Financial_Reform_EUEC_Jan2011 by shuifanglj


									       Financial Reform and the
2011   Emissions and REC
       EUEC Phoenix
       Tauna Szymanski

                                    January 31, 2011

         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

Environmental Markets in the U.S.
   – Emissions
      – Carbon (RGGI allowances, CA GHG allowances, VERs,
        compliance CRTs, CFIs) [marginal: CERs, ERUs, EUAs]
      – SO2 and NOx
      – Derivatives of the above
   – RECs (compliance and voluntary)
   – Classified as commodities; similar to energy commodities


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
  Types of Traders
   – Compliance entity vs. financial intermediary vs. offset/REC

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, 2005.


Status Quo
   Today, physically-settled spot and forward OTC
   emissions and REC trades are generally still not
   subject to regulation (assumption: falls under CEA
   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

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


Congressional Proposals (cont.)
    – Both OTC and derivatives trades prohibited
    – EPA oversight (price, position monitoring and reporting); transparency focus
    – More on futures and options than physical
    – FERC oversight, with EPA (fraud, market manipulation, excess speculation,
    – Carbon Market Efficiency Board with power to intervene like the Fed
    – Include “greenhouse gas instruments” in the CEA
    – Total ban on OTC trades


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
        – Suggests greater use of clearing organizations and exchanges

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

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
  Position limits proposed on 28 commodity derivatives

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


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?

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


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

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

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)


European Approach
  Light touch on physically settled OTC
  Financial transactions generally governed by
  the Market Abuse Directive and Markets in
  Financial Instruments Directive (MiFID)
   – Ongoing oversight, operational and reporting


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

  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 carbon-
  specific bill
    – State and regional efforts may duplicate or exceed federal


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


Tauna Szymanski
Hunton & Williams LLP



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