CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

CBO

Evaluating Limits on 

Participation and 

Transactions in 

Markets for 

Emissions 

Allowances

DECEMBER 2010

© fotosearch/Superstock
Pub. No. 4135
The Congress of the United States O Congressional Budget Office

A

STUDY

CBO

Evaluating Limits on Participation and 

Transactions in Markets for 

Emissions Allowances

December 2010
CBO
Preface

CBO

In response to concerns that the accumulation of greenhouse gases in the atmosphere 

could have serious and costly effects, the Congress has considered creating a nationwide capand-trade program that would limit emissions of those gases below the levels projected under 

current law and would allow trading of rights (allowances) to produce those emissions. The 

ability to buy and sell allowances would reduce the cost to the economy of meeting the cap by 

letting market forces determine where, how, and when the associated cuts in emissions would 

be made. However, in creating markets for allowance trading, policymakers would face important questions about how best to ensure that any instability in those markets did not raise the 

cost of reducing emissions or spill over to the rest of the U.S. economy—as happened with 

instability in mortgage markets during the recent financial crisis.

Various types of participants would probably be active in allowance markets, including covered entities (emitters that must comply with the cap); other entities that would receive allowances from the government and want to sell them; and numerous banks, investors, and other 

parties that would buy allowances from, and sell them to, the first two types of participants. 

Transactions in allowance markets would most likely include allowance derivatives (financial 

contracts whose value would depend on the future price of allowances). Although broad participation and derivatives transactions are common in many markets—such as those for agricultural and energy commodities—some observers have proposed excluding certain market 

participants or transactions under a potential cap-and-trade program to protect allowance 

markets and the broader economy from unwanted risks. 

This Congressional Budget Office (CBO) study—prepared at the request of the Chairman of 

the Senate Committee on Energy and Natural Resources—examines the likely impact of prohibiting allowance trading by parties other than covered entities or allowance recipients and of 

banning the use of allowance derivatives. The report also discusses some alternative restrictions on participation and transactions in allowance markets that could impose lower costs 

on covered entities while reducing the risk of instability in those markets and in the overall 

economy. In keeping with CBO’s mandate to provide objective, impartial analysis, this study 

makes no recommendations. 

Andrew Stocking of CBO’s Microeconomic Studies Division wrote the study, under the 

guidance of Joseph Kile and David Moore. Terry Dinan, Mark Hadley, Deborah Lucas, 

David Torregrosa, and Steven Weinberg of CBO provided helpful comments on earlier drafts, 

as did Scott Irwin of the University of Illinois at Urbana-Champaign, Irina Leonova of the 

Commodity Futures Trading Commission, and Jeffrey Hopkins of Rio Tinto. (The assistance 

of external reviewers implies no responsibility for the final product, which rests solely with 

CBO.)
CBO

PREFACE

Christian Howlett edited the study, and Kate Kelly proofread it. Maureen Costantino 

prepared the report for publication, with assistance from Jeanine Rees, and designed the 

cover. Monte Ruffin oversaw the printing of the report, Linda Schimmel handled the print 

distribution, and Simone Thomas prepared the electronic versions for CBO’s Web site 

(www.cbo.gov).

Douglas W. Elmendorf

Director

December 2010
Contents

CBO

Summary vii

Overview of Allowance Markets in a Proposed Cap-and-Trade Program 1

Participants in Allowance Markets 1

The Market for Allowance Derivatives 2

The Potential Scale of the Derivatives Market 2

Concerns About Allowance Markets 4

Systemic Risk 4

Lack of Transparency 5

Decoupling and Price Bubbles 5

Manipulation 5

Limits on Market Participants 6

Prohibition on Traders 6

Position Limits 8

Circuit Breakers 9

Limits on Derivatives 10

Prohibition on Derivatives 11

Reliance on Centralized Clearing 12

Trading Through Formal Exchanges 13

Increased Regulation of Over-the-Counter Trading 14

Table

1. Sizes of Derivatives Markets for Emissions Allowances, Financial 

Products, and Various Commodities, 2009 3

CBO

Summary

Following the recent financial crisis, concerns about 

how financial markets function and what can destabilize 

them have increased. In a cap-and-trade program to 

reduce greenhouse gas emissions—such as the programs 

that have been considered by the Congress—a central feature would be the markets in which emissions allowances 

would be traded. Thus, issues of key interest to policymakers designing such a program include what kinds of 

participants and transactions would be permitted in 

allowance markets. 

