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Senators call for financial reform before cap and trade

If supporters of creating a cap-and-trade program to address global warming want to grab the attention of skeptics on Capitol Hill, they might start by convincing the nation's most famous financier, Warren Buffett.

"We have to work it out so that Warren Buffett understands why he's better off under a trading system than he is under a command-and-control system," said Bill Tyndall, Duke Energy Corp.'s senior vice president for policy.

Buffett's long-standing concerns about unrestricted financial derivatives markets have been absorbed by key senators, who continue to harbor doubts about a market-based system for reducing greenhouse gases as they consider federal climate legislation.

David Sokol, chairman of the Midwestern utility MidAmerican Energy Holdings Co., which is owned by Buffett's investment group Berkshire Hathaway Inc., has been an outspoken critic of using a cap-and-trade program to reduce heat-trapping carbon dioxide emissions. Sokol echoes Buffett's concerns about risks associated with financial derivatives, which helped trigger last year's economic collapse. This week, Buffett paid $26 billion for Burlington Northern Santa Fe Corp., lending support not only to the railroad industry but also to the high-carbon coal industry that relies on railroads.

But now, Buffett's critique of financial trading -- and, through Sokol, a future market for carbon derivatives -- is causing cap-and-trade proponents heartache as regulatory reforms that could address some of those concerns have been stalled for months on Capitol Hill.

Sen. Blanche Lincoln (D-Ark.), chairwoman of the Senate Agriculture Committee, has said Congress will probably have to pass financial reforms that regulate the $300 trillion over-the-counter derivatives market before passing carbon cap-and-trade legislation.

Over-the-counter derivatives are unregulated, privately traded financial contracts used for hedging commodity prices and speculating on price changes. The House-passed climate bill and the pending Senate cap-and-trade bill from Sens. John Kerry (D-Mass.) and Barbara Boxer (D-Calif.) envision the trading of carbon allowance and offset contracts as exchange-traded deals and over-the-counter derivatives contracts.

'Deep suspicion' about cap-and-trade regime

"We are now well past a year since the calamities that we saw in our economy, and we still have yet to put in the needed reforms that need to be there," Lincoln said yesterday. "So the financial regulatory reform bill is definitely one where we are working in tandem with Chairman Dodd to really put together our portion of that, so that when he's ready to go, we can merge those two."

Sen. Christopher Dodd (D-Conn.), chairman of the Banking Committee, next week plans to unveil the Democrats' plan for overhauling financial regulations. Increased regulation of over-the-counter derivatives proposed by the Obama administration is expected to be either included in that package or rolled into the proposal after going through Lincoln's Agriculture Committee. Her committee, which she took over in September, has yet to schedule a markup or additional hearings on derivatives regulation.

The House Financial Services Committee has already passed sweeping financial reforms, but the Senate is expected to be more difficult. Republicans have not yet offered their support for Dodd's proposal.

Lincoln is among the chief Democratic swing votes. She also has said she is concerned about viewing cap and trade as the only means to reducing U.S. carbon emissions.

Republican leaders, including Sen. Lisa Murkowski (R-Alaska), ranking member of the Energy and Natural Resources Committee, also said financial reform will probably need to come first to get Republican support.

"You're essentially setting up a brand-new currency here," she said yesterday. "The American public is more than just a little suspicious about what goes on in the trading world. It's not clear and not transparent, and nothing I've seen allows it to be so. There's a deep suspicion about setting up such a regime."

Paul Bledsoe, communications and strategy director for the National Commission on Energy Policy, a bipartisan policy group that supports using cap and trade, said financial reforms will have to precede the climate bill.

"Market-based programs were a positive, vote-attracting statement until about 14 months ago," he said.

Major Wall Street firms and utilities are pressing Congress to act, before U.S. EPA does, to put a cap-and-trade program in place that creates certainty about future climate regulations. They argue that environmental markets work, and there's enough proof in the pudding in the existing U.S. cap-and-trade program to reduce acid rain pollutants and in Europe, which is a year into its phase-two Kyoto Protocol emissions-reduction program.

Bankers warn of 'rate shock' without offsets

Beyond that, those supporters say they need the full array of trading options for a market-based emissions trading system to work.

