Who Will Mind the Carbon Store?

More attention will be focused on climate change this week as the U.S. Senate Environment & Public Works Committee unveils its highly anticipated climate change bill. Senator Barbara Boxer (D-California) is expected to officially present her plan(.pdf) and start what many hope will be a strong push to finalize a greenhouse-gas (GHG) regulatory framework before the Climate Summit in Copenhagen this winter.

The Boxer Plan, like its House counterpart, (.pdf) adopts what is called a cap-and-trade system for regulating GHG. A cap part of the system sets an overall “cap” on greenhouse-gas emissions by limiting the amount of GHG that can be emitted in a given year. The trade part of the regulation then allocates “carbon credits” to polluters equal to the amount of pollution they set in the cap. The credits are like permits to pollute, and allow companies to emit one unit of GHG for every credit they have. Companies can use the credits to emit GHG or they can reduce their emissions and sell any remaining credits to other companies. The trade feature of the system promotes the most cost effective reduction of emissions by incentivizing companies who can reduce emissions at a cost less than the price of buying credits to do so and profit by selling their unused credits to others.

"Do we want to repeat the adverse impacts of excessive speculation in the crude oil market last year for carbon?"

The easiest way to sell unused carbon credits would be in a market like the Chicago Commodity Exchange. The commodities market allows all types of commodities such as corn, wheat, and oil to be bought and sold. Anyone can buy commodities; accordingly this open access creates opportunities for speculation. When speculators think that the future price of a product will increase over time they will buy up the product so that they can sell it at that higher price. When speculators buy a commodity, less of the commodity is then available to be sold on the market; as a result, the price of the commodity increases. Speculators typically only buy commodities so that they can then sell them at a higher price in the future. Logically speculators run into conflicts with companies that use commodities because they have to pay higher prices to buy commodities from speculators than they would if speculators were not artificially inflating the price by buying it up. The high price of gas in 2007 and 2008 is used as an example of when a commodity’s price increased due to speculation rather than actual scarcity of the commodity.

The speculation problem is one of the major concerns among Congressmen in the debate on cap-and-trade regulation. In particular, one of the most important questions is who will regulate the market. In one of the most recent hearings on cap-and-trade Gary Gensler, Chairman of the Commodity Futures Trading Commission, made a pitch to the Senate Agriculture Committee to allow his commission to be in charge of regulation. This request has some wondering if the Commission is up to the task because the Commission was in charge of regulating speculation when the oil prices that were mentioned above spiked due speculation. Senator Tom Harkin asked bluntly, “Do we want to repeat the adverse impacts of excessive speculation in the crude oil market last year for carbon? Do we want to replicate the allowances and offsets, the freewheeling derivatives market that helped bring down the economy?”

In his pitch Gensler suggested that the negative side effects that the Senator mentions were due to excess speculation and that “derivatives contracts should be carefully regulated along the lines of a proposal the Obama administration already has sent to Congress as guidance for the financial services reform bill that lawmakers hope to take up later this year.” He also suggested that over-the-counter products should be limited and that most of the trading should be done on the exchange so that they could be monitored. The Chairman also added that the Commission already had experience with regulating carbon because of its work with the Chicago Climate Exchange. Currently, the Commission is classifying “the Carbon Financial Instrument contract traded on the Chicago Climate Exchange as a significant price discovery contract.”

The Commission has the most experience of any of the current federal regulators in the commodities field, and has already been selected by the House to regulate the market. The bigger question that will determine whether the Commission is successful in regulating the market is whether the reforms in the financial services reform bill are adopted. The Commission will only be as effective as the regulations that empower it to act. If financial reforms are not adopted the carbon market could become as susceptible to speculation as other commodity markets. If there is uncertainty as to whether the Commission will be able to control speculation one of the best solutions would be to limit who can purchase the credits. Only allow those who are issued credits by the government to buy and sell on the market, and set an expiration date on the credits so that there is an incentive to sell them rather than hold on to them for long-term gain.

Regardless of who regulates, the most important question is how much power will they have to regulate. In order to prevent speculation, Congress will have to complete the reforms proposals they have started to ensure that appropriate oversight is present in the carbon market.