Under a cap-and-trade program, entities covered by the 

cap—which could include oil refiners, natural gas distributors, and large electricity generators that use fossil 

fuels—would be required to hold government-issued 

allowances that would give them the right to emit a specific amount of greenhouse gases into the atmosphere. 

Those covered entities would be free to buy and sell 

allowances, which would give rise to markets to facilitate 

that trading. Active allowance trading would reduce the 

total cost of meeting a cap on emissions by helping covered entities manage fluctuations in their need for allowances caused by changes in the production of emissionsintensive goods and services. 

At the same time, observers worry that active allowance 

markets could foster complex or opaque transactions, 

price bubbles, market manipulation, or other instabilities 

that could raise the cost of reducing emissions and harm 

the broader economy. That potential has spurred proposals to prohibit or otherwise limit certain types of market 

participants or transactions under a cap-and-trade program. This analysis finds that less restrictive limits would 

generally have a greater chance of addressing observers’ 

concerns, with fewer negative effects, than outright 

prohibitions would.

Concerns About Allowance Markets

Unless regulation prevented it, allowance markets would 

probably attract many of the same types of traders and 

transactions as existing markets for agricultural, energy, 

and financial products. Besides covered entities (and 

other entities that might receive allowances from the 

government), traders would include banks, investors, 

and other parties that would not be subject to a cap on 

emissions but would facilitate transactions by trading 

allowances with covered entities. The transactions of 

those various parties would probably include allowance 

derivatives—financial contracts that, for example, would 

guarantee the holder a price for a specific number of 

allowances at a specified future time. Such traders and 

transactions are common in existing allowance markets, 

including the ones created by current cap-and-trade programs for greenhouse gas emissions in the northeastern 

United States and the European Union. 

Some observers, however, are concerned that transactions 

by traders who are not covered entities (sometimes called 

“speculators”) and derivatives transactions can pose risks 

to the stability of allowance markets and reduce the costeffectiveness of a cap-and-trade program. For example, 

concerns exist that speculative traders and complex or 

opaque financial transactions can make allowance markets less transparent, cause allowance prices to spike and 

perhaps differ (become “decoupled”) from the cost of 

reducing emissions, or contribute to market manipulation. Moreover, instability in allowance markets might 

harm the broader economy. That concern is underscored 

by the recent collapse of the market for private mortgagebacked securities, which illustrated how disruptions in 

one market or sector of the economy can spill over into 

other markets—a phenomenon known as systemic risk.

Limiting Participants in 

Allowance Markets

To reduce worries about systemic risk, price decoupling, 

and manipulation, some observers have proposed limiting participation in allowance markets only to covered 

entities. Prohibiting other parties from trading in 
VIII EVALUATING LIMITS ON PARTICIPATION AND TRANSACTIONS IN MARKETS FOR EMISSIONS ALLOWANCES

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allowance markets, however, would most likely raise costs 

for covered entities by reducing market liquidity (the ease 

with which firms could buy or sell large quantities of 

allowances without affecting their current market price). 

In addition, a ban on certain participants would be 

difficult and costly to enforce.

Such a ban would also be unlikely to address concerns 

about allowance markets effectively. The reason is that 

the same financial incentives that would motivate noncovered entities to participate in the market—the ability 

to profit from absorbing the risk of price changes or the 

potential to realize gains from investing in allowances—

would probably cause some covered entities to pursue 

those same opportunities. But to the extent that those 

covered entities were less effective at doing so than the 

excluded participants, the cost of complying with the 

program would be higher and market stability could 

decline. 

Alternatively, participation limits that were less stringent 

and more targeted could address some of the concerns 

noted above at a lower cost. For example, many markets 

for agricultural, energy, and financial products have 

implemented “position limits,” which restrict the number 

of contracts a participant can hold. Many of those markets also use “circuit breakers,” which limit the total 

amount by which prices can rise or fall over a given 

period. Position limits would probably lessen the possibility of systemic risk and manipulation in allowance markets, and circuit breakers would reduce the likelihood 

that allowance prices would become decoupled from the 

cost of reducing emissions. Both types of regulations have 

the drawback of tending to make prices less informative, 

but they would impose lower costs on covered entities 

than a ban on certain participants would.

