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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

**Interpretive Letter #1040**

**September 2005**

September 15, 2005

Subject: **\[ \]** ("Bank") Emissions Derivatives Proposal

Dear **\[ \]**:

This is in response to the Bank's request to engage in
customer-driven[^1] physically settled derivative transactions in
emissions allowances. The Bank also requests to enter into physical
transactions in emissions allowances to manage the risks of the
emissions derivatives transactions. For the reasons discussed below, we
conclude that the Bank may engage in the transactions it proposes,
provided the Bank's examiner-in-charge is satisfied that the Bank has
adequate risk management and measurement systems and controls to conduct
the activities on a safe and sound basis.

#### I. Background

The Bank currently engages in a variety of financial intermediation
transactions involving a wide range of energy-related commodities. The
Bank has received authority to engage in perfectly matched cash-settled
emissions derivative transactions to enable its customers to manage the
price risk associated with various commodities including emissions
allowances, subject to certain conditions.[^2] The Bank now proposes to
enter into physically settled emissions derivatives transactions.[^3]
The Bank also proposes to hedge the market risk associated with the
proposed emissions derivatives transactions on a
transaction-by-transaction or portfolio basis, primarily with physical
emissions allowances.[^4] The Bank represents that it will engage in the
proposed emissions derivative transactions and hedges solely for the
accommodation of customers or for its own risk management purposes.

The proposed emissions derivatives transactions[^5] will be linked to
three emission allowance markets: the U.S. SO2 (Sulfur Dioxide)[^6] and
NOx (Nitrogen Oxide)[^7] markets and the European Union's CO2 (carbon
dioxide[^8]) market.[^9] These emissions markets are volatile and 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.[^10]

In view of the current market, the Bank proposes to physically settle
its customer-driven emissions derivatives transactions and use physical
hedges in emissions allowances. The Bank believes these physical
transactions are a natural extension of the Bank's existing financial
intermediation activities in emission derivatives and other energy
commodities and will benefit the customer as well as the Bank.[^11] The
major difference between financial intermediation activities the OCC has
previously approved for the Bank and the proposed emissions derivatives
transactions is that the proposed transactions will be physically
settled. The Bank contends that physical settlement of emissions
derivatives does not pose the same risks as other physical commodities,
such as natural gas and petroleum, because physical settlement of
emissions derivatives essentially involves a book entry in the relevant
governmental agency's database. For example, in the SO2 and NOx markets,
the EPA records the allocation and transfer of SO2 and NOx allowances in
its ATS database.[^12] The EU maintains a similar tracking system for
CO2 emission allowances.

The Bank believes its emissions derivative business will provide its
customers risk management tools in substantively the same manner as the
Bank provides such tools in connections with its existing energy
commodity business. For example, a utility that is net short SO2
allowances in the near term either must purchase additional emission
allowances or reduce its existing emissions in order to maintain
operations. It can purchase near term forward emission allowances
through the derivatives market and can compare the cost of the
technological abatement to arrive at the most efficient way to continue
its operations in the long run. The derivatives markets also enable the
utility to forecast the cost of allowances into the future and lock in
supply at prices it deems attractive. A utility that is net long SO2
allowances can enter into forward contracts or can sell call options to
lock in pricing it deems attractive and thus generate additional
revenue.

