### MEMORANDUM

To: Kevin Culligan, Erich Eschmann, Scott Benolkin, EPA/CAMD

From: Barry Galef, Bansari Saha, Jason Lee, Bickey Rimal, ICF International

Subject: Transaction Costs in Allowance Trading Markets

Date: September 17, 2008

This memorandum summarizes ICF’s interim findings on the magnitude of transaction costs in allowance trading markets. These findings are primarily based on limited conversations with brokers and consultants, review of literature on transaction costs, and information available on broker and exchange websites. 1



### Our findings suggest that the costs are fairly standardized and are generally low compared to

the value of allowances. We found that transac tion costs are usually well below the 1- to 2- percent range of allowance values typically quoted in the economics literature. 2 

### From our discussions with the industry consultant, we also learned that there is enough competition amongst the approximately fifteen brokerage houses that any attempt at charging fees in excess of market standards will be bid down through competition and entry. In many instances, larger clients can negotiate fees even lower than market averages. Moreover, we recently saw exchanges such as Chicago Climate Exchange and New York Mercantile Exchange adding the

SO2 and NOx allowances to their list of commodities.

In this memorandum, we first present the textbook definition of transaction costs discussing the components that constitute the costs. We then present our findings on the magnitude of transaction costs in the allowance trading markets, based on the information we were able to collect in the last few days. In the third and final section, we quantitatively analyze the magnitude of the costs in the CAIR NOx Program.

Definition of Transaction Costs

Transaction costs are costs associated with the exchange of goods or services. In the allowance trading market, transaction costs are often considered to be the fees charged by brokerage firms. These fees are the direct cost s associated with buying and selling allowances. In addition to these direct costs, there may also exist indirect costs (or, as one broker we spoke with called it, costs for “quasi-consulting servic es”). If a company needs some expert analysis or opinions to maximize the value of its allowances, the cost of that analysis can be considered an indirect transaction cost because it is indirectly related to actual execution of the trades. In most cases, costs for these analytical services are not included in the standard fees, but brokers pointed out that these services are only required only in a relatively small fraction of trades (perhaps in the range of 5--10 percent of all trades).

1 We called various brokerage firm s listed on the CAMD website, http://www.epa.gov/airmarkets/trading/buying.html , and were able to interview representatives from two brokerage houses in the last week or so. At their requests though, we would like to keep broker identities

and their affiliations confidential.

2 Transaction costs in some “thin” markets--such as those for renew able energy credits—could be higher at 3 to 3.5 percent, according to the industry consultant we spoke with.2 

### In economic theory, transaction costs have thr ee components: information and search costs, bargaining costs, and policing and enforcement costs. 3 4 

### The first two components—information and search costs, and bargaining costs—are standar d services provided by brokerage firms. These firms facilitate transactions through price discovery and matching buyers with sellers. Once the potential counterparty is identified, the buyers and sellers usually complete the transaction with each other (see Footnote #6 for a variant to this situation). The identities of buyers and sellers are protected during this process.

Brokerage firms also provide various consulting services or other analytical support based on client needs. In most cases, it appears that they provide these services at no extra charge provided that the clients enter into an agreement to trade exclusively with them. In some cases, though, there seem to be an additional fee, as discussed below. These types of services could include analyzing, advising, and strategizing based on the client’s needs. Our discussions with the industry consultant confirmed that these indire ct services are typically for short-term (i.e., a few months to a year) market projections based on brokers’ anticipation about various market parameters (for e.g., studying what demand might be based on coal use, expectations about the degree to which the next summer months can affect electricity demand, etc.). These expert opinions do not involve any sophisticated mode ling by the brokerage firms and large EGUs are unlikely to rely on them because of doubts about their unbiasedness. Given that most firms may not require added payments for conducting thes e services and these se rvices seem to be of low relevance to compliance behavior, costs for these quasi-consulting services appear to be

trivial in relation to overall transaction costs. 5



### The third component, the cost of policing and enforcement, is somewhat difficult to interpret because the cost to prevent a potential conflict between the seller and the buyer is included in the fees charged by the brokerage firms. For ex ample, if a buyer or seller does not have good credit, then the brokerage firm can work as an intermediary in the process of exchanging funds by opening an escrow account. 6 

### Moreover, a seller or buyer occasionally may wish to conduct the transaction using an exchange. In that case, the cost of using the exchange is an added cost but it does prevent any conflict that could occur from the transactions. 7 

### Though the costs of policing and enforcement to prevent a conflict between the seller and the buyer are included in the fees charged by brokerage firms, a conflict between a seller/buyer and the brokerage firm is not. However, we think a possibility of the brokerage firm counterfeiting allowances is very small given that maintaining a good reputation is essential for client-oriented businesses. 8

3 North and Thomas (1973).

4 These costs also include any profits a part icipant in a transaction needs to secure.

5 One broker we spoke with suggested that the average fee for these services range between $5,000- $10,000 and that they typically provi de these services for very few trad es. Thus, these costs appear to be fairly small and unlikely to make a signif icant difference to our conclusions.

