vice versa), the possibility of intermarket price manipulation exists. Without
the information available to FERC, it will be difficult to obtain a comprehensive
overview of supply and demand in the emissions market.
If an OTC market for allowance derivatives were to develop, no federal agency
would have much authority over it, or much information about trading volumes,
prices, and market conditions. The extent to which existing OTC markets in
financial and energy markets facilitate manipulation is controversial.82 It is clear that
the exchange and OTC markets are economically linked and that swaps and futures
are interchangeable from the trader’s point of view, and that therefore prices in one
market affect the other. Some argue that OTC manipulation is unlikely because all
participants are sophisticated and because manipulation of exchange market prices,
which are visible and often used in the spot market, is likely to be more profitable.
Others argue that the less-transparent OTC market is where a would-be manipulator
might choose to accumulate market power, out of the regulator’s sight. In any case,
the issue is now squarely before the Congress, and emissions trading is unlikely to
present any strategies for manipulation not already found (or suspected) in the energy
82 See CRS Report RS21401, Regulation of Energy Derivatives, by Mark Jickling.
Transparency Versus Confidentiality
In order for the cap-and-trade system to work, firms must have clear price
signals to guide their investment decisions. Reliable and transparent prices also
foster liquid secondary markets, which in turn can make pricing more efficient.
To public investors and customers, transparency means primarily the availability
of timely and affordable price information. Without such information, they are prey
to better-informed market insiders. Both SEC and CFTC have well-established
standards in this area.
The more difficult issue is how much information the public needs about how
prices are set. Confidence in the market depends on investors believing that prices
are determined fairly, in response to real economic factors, and not manipulated.
Providing that assurance is a major function of the regulators.
But there are limits to transparency; beyond a certain point, it becomes very
expensive and may harm the market. The discussion above about the market impact
of large trades is one example of this. Large traders prefer to trade anonymously, in
order that other traders not jump in and sell when they are selling, or buy when they
are buying, raising their transactions costs. In the stock market, a number of
electronic trading venues have thrived in competition with the major exchanges by
offering anonymity to large institutional traders. The potential danger here, however,
is that a fragmented, or two-tier, market may evolve, where market professionals and
large traders deal with each other at prices better than those they offer to the public.83
Regulators also want information that traders would prefer to keep private.
Large positions in futures, as noted above, are reported to the CFTC but not made
public. There have been no instances to date of trading abuses involving mishandling
of large trader data.
In the emissions market, government agencies would have access to large
amounts of price-sensitive data. The EPA, first of all, would have full information
about the total number of allowances to be issued, and how they were to be allocated.
It would also have data on actual measured emissions, which could send important
price signals under certain market conditions.
Safeguarding this kind of information, however, need not present any special
regulatory problems. Many federal agencies already generate statistics and forecasts
that affect market prices — macroeconomic and agricultural data are examples —
and existing procedures and laws appear to work well to prevent pre-publication
83 This was the case a few years ago with Nasdaq and Instinet, a trading system used only
by Nasdaq intermediaries. The SEC responded by requiring that Nasdaq trading screens
display price quotes from all electronic marketplaces handling Nasdaq shares.
Both the European Union’s Emissions Trading Scheme and the U.S. Title IV
sulfur dioxide program have insights into regulatory issues that may face any future
U.S. carbon market. A review of the initial operations of the EU-ETS indicates some
potential pitfalls facing a future U.S. market. The 2006 price crash, by weakening the
financial incentive to reduce pollution, undermined the basic rationale for the ETS.
Although the problem did not originate in the secondary market, it did raise questions
about the adequacy of market regulation. In particular, many observers suspect that
information about the size of allocations leaked before official publication, and that
certain traders profited from this knowledge. Traders with nonpublic information on
certified emissions data — which gives an indication of future demand for
allowances — may also have profited.
A review of Title IV’s much longer trading history reveals at least two trends
that are likely to continue in a carbon market and to challenge regulators. First, there
is a trend toward more diverse, non-traditional participants in the Title IV market.
Like the Title IV market, the economic importance of a carbon market will likely
draw in entities not directly affected by the reduction requirements, such as financial
institutions. These entities’ motivations may be equally diverse, including
facilitating projects involving the need for allowances, portfolio balancing,
intermediary fees, and trading profits.
Second, as noted, there is a trend in the Title IV market toward using financial
instruments to manage allowance price risk. Given the greater economic stakes
involved in a carbon market, this trend toward more sophisticated financial
instruments is likely to emerge early as a hedge against price uncertainty. The
emergence of entities well-versed in the use of these instruments may reinforce the
trend and make options, collars, strangles, and other structures as common in the
allowance market as they are in other commodity markets. With a more liquid and
dynamic market, a carbon market may look more like other energy markets, such as
natural gas and oil, than the somewhat sedate SO2 allowance market.