The Bank commits that it will apply to the emissions derivatives
business the same risk management processes and procedures that it
applies to its existing commodity derivative business. Specifically,
prior to engaging in emissions allowances transactions (both derivative
and physical), the Bank commits that it will adopt and implement all
necessary policies, procedures, and controls (including those set forth
in the OCC Handbook: *Risk Management of Financial Derivatives* [^13]
and OCC Banking Circular No. 277[^14]) and meet all regulatory standards
and that the Bank has in place all appropriate mechanisms to identify,
monitor, limit and control the risks inherent in these transactions. In
addition, the Bank commits to conducting a full evaluation of (i)
pricing, hedging, processing, record keeping, documentation, accounting,
operations and risk management, (ii) knowledge and staff development,
and (iii) training of personnel by the Compliance Department and
development of a supervisory framework to ensure compliance with these
policies and procedures, including trading practices. All commodity
derivative transactions, including the proposed emissions derivative
transactions, are subject to the Bank's Appropriateness Policy for
Over-the-Counter Foreign Exchange, Derivatives and Structured Securities
Transactions with Clients, and, when required, structured transactions
are subject to further review by the Bank's Policy Review Committee.
Finally, the Bank will apply the policies, procedures, and controls that
govern its existing physical commodity activities, which include the
conditions to these activities set out by the OCC in BC-277 and the *OCC
Derivatives Handbook*.[^15]

The Bank also commits that its activities in "physical" emissions
allowances will be used only to supplement the Bank's risk management
activity and to reduce risks associated with otherwise permissible
banking activities and entered into with customer-driven transactions
and not as a vehicle to speculate in emissions allowances.

#### II. Discussion

In our opinion, the Bank may engage in customer-driven, physically
settled emissions derivative transactions and hedge risks arising from
these permissible banking activities with physical transactions in
emission allowances, provided the Bank has established an appropriate
risk measurement and management process to conduct the activities on a
safe and sound basis for its emission derivative and hedging activities
that is satisfactory to the Bank's examiner-in-charge. This process is
necessary for the Bank to achieve its customer risk management
objectives in a safe and sound manner and thus must be established
before the OCC can determine that the proposed activities are
permissible.

A.  **National banks may engage in customer-driven physically settled
    emissions derivatives and hedging transactions pursuant to 12 U.S.C.
    § 24(Seventh).**

The OCC previously determined that the Bank may engage in perfectly
matched cash-settled emissions derivatives transactions.[^16] The Bank
now proposes to physically settle and hedge emission derivative
transactions on a transaction-by-transaction or portfolio basis. The
proposed physical transactions will enable the Bank to participate fully
in the emissions markets and provide customers with a broader range of
sophisticated risk management tools to address their financial, risk
management and liquidity needs. The ability to engage in physical
transactions in the emissions markets also will increase the Bank's
hedging options and its ability to control risks in its emissions
derivatives business.

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.[^17] For example, the OCC has determined that a national
bank may physically hedge the risks arising from their commodity-linked
activities in markets that involve physical delivery of commodities
where the physical hedging would achieve a more accurate and economical
hedge than cash-settled hedge transactions.[^18] The OCC concluded that
the activities were convenient and useful to bank permissible
commodity-linked activities and therefore, permissible for national
banks under 12 U.S.C. § 24(Seventh). The OCC conditioned its approval on
the condition that the transactions supplement the bank's existing risk
management activities, constitute a limited amount of a bank's risk
management activities and are used only to manage risk.

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. The OCC concluded
that physical hedging was part of or incidental to the business of
banking and a permissible activity for national banks under 12 U.S.C. §
24(Seventh), since physical hedging allows banks to reduce the risks
associated with an otherwise permissible banking activity, engaging in
commodity-linked transactions.[^19]

In these decisions, the approved activities were subject to a number of
conditions due to the 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.[^20]

The OCC has previously recognized that physical transactions in equities
are permissible hedges without limiting the positions to a nominal
percentage of the bank's risk management activities,[^21] in part
because holding equities did not pose the storage, transportation,
environmental and insurance risks associated with holding nonfinancial
commodities.[^22]

This same reasoning can be applied to physically-settled emissions
derivatives transactions and physical hedges in emission allowances. The
activities are convenient and useful to the Bank in conducting its
emissions derivatives business, and they do not pose the risks
associated with other commodities. Thus, they are permissible activities
for national banks under 12 U.S.C. § 24(Seventh).

