This article originally appeared in Point Carbon News.

At the heart of any successful cap-and-trade program is a well-functioning market for the trading of emissions allowances.  At the same time, the recent high-profile market scandals and crises have led many to question market mechanisms in general.  Rather than leading to a wholesale indictment of markets, these events should instead highlight the critical need for appropriate market design, transparency and oversight.  Luckily, Congress has the opportunity to design the carbon trading market oversight framework at a point in time before long-standing carbon trading practices and systems have been fully established.

A well-designed carbon market should reflect a balance between free market activity and regulation.  To the extent that the market cannot be manipulated or distorted, it can achieve its purpose—to spur innovation and reduce GHG emissions at the least possible cost to the economy.  Policies should include effective means to prevent excessively high prices, extreme price volatility, and irresponsible risk-taking.  Thousands of businesses would be affected by a mandatory GHG emissions trading system, and it is in the public interest to ensure the market functions efficiently and allowance prices generally reflect the balance of supply and demand.

The challenge faced by lawmakers and regulators is to create conditions that provide effective transparency and oversight while allowing market participants to structure contracts that best fit their specific circumstances.  A central question in this regard is whether carbon market transactions should be allowed to take place in the over-the-counter (OTC) market as well as on exchanges.  While exchange-based trading allows more transparency and possibly more direct access for market regulators, many argue that OTC trading should also play a key role in a carbon market.

Both exchange-based and OTC trading have their strengths and weaknesses. Trading on exchanges provides transparency, ease of oversight, the virtual absence of counterparty risk, and market liquidity. Excessive speculation can be curbed to some degree through position limits, while daily cash settlement and clearing services lower the risk of default and limit the potential for negative ripple effects if default occurs.

While exchanges are not a panacea and do not ensure the absence of excessive speculation or market manipulation, they do provide a fair trading platform for market participants and regulators alike to see and access prices for carbon commodities. The centralized, standardized, digitized, and rules-based nature of exchange-based trading lends itself to efficient and effective oversight, provided that exchanges are required to take preventive measures and regulators are authorized to protect markets from abuse. The high level of transparency associated with exchange-based trading facilitates regulatory market surveillance as well as price discovery and competitiveness.

On the other hand, exchanges only offer standardized contracts, and have significant collateral requirements, which can make it more difficult for some important market participants, such as utilities, to participate.  OTC transactions provide greater flexibility than those on an exchange, as contracts can be customized more precisely to a company’s particular risk management needs, and a wider array of assets can be used as collateral for transactions.  This can be particularly helpful both to smaller participants and to utilities, which may look to minimize their carbon risk over a period of decades while maintaining significant cash resources for infrastructure investments.  Offset contracts provide another example of the need for customization, as the volume and timing of future credits can be uncertain due to factors such as project approval, verification, and performance. A non-standard OTC contract might be necessary in such cases.

There is no question that a market approach provides the clearest and lowest-cost incentive to reduce GHG emissions and invest in new technologies. In developing the most effective carbon market, lawmakers and regulators have several options for improving oversight of exchange-based and OTC trading. They include the imposition of position limits, clearing and collateral requirements, reporting obligations, and restrictions on participation in certain types of transactions.  While OTC markets are more challenging to regulate by virtue of their decentralization and traditional lack of transparency, nothing technically prevents regulators from establishing the types of requirements above for OTC trades as well as those on exchanges.

In the end, both OTC and exchange-based systems can have roles to play in a federal carbon market, and it may be possible to maintain a role for OTC transactions while ensuring an appropriate level of regulatory oversight and efficient market operation.  The challenge faced by lawmakers and regulators is to strike the right balance between market transparency and oversight, and the ability of market participants to structure contracts that best fit their specific circumstances.

An expanded discussion of this topic can be found in the new Pew Center brief, “Carbon Market Design and Oversight: A Brief Overview.”