Order Code RL34235
Air Pollution as a Commodity: Regulation of the
Sulfur Dioxide Allowance Market
October 31, 2007
Larry Parker
Specialist in Energy and Environmental Policy
Resources, Science, and Industry Division
Mark Jickling
Specialist in Financial Economics
Government and Finance Division

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Air Pollution as a Commodity: Regulation of the Sulfur
Dioxide Allowance Market
Summary
A number of congressional proposals to advance programs that reduce
greenhouse gases (GHGs) have been introduced in the 110th Congress. Proposals
receiving particular attention would create market-based GHG reduction programs
along the lines of the allowance trading provisions of the current acid rain reduction
program established by Title IV of the 1990 Clean Air Act Amendments. Under the
program, an allowance is limited authorization to emit a ton of pollutant.
However, there are several important differences. For example, the scope of the
greenhouse gases control program would be substantially greater than the Title IV
program, involving more covered sectors and entities. This diversity multiplies as the
global nature of the climate change issue is considered, along with the multiple
GHGs involved. Thus, a carbon market is likely to involve far greater numbers of
affected parties from diverse industries than the current Title IV program.
It will also involve far greater numbers of tradeable allowances than the current
Title IV program. Under the current program, about 9 million allowances are
allocated to over 2,000 emission sources annually. In contrast, a greenhouse gas
program that capped emissions in the electric power, transportation, and industry
sectors at their 1990 levels at some point in the future would be allocating about 4.85
billion allowances annually. Trading activities under Title IV has been increasing
since 2005. However, it doesn’t approach the anticipated volumes that would occur
if a greenhouse gas cap-and-trade program was instituted. Likewise, the economic
value of a future carbon market is likely to be substantially greater than the Title IV
program. Currently, the annual allocation of SO allowances has a market value of
2
about $4.5 billion. Using estimates of $15 to $25 an allowance, the annual allocation
of 4.85 billion allowances posited above for a greenhouse gas program would have
a market value of $72.8 billion to $121.3 billion.
Despite these differences in scope and magnitude, there are trends in Title IV
trading that are likely to continue in a carbon market. First, there is a trend toward
more diverse, non-traditional participants in the Title IV market. Like the Title IV
market, the economic importance of a carbon market will likely draw in entities not
directly affected by the reduction requirements, such as financial institutions. These
entities’ motivations may be equally diverse, including facilitating projects involving
the need for allowances, portfolio balancing, intermediary fees, and trading profits.
Second, as noted, there is a trend in the Title IV market toward using financial
instruments to manage allowance price risk. Given the greater economic stakes
involved in a carbon market, this trend toward more sophisticated financial
instruments is likely to emerge early as a hedge against price uncertainty. The
emergence of entities well-versed in the use of these instruments may reinforce the
trend and make options, collars, strangles, and other structures as common in the
allowance market as they are in other commodity markets. With a more liquid and
dynamic market, a carbon market may look more like other energy markets, such as
natural gas and oil, than the somewhat sedate SO allowance market.
2

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Overview: Title IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Administering the Program: The Environmental Protection Agency (EPA) . . . . . 4
Allowance Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Allowance Auctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Interface with Electricity Regulation: The Federal Energy Regulatory
Commission (FERC) and State Public Utility Commissions (PUCs) . . . . . . 5
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
FERC Allowance Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
State Public Utility Commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Allowance Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Internal Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Over the Counter: Cash Market, Futures and Options . . . . . . . . . . . . . . . . . 11
Regulation of Allowances as an Exempt Commodity: Commodity Futures
Trading Commission (CFTC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Regulation of Trading Venues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
List of Tables
Table 1. Information Recorded by EPA’s Allowance Tracking System . . . . . . . . 4
Table 2. EPA Official Allowance Transfers and Transactions: 1994-2003 . . . . 11
Table 3. EPA 2007 Auction Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Table 4. SO Futures Contract Specifications . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2
Table 5. Summary of Trading Venues for Exempt
Commodities under the Commodity Exchange Act (CEA) . . . . . . . . . . . . . 17

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Air Pollution as a Commodity: Regulation of
the Sulfur Dioxide Allowance Market
Introduction
A number of congressional proposals to advance programs that reduce
greenhouse gases have been introduced in the 110th Congress. Proposals receiving
particular attention would create market-based greenhouse gas reduction programs
along the lines of the trading provisions of the current acid rain reduction program
established by the 1990 Clean Air Act Amendments.1 These “cap-and-trade” schemes
would impose a ceiling (cap) on total annual emissions of greenhouse gases and
establish a market in pollution rights, called allowances, between affected entities.
An allowance would be a limited authorization by the government to emit one metric
ton of carbon dioxide equivalent (CO e), and could be bought and sold (traded) or
2
held (banked) by participating parties.
These domestic proposals have parallels with the programs being implemented
in Europe to meet its obligations under the Kyoto Protocol. Specifically, the
European Union (EU) has decided to implement a cap-and-trade program, along with
other market-oriented mechanisms permitted under the Kyoto Protocol, to help it
achieve compliance at least cost.2 The EU’s decision to use emission trading to
implement the Kyoto Protocol is at least partly based on the successful emissions
trading program used by the United States to implement its sulfur dioxide (acid rain)
control program contained in Title IV of the 1990 Clean Act Amendments.3
These two operating cap-and-trade programs — the U.S.’s acid rain program
and the EU’s climate change program — may provide insights for the design of a
domestic greenhouse gas reduction scheme. However, while the experiences of the
EU system directly relate to the greenhouse gas reduction initiative of the domestic
legislative proposals, it has operated only a short time (see text box). The acid rain
control program has a longer operating history, although the control scheme differs
in some important ways — e.g., it is internal to one nation and involves fewer types
of sources.
1 P.L. 101-549, Title IV (November 15, 1990).
2 Norway, a non-EU country, also has instituted a CO trading system. Various other
2
countries and a state-sponsored regional initiative located in the northeastern United States
involving several states are developing mandatory cap-and-trade system programs, but are
not operating at the current time. For a review of these emerging programs, along with other
voluntary efforts, see International Energy Agency, Act Locally, Trade Globally (2005).
3 P.L. 101-549, Title IV (November 15, 1990).