Congress also has recognized the authority of national banks to engage
in commodity derivatives transactions. That authority is not limited to
cash-settled transactions. Under the Gramm-Leach-Bliley Act,[^23] banks
may offer "identified banking products" without registration under the
Securities Exchange Act of 1934,[^24] subject to banking law
requirements and supervision. "Identified banking products" include
certain swap agreements, defined as "any individually negotiated
contract, agreement, warrant, note or option that is based, in whole or
in part, on the value of, any interest in, or any quantitative measure
or the occurrence of any event relating to, one or more commodities,
securities, currencies, interest or other rates, indices, or other
assets."[^25] There is nothing in the GLBA's definition of "swap
agreement" that requires cash-settlement. Thus, physically settled
emissions derivative transactions would qualify as swap agreements and
therefore would be regarded as "identified banking products" under the
GLBA.

For these reasons, we conclude that the Bank may engage in
customer-driven physically settled emissions derivative transactions and
hedge the risks of those transactions with physical transactions in
emissions allowances pursuant to 12 U.S.C. § 24(Seventh), provided the
Bank's examiner-in-charge is satisfied that the Bank has established
adequate risk measurement and management controls to conduct its
emission derivative and hedging activities on a safe and sound
basis.[^26]

B. The derivatives and hedging activities must be conducted in a safe
and sound manner.

For the Bank to permissibly engage in the proposed activity, the Bank's
risk measurement and management capabilities must be of appropriate
sophistication to ensure that the activity can be conducted in a safe
and sound manner and in accordance with applicable law. Consequently, in
order for the OCC to conclude that this activity is permissible for the
Bank because it is part of the business of banking or convenient and
useful to conducting authorized banking activities, the Bank must
demonstrate to the satisfaction of its EIC that the Bank has established
an appropriate risk measurement and management process for its proposed
activity. As detailed further in the *OCC Derivatives Handbook* and BC
277, an effective risk measurement and management process includes board
supervision, managerial and staff expertise, comprehensive policies and
operating procedures, risk identification and measurement, and
management information systems, as well as an effective risk control
function that oversees and ensures the appropriateness of the risk
management process.

In addition to a risk management program, the Bank's process must
include an independent compliance-monitoring program to ensure ongoing
compliance with the specific commitments made by the Bank described
above.[^27] The Bank must have an adequate and effective compliance
monitoring program that includes policies, training, independent
surveillance and well-defined exception approval and reporting
procedures.

The Bank may not commence the proposed activity unless and until its
examiner-in-charge has concluded that the foregoing standards are met.

#### 

#### III. Conclusion

The Bank may conduct the proposed customer-driven, physically settled
emissions derivative business and hedge risks arising from these
permissible banking activities as an extension of its existing
energy-related commodities derivatives business, provided the Bank's
examiner-in-charge is satisfied that the Bank has adequate risk
management and measurement systems and controls to conduct the
activities on a safe and sound basis.

Sincerely,

*/s/ Julie L. Williams*

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^1]: A "customer-driven" transaction is one entered into for a
    customer's valid and independent business purpose. *See* OCC
    Interpretive Letter No. 892 (Sept. 13, 2000).

[^2]: *See* OCC Interpretive Letter No. 1039 (Sept. 13, 2005). An
    emission allowance is an authorization or license that gives
    affected entities the right to emit certain pollutants. It is not
    solely a license to pollute, however. Emission allowances may be
    bought or sold by any individual or entity that establishes an
    account at the relevant governmental authority. For those entities
    that trade emissions allowances or purchase allowance with the
    intent to "retire" them (typically environmental groups), emissions
    allowances are not used as administrative licenses, but rather are
    more akin to intangible contract rights. Thus, a hedge fund that
    purchases an emission allowance for investment acquires an
    intangible contract right that may be transferred or sold to other
    entities. Emissions allowances exist and are stored and tracked on
    the records of the relevant government body (*e.g*., U.S.
    Environmental Protection Agency ("EPA") or European Union ("EU")).
    There are no transportation, environmental, storage or insurance
    risks associated with possession of emission allowances.

[^3]: The Bank also may enter into customer-driven, cash-settled
    emissions derivatives transactions when sufficient liquidity and
    depth develops in the emissions derivatives market. The market is
    currently a physical market.

