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Go to Blog » On the one hand, they're pleased that a proposed federal greenhouse gas emissions cap-and-trade program is back on the front burner, having waited so long for the Obama administration's health-care reform effort to come first. But on the other, key provisions of the bill could force many of the pioneers of U.S. carbon trading out of what would be the world's largest carbon market, many are saying.

Though a summary of the Kerry-Lieberman bill makes it clear that the "American Power Act" doesn't seek to limit access to secondary carbon markets, language that restricts the auctioning and primary physical trading of emissions allowances and offset credits to "registered carbon market participants" is causing the most heartburn.

In the emissions trading section of the proposed bill, lawmakers stipulate that primary trading and end-delivery of emission allowances and derived futures contracts would be restricted to a separately selected group of individuals or institutions, to be determined by the Commodity Futures Trading Commission, in conjunction with U.S. EPA and the Treasury Department. Companies facing caps on their emissions levels are also allowed in.

That generally wouldn't be a problem for firms and traders, except that the bill makes no attempt to define what a registered participants is. If most actors are not included in that definition, this provision, along with an explicit ban on certain derivatives, leaves little of a federal market left to take part in, experts say.

"We can't think of any markets that restrict trading to the underlying but have unfettered access to the swaps market," said Evan Ard, director of marketing at Evolution Markets, an energy and emissions brokerage. "It just doesn't make sense for anyone to do that."

Concerns about liquidity

Traders note that in the European Union's Emission Trading System (ETS), currently the world's largest and most liquid carbon market, the vast majority of trading is in the primary, physically delivered products. These are emissions allowances and offset credits that are retired at a pre-determined date. Banks and brokerages don't normally delve into trading in secondary futures and options unless they have access to that physical market.

As Ard and others point out, the E.U. ETS began first as a forward contracts traded market, with all emissions allowances expiring at the end of the year. Later, futures contracts were added, allowing companies facing a cap on their emissions to hedge against the future cost of carbon up to a few years out. Spot trading, speculation on the day-to-day swings in prices, came only later.

Unless "registered carbon markets participants" is liberally defined, it would mark an unprecedented move by the federal government to restrict access to a commodities market, experts note. Even U.S. EPA's sulfur dioxide and nitrogen oxide trading programs, the world's first pollution trading systems, allow open access -- insiders point out that in the past, school groups have even been involved in the trading of SO2 allowances.

"It's essential for a market when it first gets started to be able to operate with a maximum amount of liquidity and with as many counterparties as you can bring into the market," argued Ard.

Some of the biggest names on Wall Street are also concerned.

"Look at the E.U. ETS," said Steven Schleimer, director of energy and environmental regulation at Barclays Capital in New York. "The vast, vast majority of transactions are physical, and there is only a minor amount of transactions that are financial, so all the liquidity is in the physical market."

Barclays currently helps its European customers hedge against future spikes in the price of emissions allowances, securing futures contracts in E.U. allowances (EUAs) good for up to five years out. But Schleimer says his bank is only able to do this because it's able to openly participate in the primary carbon market there.