MARKETS:

Traders are up and down over latest version of climate bill

NEW YORK -- Carbon market players don't know whether to love or hate the latest version of climate change and energy legislation made public by Sens. John Kerry (D-Mass.) and Joe Lieberman (I-Conn.) Wednesday.

On the one hand, they're pleased that a proposed federal greenhouse gas emissions cap-and-trade program is back on the front burner, having waited so long for the Obama administration's health-care reform effort to come first. But on the other, key provisions of the bill could force many of the pioneers of U.S. carbon trading out of what would be the world's largest carbon market, many are saying.

Though a summary of the Kerry-Lieberman bill makes it clear that the "American Power Act" doesn't seek to limit access to secondary carbon markets, language that restricts the auctioning and primary physical trading of emissions allowances and offset credits to "registered carbon market participants" is causing the most heartburn.

In the emissions trading section of the proposed bill, lawmakers stipulate that primary trading and end-delivery of emission allowances and derived futures contracts would be restricted to a separately selected group of individuals or institutions, to be determined by the Commodity Futures Trading Commission, in conjunction with U.S. EPA and the Treasury Department. Companies facing caps on their emissions levels are also allowed in.

That generally wouldn't be a problem for firms and traders, except that the bill makes no attempt to define what a registered participants is. If most actors are not included in that definition, this provision, along with an explicit ban on certain derivatives, leaves little of a federal market left to take part in, experts say.

"We can't think of any markets that restrict trading to the underlying but have unfettered access to the swaps market," said Evan Ard, director of marketing at Evolution Markets, an energy and emissions brokerage. "It just doesn't make sense for anyone to do that."

Concerns about liquidity

Traders note that in the European Union's Emission Trading System (ETS), currently the world's largest and most liquid carbon market, the vast majority of trading is in the primary, physically delivered products. These are emissions allowances and offset credits that are retired at a pre-determined date. Banks and brokerages don't normally delve into trading in secondary futures and options unless they have access to that physical market.

As Ard and others point out, the E.U. ETS began first as a forward contracts traded market, with all emissions allowances expiring at the end of the year. Later, futures contracts were added, allowing companies facing a cap on their emissions to hedge against the future cost of carbon up to a few years out. Spot trading, speculation on the day-to-day swings in prices, came only later.

Unless "registered carbon markets participants" is liberally defined, it would mark an unprecedented move by the federal government to restrict access to a commodities market, experts note. Even U.S. EPA's sulfur dioxide and nitrogen oxide trading programs, the world's first pollution trading systems, allow open access -- insiders point out that in the past, school groups have even been involved in the trading of SO2 allowances.

"It's essential for a market when it first gets started to be able to operate with a maximum amount of liquidity and with as many counterparties as you can bring into the market," argued Ard.

Some of the biggest names on Wall Street are also concerned.

"Look at the E.U. ETS," said Steven Schleimer, director of energy and environmental regulation at Barclays Capital in New York. "The vast, vast majority of transactions are physical, and there is only a minor amount of transactions that are financial, so all the liquidity is in the physical market."

Barclays currently helps its European customers hedge against future spikes in the price of emissions allowances, securing futures contracts in E.U. allowances (EUAs) good for up to five years out. But Schleimer says his bank is only able to do this because it's able to openly participate in the primary carbon market there.

Restrictive criteria irk some

Some financial giants like Barclays, JPMorgan Chase, Goldman Sachs and others seem likely to pass registration for carbon trading, but smaller institutions are particularly worried. The bill doesn't list any specific criteria that the CFTC must use in making a determination. Most doubt that all individuals and companies currently active in carbon trading would qualify if Congress leaves it up to CFTC and other regulators to determine how many actors are needed to provide adequate liquidity.

"The sum and substance of this feels fairly restrictive to me," said Dirk Forrister, managing director of Natsource. "Does that mean you pick six, or does that mean you pick 600? I don't know what it means, but it sounds like it's trying to restrict it to a fairly low number."

"It's difficult to know what sort of criteria they would use and how they would apply it," noted Henry Derwent, president of the International Emissions Trading Association (IETA). "It would be better if Congress simply recognized that a liquid market is necessary to keep costs down and directed the CFTC accordingly, rather than requiring an agency finding using criteria that leave substantial room for interpretation."

Carbon market actors are also turned off by language banning over-the-counter trades, forcing all activity onto exchange platforms hosting standardized contracts. There's also strong opposition to the price ceilings and floors the bill would impose on federal allowances -- $25 per ton at the top end and $12 at the bottom, adjustable against inflation.

Derwent said the IETA is trying to figure out if this price range would even make it possible for the United States to obtain the 17 percent reduction in emissions by 2020 as intended. He also argued that restricting trading to open exchanges would make it more difficult for utilities forced to comply with a new federal law to manage future risk.

Hope for more clarification

Still, most are trying to stay optimistic as the larger debate on Capitol Hill and elsewhere begins, pointing out the larger benefits that the act would bring if passed.

Although the bill only mandates that electricity generators acquire emissions allowances or offsets beginning in 2013, that would still double the physical size of the worldwide carbon market, even if trading activities in the United States would initially remain lower than in Europe, Barclays analysts say. Adding in natural gas distributors and large-emitting industries post-2016 would expand the universe of tradable carbon-based instruments even further.

Market players are also celebrating the continued emphasis on cap and trade over a carbon tax or other means of reducing emissions. Rob LaCount, head of the climate change and clean energy forum at IHS CERA, said the language also demonstrates how lawmakers are becoming more sophisticated in their attempts to design a federally mandated carbon market that carefully avoids causing shocks to the greater economy.

"You can definitely see the evolution of the dialogue here," LaCount said. "You see a couple trends here of trying to break down some of the uncertainties of the policy and the lingering questions about what this will all cost."

Nevertheless, LaCount agrees that clarification on what exactly "registered carbon market participants" means is needed quickly, lest most of the existing U.S. carbon market turn against the legislation.

"I can see how for entities that have been active in these markets it leaves questions about what roles do they have under this system," he said.