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CRS-2
Among the lessons that Phase 1 of
The EU’s Emissions Trading
the European Trading System may have
System (ETS) covers more than 11,500
for a similar U.S. program is that
energy intensive facilities across the 27
allowance prices are linked to the price
EU Member countries, including oil
of other energy commodities.4 Analysis
refineries, powerplants over 20 megawatts
of ETS allowance prices during Phase 1
(MW) in capacity, coke ovens, and iron
suggests the most important variables in
and steel plants, along with cement, glass,
determining allowance price changes
lime, brick, ceramics, and pulp and paper
have been oil and natural gas price
installations. Covered entities emit about
changes.5 This suggests that traders
45% of the EU’s carbon dioxide
will pursue arbitrage strategies
emissions. The trading program covers
neither CO emissions from the
involving simultaneous transactions in
2
transportation sector, which account for
allowances and oil and gas contracts.
about 25% of the EU’s total greenhouse
For example, a trader anticipating a rise
gas emissions, nor emissions of non-CO2
in the price of oil might take a position
greenhouse gases, which account for about
in allowances in the expectation that the
20% of the EU’s total greenhouse gas
two prices would move in tandem.
emissions. A “Phase 1” trading period
Since there is widespread suspicion that
began January 1, 2005. A second, Phase
excessive speculation by hedge funds
2, trading period is scheduled to begin in
and others has affected energy prices in
2008, covering the period of the Kyoto
recent years,6 the possibility that the
Protocol, with a third one planned for
2013. (For further background on the ETS
price of allowances could also be
and its first year of operation, see CRS
subject to distortion or manipulation
Report RL33581, Climate Change: The
will be a policy concern.
European Union’s Emissions Trading
System (EU-ETS), by Larry Parker.
Taking that hint from ETS, this
Relevant directives on the EU-ETS are
report examines the Title IV sulfur
available at [http://ec.europa.eu/environ
dioxide cap-and-trade program, with a
ment/climat/emission.htm#brochure].)
focus on the market activity and the
current regulatory overlay. From that
discussion, observations are drawn about implications for a future greenhouse gas
trading scheme. No current U.S. proposal has specific provisions with respect to
carbon allowance financial instruments or who would regulate such a market or its
participants.
Overview: Title IV
4 For more on the EU-ETS, see CRS Report RL34150, Climate Change: The EU Emissions
Trading Scheme (ETS) Gets Ready for Kyoto, by Larry Parker.
5 For example, when natural gas, the cleaner fuel, becomes more expensive relative to oil,
industrial users may switch to oil, creating increased demand for allowances. Maria
Mansanet-Bataller, Angel Pardo, and Enric Valor, “CO Prices, Energy and Weather,” 28
2
The Energy Journal 3 (2007), pp. 73-92. Powernext (a French energy exchange) has
described CO prices as the cornerstone of relative energy prices for generating electricity.
2
See Jean-Francois CONIL-LACOSTE, Chief Executive Officer, Powernext SA, Market
Based Mechanisms to Fight Climate Change (2006).
6 See, e.g., Senate Permanent Subcommittee on Investigations, “Excessive Speculation in
the Natural Gas Market” (Staff Report), June 2007, 135 p.

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CRS-3
Title IV of the 1990 Clean Air Act Amendments supplements the sulfur dioxide
(SO ) command-and-control system of the Clean Air Act (CAA) by limiting total SO
2
2
emissions from electric generating facilities to 8.95 million tons annually, beginning
in the year 2000.7 Title IV essentially caps SO emissions at individual utility sources
2
operating before enactment of the CAA in 1990 (known as “existing sources”)
through a tonnage limitation, and at those plants beginning operation after enactment
(known as “new sources”) through an emissions offset requirement. SO emissions
2
from most existing sources are capped at a specified emission rate times a historical
average fuel consumption level. Beginning January 1, 2000, SO emissions from
2
new plants commencing operation after enactment must be offset — in effect, the
emissions cap for new sources is zero. Their allowances come from emissions
reductions at existing facilities. The program was implemented through a two-phase
process with the final phase beginning in 2000.
To implement the SO reduction program, the law creates a comprehensive
2
permit and emissions allowance system (cap-and-trade program). An allowance is
a limited authorization to emit a ton of SO during or after a specified year. Issued
2
by EPA, the allowances are allocated to existing power plant units in accordance with
formulas delineated in the law. The owner of the facility receives the allowances for
a given plant regardless of the actual operation of the plant. For example, an owner
may choose to shut down an existing power plant and use those allowances to offset
emissions from two newer, cleaner facilities. As noted, generally, a power plant that
commences operation after enactment receives no allowances, requiring new units
to obtain allowances from those with allowances, or purchase them at an EPA-
sponsored auction, in order to operate after 2000. An owner may trade allowances
nationally as well as bank allowances for future use or sale.
If an affected unit does not have sufficient allowances to cover its emissions for
a given year, it is subject to an emission penalty of $2,000 (indexed to inflation) per
ton of excess SO , and it submits to EPA a plan for offsetting those excess emissions
2
in the next year (or longer if EPA approves). Further, EPA must deduct allowances
equal to the excess tonnage from the source’s allocation for the next year.
Another EPA responsibility is to provide for allowance auctions. For the post-
2000 period, the law sets aside a percentage of available allowances for auction.
Anyone may participate in these auctions as a buyer or seller, and those selling
allowances may specify a minimum sale price. EPA may delegate or contract the
conduct of the auctions to other agencies, such as to the Department of the Treasury,
or even to nongovernmental groups or organizations. Two streams of allowances are
sold in the auctions. The first stream represents “spot sales” of allowances that must
either be used in the year they are sold or banked for use in a later year. The second
stream represents “advance sales” of allowances that must either be used in the
seventh year after the year they are first offered for sale or be banked for use in a later
7 Clean Air Act Amendments of 1999, P.L. 101-549, Title IV. For a more detail discussion
of the title, see Larry B. Parker, Robert D. Poling, and John L. Moore, “Clean Air Act
Allowance Trading,” 21 Environmental Law 2021-2068 (1991).

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CRS-4
year. For 2000 and thereafter, Title IV provides that 125,000 allowances be set-aside
annually for spot sales, and 125,000 for advance sales.
Administering the Program: The Environmental
Protection Agency (EPA)
It is EPA’s responsibility to administer the trading, banking, and auctioning of
allowances.
Allowance Accounting
EPA has developed an integrated system to track allowances (the Allowance
Tracking System — ATS);8 to verify and record SO emissions from affected units
2
(the Emission Tracking System — ETS); and to reconcile (true-up) allowances and
emissions at the end of the year. The Allowance Tracking System is the official
record of allowance transfers and balances used for compliance purposes. Each
participant in the system has an ATS account, and each account has an identification
number.
Table 1 identifies what the ATS tracks and does not track with respect to
allowance activity. As suggested, EPA primarily gathers information to ensure
compliance with the emission limitations of Title IV — the ATS is not a trading
platform. Participants are not required to record all transfers with EPA until the
affected allowances are to be used for compliance. Participants must notify EPA to
have any transfers recorded in the ATS. When parties agree on a transaction that
they want recorded on the ATS, they provide information on the buyer and seller and
the serial numbers of the affected allowances to the ATS which records the transfer.
Table 1. Information Recorded by EPA’s Allowance Tracking
System
ATS Records
ATS Does Not Record
Allowances issued
Allowance prices
Allowances held in each account
Option trades
Allowances held in various EPA reserves
Any allowance transaction not officially
reported to EPA
Allowances surrendered for compliance
purposes
Allowances transferred between accounts
8 EPA has renamed the ATS the Allowance Management System (AMS), but ATS remains
the commonly used term and will be used in this report.

