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How Carbon Markets Work in the Northeastern US
Eric De Place, 13 Nov 09

With all the hand-wringing over the alleged risk of market manipulation in cap and trade, you'd almost forget that the United States already has a carbon cap and trade program up and running. But it does.

RGGI, a regional program among 10 Northeast states, has been auctioning permits, allowing trading on a secondary market, and even, in a way, encouraging trading in derivatives. And guess what's happened so far?

...we find no evidence of anticompetitive conduct. Participation by a large number of firms is an encouraging sign of competitiveness and efficiency in the secondary market.

That's according to a May 2009 report (pdf) by Potomac Economics, the designated market monitor tasked with keeping a close eye on RGGI's market function. It's the most recent analysis available and it's an encouraging sign. But really, it's no accident that RGGI has been successful so far. Administrators have prized transparency, regulation, and oversight in ways that can usefully inform federal cap-and-trade legislation. 

I draw three major lessons from the report.

1. Keep trading transparent. Ownership of RGGI permits are are registered in a public tracking system. Futures and options are exchange-traded on the Chicago Climate Futures Exchange and the Green Exchange. Smart, because:

Public exchanges are attractive to firms that need a simple way to trade standard products. Moreover, public exchanges effectively eliminate the risk of default by counter-parties, since the exchange constantly monitors the account holdings of each participant to ensure that they have posted sufficient financial security to meet their obligations.

RGGI does allow over-the-counter (OTC) trades (trades between two private parties) for futures, options, and other derivative products. While OTC markets do provide some benefits for certain firms, they are murkier than public exchanges. And even the public exchanges may not require all the details that are important to understanding a transaction. (Potomac identified one instance in which a small quantity of allowances was traded at a price that seems too high -- and though there are a number of perfectly reasonable explanations for the trade, the exchanges did not require sufficient information from the trading parties to allow the market monitor to draw conclusions.)

2. Keep a level playing field. RGGI publicly announces the "clearing price" of its auction a pre-specified time so that all participants have access to the same information and the same time. Similarly, the US Commodity Futures Trading Commission publishes a weekly report documenting the positions, both long and short, of firms trading futures and options on the commodity exchanges. Once again, market participants operate with shared information, which curbs manipulation.

3. Keep an eye on the ball. Frequent analytical reports, like this one from Potomac, are key to ensuring that the carbon markets are well-functioning and fair. Good market monitoring can enable government regulators and administrators to act in a timely fashion if something goes awry. And they can fine-tune their policies and procedures based on good information.

They also allow the public to breath easier given all the recent nervousness about derivatives. And derivatives and secondary markets are important, as the report notes, for at least three reasons:

First, it gives firms an ability to obtain allowances at any time during the three months between the RGGI auctions. Second, it provides firms a way to protect themselves against the potential volatility of future auction clearing prices. Third, it provides price signals that assist firms in making investment decisions in markets affected by the cost of RGGI compliance.

This may all sound dull, but it's serious stuff. Well-functioning secondary markets keep costs low they help firms to take a carefully planned, financially prudent path to reducing their emissions. All of which is excellent for the public -- and excellent for the planet.

You know what they say in the financial world: "past performance is no guarantee of future results." But that doesn't mean we can't learn lessons from past performance. One lesson RGGI teaches, I think, is that it's perfectly possible to run a well-functioning carbon cap and trade market. The challenge now is doing it on a bigger canvas.

This piece originally appeared on the Sightline Institute's blog, The Daily Score
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