Regulation of secondary emissions trading would have to consider two kinds of
fraud and manipulation: fraud by traders or intermediaries against other investors,
and sustained price manipulation, which is harmful not only to market participants,
but potentially to consumers and the economy. Four federal agencies could have roles
in the regulation of a secondary market in emissions allowances. Each has attributes
that may contribute to effective regulation.
The CFTC is the agency that currently oversees the Title IV program and whose
current mission most closely resembles what a regulator of the prospective carbon
emissions market would do. Secondary CO2 trading in the EU does not appear to
differ significantly from other commodities markets. CFTC is engaged in
intermediary regulation, has experience in market surveillance to prevent or detect
fraud and manipulation, and supervises a market system — based on the self-
regulating exchange and clearing house — that has withstood severe financial
The major failing of the CFTC, according to some observers, is that it lacks the
resources and the statutory mandate to do its job.84 Futures trading has grown
explosively in recent years; CFTC employment and budget have not kept pace. The
OTC derivatives markets represent another major challenge. Many believe that the
CFTC’s limited jurisdiction over the OTC markets constitutes a regulatory gap, and
that excessive, unregulated speculation in energy contracts may be partly to blame
for high and volatile energy prices.
The SEC is much larger than the CFTC, and its enforcement programs are
widely thought of as more effective than the CFTC’s. While the CO2 market will
resemble commodities markets more closely than securities, the SEC has a number
of regulatory tools that might be appropriately applied to the emissions market.
These include regulation of insider trading and disclosure of material formation by
firms in the market. It is likely that SEC-regulated investment banks will play a
significant role in the development of a U.S. carbon trading market, as they
increasingly are doing in the Title IV market. It is also possible that CO2 derivatives
contracts or indexes could be listed and traded on securities exchanges.
If patterned after the Title IV program, EPA would be responsible for the
primary market in allowances: the original allocation and/or auction of permits to
emitting firms. It would maintain the registry of ownership of allowances. EPA
lacks experience comparable to that of the CFTC and SEC in regulating trading
markets, but the information it gathers in the primary market could be critical to
oversight of the secondary market.
FERC was granted oversight authority over bulk electricity and interstate
natural gas markets in 2005. Its experience with market surveillance and
enforcement is thus limited in comparison to the SEC and CFTC, and it does not play
an active role in overseeing the Title IV market. FERC may have a role to play,
however, based on its oversight of commodity markets with price linkages to CO2
emissions, but at this time it may be less well-equipped than the CFTC or SEC to be
the primary regulator of secondary trading.
If development of secondary trading is left to market forces, as it was in Europe,
it is possible that no single regulator would have clear jurisdiction, as is the case in
the Title IV program. CO2-related contracts, as well as the allowances themselves,
could be traded simultaneously on futures and securities exchanges, spot markets
where EPA has some jurisdiction, and OTC markets that are essentially unregulated.
This kind of regulatory fragmentation has not always worked well in financial
markets. After the stock market crash of 1987 revealed differences of opinion among
the CFTC, the SEC, and the Federal Reserve, President Reagan created the
President’s Working Group on Financial Markets,85 which remains active, conducting
84 See, e.g., U.S. Government Accountability Office, Commodity Futures Trading
Commission: Trends in Energy Derivatives Markets Raise Questions About CFTC
Oversight, GAO-08-25, October 2007, 83 p.
85 The Working Group includes the chairmen of the Fed, SEC, and CFTC, and the Secretary
studies and making recommendations on intermarket issues, as well as providing a
forum for regulatory coordination. A similar umbrella group might help to prevent
regulatory gaps or conflicts in the emissions market.
of the Treasury.
Appendix: Regulation of EU Emissions Exchanges
European Climate Exchange (ECX)
ECX is recognized as the leading secondary market for emissions trading, but
it is not itself an organized financial exchange. ECX contracts are traded on the
platform of another market, ICE Futures Europe, a Recognised Investment Exchange
in the U.K., supervised by the Financial Services Authority (FSA) under the terms
of the Financial Services and Markets Act of 2000.
“Recognition” as an investment exchange is contingent upon meeting FSA
standards regarding financial resources, controls over systems and conflicts of
interest, investor protections, fair access to trading facilities, trade recording,
disclosure, custody of customer funds, disciplinary programs, and prevention of fraud
and financial crime.
