he original concept of cap-and-trade envi- sioned that the total amount of carbon diox- ide (CO2) emissions would be capped and rights to emit would be traded. But it is inevitable that there will be demand to trade instruments other than emissions rights themselves. Specically, there will be a demand to trade derivatives on emissions rights. T
is has raised alarms in Congress, particularly
in the aermath of the energy price spike of 2008 and the nancial crisis of 2008-2009. Numerous voices inside Congress as well as outside have laid the blame for these episodes squarely on deriva- tives markets. As a result, the current regulatory environment is extraordinarily hostile to deriva- tives generally, and to carbon derivatives particu- larly. Indeed, several proposals have been intro- duced to constrain or eliminate various types of derivatives trading, including proposals to:
Impose limits (e.g., speculative limits) on the uses of these products, or on the amount of trading certain kinds of entities can un- dertake;
Restrict where and how derivatives are trad- ed, with a decided preference for trading on organized exchanges;
Text of this bill can be found at: <http://energycommerce.house.gov>.
Constrain arrangements for the allocation of performance risk, with a decided prefer- ence for “clearing” derivatives transactions through central counterparties (“CCPs”);
Ban certain derivatives altogether.
e American Clean Energy and Securities Act
(ACESA), passed by the US House of Represen- tatives in June, includes provisions mandating many of these restrictions.1
All of these proposals are misguided, some ex- tremely so. ey are predicated on a widespread misunderstanding of what derivatives are, how they work, and the reasons that rms trade them.
ese are, no doubt, provocative statements. In
this chapter I will support them by going back to basics, describing what derivatives are, why they are used, how they are traded, the abuses they are subject to, and the most ecient ways to con- strain those abuses.
is chapter is organized as follows: Section 2
gives an overview of what derivatives are and how they are traded. Section 3 discusses deriva- tives markets abuses, such as manipulation and excessive speculation, and Section 4 evaluates the potential vulnerability of carbon markets to these
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