June 02, 2009

Derivatives Trading in Climate Change Legislation

Posted on June 2, 2009 by Stephen M. Bruckner

ACES & Eights? Swaps and Other Derivatives in Climate Change Legislation


Stephen M. Bruckner

            On May 21, 2009, the House Energy and Commerce Committee approved H.R. 2454, the American Clean Energy & Security Act (ACES), by a 33-25 vote. As the Committee touts its efforts on the much-examined markup of H.R. 2454 (aka, “Waxman-Markey discussion draft”), coalitions from each side of the ideological spectrum assail the legislation as toothless and watered-down, or a disaster for the American economy.  The bill has a long way to go, including review by other House committees and, of course, the Senate, so it may be premature for Committee Chairman Henry Waxman to bestow the mantle of “decisive and historic action.” 

Buried within ACES’ cap-and-trade emissions plan are a series of provisions that detail how big banks, hedge funds, and traders can use complex securities and derivatives to profit from the new carbon allowance market.  We all watched aghast as “credit default swaps” and similar financial alchemy led to the melt down of Wall Street and the credit markets. Do these types of investments have a proper role in climate change and energy legislation?  In a bill that already has plenty of political and policy hurdles, why add financial regulation? 

Title III, Subtitle D of ACES, entitled “Carbon Market Assurance”, amends the Federal Power Act to create a financial instrument known as a “regulated allowance derivative”, which can include a “swap agreement”, and directs the Federal Energy Regulatory Commission to establish regulations for these financial vehicles.  Title III, Subtitle E of ACES, entitled “Additional Market Assurance”, addresses transactions in derivatives involving energy commodities such as coal, gasoline, and natural gas. These provisions open the door for financial institutions to partake in the new market created by ACES’ emission allowances.  It allows companies, funds, and traders to purchase and trade emission allowances, and to devise complex derivative instruments to sell and trade, picking up commissions and charging fees along the way.  As a result, the theoretical value of the allowances and their derivatives will be determined, in large part, by the manipulation and speculation of financial parties with little or no concern for carbon emission standards or federal climate policy beyond immediate monetary gain.  

Simply put, the emerging market for new carbon allowances created by the bill could be (at best) undermined or (at worst) commandeered by financial contrivances that are already partially responsible for the nation’s current financial instability.  The fundamental value of the new cap-and-trade ‘products’ will necessarily fluctuate as the emissions market adjusts and stabilizes.  If big banks and hedge funds can use puts, swaps, options and other speculative instruments, which the federal government has yet to capably regulate, the stability of emissions allowances and carbon trading could be placed at risk.  The chaos visited upon the economy at large by these and other financial instruments should cause hesitation and serious consideration as to whether they belong in Congress’ first attempt at comprehensive climate change legislation. 

Tags: Climatecap and tradeACES Waxman-Markey


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