The parent company, IntercontinentalExchange, Inc., is an American firm
headquartered in Atlanta. ICE Futures Europe was previously the International
Petroleum Exchange, the leading European energy derivatives market. In addition
to ICE Futures, ICE operates an OTC electronic platform, which is registered as an
exempt commercial market under the U.S. Commodity Exchange Act and the
regulations of the CFTC. The CFTC generally oversees, but does not substantively
regulate, the trading of OTC derivative contracts on the ICE platform. All ICE
participants must qualify as eligible commercial entities, as defined by the
Commodity Exchange Act, and each participant must trade for its own account, as
a principal. The U.K.’s FSA does not supervise the OTC emissions market.
Under FSA rules, derivatives trading is a “regulated activity,” which can only
be carried out on a recognized exchange. Traders also need FSA authorization to
participate in derivatives markets if they engage in a “specified activity,” including
(1) dealing in investments as principal; (2) dealing in investments as agent; (3)
arranging deals in investments; and (4) advising on investments. There are
exemptions from this authorization requirement for hedgers, or those who use
derivatives to mitigate risks in their normal course of (unregulated) business.
ICE operates its sales and marketing activities in the U.K. through ICE Markets
which is authorized and regulated by the FSA as an arranger of deals in investments
and agency broker.
ECX, through ICE Futures, offers futures contracts and options based on EUAs.
One contract represents 1,000 tonnes of CO2 EU Allowances, or 1,000 EUAs. ECX
is not a spot market.
BlueNext was formed in December 2007, when NYSE Euronext (the holding
company that owns the New York Stock Exchange) and Caisse des Depot (the
French government’s investment company, or sovereign wealth fund) purchased the
weather and carbon trading operations of Powernext, an exchange that trades spot
and futures contracts in electricity and natural gas. BlueNext is currently the leading
spot market for EUAs, but expects to add EUA futures contracts and contracts based
on CERs during 2008.
Like Powernext, BlueNext is classified as an investment company which
manages a multilateral trading facility, and is registered with the Comité des
Etablissements de Crédit et des Entreprises d’Investissement under the oversight the
Autorité des Marchés Financiers (AMF), or Financial Market Authority. The
Commission de Régulation de l’Energie (CRE) and the DIDEME (French Ministry
of Finance) also have regulatory roles.
General organization and operating principles of trading markets are established
by the AMF through its “Règlement général.” The AMF’s membership comprises
various professional categories involved in the securities market such as exchange
intermediaries, industrial and commercial firms, institutional investors and
employees’ representatives. The sixteen members of the AMF are appointed for a
four-year period by decree of the ministry in charge of Economy and Finance.
The AMF is responsible for the proper working of regulated exchange markets.
It supervises compliance with exchange rules and regulations by investment
companies operating in France, and exchange compliance with the AMF’s own rules.
It has the power to impose sanctions on violators.
Nord Pool was the first exchange to trade emissions allowances, but it has not
kept up with ECX and BlueNext in trading volume. It offers spot forward contracts
for EUAs and CERs (where actual delivery of an allowance always occurs), in
addition to its primary business, which is spot trading of electrical power among the
As a regulated exchange, Nord Pool maintains a market surveillance operation,
and reports formally to the Norwegian Kredittilsynet (Financial Supervisory
Authority) and the NVE (the Norwegian energy regulator).
Market participants are required to report all non-exchange (OTC) trades, to
disclose all inside information that is likely to have a price impact, and to refrain
from trading while holding such information. The exchange provides a mechanism
for disclosing price-sensitive information, called the Urgent Market Message
(UMM), which can be sent any time day or night. Price manipulation is defined in
Nord Pool rules and prohibited.
Nord Pool also operates a clearing house, which clears both exchange and OTC
transactions and is registered with the Kredittilsynet.
European Energy Exchange (EEX)
The EEX, in Leipzig, Germany, operates a spot market for EUAs, in addition
to a natural gas spot and futures market. Under German law, the exchange maintains
a Market Surveillance Department (HUSt), which is autonomous and independent
of the exchange itself. HUSt reports twice a month to the exchange supervisory
authority, which is part of the Saxon Ministry for Economic Affairs and Labor. The
supervisory authority conducts inspections and issues instructions to the exchange’s
management board, and may order HUSt to conduct investigations. HUSt’s
investigative authority extends beyond members of the exchange to anyone who may
be involved in suspicious circumstances or grievances involving exchange trading
HUSt also reports to the federal Financial Supervisory Authority (BaFin).
Because of the number of international trading participants, HUSt reports
regularly to a range of foreign financial and energy regulators, including the U.S.