Carbon Market Design and Oversight: A Short Overview

February 17, 2010

Download the full brief (pdf)

At the heart of any successful cap-and-trade program is a well-functioning market for the trading of
emissions allowances. The sulfur dioxide allowance market created under 1990 Clean Air Act
Amendments to control acid rain is an example of such a success. At the same time, several recent highprofile
market crises, such as the 2008 petroleum price spike, the crash of subprime mortgage and credit
default swap (CDS) markets, the Lehman bankruptcy, and the Madoff Ponzi scheme have led many to
question market mechanisms.

Yet, these events should not be viewed as indictments of markets in general, as our entire economy is in
fact a market-based system. Rather, they serve to 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. This presents the opportunity to get the system right from the
outset.

Oversight is critical because a carbon market will be intimately connected to other energy markets,
including natural gas, coal, petroleum, and electricity. Because of these links, the potential exists for
manipulation of one or more of these markets to result in pricing issues in the others. Furthermore,
while a carbon market has many characteristics of a traditional commodity market, it also differs in two
important aspects:

  • First, the carbon market exists specifically to address an environmental goal—to reduce greenhouse gas (GHG) emissions—and regulated entities will have no choice but to participate.
  • Second, there is a limited supply of emissions allowances, determined by the government, which
    will decrease over time.

So in essence, both demand and supply are created by the government. To address these realities,
lawmakers should build upon best practices and lessons from a number of existing markets to create the
optimal design and oversight mechanisms to ensure a viable, transparent, and robust carbon market.

Click here for a related article that appeared in Point Carbon News.

Click here for the press release.