A historic bill passed in the House of Representatives proposes a U.S. carbon market.

The United States took a big step toward creating a much-anticipated mandatory carbon cap-and-trade market as a bill was passed in the House of Representatives in June 2009. The proposed plan for a U.S. carbon market from Representatives Henry Waxman and Edward Markey was the most detailed bill to make its way into the Congressional spotlight in 2009, and could be the legislation that many in the United States and abroad have been waiting for.

While cap-and-trade supporters lauded the bill for its goal to bring carbon emissions down over the next 41 years, others wonder just what the legislation will look like after it is ultimately melded with a Senate version.

Washington, D.C. legal experts and cap-and-trade insiders say efforts to pass such legislation in 2009 were a bit too optimistic. The Senate picked up the bill over the summer and a draft bill was released at the end of September. But the legislation is in a holding pattern until the U.S. healthcare legislation is completed. The push for cap-and-trade legislation is driven by a number of factors, such as the current administration's call for cap-and-trade to be part of a larger U.S. energy overhaul, and international pressure to partake in the United Nations conference on climate policy in Copenhagen in December 2009.

"It's encouraging that the United States, even in the midst of one of the worst recessions in its history, is moving forward with changes to the way we do business because of the environment," says Jack Cogen, chief executive officer of Natsource, a leading provider of asset management and other services in global emissions and renewable energy markets. "And they are using it as an opportunity to develop new industries for our future."

But cap-and-trade is opposed strongly by those in the U.S. Congress who argue that it will cost too much. With such a polarizing issue, 2009 will go down as one of the most pivotal years in carbon policymaking. If and when it arrives, the United States would be a major entrant into the relatively young international carbon marketplace. Some estimate international carbon trading could reach $1 trillion in the United States by 2020 and $5 trillion globally. Because carbon markets in the United States, Europe and Asia are politically created and managed, a look at the Waxman-Markey bill will help shed some light on where the United States is going on this issue.

The Waxman Cometh

The 1,400-plus page Waxman-Markey bill, the American Clean Energy and Security Act, calls for carbon emission reductions of 17 percent from 2005 levels by 2020 and 83 percent by 2050.

Bill Bumpers, a partner in the law firm Baker & Botts and chair of the firm's global climate practice, says the House bill is a "very mature, pretty centrist piece of legislation."

While debate over the likelihood of passage in 2009 continues, Bumpers says, "What matters is that the United States gets a long-term, sustainable bill. We have to have a 30-year to 40-year path that markets can count on."

The House legislation would allocate 85 percent of the allowances to emitters for free in initial years and the remaining 15 percent of allowances will be auctioned. The bill envisions that eventually all of the allowances will be auctioned. Free allocation of allowances enables companies to get credits cheaply and theoretically prevent massive cost shocks to consumers.

Offsetting Issues

Another complicated issue is offsets. Carbon offsets are projects either inside or outside the United States that essentially are net reducers of the world's carbon emissions. Washington has looked to offsets in the European Union Emissions Trading Scheme (EU ETS) for some guidance. That market allows offsets from the United Nation's Clean Development Mechanism, which generates credits for emission-lowering projects in countries such as China by paying for improvements in that country. Those credits can then be imported into the EU ETS. Just how the House legislation will be factored into final Senate legislation is still unknown, but the issue will likely see many other suggestions as the process moves ahead.

World View

The pieces are certainly in place to create the largest carbon cap-and-trade market in the world and complement the European market. The 27-country EU ETS is firmly in place and has arguably worked quite well since its launch in January 2005. Prices have ebbed and flowed according to more traditional correlations, such as energy prices for natural gas, crude oil and coal, as well as weather. The EU ETS is the most liquid carbon market in the world and volumes have continued to grow each year as more companies and trading firms participate.

The House legislation allows linkages between the U.S. and European markets, which could lend even more liquidity to both marketplaces. With other countries such as Canada and Australia also pushing for carbon cap-and-trade markets, a global carbon marketplace is emerging. How that fragmented patchwork will come together will be addressed at the U.N. Climate Change Conference in Copenhagen in December 2009. This meeting could bring the United States into the international fold on climate change and possibly China. Expectations that the U.N. meeting will end with a signed deal are unclear. Many are unsure if the United States will be able to generate the support needed in Congress to sign off on a treaty. But if President Barack Obama can carry a passed or nearly approved version of a bill to the meetings, he may be able to bring China, and perhaps India, into the fold. What this means for CME Group is the likely prospect that its Green Exchange Venture will be in a strong position to capitalize on a new U.S. market, if not an international market, for carbon.

"The Green Exchange, with CME Group and the partnership we've put together, with major market participants, has the potential to dominate this space," says Andy Ertel, president of Evolution Markets, a founding stakeholder in the Green Exchange Venture. "Carbon belongs side-by-side with energy."

Are Carbon Markets Diamonds in the Rough ?

Carbon would become one of the largest commodity markets in the world if and when the United States adopts cap-and-trade legislation, putting the Green Exchange Venture in position to be a major market for U.S. emissions. When it comes to new markets, there probably is not a more dynamic and compelling one than carbon.

The answer to the global debate over reduction in the six greenhouse gas equivalents, known as CO2e, has thus far been to build emissions markets where companies, utilities and individuals can buy and sell carbon-based instruments. In short, create a mandatory carbon cap-and-trade market.

The largest emissions market in the world currently resides in Europe, with the EU Emissions Trading Scheme launchedin 2005. The U.S. market could be much larger, if legislation is passed.

"The model of how the United States market trades mechanically will be very similar to how it trades within Europe," says Jubin Pejman, vice president of the Americas for Trayport, a multi-asset class company that provides connectivity to 55 markets globally. "And once these markets are normalized, you will be able to do spreads between the North American and European markets, which is what some traders are looking for when they trade energy products. So it will open things up where people can trade carbon, energy and power on exchanges, as well as over-the-counter (OTC) markets. That transforms the trading mentality in America."

A Green Venture

Such is the backdrop for the Green Exchange Venture, an initiative to develop an exchange for "green" products between CME Group and a number of major market participants.

The products to be traded on the Green Exchange Venture were originally launched on NYMEX in 2008. Now the Green Exchange Venture is in the process of applying for Designated Contract Market (DCM) status. Futures contracts on carbon, sulfur dioxide, nitrogen dioxide, nitric oxide and nitrous oxide are currently listed on NYMEX and trade on the CME Globex electronic platform, with plans to add new products. And market participants can submit OTC transactions for clearing through the flexible CME Clearport service. The contracts will migrate to the Green Exchange Venture once it becomes a DCM.

Felix Carabello, director of alternative investment products at CME Group, says the Green Exchange Venture is doing more than converting to a DCM; it is building a new market with partners.

"We are working with the founding members to create the new Green Exchange Venture," Carabello says. "We are also working to build a market ecosystem. It's not enough to just launch and then list these contracts. Exchanges need to build markets around these contracts with the right market makers and the right liquidity providers." Given the correlation of carbon with other markets, such as energies and weather, CME Group and the Green Exchange Venture are in a strong position to capitalize.

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