Current Situation and Oversight Considerations for Policymakers
GAO-10-851R: Published: Aug 19, 2010. Publicly Released: Sep 20, 2010.
This letter is our response to a congressional request concerning carbon trading in the United States and various design and implementation issues to be considered in discussions about a possible national carbon trading program. Industrial activities in the United States emit significant amounts of carbon dioxide and other greenhouse gases each year, substantially affecting the earth's climate, according to the National Academy of Sciences. In an effort to reduce these emissions, some have suggested capping emissions and allowing them to be traded in secondary markets just as other commodities are traded. We briefed congressional committee staff on the results of our work on July 23, 2010. Specifically, we provided information on (1) carbon-related products currently traded in the United States and the extent of trading; (2) risks and challenges posed by these products; (3) the extent to which and how these products are regulated; and (4) issues that market observers identified for policymaker consideration as part of creating a national cap-and-trade carbon market.
Various carbon products are traded in the United States, but volumes have been small compared to other commodity markets. The products traded include carbon allowances, which entitle the holder to emit a specific amount of a greenhouse gas, and carbon offsets, which are measurable reductions of greenhouse gas emissions from an activity or project in one location that are used to compensate for emissions occurring elsewhere. Derivatives on carbon products are also traded in the United States, including primarily futures contracts. Although no official measure of volume of trading exists, various sources estimated that from $2.4 billion to $2.7 billion of carbon products traded in United States in 2009, with offsets accounting for around $74 million. U.S. carbon trading volumes appear to have fallen sharply in 2010, with volumes of Regional Greenhouse Gas Initiative (RGGI) allowances trading at around 15 percent of their 2009 levels as of June 2010. Carbon product trading poses various risks and challenges that were similar to those found in other commodity markets. For example, carbon products pose market risk, which is the exposure to losses from changes in product prices. Similarly, carbon product markets face the risk of potential manipulation and fraud. Although no fraud involving carbon products has been identified in the United States since 2001, carbon products traded in Europe have been part of several fraudulent activities, including those involving value-added tax violations. Carbon markets could be significantly affected by political or regulatory changes after implementation of any U.S. cap-and-trade program, but market observers noted that this risk could be mitigated by including elements in the program that increased certainty of its duration and features. Under the Commodity Exchange Act (CEA) carbon emissions are considered to be an "exempt commodity." Before Congress amended the CEA in the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act, Pub. L. No. 111-203), derivatives on exempt commodities were eligible for limited oversight by the primary U.S. commodities regulator, Commodity Futures Trading Commission (CFTC). They could be traded between qualified parties on an over-the-counter (OTC) basis generally free from CFTC regulation. CFTC's authority over such trading was limited to instances in which CFTC suspected fraud or manipulation. Although typical transactions in carbon emissions qualified for OTC trading, to date market participants have traded carbon products mostly on exchanges subject to CFTC's full authority. The Dodd-Frank amendments, which are not yet in effect, replaced this regime with clearing requirements and other requirements intended to increase transparency of the OTC derivatives market and reduce the potential for counterparty and systemic risk. The amendments provide an exemption from clearing, exchange trading, and other requirements for counterparties that qualify as end users. The market participants, academics, regulators, and other market observers that we spoke with identified several issues for policymakers' consideration in the event that the United States implements a national cap-and-trade program. Some noted that the design of the primary carbon market can significantly affect the secondary carbon market. We recommend that the Chairman of the CFTC ensure that the interagency working group created by the Dodd-Frank Act explores (1) how the design of any primary carbon market could affect the liquidity of any secondary market trading; (2) the structure of the secondary market, including the role OTC markets may play in carbon trading; and (3) the resources federal regulators may need to effectively oversee domestic carbon markets.
Recommendation for Executive Action
Status: Closed - Implemented
Comments: On January 18, 2011, the Interagency Working Group for the Study on Oversight of Carbon Markets, which was created under the Dodd-Frank Act, issued its report on how carbon product markets should be structured and overseen. The interagency group's report identifies features of the primary market that could increase liquidity and market quality, including noting that some or all of the allowances associated with a given year's emission limit could be introduced years in advance. The report also states that transparency of information is needed to allow participants to assess current and future supply and demand conditions for allowances and offsets. Our report noted that whether to allow allowance banking was one aspect of the primary market that could affect secondary market liquidity. The interagency group's report notes that permitting the banking of allowances will lead to closer linkages between allowance prices in the secondary market and the prices of certain allowance derivatives. Banking was also seen as helping to mitigate price volatility by providing an inventory of allowances that can be drawn on in response to unanticipated price shocks. Regarding the secondary markets and the role of over-the-counter (OTC) markets, the interagency group's report notes that a main benefit of OTC markets is that they allow market participants to engage in transactions of customized derivative contracts that facilitate the hedging of or gaining exposure to market factors, or to otherwise meet their unique risk-management needs. In addition, the report notes that the ability to engage in OTC trading can be particularly important in the early years of a market because OTC trading permits new transaction types to emerge, which, over time, may become sufficiently standardized and commonplace to sustain migration to an organized exchange markets. The interagency group's report cautions that OTC derivative markets to date have tend to be less transparent and lack centralized aggregation of information prices, trades and positions. However, the report notes that changes brought by the Dodd-Frank Act will alleviate many of these concerns by requiring the public reporting of certain details of all swaps and security-based swaps. Finally, regarding resources for regulatory oversight, the interagency group's report notes that regulators often have employed self-regulation by the industry to serve as the first line of oversight of activity in the market with the exchanges expected to have certain rules to govern activity in the market, ensure that those rules are being enforced and to maintain adequate resources and staff to oversee the activity on their markets. In a recent Congressional testimony, the CFTC Chairman did not specifically address carbon products, but noted that his agency's current funding is already far less than what is required to properly fulfill the significantly expanded mission given to it by the Dodd-Frank Act.
Recommendation: The Chairman of the CFTC should ensure that the interagency working group created by the Dodd-Frank Act explores (1) how the design of any primary carbon market could affect the liquidity of any secondary market trading; (2) the structure of the secondary market, including the role OTC markets may play in carbon trading; and (3) the resources federal regulators may need to effectively oversee domestic carbon markets.
Agency Affected: Commodity Futures Trading Commission