David Hunter, U.S. policy chief for the International Emissions Trading Association (IETA), said that while carbon market oversight is critical, financial regulations don't necessarily have to come first.

"We have a lot of experience with environmental markets in this country, a lot of experience in Europe, and the chairman of the CFTC [Commodity Futures Trading Commission] has a pretty good idea of what it takes to regulate these markets," Hunter said.

"I don't think we need to wait for the broader financial derivatives reform legislation to go forward in order to move ahead. We know what to do on carbon markets, and we should move ahead now."

Hunter and other bankers argue that carbon markets are less susceptible to manipulation and major price spikes. Physical delivery constraints, pipeline disruptions and trading time limits that open the door to gaming oil, natural gas and electricity trading wouldn't really exist in a carbon market.

"Duke, and large U.S. carbon-emitting industries in general, is going to be totally dependent on a functioning market if we're going to make this thing work," Duke Energy's Tyndall said at a Washington symposium this week sponsored by IETA. "If there are not domestic offsets and international offsets from day one, there's rate shock."

North Carolina-based Duke, which serves the Midwest and Southeast, is among the largest coal generators in the country. The utility has long supported cap-and-trade legislation designed to control the cost of reducing emissions as it deploys clean energy technology.

"As you start restricting the a la carte menu of options that you draw from in designing the policy, you really do risk losing the benefits of the trade element, which is the cost-containment mechanism underlying the policy," said Ben Feldman of J.P. Morgan.

Soothing fears

The "trade" part of the proposed cap-and-trade program has amassed critics among Republicans and Democrats in the past year. Sens. Maria Cantwell (D-Wash.) and Byron Dorgan (D-N.D.), both of whom support measures to address climate change, are deeply skeptical about whether a market-based system for reducing greenhouse gas emissions can be safeguarded from abuse and manipulation.

Supporters consider the trade part to be a major cost-containment component of the bill, creating the kind of flexibility companies need to meet reduction requirements cost-effectively and over a long enough time to adapt new technology.

Meanwhile, the CFTC, which could end up regulating the cash and derivatives carbon market, is still working to convince Congress that it is ready to do so.

Chairman Gary Gensler told the IETA symposium in Washington that broad market reforms are critical for a cap-and-trade program to operate effectively.

"What the administration put forward and what Congress is looking at for over-the-counter derivatives is needed to address a big gap in our regulatory system," Gensler said. "But in addition, I'd say it's a critical component of the oversight of the trading market of these carbon allowances."

Reforms of the U.S. regulatory system and the cap-and-trade bill will intersect at some point, Gensler said, but it's up to Congress as to when. "The unique nature of this market is still yet to be defined," he said, suggesting that some over-the-counter derivatives would have to be carefully tailored for the carbon emissions allowance market.

Utilities and companies trading financial futures and derivatives tied to emissions allowances will want to shape contracts to limit long-term risks. "The best way to have confidence in that is if the dealers are fully regulated, we bring the standardized part of the market into clearinghouses and exchanges, yet still oversee dealers even for the tailored products," he said.

Seeking protection from 'side bets'

In a recent letter to Boxer and Kerry, about 35 trade groups for energy-intensive industries called on the Senate not to delay derivatives reform. The groups referred to the proposed cap-and-trade program as a "pollution reduction and investment," or PRI, system. "Our groups are concerned with the potential consequences of creating a PRI market-based carbon market without a preexisting, transparent and comprehensive oversight and regulatory framework," the letter said.

Action by Congress is needed to "close the existing loopholes" and extend rules to domestic and international environmental markets.

"As has become evident," said the groups, "the recent U.S. financial collapse was caused in part by a massive unregulated 'side-bets' on the over-the-counter derivatives markets and by extreme commodity price volatility and excessive speculation."

The groups expressed concern that the House bill creates loopholes for banks and hedge funds, and called for mandatory exchange trading for all emissions allowances and offsets. They also warned against passive investors, such as financial institutions, holding large, open-interest positions, as they do in some energy commodities.

"Since this kind of carbon hoarding would create excessive speculation and increase compliance costs for covered entities, passive index funds and exchange-traded funds should be prohibited from participating in the trading of carbon," they said.

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