[^4]: The Bank also may hedge with cash-settled over-the-counter
    transactions and, when sufficient liquidity and depth develops in
    the market, exchange-traded futures and options. The Bank also may
    enter into to back-to-back hedges with market participants or with
    nonbank affiliate. If the Bank engages in transactions with
    affiliates, the Bank represents that it will comply with the
    requirements of sections 23A and 23B of the Federal Reserve Act and
    the Federal Reserve Board's Regulation W and with the Bank's Section
    23A and 23B and Regulation W policy.

[^5]: "Emission derivatives transactions" encompass all transactions
    where a portion of the return (including interest, principal or
    payment streams) is linked to the price of the allowances to emit
    sulfur dioxide, nitrogen oxides and carbon dioxide, including
    derivatives transactions such as futures, forwards, options, swaps,
    caps, and floors.

[^6]: ^?^ The Acid Rain Program, which created the SO2 emission
    allowances, was established to achieve significant reductions in
    SO2, the primary cause of acid rain. The SO2 market is the most
    liquid of the environmental markets and trades actively on a daily
    basis.

[^7]: NOx emission allowances program, now known as the NOx SIP Call
    budget trading program, is similar to the SO2 emissions allowance
    program.

[^8]: The CO2 program includes CO2 and other green house gases regulated
    under the Kyoto Treaty. The CO2 program is currently in a pilot
    phase.

[^9]: These emission allowance programs are based on a "cap and trade"
    design. For example, in the SO2 Allowance Program, affected
    utilities are allocated allowances based on their historic fuel
    consumption and a specific emissions rate. Each allowance permits a
    unit to emit one ton of SO2 during or after a specified year. The
    EPA, in a central database called the Allowance Tracking System
    ("ATS") records SO2 allowances. Allowances are issued in the ATS on
    a vintage year basis from 2000-2030. On an annual basis, for each
    ton emitted, one ton is then retired in the ATS. Affected sources
    with shortfalls of allowances may buy them from sources that have
    reduced emissions below their allocated level. Unused allowances of
    a given vintage year may also be "banked forward" to the next or
    future years.

[^10]: In the U.S., the primary liquidity source for emissions
    allowances trading is in the OTC markets. There is no established
    exchange-based trading. The Chicago Climate Exchange has received
    Commodity Futures Trading Commission ("CFTC") approval for SO2
    futures, and the NYMEX has proposed to open a market as well. The
    exchanges have yet to provide the liquidity necessary to encourage
    active trading. In Europe, several exchanges are developing products
    linked to emissions allowances, but none are actively trading at
    this time.

[^11]: The CFTC views emissions allowances as "commodities" under the
    Commodity Exchange Act. For example, the CFTC approved the
    application of the Chicago Climate Futures Exchange ("CCFE") for
    designation as a contract market. The CCFE had proposed to offer
    trading on emissions allowances and offer options on emissions
    allowance futures. *See* CFTC Letter and Order Regarding the
    Application of the CCFE for Designation as a Contract Market (Nov.
    9, 2004) and the CFTC Staff DCM Designation Memorandum Regarding the
    CCFE Application (Nov. 3, 1994).

[^12]: The ATS discloses the identity of buyers and sellers, but does
    not provide price information. Instead emission allowance price
    information is discoverable through brokers or direct discussions
    with other market sources. The Argus AIR Daily produces daily,
    weekly and monthly indices for the SO2 (SOPI Indices) and NOx (NOPI
    indices) spot markets. The SOPI and NOPI indices (often called the
    AIR Daily indices), track the SO2 and NOx markets by means of a
    daily phone survey of active brokers and traders.

[^13]: OCC Handbook: *Risk Management of Financial Derivatives* (Jan.
    1997) ("*OCC Derivatives Handbook*").

[^14]: OCC Banking Circular No. 277 (Oct. 27, 1993) ("BC-277").

