CBO Produces New Study on Cap-and-Trade

December 11th, 2010
in Background

The Congressional Budget Office (CBO) has just produced a study for implementing cap-and-trade - a program that would limit emissions of those gases below the levels projected under current law and would allow trading of rights, or allowances, to produce those emissions. In creating markets for allowance trading, 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 spill over to the rest of the U.S. economy (as happened with instability in mortgage markets during the recent financial crisis). Some observers have proposed excluding certain participants or transactions from allowance markets.

Follow up:

This study examines the likely impact of prohibiting allowance trading by entities not directly covered by a cap-and-trade program and of banning the use of allowance derivatives. The report also discusses some alternative restrictions on participation and transactions in allowance markets that could impose lower costs on covered entities while reducing the risk of instability in those markets and in the overall economy.

Following the recent financial crisis, concerns about how financial markets function and what can destabilize them have increased. In a cap-and-trade program to reduce greenhouse gas emissions--such as the programs that have been considered by the Congress--a central feature would be the markets in which emissions allowances would be traded. Thus, issues of key interest to policymakers designing such a program include what kinds of participants and transactions would be permitted in allowance markets.

Under a cap-and-trade program, entities covered by the cap--which could include oil refiners, natural gas distributors, and large electricity generators that use fossil fuels--would be required to hold government-issued allowances that would give them the right to emit a specific amount of greenhouse gases into the atmosphere. Those covered entities would be free to buy and sell allowances, which would give rise to markets to facilitate that trading. Active allowance trading would reduce the total cost of meeting a cap on emissions by helping covered entities manage fluctuations in their need for allowances caused by changes in the production of emissions-intensive goods and services.

At the same time, observers worry that active allowance markets could foster complex or opaque transactions, price bubbles, market manipulation, or other instabilities that could raise the cost of reducing emissions and harm the broader economy. That potential has spurred proposals to prohibit or otherwise limit certain types of market participants or transactions under a cap-and-trade program. This analysis finds that less restrictive limits would generally have a greater chance of addressing observers' concerns, with fewer negative effects, than outright prohibitions would.

Unless regulation prevented it, allowance markets would probably attract many of the same types of traders and transactions as existing markets for agricultural, energy, and financial products. Besides covered entities (and other entities that might receive allowances from the government), traders would include banks, investors, and other parties that would not be subject to a cap on emissions but would facilitate transactions by trading allowances with covered entities. The transactions of those various parties would probably include allowance derivatives--financial contracts that, for example, would guarantee the holder a price for a specific number of allowances at a specified future time. Such traders and transactions are common in existing allowance markets, including the ones created by current cap-and-trade programs for greenhouse gas emissions in the northeastern United States and the European Union.

Some observers, however, are concerned that transactions by traders who are not covered entities (sometimes called "speculators") and derivatives transactions can pose risks to the stability of allowance markets and reduce the cost-effectiveness of a cap-and-trade program. For example, concerns exist that speculative traders and complex or opaque financial transactions can make allowance markets less transparent, cause allowance prices to spike and perhaps differ (become "decoupled") from the cost of reducing emissions, or contribute to market manipulation. Moreover, instability in allowance markets might harm the broader economy. That concern is underscored by the recent collapse of the market for private mortgage-backed securities, which illustrated how disruptions in one market or sector of the economy can spill over into other markets--a phenomenon known as systemic risk.

Limiting Participants in Allowance Markets

To reduce worries about systemic risk, price decoupling, and manipulation, some observers have proposed limiting participation in allowance markets only to covered entities. Prohibiting other parties from trading in allowance markets, however, would most likely raise costs for covered entities by reducing market liquidity (the ease with which firms could buy or sell large quantities of allowances without affecting their current market price). 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 noncovered entities to participate in the market--the ability to profit from absorbing the risk of price changes or the potential to realize gains from investing in allowances--would probably cause some covered entities to pursue those same opportunities. But to the extent that those covered entities were less effective 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. Many of those markets also use "circuit breakers," which limit the total amount by which prices can rise or fall over a given period. Position limits would probably lessen the possibility of systemic risk and manipulation in allowance markets, and circuit breakers would reduce the likelihood that allowance prices would become decoupled from the cost of reducing emissions. 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

Participants in many markets for commodities or financial securities use derivatives extensively to reduce their exposure to changes in prices. However, certain types of derivatives played key roles in the recent financial crisis, and their potential complexity and opacity have prompted concerns that derivatives in allowance markets could also foster systemic risk and decrease transparency.

Some observers have responded to those concerns by proposing 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 markets--and might even increase that risk. In particular, the costs associated with absorbing price uncertainty could encourage firms to seek the benefits of derivatives from other financial transactions that would be harder to regulate or less transparent because they might, for example, occur in markets outside the United States. Consequently, enforcing a ban on derivatives would be difficult and expensive.

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. In addition, raising transaction fees on trades that occurred "over the counter" rather than through a clearing house or exchange would create an incentive to move trading to those more transparent settings. And if set correctly, the fees would also cover the cost of the risks posed by transactions that were not suited to clearing houses or exchanges. Such changes would address concerns about systemic risk and lack of transparency while continuing to allow covered entities to use derivatives to reduce their costs of complying with a cap-and-trade program.

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) includes similar changes to existing financial markets. The law requires the federal agency that regulates derivatives transactions in commodity markets to set position limits for exchange-traded derivatives on all energy, metal, agricultural, and other physical commodities. It also expands the use of clearing houses and exchanges and increases regulation of over-the-counter derivatives. Although the regulations implementing the Dodd-Frank law are still being drafted, the law's provisions would probably apply to any allowance markets created as part of a nationwide cap-and-trade program for greenhouse gas emissions.

source: CBO paper

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