- Explores and develops market-based solutions.
Passage of climate legislation will mark the beginning, not the end, of the effort to design a sound, market-based system for incentivizing transitioning U.S. to a low-carbon, high efficiency (LCHE) economy. This project will produce the analytic and consultative work needed to design the regulatory framework necessary to oversee and support an effective, transparent national carbon market.
Initial report to the Walker Foundation
February 1, 2010
Sound carbon market regulation will be vital for a smooth transition to a low-carbon, high efficiency economy in the U.S. With the support of a grant from the Walker Foundation, Environmental Defense Fund (EDF) is helping to design a regulatory framework to support and oversee an effective, transparent national carbon market. Our recent achievements and activities include the following:
• Educating professional staff on the Senate Banking Committee and Senate Agriculture Committee, as well as staff of leading Senators, about the importance of well designed rules for the carbon market and the treatment of the carbon market in broader financial regulatory reform.
• A keynote presentation by Nat Keohane, EDF’s director of economic policy and analysis, on carbon market regulation, titled “Maintaining Order Through Oversight,” to the 4th Annual Carbon Trading Summit (New York, January 26, 2010, http://www.carbontradingevent.com). The theme of the conference was, “Exploring Regulatory Developments and Investment Opportunities across the Carbon Credit Markets.” The conference audience included senior executives from investment banks, pension funds, hedge funds, private equity and venture capital firms, utilities, law firms and non-governmental organizations.
• Discussions with other experts in the field, whose knowledge helps to inform our recommendations for a robust regulatory framework. We have already met with offset project developers and brokers, financial analysts at the carbon desks of major investment banks, and staff at the Nicholas Institute for Environmental Policy Solutions.
These activities build on our earlier work, which has included meetings with U.S. Treasury staff and with high-level staff at the Commodities Futures Trading Commission (CFTC) including CFTC Chairman Gary Gensler. Discussions have focused on issues of market design (centering around our proposal to restrict allowances trading to regulated exchanges); regulatory oversight (including the tools available to the CFTC and Congress to bolster confidence in carbon markets and ensure adequate liquidity while limiting volatility); and the interaction between market performance and other aspects of cap-and-trade program design (such as the potential for gaming and manipulation that could arise by imposing hard ceilings on allowance prices).
A key area of focus in the coming months will be on the treatment of offsets credits. A well-designed system of offsets can expand the scope of the carbon market, tapping into a range of emission reduction opportunities and lowering costs for compliance entities. However, offsets present particular challenges for carbon market regulation. While we are confident in our recommendation that trading of allowances and allowance derivatives be restricted to registered exchanges, the more varied and site-specific nature of offset contracts means that they are not well-suited to exchange trading. A priority for our work, therefore, is to develop a framework for regulating offsets projects that is fully transparent and prevents systemic risk associated with over-reliance on a single offset project type, while promoting capital investment and recognizing the need for flexibility in writing offset project contracts.
EPA’s Final Mandatory Reporting of Greenhouse Gases Rule went into effect January 1, 2010. Though the rule does not directly regulate market functioning, it provides an example of a regulation that, as part of an overall framework, will enhance market transparency and performance by ensuring rigorous, timely, and comprehensive reporting of emissions.
The U.S. carbon market will be the first totally new kind of market in the U.S. in two centuries. It will be based on the “trial run” of successful sulfur dioxide trading over the past two decades, but will be broad in scope and affect every part of the economy. The carbon market will use a cap and trade approach to implement the deliberately chosen, long-term public objective to transition to a LCHE economy. There will be a welter of special interests trying to influence the design and operation of that market for their own purposes.
The experience of the past two years has driven home the necessity of fair, strong and even-handed regulation and oversight of markets to prevent market manipulation, minimize “herd” behavior, and preserve the integrity of market instruments. EDF will mount a sustained analytic effort to develop regulations and operating principles that will ensure that the carbon market is transparent, effective, and scam resistant.
It is hard to overstate the importance of “getting the design of the carbon market right.” Without that, it will be virtually impossible to avoid the catastrophic consequences of global warming. So the stakes are very high. Two threats exist: one is the threat of no, or inadequate, regulation which could lead to market abuse and/or malfunction, which could in turn lead to broad public backlash against the whole effort of reducing carbon emissions. The second threat is over, or micro-regulation, which could have a suffocating or paralyzing effect on the market-based forces on which we must rely to reduce carbon emissions and stabilize the climate — entrepreneurial initiative and innovation.
EDF has unparalleled experience in the design of regulatory frameworks for market-based cap and trade systems (e.g., the “acid rain” amendments to the Clean Air Act in 1990), and will draw on the international networks to which we belong that are studying this problem.
(Check sent: 12/15/2009)