Limiting Derivatives Transactions in 

Allowance Markets

Participants in many markets for commodities or financial securities use derivatives extensively to reduce their 

exposure to changes in prices. However, certain types 

of derivatives played key roles in the recent financial 

crisis, and their potential complexity and opacity have 

prompted concerns that derivatives in allowance markets 

could also foster systemic risk and decrease transparency. 

Some observers have responded to those concerns by proposing that a potential cap-and-trade program prohibit 

the trading of allowance derivatives. Not being able to use 

derivatives contracts, however, would increase covered 

entities’ exposure to changing allowance prices, which 

would raise the costs of complying with the cap-andtrade program. Moreover, like banning certain market 

participants, prohibiting derivatives would probably not 

reduce the risk of disruptions in allowance markets—and 

might even increase that risk. In particular, the costs associated with absorbing price uncertainty could encourage 

firms to seek the benefits of derivatives from other financial transactions that would be harder to regulate or less 

transparent because they might, for example, occur in 

markets outside the United States. Consequently, enforcing a ban on derivatives would be difficult and expensive. 

Other approaches could be more effective than a ban at 

addressing concerns about derivatives. For instance, 

increasing reliance on centralized clearing houses (institutions that facilitate the settlement of transactions between 

two parties) and on exchanges (organized markets, such 

as the Chicago Mercantile Exchange, where standardized 

financial transactions take place) would increase transparency and probably reduce systemic risk in allowance markets. In addition, raising transaction fees on trades that 

occurred “over the counter” rather than through a clearing house or exchange would create an incentive to move 

trading to those more transparent settings. And if set correctly, the fees would also cover the cost of the risks posed 

by transactions that were not suited to clearing houses or 

exchanges. Such changes would address concerns about 

systemic risk and lack of transparency while continuing 

to allow covered entities to use derivatives to reduce their 

costs of complying with a cap-and-trade program.

The recently enacted Dodd-Frank Wall Street Reform 

and Consumer Protection Act (Public Law 111-203) 

includes similar changes to existing financial markets. 

The law requires the federal agency that regulates derivatives transactions in commodity markets to set position 

limits for exchange-traded derivatives on all energy, 

metal, agricultural, and other physical commodities. It 

also expands the use of clearing houses and exchanges and 

increases regulation of over-the-counter derivatives. 

Although the regulations implementing the Dodd-Frank 

law are still being drafted, the law’s provisions would 

probably apply to any allowance markets created as part 

of a nationwide cap-and-trade program for greenhouse 

gas emissions.
CBO

Evaluating Limits on Participation and 

Transactions in Markets for Emissions Allowances

Overview of Allowance Markets in a 

Proposed Cap-and-Trade Program

In light of concern about global climate change, the Congress has considered policies that would reduce emissions 

of carbon dioxide and other greenhouse gases (GHGs) by 

establishing a cap-and-trade program for those emissions.1

 Under such a program, the government would set 

a limit on total GHG emissions in a given year and 

would issue allowances (rights to emit) equal to that overall limit, or cap, on emissions. Entities covered by the 

cap—such as oil refiners, natural gas distributors, large 

electricity generators, and other firms that emit large 

quantities of greenhouse gases—would be required each 

year to submit a number of allowances equal to their 

GHG emissions from the previous year. 

The cap-and-trade program would give rise to a set of 

interrelated allowance markets, including a primary market, in which the government would initially distribute 

allowances by auctioning them off or giving them away 

for free, and a secondary (or resale) market, in which various parties would subsequently buy and sell allowances. 

The price of allowances in those markets would probably 

change frequently as buyers and sellers assessed new 

information about the cost of reducing emissions and the 

demand for allowances.2

 Those price changes in turn 

would lead to shifts in production and consumption of 

emissions-intensive goods and services. The changing 

allowance price, and the constant adjustments by producers and consumers that would result, would lead covered 

entities to seek the least expensive combination of cuts in 

emissions and purchases of allowances to comply with the 

cap, thus guiding the economy toward the lowest-cost 

approach to reducing GHG emissions to meet the cap. 

