Evaluating Limits on Markets for Emissions Allowances

December 13, 2010

Congress recently considered creating a nationwide cap-and-trade program that would limit emissions of greenhouse gases below the levels projected under current law and would allow trading of rights, or allowances, to produce those emissions. The ability to buy and sell allowances would reduce the cost to the economy of meeting the cap by letting market forces determine where, how, and when the associated cuts in emissions would be made. However, in creating allowance markets, policymakers would face important questions about how best to ensure that any instability in those markets did not raise the cost of reducing emissions or spread to the rest of the U.S. economyas happened with instability in mortgage markets during the recent financial crisis. Last Friday, CBO releaseda studyprepared at the request of the Chairman of the Senate Energy and Natural Resources Committeeexamining the likely impact of alternative possible limits on the types of participants and transactions permitted in allowance markets.

Various types of participants would probably be active in those markets, including entities that must comply with the cap on emissions (including oil refiners, natural gas distributers, and large electricity generators that use fossil fuels, for example), other entities that would receive allowances from the government and want to sell them, and numerous banks, investors, and other parties that would buy allowances from, and sell them to, the other two types of participants. Transactions in allowance markets would most likely include allowance derivatives (financial contracts whose value would depend on the future price of allowances).

Although broad participation and derivatives transactions are common in many marketssuch as those for agricultural commodities and energy productssome observers have proposed excluding certain participants or transactions to protect allowance markets and the broader economy from unwanted risks. CBOs analysis finds that less restrictive limits would generally have a greater chance of addressing observers concerns, with fewer negative effects, than outright prohibitions would.

Limiting Participants in Allowance Markets

To reduce worries about systemic risk, price decoupling (when allowance prices differ from the cost of reducing emissions), and manipulation, some observers have proposed limiting participation in allowance markets only to covered entities. Prohibiting other parties from trading in allowance markets would most likely raise costs for covered entities by reducing market liquidity. In addition, a ban on certain participants would be difficult and costly to enforce.

Such a ban would also be unlikely to address concerns about allowance markets effectively. The reason is that the same financial incentives that would motivate non-covered entities to join the marketthe ability to profit from absorbing the risk of price changes or the potential to realize gains from investing in allowanceswould probably cause some covered entities to pursue those same opportunities. But to the extent that those covered entities were less experienced at doing so than the excluded participants, the cost of complying with the program would be higher and market stability could decline.

Alternatively, participation limits that were less stringent and more targeted could address some of the concerns noted above at a lower cost. For example, many markets for agricultural, energy, and financial products have implemented position limits, which restrict the number of contracts a participant can hold, and circuit breakers, which limit the total amount by which prices can rise or fall over a given period. Both types of regulations have the drawback of tending to make prices less informative, but they would impose lower costs on covered entities than a ban on certain participants would.

Limiting Derivatives Transactions in Allowance Markets

Certain types of derivatives played key roles in the recent financial crisis, and their potential complexity and opacity have prompted concerns about the possible effect of such contracts in allowance markets. Some observers have therefore proposed that a potential cap-and-trade program prohibit the trading of allowance derivatives. Not being able to use derivatives contracts, however, would increase covered entities exposure to changing allowance prices, which would raise the costs of complying with the cap-and-trade program. Moreover, like banning certain market participants, prohibiting derivatives would probably not reduce the risk of disruptions in allowance marketsand might even increase that risk.

Other approaches could be more effective than a ban at addressing concerns about derivatives. For instance, increasing reliance on centralized clearing houses (institutions that facilitate the settlement of transactions between two parties) and on exchanges (organized markets, such as the Chicago Mercantile Exchange, where standardized financial transactions take place) would increase transparency and probably reduce systemic risk in allowance markets. The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act includes similar changes to existing financial markets. Although the regulations implementing that law are still being drafted, the laws provisions would probably apply to any allowance markets created as part of a nationwide cap-and-trade program.

This study was prepared by Andrew Stocking of CBOs Microeconomic Studies Division.