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CRS-5
To facilitate its primary compliance responsibility, EPA assigns each allowance
allocated a unique 12-digit serial number that incorporates the first year it can be used
for compliance purposes. These allowances may be held in one of two types of ATS
accounts. First, there are Unit Accounts where allowances provided under Title IV
allocation formulas are deposited and where allowances are removed by EPA for
compliance purposes. Second, there are General Accounts that may be created by
EPA for anyone wishing to hold, trade, or retire allowances. Participating entities
with General Accounts include (1) utilities who keep a pooled reserve of allowances
not needed immediately for compliance (i.e., an allowance bank); (2) brokers who
need a holding account for allowances in the process of being bought or sold; (3)
investors holding allowances for future sale; and (4) environmental and other groups
holding allowances they wish to remove from the market (i.e., retire).
Allowance Auctions
A key provision of Title IV to ensure liquidity in the SO markets for new
2
entrants is the EPA allowance auction. As noted above, the EPA is required to
auction 250,000 allowances annually in two streams, spot and advance. The auctions
began in 1993 and are held annually — usually on the last Monday in March. Sealed
bids entailing the number, type, and price, along with payment, are sent to EPA no
later than three business days before the auctions.
The auctions sell the allowances according to bid price, starting with the highest
bid and continuing down until all allowances are sold or there are no more bids.
Unlike allowances offered by private holders for auction, these EPA allowances do
not have a minimum price.
For the first 13 years, the auctions were conducted by the Chicago Board of
Trade (CBOT) for EPA. CBOT received no compensation for the service, nor was
it allowed to charge fees. Beginning in March 2006, CBOT decided to stop
administering the auctions, resulting in EPA now conducting them directly.
Interface with Electricity Regulation: The Federal
Energy Regulatory Commission (FERC) and State
Public Utility Commissions (PUCs)
Background
The 1990 Clean Air Act Amendments were enacted during a time of transition
in the electric utility industry. There are three components to electric power delivery:
generation, transmission, and distribution. Historically, electricity service was
defined as a natural monopoly, meaning that the industry had (1) an inherent
tendency toward declining long-term costs, (2) high threshold investment, and (3)
technological conditions that limited the number of potential entrants. In addition,
many regulators considered unified control of generation, transmission, and
distribution the most efficient means of providing service. As a result, most people
(about 75%) were served by vertically integrated, investor-owned utilities.

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CRS-6
The Public Utility Holding Company Act (PUHCA)9 and the Federal Power Act
(FPA) of 1935 (Title I and Title II of the Public Utility Act)10 established a regime
for regulating electric utilities that gave specific and separate powers to the states and
the federal government. Essentially, a regulatory bargain was made between the
government and utilities. Under this bargain, utilities must provide electricity to all
users at reasonable, regulated rates in exchange for an exclusive franchise service
territory. State regulatory commissions address intrastate utility activities, including
wholesale and retail rate-making. Authorities of these commissions tend to be as
broad and varied as the states are diverse. At the least, a state public utility
commission will have authority over retail rates, and often over investment and debt.
At the other end of the spectrum, the state regulatory body will oversee many facets
of utility operation. Despite this diversity, the essential mission of the PUC is the
establishment of retail electric prices. This is accomplished through an adversarial
hearing process complete with attorneys, briefs, witnesses, etc. The central issues in
such cases are the total amount of money the utility will be permitted to collect
(revenue requirement) and how the burden of the revenue requirement will be
distributed among the various customer classes (rate structure).11 This is commonly
known as “rate of return” (ROR) regulation.
Under the regime set up by FPA, federal economic regulation addresses
wholesale transactions and rates for electric power flowing in interstate commerce.
Historically, federal regulation followed state regulation and is premised on the need
to fill the regulatory vacuum resulting from the constitutional inability of states to
regulate interstate commerce. In this bifurcation of regulatory jurisdiction, federal
regulation is limited and conceived to supplement state regulation. The Federal
Energy Regulatory Commission (FERC) has the principal functions at the federal
level for the economic regulation of the electricity utility industry, including financial
transactions, wholesale rate regulation, transactions involving transmission of
unbundled retail electricity, interconnection and wheeling of wholesale electricity,
and ensuring adequate and reliable service. In addition, until passage of the 2005
Energy Policy Act (EPACT05),12 the Securities and Exchange Commission (SEC)
regulated utilities’ corporate structure and business ventures under PUHCA to
prevent a recurrence of the abusive practices of the 1920s (e.g., cross-subsidization,
self-dealing, pyramiding, etc.).
This comprehensive, cost-based approached to regulation began to undergo
change in the 1970s and 1980s as passage of the Public Utility Regulatory Policies
9 15 U.S.C. 79 et seq.
10 16 U.S.C. 791 et seq.
11 For a comprehensive discussion of state and federal regulation, see Robert Poling, et. al.,
Electricity: A New Regulatory Order? Report for the Committee on Energy and Commerce,
House of Representative (June 1991), committee print.
12 P.L. 109-58.

