March 5, 2010
By Janet Peace and Timothy Juliani
This article originally appeared in Point Carbon News.
At the heart of any successful cap-and-trade program is a well-functioning market for the trading of emissions allowances. At the same time, the recent high-profile market scandals and crises have led many to question market mechanisms in general. Rather than leading to a wholesale indictment of markets, these events should instead highlight the critical need for appropriate market design, transparency and oversight. Luckily, Congress has the opportunity to design the carbon trading market oversight framework at a point in time before long-standing carbon trading practices and systems have been fully established.
A well-designed carbon market should reflect a balance between free market activity and regulation. To the extent that the market cannot be manipulated or distorted, it can achieve its purpose—to spur innovation and reduce GHG emissions at the least possible cost to the economy. Policies should include effective means to prevent excessively high prices, extreme price volatility, and irresponsible risk-taking. Thousands of businesses would be affected by a mandatory GHG emissions trading system, and it is in the public interest to ensure the market functions efficiently and allowance prices generally reflect the balance of supply and demand.
The challenge faced by lawmakers and regulators is to create conditions that provide effective transparency and oversight while allowing market participants to structure contracts that best fit their specific circumstances. A central question in this regard is whether carbon market transactions should be allowed to take place in the over-the-counter (OTC) market as well as on exchanges. While exchange-based trading allows more transparency and possibly more direct access for market regulators, many argue that OTC trading should also play a key role in a carbon market.
Both exchange-based and OTC trading have their strengths and weaknesses. Trading on exchanges provides transparency, ease of oversight, the virtual absence of counterparty risk, and market liquidity. Excessive speculation can be curbed to some degree through position limits, while daily cash settlement and clearing services lower the risk of default and limit the potential for negative ripple effects if default occurs.
While exchanges are not a panacea and do not ensure the absence of excessive speculation or market manipulation, they do provide a fair trading platform for market participants and regulators alike to see and access prices for carbon commodities. The centralized, standardized, digitized, and rules-based nature of exchange-based trading lends itself to efficient and effective oversight, provided that exchanges are required to take preventive measures and regulators are authorized to protect markets from abuse. The high level of transparency associated with exchange-based trading facilitates regulatory market surveillance as well as price discovery and competitiveness.
On the other hand, exchanges only offer standardized contracts, and have significant collateral requirements, which can make it more difficult for some important market participants, such as utilities, to participate. OTC transactions provide greater flexibility than those on an exchange, as contracts can be customized more precisely to a company’s particular risk management needs, and a wider array of assets can be used as collateral for transactions. This can be particularly helpful both to smaller participants and to utilities, which may look to minimize their carbon risk over a period of decades while maintaining significant cash resources for infrastructure investments. Offset contracts provide another example of the need for customization, as the volume and timing of future credits can be uncertain due to factors such as project approval, verification, and performance. A non-standard OTC contract might be necessary in such cases.
There is no question that a market approach provides the clearest and lowest-cost incentive to reduce GHG emissions and invest in new technologies. In developing the most effective carbon market, lawmakers and regulators have several options for improving oversight of exchange-based and OTC trading. They include the imposition of position limits, clearing and collateral requirements, reporting obligations, and restrictions on participation in certain types of transactions. While OTC markets are more challenging to regulate by virtue of their decentralization and traditional lack of transparency, nothing technically prevents regulators from establishing the types of requirements above for OTC trades as well as those on exchanges.
In the end, both OTC and exchange-based systems can have roles to play in a federal carbon market, and it may be possible to maintain a role for OTC transactions while ensuring an appropriate level of regulatory oversight and efficient market operation. The challenge faced by lawmakers and regulators is to strike the right balance between market transparency and oversight, and the ability of market participants to structure contracts that best fit their specific circumstances.
An expanded discussion of this topic can be found in the new Pew Center brief, “Carbon Market Design and Oversight: A Brief Overview.”
Janet Peace is Vice President for Markets and Business Strategy at the Pew Center on Global Climate Change.
Timothy Juliani is the Pew Center's Director of Corporate Engagement.
By Truman Semans, Director for Markets and Business Strategy, Tim Juliani and Andre de Fontaine, Markets and Business Strategy Fellows
Recent months have seen an explosion of activity on climate change, to the point where it is now almost impossible to pick up a newspaper without reading about a major new climate-related initiative from the business or policymaking community. This is not surprising, as it is clear that climate change will have economy-wide impacts, and create regulatory, physical, and reputational risks for a wide range of companies.
Manufacturing is not immune from these effects, for as a sector it represents nearly one-fifth (19 percent) of domestic direct emissions, and it is indirectly responsible for an additional 11 percent of emissions through electricity use. Furthermore, for powered manufactured goods such as appliances, electronics and autos, up to 90+ percent of emissions are created from product use, not their manufacture. Considering this greenhouse gas footprint, it is clear that manufacturing will be significantly impacted by any future climate change regulatory regime, and must now, as a sector, begin to confront the risks and opportunities that climate change presents. This includes awareness of and engagement in the national policy debate, as well as examining how climate can be factored into core business strategies.