Currently, cap-and-trade programs for GHG emissions 

are operating in Europe (covering 29 countries) and in 

the northeastern United States (covering 10 states). 

Cap-and-trade programs for emissions of sulfur dioxide 

and nitrogen oxides are also in effect across the United 

States. Those programs, the oldest of which began in 

1995, include active primary and secondary markets for 

allowances. 

Participants in Allowance Markets 

Under a nationwide cap-and-trade program for GHG 

emissions, allowance markets would most likely include 

several types of participants with various objectives: 

 Energy producers and other covered entities that 

would have to comply with the cap on emissions; 

 Entities that would receive allowances from the government but would not be subject to the cap;3

 and 

 Businesses and individuals—mainly banks and inves1. See Congressional Budget Office, The Economic Effects of Legisla- tors, as well as companies that use emissions-intensive 

tion to Reduce Greenhouse-Gas Emissions (September 2009).

2. For more about allowance prices and the possible effects of placing 

upper or lower limits on them, see Congressional Budget Office,

Managing Allowance Prices in a Cap-and-Trade Program (November 2010).

3. Past proposals have called for allocating allowances to state governments, electricity distributors, or industries that might suffer 

from a competitive disadvantage in world markets because of the 

higher prices for emissions-intensive goods and services. 
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goods and services—that would trade allowances and 

related financial products with the first two types of 

participants and with each other.4

The third group is sometimes referred to as speculators or 

traders. However, speculation and trading for reasons 

other than complying with the cap would not be limited 

to that group; entities in the first two categories would 

have incentives to engage in those activities as well. 

Generally speaking, the inclusion of more traders with 

diverse trading objectives would cause allowance markets 

to become more liquid, meaning that all participants 

could buy or sell allowances more easily without affecting 

the price of an allowance. Allowances traded in a liquid 

market would be considered safer because market participants could buy or sell allowances more quickly if their 

needs changed.

The Market for Allowance Derivatives 

The establishment of a secondary allowance market 

would be expected to spawn a market for allowance derivatives—financial contracts whose value would depend on 

the future price of allowances. Derivatives could be used 

by covered entities and other participants in allowance 

markets to protect themselves from changing prices, in 

the same way that derivatives on agricultural commodities let farmers lock in prices for their crops before those 

crops are harvested or even planted. 

The most common types of derivatives are forward, 

futures, and options contracts, which are used extensively 

by participants in many sorts of markets. A forward contract is an agreement to exchange a fixed quantity of a 

good at an agreed-upon price on a specified future date. 

A futures contract is a type of forward contract with standardized quantities and delivery dates that is traded on an 

exchange (an organized market, such as the New York 

Mercantile Exchange or the Chicago Board Options 

Exchange). An options contract gives its holder the right 

(but not the obligation) to buy or sell a good at a specific 

price on the specified future date. Buying a forward or 

futures contract for allowances would lock in a future 

transaction price for those allowances, whereas buying an 

options contract would give the holder the choice of trading a specified number of allowances in the future at a 

predetermined price in return for an up-front fee. Producers and consumers of energy products—who would 

also be many of the covered entities in an allowance 

market—are accustomed to using such derivatives contracts to manage risks to their operating costs posed by 

changes in energy prices. 

Southwest Airlines’s use of derivatives offers an example 

of how covered entities and other participants might 

interact in a market for allowance derivatives. The company made a well-known decision to reduce its exposure 

to changing prices for jet fuel by entering into derivatives 

contracts with other market participants. In 2008, when 

the price of crude oil (from which jet fuel is made) rose to 

more than $140 a barrel, Southwest Airlines was paying 

market participants with whom it had entered into 

crude-oil derivatives contracts only $51 a barrel for a 

large portion of its fuel. When those contracts were created, the other parties to them presumably did not expect 

that oil prices would rise above that level. Alternatively, if 

the price of oil had fallen to $30 a barrel rather than 

increasing to $140, those participants would have made 

money on the contracts. However, regardless of the outcome, Southwest Airlines benefited from its derivatives 

contracts because they reduced the company’s exposure to 

price uncertainty. 