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CRS-7
Act of 1978 (PURPA)13 and the Fuel Use Act of 1978 (FUA)14 helped establish
independent electricity generators — electricity producers who sold at wholesale and
had no exclusive franchise area. Building on the perceived success of these
independent generators under PURPA, the Energy Policy Act of 1992 (EPACT92)
created a new category of wholesale electric generators called Exempt Wholesale
Generators (EWGs) that are not considered utilities and not regulated under
PUHCA.15 EWGs, also referred to as merchant generators, were intended to create
a competitive wholesale electric generation sector. EPACT92 effectively initiated
deregulated wholesale generation by creating a class of generators that were able to
locate beyond a typical service territory with open access to the existing transmission
system. EPACT05 continued this process by adding provisions to address system
reliability, repeal PUHCA, and modify PURPA.16
The current status of these initiatives and resulting state responses is a mixture
of states with traditional, comprehensive ROR regulation of electricity and those with
a restructured industry with segmented generation, transmission, and distribution
components. Over the past 20 years, some States have truncated their ROR regulation
to the extent they have chosen to restructure their industry in response to Federal
initiatives. In states that have not restructured, the system operates as it has since
enactment of the Federal Power Act, with retail consumers paying one price that
includes transmission, distribution, and generation. This is referred to as a bundled
transaction. In states that have restructured, consumers are billed for separate
transmission, distribution, and generation charges. This is referred to as unbundled
electricity service. In those states, retail consumers are allowed to choose their retail
generation supplier; however, few states actually have competitive markets for retail
choice (exceptions include Texas and Massachusetts). FERC regulates all
transmission, including unbundled retail transactions.17
13 P.L. 95-617, 16 U.S.C. 2601.
14 P.L. 95-620.
15 Exempt Wholesale Generators may sell electricity only at wholesale. EWGs may be
located anywhere, including foreign countries. Before enactment of EPACT05, utility
generators were limited by the Public Utility Holding Company Act of 1935 (PUHCA) to
operate within one state.
16 In repealing PUHCA, EPACT05 provides that FERC and state regulatory bodies must be
given access to utility books and records. Also, FERC is given approval authority over the
acquisition of securities and the merger, sale, lease, or disposition of facilities under FERC’s
jurisdiction with a value in excess of $10 million. With respect to PURPA, EPACT05
repeals the PURPA mandatory purchase requirement for new contracts if FERC finds that
a competitive electricity market exists and a qualifying facility has adequate access to
wholesale markets. Among its provisions to address reliability, FERC is authorized to certify
a national electric reliability organization (ERO) to enforce mandatory reliability standards
for the bulk power system. For more information on EPACT05, see CRS Report RL33248,
Energy Policy Act of 2005, P.L. 109-58, Electricity Provisions, by Amy Abel.
17 On October 3, 2001, the U.S. Supreme Court heard arguments in a case (New York et al.
v. Federal Energy Regulatory Commission) that challenged FERC’s authority to regulate
transmission for retail sales if a utility unbundles transmission from other retail charges. In
states that have opened their generation market to competition, unbundling occurs when
(continued...)

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CRS-8
FERC Allowance Accounting
With the restructuring of the electric utility industry, FERC generally does not
set cost-based rates for electricity generation under its jurisdiction. Rather, FERC
conducts a two-pronged horizontal and vertical market power analysis to determine
an entity’s eligibility for “market-based” wholesale rates.18 If eligible, the entity may
set its wholesale prices according to market demand, not according to production
costs.
Because of the market-based nature of FERC wholesale rates, allowances are
an accounting issue, not a ratemaking issue for FERC. Electric public utilities and
licensees within FERC jurisdiction are required to maintain their books and records
in accordance with FERC’s Uniform System of Accounts (USofA).19 The USofA
guides the jurisdictional entity in understanding the information it needs to report on
various FERC forms. Included in the USofA are instructions on how to account for
allowances allocated to the entity under the 1990 Clean Air Act, or acquired by the
entity for speculative purposes. Allowances owned for other than speculative
purposes are accounted for at cost in either Account 158.1 (Allowance Inventory),
or Account 158.2 (Allowances Withheld) as appropriate. Allowances acquired for
speculative purposes are accounted for in Account 124 (Other Investments).20
By defining allowance value in terms of historic costs, allowances allocated by
EPA to entities are valued at zero. FERC does require that the records supporting
Account 158.1 and 158.2 be maintained “in sufficient detail so as to provide the
number of allowances and the related cost by vintage year.” Likewise, the Uniform
System of Accounts also provides instruction on accounting for gains and losses from
selling allowances.
17 (...continued)
customers are charged separately for generation, transmission, and distribution. Nine states,
led by New York, filed suit, arguing that the Federal Power Act gives FERC jurisdiction
over wholesale sales and interstate transmission and leaves all retail issues up to the state
utility commissions. Enron in an amicus brief argued that FERC clearly has jurisdiction
over all transmission and FERC is obligated to prevent transmission owners from
discriminating against those wishing to use the transmission lines. On March 4, 2002, the
U.S. Supreme Court ruled in favor of FERC and held that FERC has jurisdiction over
transmission, including unbundled retail transactions.
18 FERC Order 697, Market-Based Rates for Wholesale Sales of Electric Energy, Capacity
and Ancillary Services by Public Utilities, Docket No. RM04-7-000, Final Rule (issued June
21, 2007).
19 Code of Federal Regulations, Title 18, Conservation of Power and Water Resources, Part
101.
20 Code of Federal Regulations, Title 18, Conservation of Power and Water Resources, Part
101. Allowance accounting is described under General Instructions Number 21.

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CRS-9
It should be noted that the Internal Revenue Service (IRS) also values
allowances allocated by EPA to an entity on a zero-cost basis.21
State Public Utility Commissions
In states with bundled rates, the valuing and disposition of allowances is more
than an accounting issue, it is also a ratemaking issue. During and after passage of
Title IV, there was substantial debate and studies were done on the role of the PUCs
in facilitating (or hindering) allowance trading.22 In Title IV, the regulatory treatment
of allowances is left to the appropriate state and federal regulatory bodies. Title IV
contains no mandated requirements regarding the treatment of allowance transactions
in state utility rate proceedings. Basically, Congress chose to leave the state
commissions free to apply any rate treatment they deem reasonable and appropriate.
The states responded in a diverse manner, some states issuing broad guidelines
on treatment of allowance transactions while others decided such events on a case-
by-case basis. An analysis of the interaction between PUCs and the allowance
system made three general observations about the resulting PUC treatment of
allowances: (1) regulations tend to require 100% of both expenses and revenues from
allowances to be returned to ratepayers with net gains (losses) incurred used to offset
(or increase) fuel costs; (2) a few states have allowed utilities to retain some of the
profits as an incentive to sell excess allowances; (3) state regulations tend to be
tailored to a state’s specific circumstance — “allowance rich” states have regulations
encouraging sales, “allowance poor” states have regulations encouraging purchases.23
The focus of PUC decisions has not been to encourage allowance transactions, but
generally to ensure ratepayers and not shareholders receive the benefits of the
allowances. In some cases, PUCs have also used their authority to encourage utilities
to protect high-sulfur coal production, even if it is not the most cost-effective control
strategy.24
Allowance Transactions
Internal Transfers
When the 1990 Clean Air Act Amendments were enacted, about 75% of the
allowances were allocated to vertically integrated, ROR regulated entities. Today,
21 Treatment of emission allowances under the Federal income tax is spelled out in Rev. Rul.
92-16, Internal Revenue bulletin, No. 1992-12, March 23, 1992, p. 5 and Rev. Proc. 92-91,
Internal Revenue Bulletin, No. 1992-46, November 16, 1992-13, p. 32-33. See also,
Announcement 92-50, Internal Revenue bulletin, No. 1992-12, March 30, 1992, p. 32.
22 For example, see Kenneth Rose, et. al., Public Utility Implementation of The Clean Air
Act’s Allowance Trading Program, National Regulatory Research Institute, May 1992.
23 Elizabeth M Bailey, Allowance Trading Activity and State Regulatory Rulings: Evidence
from the U.S. Acid Rain Program, MIT, March 1998, pp. 9-10.
24 See Ken-Ichi Mizobuchi, The Movements of PUC Regulation Effects in the SO Emission
2
Allowance Market, Kobe University, May 2004.