Although a handful of scientists on the fringe continue to garner press attention with their contrarian views, the overwhelming majority of the scientific community believes that the warming in the atmosphere is unequivocal, and that the warming is human-induced. The latest report of the Intergovernmental Panel on Climate Change (IPCC) – a group of 2,500 climate scientists from across the globe that evaluate the peer-reviewed research on this issue – asserts that there is a greater than 90 percent certainty that most of the warming over the past century is human induced, and that a range of impacts are already being observed.
As the science has strengthened over the last decade, momentum has grown at the local, state and federal level to enact policies that reduce GHG emissions. Today, nearly all 50 states have enacted some form of climate-related standard, while the past several years have seen a steady increase in the level of Congressional attention to climate change.
A carbon-constrained future is imminent, a fact that many businesses now realize. In a survey of large corporations conducted during the development of the Pew Center’s 2006 report, Getting Ahead of the Curve: Corporate Strategies That Address Climate Change, 67 percent of businesses said they expect greenhouse gas regulations to take effect between 2010 and 2015.
A further 17 percent expect this before 2010. This implies climate legislation will pass Congress even sooner. The question now is not whether legislation will pass, but about its timing and the form it will take. Companies that prepare for this future will be the winners, while the rest will be left playing catch up.
Action on emissions
Manufacturing operations that are most likely to be affected by climate change regulations are those that result in significant direct greenhouse gas emissions (GHG), such as cement, iron and steel production, as well as those that are highly energy intensive, such as paper and chemicals operations. Climate change rules are likely to result in upward pressure on energy prices, which means that operational efficiency improvements will have greater benefit than in the past as a basis for advantage. Companies such as DuPont, which figures it has saved over $3 billion from efficiency since 1990, demonstrate the financial benefits embedded in these efforts. Manufacturers that produce highly efficient consumer products will also gain a competitive advantage over producers of similar, but more energy intensive goods and services.
Driven at least partly from a desire to influence the policy debate, a growing number of leading companies across many industries are now openly calling for national GHG limits. One of the most significant recent developments was the formation earlier this year of the U.S. Climate Action Partnership (USCAP). This coalition is an unprecedented collaboration of 23 major corporations and six leading nongovernmental organizations that is calling on Congress to enact mandatory, economy-wide climate protection legislation at the earliest date possible. Specifically, the group recommends Congress establish an emissions reduction pathway with short and mid-term targets equivalent to: between 100-105 percent of today’s levels within five years of rapid enactment; between 90-100 percent of today’s levels within 10 years; and between 70-90 percent of today’s levels within 15 years. Additionally, USCAP recommends a long-term reduction target of 60-80 percent below current levels by 2050.
USCAP believes a cap-and-trade system should be the cornerstone policy to meet these targets, but that additional policies should also be pursued in sectors such as transportation and buildings, in which the initial price signal from cap-and-trade will not be sufficient to reduce emissions and advance new technologies. The coalition also recommends that a federal technology research program be established that provides stable, long-term financing for low-GHG technologies. Additionally, Congress should urge the administration to engage in international negotiations with the aim of establishing emission reduction commitments by all major emitting countries.
The companies involved in USCAP, which include major manufacturers such as Alcoa, Caterpillar, Dow, DuPont, GE, John Deere, Johnson and Johnson – and the big three U.S. automakers – have chosen to become closely involved in the policymaking process because they realize, as the popular saying goes, “If you’re not at the table, you’re on the menu.” Yet, to earn a credible seat at the policymaking table, many companies have found they need to demonstrate their own commitment through meeting their own voluntary emission reduction goals. According to the Pew Center’s research, companies that have taken these steps report financial benefits from a range of climate-related programs, including energy efficiency improvements, process changes, fuel switching, and customer relations (see chart).
The Pew Center’s research found that the ultimate achievement related to climate is a game-changing strategy that allows a company to jump ahead of competitors by creating new markets or reshaping the rules of existing markets in their favor – for climate this means reshaping policy. And such strategies are beginning to emerge. GE and BP are working together to develop up to 15 clean-burning fossil-fuel based power plants that will separate and burn hydrogen while capturing and piping the resulting carbon dioxide into either deep geologic formations or existing oil wells to boost petroleum production. At the same time, BP is also partnering with DuPont to produce biobutanol, a biologically-derived, lower carbon transportation fuel that could replace ethanol for a wide-range of applications in the economy for significant market segments.
The consequences of climate change policy will be most severe for those who do nothing to prepare for it today. By engaging in the policy debate now, firms will help shape the carbon-constrained future in which they will operate. And while there is undoubtedly risk from climate regulation, there is also a great opportunity for the U.S. manufacturing sector to lead the world in producing new climate-friendly products and technologies, thereby helping not only the climate, but also the top and bottom lines.
Truman Semans is the Director for Markets and Business Strategy at the Pew Center on Global Climate Change. He manages the Center's Business Environmental Leadership Council (BELC), a group of 43 largely Fortune 500 corporations working with the Pew Center to address issues related to climate change, and directs Pew research on business and climate. He has consulted with McKinsey & Co. and served as the U.S. Treasury Department’s International Economist on global environment and natural resources.
Timothy Juliani and Andre de Fontaine are Markets and Business Strategy Fellows at the Pew Center on Global Climate Change. They work with the Center's BELC and engage in Pew Center analytic work on climate-related markets and investment issues.