Diverging views about how to regulate trillion-dollar carbon trading markets that would grow under a cap-and-trade law have emerged as a major hurdle for Democrats trying to pass a climate bill this year.
Some prominent senators on energy issues say the House-passed climate bill would not prevent a repeat of alleged speculation or manipulation in oil markets in recent years.
At the same time, some banks and energy companies are warning against excessive market controls that could crimp companies' ability to hedge risks and control costs under a carbon regime.
The discussions about how to regulate carbon allowance and derivative markets are unfolding at a time when lawmakers want to show they are not enabling Wall Street banks to launch another complex financial trading system that could spin out of control.
"The last kind of headline that members of Congress will want is billions in bonuses for Wall Street because of the way they have manipulated the cap-and-trade market," said Norm Ornstein, a congressional expert with the American Enterprise Institute. "That is not something they can tolerate."
Ornstein predicts that lawmakers will ultimately put "fairly stiff regulatory requirements in place" rather than leaving the parameters of the market to Wall Street.
But just how tough the controls should be is a measure of intense debate, especially in an arena as complex as financial regulation. Another complicating factor: decisions about carbon market oversight are bound up in larger efforts involving multiple committees to overhaul regulation of oil, natural gas and other commodity markets.
The House-passed climate bill, H.R. 2454 (pdf), would place the Federal Energy Regulatory Commission in charge of emissions allowance markets while the Commodity Futures Trading Commission would oversee carbon allowance futures and other derivatives.
The bill includes a suite of new controls over derivatives trading in both carbon and other energy commodity markets, including a ban on loosely regulated over-the-counter trading.
What do senators want?
The odds are low that the House bill will be the last word. Indeed, the House provisions that toughen CFTC controls over various derivative markets are "placeholders" that would be nixed upon passage of subsequent derivatives legislation.
Sen. Byron Dorgan (D-N.D.) drew considerable attention last week with a floor speech that went far beyond a call for tight market controls. Dorgan -- a senior member of the Energy and Natural Resources Committee and a member of the Senate Democratic leadership -- said there should not be a trading market at all.
"I have very little interest in consigning our low-carbon future to a trading system of carbon securities that will be controlled by the biggest trading companies in the world," Dorgan said. "And it would not be very long before these entities will have created derivatives, swaps, synthetic CDOs [collateralized debt obligations], and more. It will be a field day for speculation, which I think is not in the interest of this country."
But Dorgan's view collides with many other Democrats who are crafting the climate bill.
Environment and Public Works Chairwoman Barbara Boxer (D-Calif.) has promised the bill will ensure transparent markets but have markets nonetheless. Boxer said this week the Senate measure would draw substantially from a carbon markets oversight bill (S. 1399 (pdf)) recently introduced by Sens. Dianne Feinstein (D-Calif.) and Olympia Snowe (R-Maine).
That bill puts CFTC at the helm of all carbon markets and create a new controls and oversight, such as establishment of a new carbon oversight office at CFTC, and requiring that many derivatives be traded through "carbon allowance derivative trading facilities" registered with CFTC, among other provisions.
Feinstein said the bill has been "vetted" and is a "good strong bill."
"Now is it perfect? Probably not, so I would welcome any comments Senator Dorgan might care to make. I don't think he's actually seen our legislation," Feinstein said.
It remains unclear how broadly Dorgan's view is shared in the Senate. Dorgan said he hosted a recent meeting in his office with other senators -- who he did not name -- about carbon trading issues.
Dorgan told E&E only that "there are a number of senators who have similar interests and concerns" about carbon markets. But cap and trade remains the only vehicle under major consideration.
There have been several other senators crying foul over "excessive speculation" in commodity markets for several years.
These lawmakers, and some other market experts, blame excessive speculation for last year's high of nearly $150 per barrel of oil, but the degree to which speculation drove up prices is hotly debated. Lawmakers wary of a freewheeling new carbon market also point to California's power crisis caused by Enron's manipulation in the electricity market.