---

CRS-10
that percentage has shifted with more allowances allocated to independent generating
entities as some utilities have divested themselves of their generating assets. This
diversification of ownership is reflected to some degree in the ATS statistics on
official transfers and transactions.25 As indicated by Table 2, in the first two years
of trading, transfers between economically unrelated entities were a small percentage
of total transfers. More recent data suggest that transfers between unrelated entities
account for about 50% of total transfers. However, it is clear that internal transfers
remain a major part of the allowance market, even in a restructured industry, and that
the total number of official transactions occurring is quite modest.
Internal transfers (i.e., transfers within or between economically related entities)
tend to be transacted in accordance with agreements that the utility and/or holding
company has filed with the appropriate state PUC, or FERC, or both.26
25 “Official” here means that the transfer has been recorded by the ATS. The actual transfer
of ownership may have occurred earlier. As noted earlier, parties are not required to notify
the ATS of any transfer within a specific time period and may choose for some reason to
delay informing the ATS of a transfer.
26 For example, see the now terminated agreement AEP System Interim Allowance
Agreement filed with the FERC on August 30, 1996 in Docket No ER96-2213-000
designated as Appalachian Power Company Supplement No. 9 to Rate Schedule FPC No.
20; Columbus Southern Power Company Supplement No. 3 to Rate Schedule FPC No. 30;
Indiana Michigan Power Company Supplement No. 10 to Rate Schedule FPC No. 17;
Kentucky Power Company Supplement No. 6 to Rate Schedule FPC No. 11; and, Ohio
Power Company Supplement No. 9 to Rate Schedule FPC No. 23. Agreement terminated
by FERC, effective January 1, 2002, in accordance with the mutual consent of the parties
thereto.

---

CRS-11
Table 2. EPA Official Allowance Transfers and Transactions: 1994-2003
Transfers
between
Transactions
Total
economically
Percent of
Total
between
Percent of
Transfers
Year
distinct
Total
Number of
economically
Total
(millions of
organizations
Transfers
Transactions
distinct
Transactions
allowances)
(millions of
organizations
allowances)
1994
9.2
0.9
9.8%
215
66
30.7%
1995
16.7
1.9
11.4%
613
329
53.7%
1996
8.2
4.4
53.7%
1,074
578
53.8%
1997
15.2
7.9
52.0%
1,429
810
56.7%
1998
13.5
9.5
70.4%
1,584
942
59.5%
1999
18.7
6.2
33.2%
2,832
1,743
61.5%
2000
25.0
12.7
50.1%
4,690
2,889
61.6%
2001
22.5
12.6
56.0%
4,900
2,330
47.6%
2002
21.4
11.6
54.2%
5,755
2,841
49.4%
2003
16.5
8.1
49.1%
4,198
1,544
36.8%
2004
15.3
7.5
49.0%
20,000
n/a
n/a
2005
19.9
10.0
50.3%
5,700
n/a
n/a
Source: U.S. Environmental Protection Agency, 2007.
Over the Counter: Cash Market, Futures and Options
Beyond restructuring, other entities are emerging as participants in the
allowance markets. This increased diversity of interest in the allowance market is
reflected in the most recent (2007) EPA allowance auction. As indicated by Table
3, several brokerages have created positions in the allowance market, both for
themselves and their clients. This may suggest an increasing importance of
intermediaries to the functioning of the allowance market, the development of a more
liquid market, and to the maturing of that market.

---

CRS-12
Table 3. EPA 2007 Auction Results
(Winners of more than 20 allowances)
Percent of Total
Spot Market Bid Winners
Quantity
Allowances offered
(125,000)
Morgan Stanley
50,000
40.00%
KS&T, LP
30,575
24.46%
Saracen Energy LP
15,000
12.00%
Transalta Energy Marketing U.S.
9,900
7.92%
South Carolina Public Service Authority
7,500
6.00%
Alpha
5,000
4.00%
Constellation Energy Commodities Group,
2,500
2.00%
Inc.
Merrill Lynch Commodities Inc.
2,500
2.00%
The Detroit Edison Company
2,000
1.60%
TOTAL SPOT
124,975
99.98%
Percent of Total
7 Year Advance Bid Winners
Quantity
Allowances offered
(125,000)
American Electric Power
80,000
64.00%
DTE
30,000
24.00%
Cantor Fitzgerald Brokerage
10,000
8.00%
Bear Energy
4,986
3.99%
TOTAL ADVANCE
124,986
99.98%
Source: Environmental Protection Agency, 2007
The basic market for allowance trading is the Over-The-Counter (OTC) market.
The most common trading structure involves spot sales with immediate settlement
accounting and delivery into EPA’s Allowance Tracking System (ATS) with
payment by wire transfer in three business days.27 Daily spot trading volumes for
immediate settlement are estimated in the 10,000 to 25,000 ton range.28 Forward
27 Peter Zaborowsky, The Trailblazers of Emissions Trading, Evolution Markets Inc. (April
23, 2002).
28 Ibid. In September 2007, the monthly volume was estimated at 175,000-200,000 by
Evolution Markets Inc., who termed it low volume. Evolution Markets Inc., SO Markets
2
(continued...)

