Financial Reform and the Emissions and REC Markets

Transcription

1 2011 Financial Reform and the Emissions and REC Markets EUEC Phoenix Tauna Szymanski January 31, 2011 Overview How will carbon and other environmental markets be affected by financial reform? Congressional thinking to date Dodd-Frank CFTC activity (carbon market study) European activity Conclusions 2 1

2 Environmental Markets in the U.S. Products Emissions Carbon (RGGI allowances, CA GHG allowances, VERs, compliance CRTs, CFIs) [marginal: CERs, ERUs, EUAs] SO 2 and NOx Derivatives of the above RECs (compliance and voluntary) Classified as commodities; similar to energy commodities 3 Environmental Markets in the U.S. (cont.) Types of Trades Physically settled vs. cash-settled Forward vs. spot delivery OTC/brokered vs. exchange-traded As markets mature, more trades are done on exchanges (Primary vs. secondary vs. derivative = CFTC categorization) Types of Traders Compliance entity vs. financial intermediary vs. offset/rec developer 4 2

3 Early Government Position o Office of the Comptroller of the Currency, Administrator of National Banks, issued an Interpretive Memorandum in 2005 stating that physical settlement of emissions allowances does not pose the same risk as other physical commodities: o Physical settlement of emissions derivatives and hedging with physicals would not pose [the same risks as other physical commodities]. Emissions allowances are not tangible physical commodities such as electricity or natural gas. Rather they are intangible rights or authorizations. They exist only as a book entry in an emissions account. Sept. 15, Status Quo Today, physically-settled spot and forward OTC emissions and REC trades are generally still not subject to regulation (assumption: falls under CEA exclusions) No comprehensive explicit regulatory regime providing oversight of these markets Except for exchange-based trades (Green Exchange, CCFE) Since 2008 increasing concern about fraud, market manipulation, excess speculation 6 3

4 Congressional Proposals Issue not driven by lobbyists but by current events Enron, Amaranth, oil prices, CDS Why oversee private carbon trading? New, large market Who will regulate (FERC, CFTC, EPA, SEC, new agency) Who will be regulated What to regulate How to regulate 7 Congressional Proposals (cont.) Cantwell-Collins Both OTC and derivatives trades prohibited Feinstein-Snowe EPA oversight (price, position monitoring and reporting); transparency focus Waxman-Markey More on futures and options than physical FERC oversight, with EPA (fraud, market manipulation, excess speculation, transparency) Kerry-Lieberman Carbon Market Efficiency Board with power to intervene like the Fed Include greenhouse gas instruments in the CEA Total ban on OTC trades 8 4

5 CBO Study Chairman of Senate Energy and Natural Resources Committee requested study on impact of: limiting allowance trading to covered entities only banning allowance derivatives Report issued in December 2010 Limiting participation would reduce liquidity and raise costs Suggests position limits and circuit breakers as alternative Banning derivatives would increase exposure to price volatility Suggests greater use of clearing organizations and exchanges 9 Positions of Trading Community Ultimate goal is to reduce GHG emissions at the lowest cost Should not differentiate carbon from other energy commodities Except to note that supply of physical emissions allowances is fixed and will decline over time => necessary price increases over time OTC trading important because develops new products and instruments to lower cost of compliance Derivatives important to manage risk and temper volatility Need financial institutions to invest in the risk that compliance entities are trying to hedge Should not restrict participation; liquidity is important Young markets are always volatile 10 5

6 Dodd-Frank Summary Wall Street Reform and Consumer Protection Act ( Dodd-Frank ) July 2010 Primary regulatory responsibility for OTC derivatives shared between CFTC and SEC Requires central clearing for certain swaps Exemption for end-users hedging commercial risks Swaps subject to clearing requirement are required to be traded on an exchange or swap execution facility (unless unavailable) All swaps, regardless of whether they are cleared, must be reported Position limits proposed on 28 commodity derivatives 11 Dodd-Frank (cont.) Swap = any agreement that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind ; that is, or in the future becomes, commonly known to the trade as a swap ; or that is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (v) 12 6

7 Dodd-Frank (cont.) But definition of swap excludes sale of a nonfinancial commodity... for deferred shipment or delivery, so long as the transaction is intended to be physically settled. (CEA Section 1a(47)(B)(ii)) Analogous to the Section 1a(19) definition for future delivery known as the forward contract exclusion Therefore excluding physically settled emissions and REC transactions (for now) Question: physically settled options? 13 Section 750 Carbon Market Study Only specific mention of carbon in bill Mandates study on the oversight of existing and potential carbon markets to ensure an efficient, secure, and transparent carbon market, including oversight of spot markets and derivative markets by interagency working group headed by the CFTC Also: USDA, Treasury, SEC, EPA, FERC, FTC and EIA Comments were due Dec. 17, 2010; asked 10 questions 23 comments received Study was issued Jan. 18, 2011; 52 pages 14 7

8 Section 750 Study (cont.) Unique Features of Carbon Markets Created by legislators Market design features like banking and borrowing can significantly temper price volatility Fixed and declining supply of allowances Needed for compliance purposes Unique concerns of offset developers In the US, most proposed and existing allowance markets require public disclosure of ownership 15 Section 750 Study (cont.) Noted lower risk of price volatility because of ability to instantaneously deliver and likelihood of a single national market (no location-specific price fluctuations like in other commodities markets) Notes that Dodd-Frank and existing CEA do not regulate the physical markets, but suggests Congress could consider whether to do this by: Market design, self-regulation programs, position reporting, transaction monitoring, price and volume reporting, and position and participation limits 16 8

9 Section 750 Study (cont.) The current legal framework for oversight of derivatives markets, as enhanced by the Dodd-Frank Act, when it becomes effective in July 2011, will provide for robust and effective oversight of carbon derivatives markets and closely linked derivative markets such as those based on energy commodities (p. 51) primary and secondary carbon allowance and offset markets will not be subject to the same comprehensive oversight as derivative markets (p. 51) 17 European Approach Light touch on physically settled OTC transactions Financial transactions generally governed by the Market Abuse Directive and Markets in Financial Instruments Directive (MiFID) Ongoing oversight, operational and reporting requirements 18 9

10 European Approach (cont.) Current proposals to enhance market oversight for EU carbon market Studies in light of recent fraud in EU Allowance markets; legislative proposals expected end of 2011 after broad stakeholder consultation in early 2011 VAT fraud (not carbon-specific) phishing attacks unauthorized registry account access CER recycling MiFID review consultation currently querying whether to classify EUAs as financial instruments 19 Conclusions Evolution in legislator/regulator thinking on all OTC trades Dodd-Frank will address carbon derivatives Effective July 2011; regulatory efforts will continue throughout 2011 Some exemptions for end-users RECs? Physically settled trades may see future regulation in a carbonspecific bill State and regional efforts may duplicate or exceed federal requirements 20 10

11 Conclusions (cont.) Expect position limits, reporting, more central clearing, more exchange and fewer OTC derivative trades Extent of regulation will depend on who you are Unclear: market participation limits, regulation of physicals If and when Congress enacts cap-and-trade or federal RES, it will need to determine whether Dodd-Frank is sufficient or whether carbon and REC-specific market oversight provisions are warranted Stay tuned 21 Tauna Szymanski Hunton & Williams LLP