Sen. Maria Cantwell (D-Wash.) is another Democrat who has actively pursued greater oversight and enforcement authority in energy markets. Cantwell has not explicitly said she opposes the market set up under the House cap-and-trade bill but is nonetheless skeptical of the measure.
"I am more of a fan of an auction," Cantwell said. "We're in the midst of making reforms to our oversight of these derivatives anyway, right? Like we are still in the middle of that anyway so there is ... lots to work on to get a handle on trading these days," she said.
Cantwell said she understands Boxer and Feinstein are working on reforms to make the trading fair, but the financial crisis has left her less than confident this can be achieved.
"I think right now we have had the worst economic crisis we've seen since the depression caused by a lack of regulation and trading and we still haven't fixed that yet, so it is a little hard to imagine that we could get there." she said. "It's not impossible but it's hard to imagine."
One former CFTC official said lawmakers are right to be concerned about creation of new carbon markets. "Those skeptical of carbon markets probably have a very strong ground to stand on," said Michael Greenberger, who headed CFTC's Division of Trading and Markets under President Clinton and is now a professor at the University of Maryland School of Law.
"My suspicion is that Dorgan and Cantwell see right now we are in the status quo situation with extreme volatility in crude oil, heating oil" and others, Greenberger said. "The carbon market is a market that will be sensitive to volatility, the physical commodity will be shrinking while I expect, and others expect, the [underlying derivatives] market will be expanding. In a market of that sort I think the betting would be it would be an exceedingly volatile market."
While it is not an issue that may be on the front burner for a lot of senators, Greenberger said the group has enough knowledge and clout that carbon market regulations will need to be ironed out among the Senate Democrats along with the free emission allocations, trade protections for energy-intensive industries and overall emission reduction targets.
"I wouldn't count out their influence," Greenberger said. "I am not saying they would prevail, but I wouldn't say it is an open-and-shut case. The question is whether ... those that are worried about volatility and excessive speculation coalesce around something that could be meaningful."
Aside from Dorgan, Cantwell, Feinstein and Snowe, other Senate Democrats that would like to see much greater regulation of energy commodity and derivative markets in general include Sens. Carl Levin (D-Mich.), Tom Harkin (D-Iowa), Joe Lieberman (I-Conn.), Susan Collins (R-Maine.) and Jeff Bingaman (D-N.M.).
Neutered market?
But in the senators' attempts to make sure the carbon market would not run amok, there is a significant risk the market could be overregulated, making it extremely inefficient and dampening innovation that could help the overall objective of reducing carbon emissions, according to Kevin Book, managing director at ClearView Energy Partners LLC.
Like Greenberger, Book said a "properly structured" carbon market will be volatile but it is the only way to create an efficient, liquid atmosphere that inspires innovation that will in the long run keep prices low as companies can properly hedge their emissions.
"It's not clear that [Dorgan] or Senator Cantwell or for that matter any of them is aware of what happens if a market is under-capitalized," Book said. "The biggest risk in the carbon market isn't manipulation or risk of manipulation or commodity price inflation, I think the problem is there needs to be a great need for innovation."
Similarly, the International Emissions Trading Association said last month that the House bill "appropriately" calls for regulatory oversight of carbon markets but also goes too far.
The group -- which includes a host of energy, financial and other companies -- said a ban on over-the-counter trading would "impair the ability of the market to deliver the risk management tools that reduce costs for companies and consumers."
The group's nearly 170 members include BP, Morgan Stanley, American Electric Power Co. Inc., E.ON AG, Goldman Sachs and other energy, financial companies and carbon market companies.
David Hunter, the group's director of U.S. policy, said it is "entirely possible that Congress will unnecessarily clamp down on the markets."
"I think carbon markets can deliver a lot of benefits, and they are the most effective way and the most efficient way of reducing emissions," Hunter said. "If you impose unnecessary restrictions on those markets, you are going to be losing some of the benefits, some of the advantages to having those markets in the first place."
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