---

CRS-13
settlement transactions are less common and are fairly short-dated — 6 to 18 months
out. Vintage swaps also occur in both markets with the difference in value usually
paid in additional allowances rather than cash.29 This preference for allowances
reflects regulated entities’ desire to keep these transactions non-taxable under current
IRS regulations. Cash market transactions are facilitated in some cases through
available electronic trading platforms, such as Intercontinental Exchange, Inc. (ICE)
and TradeSpark (CantorCO2e), and by the emergence of a number of allowance
brokers. Currently, EPA lists a dozen allowance brokers on its website.30 A similar
list is available from the Environmental Markets Association — a trade association.31
Brokers tend to be registered with the SEC and one or more Self-Regulatory
Organizations, such as FINRA; but participation in this market would not in itself
make a firm subject to SEC regulation. Four brokers — Cantor Fitzgerald,
Evolution, ICAP Energy, and TFS Energy — form the basis of the Platts emission
price index. Argus AIR Daily also produces price indices through daily phone
surveys of active brokers.
Two exchanges provide SO future contracts as well as clearing services: New
2
York Mercantile Exchange (NYMEX) and Chicago Climate Futures Exchange
(CCFE). The availability of exchanges as a trading platform for allowances or to
clear transactions was cheered by traders when established in late 2004 and 2005.
As stated by the Environmental Markets Association with respect to NYMEX’s
decision: “NYMEX does offer information on power, and any time you have them
expanding into our market, that’s going to create opportunities for people who may
be using other products to take a second look at emissions.”32 Both exchanges offer
standardized and cleared futures contracts, along with clearing services for off-
exchange transactions. As reported by Platts, futures volume on both exchanges
have expanded greatly over the past year. SO futures trading on the CCFE was
2
nearly 1.9 million allowances in the first half of 2007, compared with about 500,000
during the same time in 2006. For the NYMEX, volumes in the first half of 2007
was 665,000 allowances — a more than three-fold increase over the first half of
2006.33 Table 4 summarizes the basic features of the trading instruments.
28 (...continued)
— September 2007 at [http://www.evomarkets.com/assets/mmu/mmu_so2_sep_07.pdf].
29 The first year an allowance may be used for compliance is called its “vintage.” This
situation can result in entities engaging in a “vintage swap.” For example, a “vintage swap”
may occur because one entity has excess allowances in the upcoming year (2008) but
anticipates it will have insufficient allowances in 2009. Another entity may be in the
opposite position because of planning future emission reductions. The two entities agree
to “swap” allowances to improve their allowance streams over these years.
30 EPA Website: [http://www.epa.gov/airmarkets/trading/buying.html].
31 EMA Website: [http://www.environmentalmarkets.org/page.ww?section=About+
Us&name=Company+Directory].
32 Comment of Matt Most, Emissions Market Association, as reported in Platts Emissions
Daily, “Emissions market hails NYMEX move,” February 15, 2005, p. 1.
33 Platts Emissions Daily, “Emissions exchanges continue to grow SO , NOx futures
2
markets,” August 10, 2007, p. 1.

---

CRS-14
Table 4. SO Futures Contract Specifications
2
NYMEX
CCFE
Trading Platform
ClearPort
ICE
Clearing Organization NYMEX
ClearPort
The Clearing Corporation
Clearing
(CCorp)
Self Regulatory
NYMEX and National
National Futures
Organization
Futures Association
Association (NFA)
(NFA)
CFTC Regulatory Status
Designated Contract
Designated Contract
Market
Market
Contract size
100 SO allowances
25 SO allowances
2
2
Minimum Price
$25 per contract
$2.50 per contract
Fluctuation
Settlement
Physical through EPA’s
Physical through EPA’s
ATS
ATS
Symbol
RS
SFI
Source: NYMEX and CCFE.
In April, 2007, the CCFE began offering SO options.34 For October 2007, the
2
CCFE offers European-style options35 on its futures contracts for expiration on the
October 2007, November 2007, December 2007, April 2008, and December 2008
futures contracts.36 As with the futures market, participants are required to settle their
delivery obligations via the ATS. Volume remains light with the CCFE reporting
in July that there were 200 calls on July contracts, 5,315 calls and 411 puts on August
2007 contracts, 740 calls and 46 puts on September 2007 contracts, and 440 calls on
the December 2007 contracts.37 The spike in calls and puts in the August 2007
contracts in July may reflect a peak in allowance prices that occurred in July 2007
and future uncertainty about allowance price direction over the summer.38 The
NYMEX does not offer SO options.
2
34 Chicago Climate Futures Exchange, Chicago Climate Futures Exchange to Launch
Options market on Sulfur Financial Instrument Futures Contracts, Chicago, April 5, 2007.
35 An option that can only be exercised for a short, specified period of time just prior to its
expiration, usually a single day. “American” options, however, may be exercised at any time
before expiration.
36 For current options market data, see [http://www.ccfe.com/mktdata_ccfe/sfi_options.jsf].
37 CCFE Market Report, CCFE SFI Options, (July 2007), p. 3, table 4.
38 Traditional Financial Services (a brokerage firm) noted the peak in allowance prices in
July because of higher than expected storage in the natural gas markets. See TFS, Global
Environmental Markets, August 2007, available at [http://www.tfsbrokers.com/pdf/
global-reports/2007/tfs-ger-08-07.pdf].

---

CRS-15
Regulation of Allowances as an Exempt
Commodity: Commodity Futures Trading
Commission (CFTC)
Definition
The Commodity Exchange Act provides the basis for federal regulation of
“derivative” transactions in contracts based on commodity prices. Pursuant to the
act, the Commodity Futures Trading Commission (CFTC) regulates the futures
exchanges, such as NYMEX, and certain other derivative transactions that occur off-
exchange. The CFTC’s authority varies according to the identities of the market
participants and the nature of the underlying commodity. In general, the CFTC does
not regulate spot (or cash) trades in commodities, or forward contracts that will be
settled by delivery of the physical commodity (which are also considered cash
sales).39
In terms of allowances, the CFTC’s jurisdiction is confined to trades that take
place on those markets it regulates. It has no jurisdiction over spot trades in
allowances, full jurisdiction over futures and options trades on regulated exchanges,
and limited jurisdiction over derivatives trades on certain other markets subject to
lighter regulation than the exchanges.
Allowances are regulated by the CFTC as exempt commodities under the
Commodity Futures Modernization Act of 2000.40 The Commodity Exchange Act
defines an exempt commodity as any commodity other than an excluded commodity
(e.g., financial indices, etc.) or an agricultural commodity. Examples include energy
commodities and metals. Emission allowances are related to energy production. This
designation has been supported by other federal entities. In a 2005 Interpretive Letter
approving physically settled emission derivatives transactions, the Office of the
Comptroller of the Currency, Administrator of National Banks, states that physical
settlement of emission allowances do not pose the same risk as other physical
commodities:
The proposed emissions derivatives transactions [e.g., futures, forwards, options,
swaps, caps, and floors] will be linked to three emission allowance markets: the
U.S. SO (Sulfur Dioxide) and NOx (Nitrogen Oxide) markets and the European
2
Union’s CO (carbon dioxide) market. These emissions markets are volatile and
2
price fluctuates considerably. Market participants manage price risk through the
use of derivative structures, such as forwards, futures, options, caps and floors.
These derivatives are generally physically settled, because the current emissions
market is primarily physical in nature. ...
39 The CFTC has occasionally brought enforcement actions for fraud in the spot market, but
these are rare. The legislative history does not suggest that Congress meant the CFTC to be
a regulator of cash commodity markets.
40 See CFTC approval of CCFE application for designation as a Contract Market: Order of
Designation: In the Matter of the Application of the Chicago Climate Futures Exchange,
LLC for Designation as a Contract Market, November 9, 2004.