The Potential Scale of the Derivatives Market 

Given regulation consistent with that of other derivatives 

markets, the market for allowance derivatives would 

probably be smaller than those other markets, even ones 

that had a smaller primary market for the underlying 

commodity. Analysis by the Congressional Budget Office 

(CBO) of two legislative proposals in the 111th Congress 

suggests that allowances distributed in the primary market during the first year of a cap-and-trade program 

would have had a total value of roughly $70 billion to 

$80 billion (see Table 1).5

 Transactions in the associated 

4. In U.S. markets for wheat, corn, soybeans, gasoline feedstock, and 

natural gas, traders that do not classify themselves as commercial 

participants who produce, process, or use the traded commodity 

account for about two-thirds of the markets’ total participants and 

capital. See Commodities Futures Trading Commission, Commitments of Traders: Disaggregated Futures and Options Combined 

Report (April 20, 2010).

5. See Congressional Budget Office, cost estimate for H.R. 2454, 

American Clean Energy and Security Act of 2009 (June 5, 2009), 

and cost estimate for S. 1733, Clean Energy Jobs and American 

Power Act (December 16, 2009). Neither of those bills became 

law, although H.R. 2454 was passed by the House and S. 1733 

was ordered reported by the Senate Committee on Environment 

and Public Works.
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Table 1.

Sizes of Derivatives Markets for Emissions Allowances, Financial Products, and 

Various Commodities, 2009

Source: Congressional Budget Office.

Note: OTC = over the counter; GHG = greenhouse gas; EU = European Union; n.a. = not available; * = levels could not be determined in 

advance.

a. For proposed allowance markets, the estimated value of the primary market is based on the total value of the allowances that would be 

allocated in the first year of the program; for existing allowance markets, the estimated value of the primary market is based on the total 

value of newly allocated allowances in 2009, assuming allowance prices of $20 for the EU program, $3.50 for the U.S. Regional Greenhouse Gas Initiative, and $90 for the U.S. sulfur dioxide program. For other markets, the value of the primary market represents the total 

amount of a given Treasury security issued, agricultural commodity produced, or energy commodity consumed in 2009, multiplied by an 

average price for that year.

b. The estimated value of the exchange-traded derivatives market is based on the total value of transactions involving exchange-traded 

futures contracts in 2009 from IntercontinentalExchange, CME Group, and the Kansas City Board of Trade. (Futures contracts make up the 

bulk of the market for exchange-traded derivatives.)

c. The estimated value of OTC derivatives transactions comes from Bank for International Settlements, Triennial and Semiannual Surveys: 

Positions in Global Over-the-Counter Derivatives Markets at End-June 2010 (Basel, Switzerland: BIS, November 2010).

d. The American Clean Energy and Security Act of 2009.

e. The Clean Energy Jobs and American Power Act.

f. Information for the U.S. market for nitrogen oxide allowances is not available. 

GHG Allowances

Under H.R. 2454d 69 * * *

Under S. 1733e 78 * * *

EU's Emission Trading System 39 71 1.8 n.a.

U.S. Regional Greenhouse Gas Initiative 0.7 2 3.5 n.a.

Sulfur dioxide 0.8 0.7 0.8 n.a.

5-year Treasury notes 460 10,200 22 66,000 

10-year Treasury notes 260 22,800 88 148,000 

30-year Treasury bonds 140 7,300 52 47,000 

Wheat 13 700 54 1,400 

Soybeans 33 2,200 66 4,400 

Corn 52 1,300 25 2,600 

Crude oil 420 14,400 34 28,800 

Natural gas 90 5,000 56 10,000 

Estimated Ratio of 

(Billions of dollars)c

Derivatives Market

OTC-Traded 

Estimated Value of

Markets for Emissions Allowances 

Other Markets

Financial Products

(Billions of dollars)a

Primary Market 

Estimated Value of 

(Billions of dollars)b

Derivatives Market 

Exchange-Traded 

Estimated Value of 

Primary Market

Derivatives to

Exchange-Traded 

Proposed Nationwide U.S. Market for 

Existing Markets for GHG Allowances

Other U.S. Allowance Marketsf

Agricultural Commodities

Energy Commodities
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derivatives market would mostly likely have had a larger 

total value than that—as is the case in other markets for 

commodities and securities. For example, in markets for 

agricultural, energy, and financial products, the value of 

derivatives traded in 2009 on an exchange was 20 to 90 

times larger than the value of the primary market for the 

underlying commodity. 