6 Brokers told us they do not generally handle the mone tary exchanges and prefer that buyers and sellers directly conduct the financial transaction. If ther e are credit concerns, however, some brokerage houses will undertake the “clearing functions”. These cleari ng functions may include the use of escrow accounts or ensuring allowances get delivered on time. If br okers are asked to provid e these services, they typically provide them as complimentary services as long as their brokerage firm is the exclusive agent in the transaction (i.e., to maintain long-term client relationships). Moreover, costs for these clearing services tend to be fairly small, according to the industry consultant we spoke with.

7 The cost of using the exchange is an added cost but this cost is also trivial at less than 0.1 percent of allowance price.

8 In 2002, Calpine sued its broker when the compan y learned that some allowances it had purchased

were not available.3 

### Fees Charged by Brokerage Firms

The fees charged by brokerage firms seem to be standard and fairly small compared to allowance prices. We conducted interviews with two brokerage firms and both quoted fees in the same range. Moreover, when asked the same question during our interview with the industry consultant, his response was strikingly similar to those given to us by the brokers, providing confirmation that these fees are well standardized due to the competitive nature of the brokerage business. Finally, the range for these fees is also comparable to the range we had

found in our literature review. 9



### The typical fees charged by brokerage firms for each allowance market are shown below.

Exhibit 1: Transaction Fee as a Percentage of Allowance Price

Allowance Type Allowance Price ($/ton) Broker Fee ($/ton) Broker Fee as a percentage of

Allowance Price

SO2* 300 0.50 < 0.2 %

Seasonal NOx* 850 10-15 < 1.8 %

Annual NOx* 5000 20-25 < 0.5 %

Note : The allowance prices are prices before CAIR was vacated by the DC circuit court. *The allowance price for SO2, Seasonal NOx, and Annual NOx are the spot price, seasonal NOx 2008 price, and annual NOx 2009 price, respectively.

Source : Evolution Markets ( http://new.evomarkets.com/index.php?page=ResourcesMarket_Updates-Monthly_Market_Updates )



### Given that the SO2 allowance price was about $300/ton just days before the CAIR vacatur, the transaction costs appear to be less than 0.2 percent of the allowance value. Considering the fact that SO2 allowance price was hovering around $550/ton in the second half of 2007 and gradually came down to the $300/ton level, trans action costs for SO2 allowances could have been significantly lower than 0.2 percent of the allowance value if CAIR had not been vacated. 10 

### For seasonal NOx allowances, the price was $850/ton, so these costs are less than 1.8 percent. For CAIR annual NOx allowances, the allowance price was $5,000/ton before CAIR was vacated by the court, which translates to less than 0.5 percent. 11

9 One industry expert, Gary Hart, had stated that the typical fee charged by brokerage firm is $0.50 for each SO2 allowance. His statement is presented in “The U.S. Acid Rain Program: Key Insights from the Design, Operation, and Assessment of a Cap-and-Trade Program.”

10 “ SO2 Markets – July 2008 Monthly Ma rket Update,” Evolution Markets, http://new.evomarkets.com/index.php?page=Emissi ons_Markets-Markets-NOx_Seasonal_Allowances

11 The seasonal NOx price of $850/ton and the annual NOx price of $5,000/ton were in effect days before the CAIR ruling. In general, prices were in the ra nge of $750/ton to $850/ton for seasonal NOx allowances and in the range of $3,000/ton to $5,000/ton for the an nual NOx allowances in 2008, according to the “NOx Monthly Market Update (07/08 )” published by Evolution Markets.4 

### Exchange Fees

According to our research, costs of using exchanges are much lower than the fees charged by brokerage firms, as shown in Exhibit 2 below. On a per ton basis, these exchange fees translate to less than 10 cents/ton for SO2, less than a dollar/ton for seasonal NOx and up to $2.50/ton for annual NOx, which are much lower than the broker fees shown in Exhibit 1 above.