[^15]: The Bank commits that the volume of its risk management activity
    with respect to emissions derivatives will be a small percentage of
    the Bank's overall commodity derivatives risk management activity.
    The proposed physical transactions in emissions allowances are
    expected to be a significant percentage of the Bank's risk
    management activities in emission derivatives, however. This
    reflects the fact that the current emissions market is primarily a
    physical market and thus, hedges will be in the appropriate physical
    vintage. Given the intangible nature of the emission allowances,
    discussed below, this level of physical activity is not excessive.

[^16]: OCC Interpretive Letter No. 1039, *supra*.

[^17]: *See, e.g.*, OCC Interpretive Letter No. 937 (June 27, 2002)
    (national bank may engage in customer-driven, cash-settled
    electricity derivative transactions and hedge risks arising form
    those permissible banking activities, provided the bank has an
    appropriate risk management and measurement process in place) and
    OCC Interpretive Letter No. 962, (April 21, 2003) (national bank may
    settle and hedge its customer-driven bank permissible electricity
    derivative transactions by transitory title transfers).

[^18]: OCC Interpretive Letter No. 632 (June 30, 1993).

[^19]: OCC Interpretive Letter No. 684 (Aug. 4, 1994).

[^20]: The Bank has represented that the proposed physical transactions
    are subject to the EPA's regulatory scheme but are not subject to
    Federal Energy Regulatory Commission or CFTC regulatory
    jurisdiction. The EPA regulatory scheme is centered on maintaining
    the integrity of the allowance trading system and ensuring that
    end-users (utilities) are relying on genuine allowances and that a
    unit's emissions do not exceed the number of allowances it holds.
    This is accomplished through an Allowance Tracking System that
    records allowance transfers.

[^21]: As a policy matter, the OCC has limited national banks' equity
    holdings with voting rights to no more than 5% of a class of
    securities of any issuer. *See* OCC Interpretive Letter No. 935 (May
    14, 2002).

[^22]: *Id*. *See also* OCC Interpretive Letter No. 892, *supra*
    (national banks use of equities to hedge permissible equity
    derivative transactions provides the most accurate, least costly
    hedges, and thus is convenient and useful in conducting permissible
    banking activities, and incidental to the business of banking).

[^23]: *See* Gramm-Leach-Bliley Act, §§ 201, 202, and 206, P.L. 106-102,
    113 Stat. 1338 (1999) ("GLBA").

[^24]: 15 U.S.C. § 78a, *et seq*.

[^25]: *See* GLBA §§ 201, 202, and 206.

[^26]: The Bank also may engage in customer-driven cash-settled
    emissions derivative transactions and hedging with cash-settled
    emissions allowances pursuant to 12 U.S.C. § 24(Seventh), provided
    the Bank has established an appropriate risk measurement and
    management process for its emissions derivative and hedging
    activities.

[^27]: The OCC has long considered safety and soundness issues when
    determining whether an activity is part of, or incidental to the
    business of banking. *See, e.g.*, OCC Interpretive Letter No. 892,
    *supra* (national bank may engage in equity hedging activities only
    if it has an appropriate risk management process in place); OCC
    Interpretive Letter No. 684, *supra* (commodity hedging is a
    permissible banking activity provided the activity is conducted in
    accordance with safe and sound banking practices); *Decision of the
    Office of the Comptroller of the Currency on the Request by* *Chase
    Manhattan Bank, N.A. to Offer the Chase Market Index Investment
    Deposit Account* (Aug. 8, 1988), 1988 OCC Ltr. LEXIS 266 (national
    banks have the authority to establish and determine the amount of
    the payments to be made and received under their deposit and loan
    contracts by reference to any index or standard as long as the bank
    is in compliance with safe and sound banking principles); and OCC
    Interpretive Letter No. 376 (Oct. 22, 1986) (indemnification from
    losses resulting from participation in the bank's fiduciary
    securities lending program is a permissible incidental activity
    provided the indemnification is consistent with OCC guidance and
    safety and soundness).