Derivatives markets for emissions allowances also exist 

under current cap-and-trade programs, such as the GHG 

programs in Europe and the northeastern United States 

and the nationwide sulfur dioxide program in the United 

States. In those markets, the value of exchange-traded 

derivatives tends to be one to four times larger than the 

value of the allowances released in a single year under 

those programs. The parallels between those markets and 

a proposed national market for GHG allowances suggests 

that the ratio between the value of exchange-traded derivatives and the value of allowances could be similar—and 

thus much smaller than the ratio for other commodities.

Trades on exchanges account for only part of a derivatives 

market, however. Other derivatives trade in over-thecounter (OTC) transactions, in which contracting terms 

are flexible and contracts are negotiated bilaterally 

between two market participants. An OTC transaction 

could include customized delivery dates and quantities to 

meet the specific needs of the buyer or seller, as opposed 

to the standard delivery dates and quantities in exchangetraded contracts.

OTC derivatives transactions tend not to be tracked or 

registered centrally, making it difficult to estimate the 

number of such transactions.6

 A recent report suggests 

that OTC derivatives transactions have about seven times 

the total value of exchange-traded derivatives transactions 

for financial products but less than twice the value of 

exchange-traded derivatives transactions for agricultural 

and energy commodities.7

 (No estimates exist of the value 

of OTC transactions for existing cap-and-trade programs, 

although such transactions regularly occur.) Those comparisons suggest that the value of OTC allowance derivatives would most likely exceed the value of the primary 

allowance market, although whether the relationship 

would resemble those in agricultural and energy markets 

or those in financial-product markets is unclear. 

Concerns About Allowance Markets 

Whatever the size of allowance markets under a potential 

nationwide cap-and-trade program for greenhouse gases, 

some observers have expressed fears that those markets 

would be vulnerable to disruptions that could affect the 

U.S. economy—much as problems in mortgage markets 

contributed to the recession that began in 2008. Other 

observers worry that even if allowance markets did not 

become disruptive to the U.S. economy, the presence of 

derivatives and speculators could reduce the markets’ 

transparency, decouple the price of allowances from the 

cost of reducing emissions, or lead to outright manipulation. Any of those outcomes would increase the cost of a 

cap-and-trade program to the U.S. economy.

To address such concerns, various observers have suggested limiting the types of traders or transactions that 

would be permitted in national GHG allowance markets, 

even if broader participation or the use of derivatives 

would reduce costs in those markets. (The possible effects 

of such limits are discussed later in this study.) 

Systemic Risk 

U.S. economic activity is closely linked to the production 

and consumption of emissions-intensive goods and services. That connection has caused some observers to 

worry about the possibility that shocks to allowance markets could spill over to the broader U.S. economy. For 

example, a rapid increase in allowance prices could raise 

electricity prices, which would harm U.S. businesses that 

rely on electricity. The risk of cascading disruptions from 

the market for a single asset, such as allowances, to other 

markets and possibly the entire U.S. economy is called 

systemic risk. 

6. Changes recently enacted in the Dodd-Frank Wall Street Reform 

and Consumer Protection Act (Public Law 111-203) are expected 

to reduce the difficulty of tracking OTC transactions by placing 

the OTC derivatives market under the jurisdiction of the Commodity Futures Trading Commission and by shifting more such 

transactions to organized exchanges or clearing houses. 

7. See Bank for International Settlements, Triennial and Semiannual 

Surveys: Positions in Global Over-the-Counter Derivatives Markets 

at End-June 2010 (Basel, Switzerland: BIS, November 2010), 

www.bis.org/publ/otc_hy1011.pdf. Estimates of the total volume 

of U.S. exchange-traded commodities are based on unpublished 

information provided by the Commodity Futures Trading Commission. Part of the reason for the relatively greater value of OTC 

derivatives transactions in financial markets is that factors affecting the performance of financial products are less standardized 

and financial markets include a larger number of affected entities 

with diverse needs to hedge against risk.
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The danger of systemic risk from a commodity market 