Exhibit 2: Summary of Trading Fees per Contract at CCFE and NYMEX

Product CCFE Green Exchange (NYMEX)

Contract

Size Member Fee (per contract) NonMember Fee (per contract) Contract

Size Transaction Fee (per contract)

SO2 Futures 25 tons $1.60 $2.00 100 tons $6.00

Seasonal NOx Futures 5 tons $2.00 $2.50 10 tons $7.00

Annual NOx Futures 1 ton $2.00 $2.50 10 tons $7.00



### The actual transaction fees for using exchanges are thus less than 0.1 percent of the allowance values, as shown in Exhibits 3 and 4 below. Exhibit 3 presents exchange fees related to the US SO2 and NOx markets while Exhibit 4 presents comparable numbers for the EU CO2 market.

Exhibit 3: Summary of Trading Fees per Contract in terms of percentage of Allowance Price

Product CCFE Green Exchange (NYMEX)

Member

Fee NonMember

Fee Transaction Fee

SO2 Futures 0.02% 0.03% 0.02%

Seasonal NOx Futures 0.05% 0.06% 0.08%

Annual NOx Futures 0.04% 0.05% 0.01%

Note: This table has been corrected to take into account the size of each contract.5 

### Exhibit 4: Transaction Fee at selected Exchanges for CO2

Allowance

Exchange Transaction Fee ($ per 1,000 metric tons) Transaction

Fee as a percentage of

CO2 Allowance

Value

ECX 2.8 - 3.5 0.01%

NordPool 4.2 0.01%

EEX 1.4 - 4.2 0.01%

Green Exchange (NYMEX) 2 0.01%

The CO2 Allowance price was $34.28 (as of 09/05/08) Source: Point Carbon ( http://www.mfe.govt.nz/publications/climate/issuesinternational-carbon-market-oct07/html/index.html ), NYMEX ( http://nymex.greenfutures.com/markets/ )



### There are additional fees associated with using the exchanges, such as annual fees and application fees, but we assume those are paid by brokers annually, and are minimal costs of doing business for brokerage firms.

Estimating Transaction Costs for the NOx Program

We quantified the total transaction costs under the CAIR NOx program by using emission projections from IPM. We also estimated the number of allowances that each fossil unit could get by assigning the allowances given to each state in proportion to the heat input in 2010, adjusted for fuel type. This fuel type adjustment counted only 60 percent of the heat input for oil units and 40 percent for gas units, paralleling how the allowances are calculated for each state. Once the NOx allowances for each unit under CAIR are estimated, we calculated the number of allowances each unit would need to sell or buy. These make up the number of allowances that need to be transacted. We then applied the $20 to $25 per ton for the transaction fee to estimate the overall percentage of transaction costs as a share of total allowance transactions. Results indicate that transaction costs for the NOX program were generally very small at less than one-half of one percent.

Exhibit 5: Summary of Transaction Costs under CAIR Annual NOx Program in 2010

Fee for Transacting NOx Allowance $20 - $25/ton

Total Transaction Costs $21 – $26 million

Total Value of Transacte d Allowances $5.28 billion

Transaction Costs (%) 0.4 – 0.5%

Note: We used $5,000/ton for the NOx allowance pr ice since that was the market price before the CAIR vacatur. Even if we use the IPM projecte d price of $1,079/ton for CAIR NOx allowance in 2010, the percentage of the transacti on cost is only about 2 percent.6 

### Using information gathered from our discussions with brokers, we also quantified the costs for advisory services charged by brokerage firms fo r their market analyses. We estimated the number of utility operators to be about 360 and assumed that 5 to 10 percent of them could seek some sort of advisory services each year (using approximate figures quoted by a broker). We then multiplied the resulting operators seeking consulting services by $5,000 - $10,000, which was the fee range also suggested by the brok er in our conversation. As shown in Exhibit 6 below, the resulting estimated cost of advisory services are very small compared to the transaction costs charged by the brokerage firm s. When these advisory service costs are added to the transaction costs, the overall transaction cost percentages remain very close to the 0.4 – 0.5 percent of the total NOx allowance value.

Exhibit 6: Summary of Advisory Service Costs under CAIR Program in 2010

Fee for Each Advisory Service $5,000 - $10,000

Number of Operators 360 12

% of Operators Seeking Advisory Service 5% -10%

Total Costs of Advisory Service $90,000 - $360,000



### These costs appear on their face to be too small too discourage the affected units from seeking a distribution of emissions close to the least-cost outcome. Moreover, these low transaction cost estimates also seem to validate the industry consultant’s opinion that transaction costs are generally very small and are not expected to affect program outcome. 13 

### As we have already discussed with you, it should be possible to strengthen this tentative conclusion, though, using a simple modeling approach.

12 From the units we projected to be participating in the transactions under CAIR in 2010, we matched their ORIS codes with the Operator ID numbers in the latest eGRID database to identify the unique number of operators under CAIR.

13 The consultant felt that high transaction costs, if present, might discourage speculators but are unlikely to affect those who need to trade for compliance purposes.