Futures Industry - Carbon trading in the U.S. is a lot closer than many realize. Both presidential candidates agree that an emission trading system, also known as cap-and-trade, would be the best way to reduce America’s greenhouse gas emissions. So no matter who wins the election this fall, the next administration can be expected to propose the creation of a system for trading carbon emission allowances. The resulting U.S. carbon market could be up and running by as early as 2012, and annual turnover could be worth between $40 billion and $150 billion in the first year of the program.
As a comparison, the largest existing greenhouse gas market, the European Union Emission Trading System, exchanged 28 billion euros ($38 billion) worth of allowances in 2007, and so far this year the turnover has been almost twice as large. Although only 28% of the volume is traded on exchanges, this proportion has been rising as the market has matured. Additional volume also comes to the exchanges via the clearing of contracts traded over-the-counter.
Because carbon markets are a direct result of political decisions, a thorough understanding of current and potential climate change policies is crucial to seizing upcoming carbon trading opportunities in the U.S. This article summarizes the main policy trends, discusses the likely features of an emissions trading framework and highlights the potential problems and obstacles.
Existing Carbon Markets
Although a national market is still several years off, there are already several initiatives at the regional level that are at a more advanced stage of development. In fact, the Regional Greenhouse Gas Initiative (RGGI), a carbon market created by 10 northeastern and mid-atlantic states is due to start in January 2009. Under RGGI, all the New England states and New York, New Jersey, Delaware and Maryland have agreed to curb emissions from the power sector. Utilities’ emissions will be capped starting January 2009, and power companies will have to bring their carbon dioxide output down to the mandated limit by reducing their own emissions, purchasing emission allowances from other players, and buying carbon offsets, which are credits issued by projects that reduce or sequester greenhouse gases.
The first transactions in RGGI have already started taking place. A total volume of close to 150,000 short tons of CO2 (roughly 135,000 metric tons) has been traded already. The price of these allowances averages about $8.09 per short ton, which would equal roughly $7.34 if measured in metric tons. The largest transaction, 50,000 short tons, involved a "compliance player," namely a power company that will need to procure allowances, while the other transactions were small volume deals between traders and boutique investors looking to establish a presence in the market. Most transactions were futures trades, with only one option trade reported so far. As allowances have not been issued yet, there is no spot market. The first batch of allowances will be issued by participating states and auctioned on Sept. 25.
Besides this burgeoning mandatory carbonmarket, the U.S. is also seeing growth in voluntary carbon trading, as companies and individuals seek to offset their greenhouse gas footprint by purchasing emission reduction credits. Increasingly, corporate entities participate in this voluntary GHG market as "pre-compliance" buyers, hoping that their efforts to reduce emissions now will be recognized and receive some form of "early action" credit under a future mandatory program. The market is almost exclusively a spot market dominated by over-the-counter transactions, and was worth an estimated $400 million in 2007.
The U.S. voluntary market also includes a unique institution, the Chicago Climate Exchange. The CCX offers companies an opportunity to formalize a commitment to reducing GHG emissions and provides a platform for trading credits. Companies that fail to cut emissions beyond their target of 1% a year can buy offsets on the exchange, which also accredits offset projects via third party verifiers. By offering a standardized contract for offsets and emission reductions, the Carbon Financial Instrument, the CCX has become one of themain trading places for offsets. The CCX also launched in January 2007 a derivatives platform for "climate futures," including CFI futures that had traded over 10.5 million tons by the end of May 2008.
Lastly, trading of global carbon commodities has started on selected U.S. exchanges. Notably, the Green Exchange, founded by the New York Mercantile Exchange in partnership with large financial players and energy traders, offers contracts for existing carbon commodities and will start offering a standard RGGI contract in the fall. Similarly, the holding company for the CCX and its London-based affiliate, the European Climate Exchange, has announced plans to offer standard contracts for carbon commodities under upcoming U.S. cap-and-trade programs.
Both RGGI and the voluntary markets, however, remain relatively small compared to the potential size of a federal program.
The Path Towards a Federal Carbon Market
While the current administration opposes binding carbon reduction targets and cap-and-trade in particular, policymakers in Congress have tried to pass legislation laying the foundations for a federal GHG reduction program involving cap-and-trade.
The American Climate Security Act (S.2191), also known as the Lieberman- Warner bill, was the most developed attempt so far. Introduced by Senators Joe Lieberman (I-Conn.) and John Warner (RVa.) in October 2007, the bill proposed to establish an economy-wide cap-and-trade program starting in 2012. The bill passed out of the Senate’s Environment and Public Works Committee in December 2007, and was debated on the Senate floor in early June. The bill needed to obtain 60 votes to overcome a filibuster but fell short by 12 votes. Thus a short majority voted to close the debate, pushing back climate legislation to the next Congress.
Several other climate change bills have been introduced in the Senate and the House, with various emission reduction targets and design features. However, the Lieberman-Warner bill is the most interesting to study as it is generally seen as the product of a compromise between various stakeholders and among the other climate bills.
Lieberman-Warner proposed setting a cap on greenhouse gas emissions at 2005 levels, with the cap starting in 2012 and then ratcheted down by 2% every subsequent year until 2050. It had a large scope, covering close to 80% of the nation’s GHG emissions andmost industrial sectors. The bill proposed allocating 40% of allowances in the early years of the program, while the percentage of allowances auctioned or used as a subsidy was to increase to 100 by 2030. These provisions, while still contested by some stakeholders, appear to be gaining support in Congress.
Looking toward a follow-up bill in 2009, one could expect a large coverage in terms of industrial sectors and at least half the allowances auctioned, with the auction share to increase in subsequent years. If the supply of allowances in 2012 is set at 5.775 billion tons, as in the Lieberman-Warner bill, and if at least 60% of these are traded or purchased through an auction, this would create a market of close to 3.5 billion tons in volume. The remaining 40% is less likely to be traded because it would be given directly to regulated companies, who need it for compliance and therefore would hold on to them.
Under the Lieberman-Warner bill, offset credits, such as credits from land-fill methane capture or forestry projects, would be allowed up to 30% of an entity’s compliance requirement. Half of the credits would have to come from domestic sources and another half could potentially be sourced from other countries. In addition, U.S. emitters would be allowed to buy UN-sanctioned international offset credits used by parties to the Kyoto protocol to meet up to 5% of their compliance obligations. Allowing these Certified Emission Reductions (CERs) into the system, as well as allowances from other emission trading schemes such as the EU ETS, would create a de-facto link to the global carbon market. This would broaden significantly the potential market, while potentially dampening slightly the impact of local fundamentals in favor of more complex global dynamics. Again, these bill provisions are not set in stone but had reached a certain level of consensus in the Senate.
This article was first published in Futures Industry, the bimonthly magazine published by the Futures Industry Association (www.futuresindustry.org). |