---

CRS-16
The OCC has previously concluded in a variety of contexts that national banks
may engage in customer-driven commodity transactions and hedges that are
physically settled, cash-settled and settled by transitory title transfer. ...
Similarly, the OCC permitted a national bank to make and take physical delivery
of commodities in connection with transactions to hedge commodity price risk
in commodity linked transactions. ...
In these decisions, the approved activities were subject to a number of conditions
due to risks associated with physical transactions in certain commodities. Those
risks included storage (e.g., storage tanks, pipelines), transportation (e.g., tankers,
barges, pipelines), environmental (e.g., pollution, fumigation, leakage,
contamination) and insurance (e.g., damage to persons and property, contract
breach, spillage). Physical settlement of emissions derivatives and hedging with
physicals would not pose those risks, however. Emission allowances are not
tangible physical commodities, such as electricity or natural gas. Rather, they are
intangible rights or authorizations. They can be bought and sold like other
commodities, but they exist only as a book entry in an emissions account.41
[footnotes omitted]
The Federal Reserve also considers emission allowances as commodities for
purposes of trading.42
Regulation of Trading Venues
The CFTC identifies four venues for trading exempt commodities under the
Commodity Exchange Act: (1) Designated Contract Markets (DCM), (2)
Commercial Derivatives Transaction Execution Facilities [none currently in
operation], (3) Exempt Commercial Markets (ECM), and (4) Over-the-Counter
(OTC) — not on a trading facility.43 As suggested by the discussion above,
allowances are traded on three of these venues. Futures contracts and clearing
services are provided by NYMEX and CCFE — both DCMs — with options also
available on the CCFE. ICE and TradeSpark — both ECMs — are used by brokers
and principals for allowance transactions. Finally, principal-to-principal transactions
and broker-assisted transactions are occurring OTC without the use of a trading
facility. Table 5 summarizes these venues and their regulation under the Commodity
Exchange Act.
For the three trading venues set out in Table 5, the degree of regulation varies,
most significantly according to the identities of the participants. Small public
investors are allowed to trade only on regulated exchanges (DCMs); these are subject
to extensive self-regulation and CFTC oversight. Electronic trading facilities, where
41 Comptroller of the Currency, Administrator of National Banks, Interpretive Letter #1040:
Emissions Derivatives Proposal, September 15, 2005.
42 Board of Governors, Federal Reserve System, JPMorgan Chase & C. New York, New
York: Order Approving Notice to Engage in Activities Complementary to a Financial
Activity, November 18, 2005.
43 See table entitled: Venues for the Trading of Exempt Commodities under the Commodity
Exchange Act (CEA), available on the CFTC website at [http://www.cftc.gov/stellent/
groups/public/@newsroom/documents/file/exemptcommoditiesvenues_091207.pdf].

---

CRS-17
small traders are not present, are subject to much less regulation, because traders are
assumed to be capable of protecting themselves from fraud. However, if an
electronic trading facility plays a significant price discovery role (that is, if the prices
it generates are used as reference points by the cash market or other derivatives
markets), the CFTC may require disclosure of certain information about trading
volumes, prices, etc. Where trades are purely bilateral, negotiated, and executed
between principals, the transaction is said to occur in the OTC market, which is
entirely exempt for CFTC regulation, with the exception of certain provisions dealing
with fraud manipulation.
Table 5. Summary of Trading Venues for Exempt Commodities
under the Commodity Exchange Act (CEA)
Exempt
OTC — Not on a
Designated
Commercial
Trading Facility
Contract Markets
Markets (CEA
(CEA Sec. 2(h)(1)-
(CEA Sec. 5)
Sec. 2(h)(3)-(5))
(2))
Commodities
No limitations
Exempt
Exempt
Permitted
commodities (e.g.,
commodities (e.g.,
energy metals,
energy metals,
chemicals,
chemicals,
emission
emission
allowances, etc.,)
allowances, etc.,)
Method of Trading
Trading can take
Electronic multi-
Non-multi-lateral
place on an
lateral trading (i.e.,
trading (e.g., dealer
electronic trading
many-to-many
markets;
facility or by open
platforms)
individually-
outcry
negotiated,
bilateral
transactions)
Notice
Must apply to and
Yes; simple notice
None; exemption is
Requirement
receive prior
containing contact
self-executing
approval from
information and
CFTC; must satisfy
description of
various non-
operations
prescriptive
designation criteria
and core principles
Participants
No limitations
Eligible
Eligible Contract
Commercial
Participants (i.e.,
Entities only —
institutions, finds,
subset of Eligible
and wealthy,
Contract
sophisticated
Participants;
individuals)
excludes
individuals but
includes funds

---

CRS-18
Exempt
OTC — Not on a
Designated
Commercial
Trading Facility
Contract Markets
Markets (CEA
(CEA Sec. 2(h)(1)-
(CEA Sec. 5)
Sec. 2(h)(3)-(5))
(2))
Intermediation
Permitted
None; principal-to-
Limited; only if
principal trading
done through
only
another Eligible
Contract
Participant
Types of
Futures and
Derivatives,
Derivatives,
Transactions
options
including swaps,
including swaps,
futures and options
futures, and
(Note: ECMs often
options
also trade products
outside CFTC
jurisdiction,
including spot and
forward contracts)
Standardized
Yes
Yes, terms set by
Usually yes when
Products?
the entity
executed on a
dealer market.
Usually no, when
executed
bilaterally
Cleared?
Transactions must
Clearing not
Can be if a
be cleared through
mandatory; if
standardized
a Derivatives
offered, it must be
contract; many
Clearing
through an SEC-
traders choose to
Organization
registered clearing
clear trades at
(DCO) approved
agency or a DCO
NYMEX or LCH
by the CFTC
(many ICE
transactions are
cleared at LCH;
other ECMs offer
clearing at
NYMEX Clearport
or The Clearing
Corp.)
Transaction
Subject to all
Only anti-
Only anti-
Prohibitions
provisions of the
manipulation and
manipulation and
CEA
anti-fraud
anti-fraud (but
anti-fraud rules do
not apply to
transactions
between Eligible
Commercial
Entities)

---

CRS-19
Exempt
OTC — Not on a
Designated
Commercial
Trading Facility
Contract Markets
Markets (CEA
(CEA Sec. 2(h)(1)-
(CEA Sec. 5)
Sec. 2(h)(3)-(5))
(2))
Self-regulatory
Yes, significant
Minimal and they
None
responsibility
self-regulatory
include nothing
responsibilities;
that goes to the
must comply on a
integrity of trading.
ongoing basis with
Responsibilities
8 designation
include a reporting
criteria and 18 core
requirement for
principles. Must
contracts over a
have compliance
minimum volume
and surveillance
threshold; ensuring
programs
compliance with
exemption
conditions; and
dissemination of
contract activity
information for
“price discovery”
contracts
Responsibility to
Comply with
Provide notice of
None
CFTC
designation criteria
operation and
and core principles
weekly transaction
data for high-
volume contracts;
report
manipulations and
fraud complaints;
maintain and
provide access to
records of activity

