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is larger than the oat, but smaller than the total amount outstanding, can squeeze the market.9

It is likely that a similar phenomenon will arise in carbon derivatives markets. Many market partici- pants will buy and hold emissions permits to meet their own emissions needs, and not trade these permits actively. For instance, a utility or cement plant that knows it needs a certain amount of per- mits over the next year may acquire these at auc- tion, or via some other allocation mechanism, and then hold them and surrender them as needed, and not participate actively in the secondary mar- ket. is would tend to restrict the “oat” of per- mits to an amount below, and perhaps well below, the total amount outstanding. Just as in Treasury markets, a derivatives market participant could exploit this limited oat to squeeze the market.

  • is prospect may also arise because it is highly

likely that emissions permits will be used as col- lateral in loans, just as Treasury securities are widely used as collateral in so-called “repurchase” (“repo”) trades. at is, owners of permits will almost certainly use them as collateral for short- term nancing transactions; these secured trans- actions can be a very inexpensive way of nancing the acquisition of permits.10 However, as Treasury market experience demonstrates, such repo trans- actions can be used to amass forward positions that exceed the available oat, and thus to execute squeezes. Just as repo squeezes are quite common in most government securities markets (includ- ing the markets for non-US government securi- ties), the prospect for repo squeezes in emissions markets is a very real one.

Moreover, it should be noted that the amount of permits outstanding will drop to very low levels even in competitive markets, making the markets vulnerable to squeezes at such times. When eco- nomic activity is robust, the demand for permits will be high and it will be ecient to draw down the supply of permits in order to meet demand. Under these circumstances, the supply of available permits may fall to very low levels, and the oat will be lower than that. e market is most vulner- able to a squeeze during these low-supply periods.

  • e timing and frequency of these low supply pe-

riods will depend in part on market design, and most notably on the frequency of permit issuance. If, for example, permits are issued annually, it will typically be optimal to draw down holdings of permits to zero immediately before the issuance of the next vintage; this is true even if permits can be carried over from one period to the next (Pir- rong, 2009). is is similar to what happens in ag- ricultural markets, where inventories are drawn down to low levels immediately before the har- vest. us, the carbon market may be particularly susceptible to squeezes right before the issuance of a new vintage, when that issuance occurs rela- tively infrequently (e.g., annually).

Squeezes may occur even when permits are is- sued more frequently, say monthly or even week- ly. Even under these circumstances, there will be times when holdings of permits are drawn to very low levels, making the market vulnerable to the ex- ercise of market power. e primary dierence is that these occurrences will not be as frequent when permits themselves are issued more frequently.

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Examples of Treasury squeezes include the infamous Solomon Brothers squeeze of the Two Year Treasury Note in 1991, and squeezes of the 30 Year Treasury Bond (allegedly by Japanese investors) in the mid-1980s. Squeezes of Treasuries became so chronic in the mid-2000s that senior Treasury ocials publicly warned market participants to crack down on the practice or face aggressive regulatory action. e Federal Reserve Bank of New York also warned market participants about squeezes. For instance, a utility could buy a permit, and then engage in a repurchase transaction with a bank. Under the repo agreement, the utility would sell the permit to the bank today at an agreed price, and then contract to buy it back in a month, say, at a dierent (and likely higher) price. e dierence between the buy and sell prices in the transaction would determine the eective interest rate in the transaction. In the transaction, the utility gets cash today and pays out cash when the repo agreement matures. is is the same cash ow pattern as in a loan.

  • e permit serves as collateral. If the utility fails to buy the permit back as agreed, the bank can sell the permit.

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