Carbon Trading: Current Situation and Oversight Considerations for Policymakers
Highlights
This letter is our response to a congressional request concerning carbon trading in the United States and various design and implementation issues to be considered in discussions about a possible national carbon trading program. Industrial activities in the United States emit significant amounts of carbon dioxide and other greenhouse gases each year, substantially affecting the earth's climate, according to the National Academy of Sciences. In an effort to reduce these emissions, some have suggested capping emissions and allowing them to be traded in secondary markets just as other commodities are traded. We briefed congressional committee staff on the results of our work on July 23, 2010. Specifically, we provided information on (1) carbon-related products currently traded in the United States and the extent of trading; (2) risks and challenges posed by these products; (3) the extent to which and how these products are regulated; and (4) issues that market observers identified for policymaker consideration as part of creating a national cap-and-trade carbon market.
Recommendations
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Commodity Futures Trading Commission | The Chairman of the CFTC should ensure that the interagency working group created by the Dodd-Frank Act explores (1) how the design of any primary carbon market could affect the liquidity of any secondary market trading; (2) the structure of the secondary market, including the role OTC markets may play in carbon trading; and (3) the resources federal regulators may need to effectively oversee domestic carbon markets. | On January 18, 2011, the Interagency Working Group for the Study on Oversight of Carbon Markets, which was created under the Dodd-Frank Act, issued its report on how carbon product markets should be structured and overseen. The interagency group's report identifies features of the primary market that could increase liquidity and market quality, including noting that some or all of the allowances associated with a given year's emission limit could be introduced years in advance. The report also states that transparency of information is needed to allow participants to assess current and future supply and demand conditions for allowances and offsets. Our report noted that whether to allow... allowance banking was one aspect of the primary market that could affect secondary market liquidity. The interagency group's report notes that permitting the banking of allowances will lead to closer linkages between allowance prices in the secondary market and the prices of certain allowance derivatives. Banking was also seen as helping to mitigate price volatility by providing an inventory of allowances that can be drawn on in response to unanticipated price shocks. Regarding the secondary markets and the role of over-the-counter (OTC) markets, the interagency group's report notes that a main benefit of OTC markets is that they allow market participants to engage in transactions of customized derivative contracts that facilitate the hedging of or gaining exposure to market factors, or to otherwise meet their unique risk-management needs. In addition, the report notes that the ability to engage in OTC trading can be particularly important in the early years of a market because OTC trading permits new transaction types to emerge, which, over time, may become sufficiently standardized and commonplace to sustain migration to an organized exchange markets. The interagency group's report cautions that OTC derivative markets to date have tend to be less transparent and lack centralized aggregation of information prices, trades and positions. However, the report notes that changes brought by the Dodd-Frank Act will alleviate many of these concerns by requiring the public reporting of certain details of all swaps and security-based swaps. Finally, regarding resources for regulatory oversight, the interagency group's report notes that regulators often have employed self-regulation by the industry to serve as the first line of oversight of activity in the market with the exchanges expected to have certain rules to govern activity in the market, ensure that those rules are being enforced and to maintain adequate resources and staff to oversee the activity on their markets. In a recent Congressional testimony, the CFTC Chairman did not specifically address carbon products, but noted that his agency's current funding is already far less than what is required to properly fulfill the significantly expanded mission given to it by the Dodd-Frank Act.
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