---

CRS-20
Exempt
OTC — Not on a
Designated
Commercial
Trading Facility
Contract Markets
Markets (CEA
(CEA Sec. 2(h)(1)-
(CEA Sec. 5)
Sec. 2(h)(3)-(5))
(2))
CFTC Oversight
Unlimited,
Limited (special
None
Authority
including
calls); Sec 8a(9)
continuous and
emergency
ongoing market
authority does not
surveillance and
apply
trade practice
programs, ability to
intervene in
markets (e.g., force
reduction/liquidati
ons of position,
alter/supplement
DCM rules).
CFTC receives
large trader reports
transaction data
and assesses
DCMs’ compliance
programs via rule
enforcement
reviews.
Source: Venues for the Trading of Exempt Commodities under the Commodity Exchange Act (CEA),
available on the CFTC website at [http://www.cftc.gov/stellent/groups/public/@newsroom/documents/
file/exemptcommoditiesvenues_091207.pdf].
Although allowances are regulated like any other commodity by the CFTC, it
should be noted that it is not a deep liquid cash market. As noted by emissions
broker Evolution Markets LLC, the affected source base for SO allowances is about
2
500 companies. The broker also estimated in 2005 that about 20 companies
represented the bulk of trading activities.44 In recommending CFTC approval of the
CCFE as a DCM, the Staff memorandum noted the following:
In futures markets generally, the existence of a liquid market for a particular
contract and the ability of an FCM to liquidate positions therein which it may
inherit from a defaulting customer are important to the financial integrity of such
an FCM and, in turn, its ability to fulfill its obligations to other customers and
to the clearing system. The EPA will facilitate the delivery process of these
contracts in a manner that makes cash positions known and compensates for any
current lack of a developed deep liquid cash market for the contracts as compared
to other futures contracts. Collectively CCorp, NFA, and EPA will carry out
financial surveillance, monitor situations, and provide information the effect of
44 Evolution Markets LLC, “An Overview of Trading Activity and Structures in the U.S.
Emissions Markets,” NYMEX Emissions Futures Seminar, July 28, 2005.

---

CRS-21
which should counterbalance any disparate effects on financial integrity, which
might be imposed by the initial lack of trading history and prices.45
Observations
Despite the tendency to view the Title IV program as a model for a future
greenhouse gas reduction scheme, there are several important differences. For
example, the Title IV program involves up to 3,000 new and existing electric
generating facilities that contribute two-thirds of the country’s SO and one-third of
2
its nitrogen oxide (NOx) emissions (the two primary precursors of acid rain). This
concentration of sources makes the logistics of allowance trading administratively
manageable and enforceable with continuous emissions monitors (CEMs) providing
real time data. However, greenhouse gas emissions are not so concentrated. In 2005,
the electric power industry accounted for about 33% of the country’s GHG
emissions, while the transportation section accounted for about 28%, industrial use
about 19%, agriculture about 8%, commercial use about 6%, and residential use
about 5%.46 Thus, small dispersed sources in transportation, residential/commercial
and agricultural sectors, along with industry, are far more important in controlling
GHG emissions than they are in controlling SO emissions. This diversity multiplies
2
as the global nature of the climate change issue is considered, along with the multiple
GHGs involved.47 Thus, a carbon market is like to involve far greater numbers of
affected parties from diverse industries than the current Title IV program.
It will also involve far greater numbers of tradeable allowances than the current
Title IV program. Under the current program, about 9 million allowances are
allocated to participating entities annually. In contrast, a greenhouse gas program
that capped emissions in the electric power, transportation, and industry sectors at
their 1990 levels at some point in the future would be allocating about 4.85 billion
allowances annually. This is a two and a half orders-of-magnitude increase over the
Title IV program and double the Phase 2 allocations under the ETS. As suggested
here, trading activities under Title IV has been increasing since 2005. However, it
doesn’t approach the anticipated volumes that would occur if a greenhouse gas cap-
and-trade program was instituted.
Finally, the economic value of a future carbon market is likely to be
substantially greater than the Title IV program. With EPA’s pending implementation
of the Clean Air Interstate Rule (CAIR), the price of a Title IV allowance has
45 The Division of Market Oversight and The Division of Clearing and Intermediary
Oversight, CFTC, DCM Designation Memorandum: Application of Chicago Climate
Futures Exchange, LLC (“CCFE”) for Designation as a Contract Market pursuant to
Sections 5 and 6(a) of the Commodity Exchange Act (“Act” or “CEA”) and Part 38 of
Commission regulations, November 3, 2004.
46 U.S. territories account for the remaining 1%. Data from EPA, Inventory of U.S.
Greenhouse Gas Emissions and Sinks: 1990-2005, April 15, 2007, p. ES-14.
47 The EU addresses this issue by having the ETS cover only 45% of its emissions and no
non-carbon dioxide emissions, as noted earlier. Still, it has 11,500 entities to oversee.

---

CRS-22
increased to about $500.48 Thus, the annual allocation of SO allowances has a
2
market value of about $4.5 billion. Using estimates of $15 to $25 an allowance, the
annual allocation of 4.85 billion allowances posited above for a greenhouse gas
program would have a market value of $72.8 billion to $121.3 billion.49 Unlike the
Title IV market, a carbon market may be quite liquid.
Despite these differences in scope and magnitude, there are trends in Title IV
trading that are likely to continue in a carbon market.
First, there is a trend toward more diverse, non-traditional participants in the
Title IV market. Like the Title IV market, the economic importance of a carbon
market will likely draw in entities not directly affected by the reduction requirements,
such as financial institutions. The motivations of these entities may be equally
diverse, including facilitating projects involving the need for allowances, portfolio
balancing, and profits earned through intermediary fees or proprietary trading.
Second, there is trend in the Title IV market toward using financial instruments
to manage allowance price risk. This trend is partly the result of the regulatory
uncertainty introduced in the allowance market by CAIR. Given the greater
economic stakes involved in a carbon market, this trend toward more sophisticated
financial instruments is likely to emerge early as a hedge against price uncertainty.
The emergence of entities well-versed in the use of these instruments may reinforce
the trend and make options, collars, strangles, and other structures as common in the
allowance market as they are in other commodity markets. With a more liquid and
dynamic market, a carbon market may look more like other energy markets, such as
natural gas and oil, than the somewhat sedate SO allowance market.
2
48 Based on data from Cantor Fitzgerald, October 2007.
49 Range based on EPA estimates for reducing emissions to 1990 levels by 2020 as required
under S. 280. See EPA, Analysis of The Climate Stewardship and Innovation Act of 2007,
July 16, 2007. For reference, a Phase 2 ETS allowance currently sells for about $32 . Data
from the European Climate Exchange, [http://www.ecxeurope.com/default_flash.asp].

---