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Tuesday, March 16, 2010

Regulating a Carbon Market: Issues Raised By the European Carbon and U.S. Sulfur Dioxide Allowance Markets

Mark Jickling
Specialist in Financial Economics

Larry Parker
Specialist in Energy and Environmental Policy

Both the European Union's Emissions Trading Scheme (EU-ETS) and the U.S. Title IV sulfur dioxide (SO2) program provide insights into regulatory issues that may face any future U.S. carbon market. From the initial operations of the EU-ETS, the 2006 price crash raised questions about the adequacy of market regulation. In particular, some suspect that information about allocations leaked before official publication, and that certain traders profited from this knowledge. 

Title IV's longer trading history reveals two important trends: (1) an increasing trend toward diverse and non-traditional participants that is likely to continue under a carbon market; (2), an increasing use of financial instruments to manage allowance price risk that is likely to expand under a carbon market as a hedge against price uncertainty. Indeed, a carbon market may look more like other energy markets, such as natural gas and oil, than the somewhat sedate SO2 allowance market. 

Regulation of emissions trading would have to consider two kinds of fraud and manipulation: fraud by traders or intermediaries against other investors, and sustained price manipulation. Four agencies could have roles in the regulation of an emissions market, each with its own attributes that may contribute to effective regulation. 

The Commodities Futures Trading Commission (CFTC) currently oversees the Title IV program and its mission most closely resembles what a regulator of a future carbon market would do, including market surveillance to prevent or detect fraud and manipulation. The major weakness of the CFTC, according to some, is that it lacks resources and the statutory mandate to do its job. Current derivatives reform proposals would greatly enlarge its regulatory scope. 

The Securities and Exchange Commission (SEC) is much larger than the CFTC, but it also faces resource and capability issues. While the CO2 market will resemble commodities markets more closely than securities, SEC has some appropriate regulatory tools applicable to an emissions market. 

The Environmental Protection Agency (EPA) would likely be responsible for the primary market in allowances. However, EPA lacks experience comparable to that of the CFTC and SEC in regulating trading markets, although the data it gathered in the primary market could be critical to oversight of the secondary market. 

Federal Energy Regulatory Commission (FERC) was granted oversight authority over bulk electricity and interstate natural gas markets in 2005. Its experience with market surveillance and enforcement is thus limited in comparison to the SEC and CFTC, and it does not play an active role in overseeing the Title IV market. 

It is possible that no single regulator would have clear jurisdiction, as is the case in the Title IV program. This kind of regulatory fragmentation has not always worked well. An umbrella group to monitor markets and provide a forum for regulatory coordination might help to prevent regulatory gaps or conflicts in the market. 

Date of Report: February 26, 2010
Number of Pages: 40
Order Number: RL34488
Price: $29.95

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