This paper is part of a series of studies on the policy design issues for cap-and-trade. As part of the Energy Security Initiative Policy Brief Series, this paper focuses on the carbon derivatives market.
The original concept of cap-and-trade envisioned
that the total amount of carbon dioxide
(CO2) emissions would be capped and rights
to emit would be traded. But it is inevitable that
there will be demand to trade instruments other
than emissions rights themselves. Specifically,
there will be a demand to trade derivatives on
This has raised alarms in Congress, particularly in the aftermath of the energy price spike of 2008 and the financial crisis of 2008-2009. Numerous voices inside Congress as well as outside have laid the blame for these episodes squarely on derivatives markets. As a result, the current regulatory environment is extraordinarily hostile to derivatives generally, and to carbon derivatives particularly. Indeed, several proposals have been introduced to constrain or eliminate various types of derivatives trading, including proposals to:
- Impose limits (e.g., speculative limits) on the uses of these products, or on the amount of trading certain kinds of entities can undertake;
- Restrict where and how derivatives are traded, with a decided preference for trading on organized exchanges;
- Constrain arrangements for the allocation of performance risk, with a decided preference for “clearing” derivatives transactions through central counterparties (“CCPs”);
- Ban certain derivatives altogether.
The American Clean Energy and Securities Act (ACESA), passed by the US House of Representatives in June, includes provisions mandating many of these restrictions.
All of these proposals are misguided, some extremely so. They are predicated on a widespread misunderstanding of what derivatives are, how they work, and the reasons that firms trade them. These are, no doubt, provocative statements. In this chapter I will support them by going back to basics, describing what derivatives are, why they are used, how they are traded, the abuses they are subject to, and the most efficient ways to constrain those abuses.
This chapter is organized as follows: Section 2 gives an overview of what derivatives are and how they are traded. Section 3 discusses derivatives markets abuses, such as manipulation and excessive speculation, and Section 4 evaluates the potential vulnerability of carbon markets to these abuses. Section 5 summarizes the ACESA provisions related to derivatives, and Section 6 evaluates the desirability of these provisions. Section 7 provides a brief summary.
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