was reinforced during the California energy crisis of 2000 

and 2001. Rapidly rising wholesale prices for electricity 

were a factor that led to repeated service cuts to various 

regions for a few hours at a time and that ultimately sent 

the state’s largest electric utility into bankruptcy. Those 

events had negative repercussions for businesses and 

industries across California.8

 Systemic risk was also evident during the nationwide 2008 financial crisis: The 

large losses that many financial institutions experienced 

on their mortgage-related assets contributed to the instability of financial and credit markets and ultimately led to 

the most severe economic downturn in the United States 

since the 1930s. The similarities between the allowance 

market and the electricity market in terms of participants 

and the scale of their involvement might suggest that the 

California example best encapsulates concerns about systemic risk in allowance markets. Regardless of what 

example is most analogous, some observers believe it is 

not worth taking the risk that an event in allowance markets could have costly implications outside those markets. 

Lack of Transparency

The recent financial crisis also focused attention on the 

issue of complex derivatives, especially certain mortgagebacked securities, that lack transparency about how much 

risk their buyers have absorbed and that involve a significant amount of leverage, or indebtedness.9

 Some observers have raised concerns that derivatives contracts in a 

potential national GHG allowance market might be 

similarly opaque. 

If the value and riskiness of such contracts were difficult 

to determine, holders of complex allowance derivatives 

could find themselves exposed to losses they had not 

anticipated. Moreover, the existence of complex, nontransparent derivatives could create an opportunity for 

some market participants to exploit those characteristics 

to extract profits from other participants who misjudged 

the derivatives’ risks. Such opaque derivatives could 

decrease the cost-effectiveness of a cap-and-trade program 

by lessening the extent to which allowance prices reflect 

market fundamentals (the collection of factors that affect 

the cost of cutting emissions, such as emissions-reducing 

technologies, consumers’ demand for emissions-intensive 

goods and services, economic growth, and regulatory 

changes). 

Decoupling and Price Bubbles 

Opaque derivatives are not the only means by which 

allowance prices could become decoupled from market 

fundamentals. That could also happen if some market 

participants based their decisions about buying or selling 

on expectations of what other participants would do 

rather than on market fundamentals. For example, if the 

fundamentals underlying an allowance derivative became 

unclear or difficult to determine, some market participants might adopt a trading strategy of following the lead 

of other participants. In that case, even participants who 

understood the market fundamentals might pursue a similar strategy, believing that they could profit more from 

following other participants than from following the 

fundamentals.

When prices become decoupled from their fundamental 

values, they can experience wide swings or even a bubble, 

similar to the ones seen with Internet-related stocks in the 

late 1990s and the real estate market in the 2000s. In 

practice, such price bubbles are often not identified 

until after they have burst, and their causes are poorly 

understood.10 Nevertheless, a price bubble in allowance 

markets could be expected to disrupt a cap-and-trade 

program. 

Manipulation 

Further concerns have been raised that some participants 

would manipulate allowance markets. For example, a 

trader or group of traders might try to corner markets by 

purchasing a large enough share of total allowances that 

they could determine prices and then sell their allowances 

back into the market for a profit. Although a covered 

entity could pursue such a manipulation strategy, it could 

only do so profitably by purchasing significantly more 

allowances than it would need for complying with the 

8. For more information about the crisis, see Congressional Budget 

Office, Causes and Lessons of the California Electricity Crisis 

(September 2001). 

9. Derivatives contracts are said to involve high degrees of leverage 

because often they are economically equivalent to borrowing 

money to buy and hold a commodity.

10. A recent paper by several Federal Reserve economists concludes 

that “economic theory provides little guidance as to what should 

be the ‘correct’ level of asset prices—including housing prices,” 

which makes identifying bubbles difficult. See Kristopher S. 

Gerardi, Christopher L. Foote, and Paul S. Willen, Reasonable 

People Did Disagree: Optimism and Pessimism About the U.S. Housing Market Before the Crash, Public Policy Discussion Paper 10-5 

(Federal Reserve Bank of Boston, September 10, 2010), abstract, 

www.bos.frb.org/economic/ppdp/2010/ppdp1005.pdf.
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cap. By contrast, market participants who were not 

covered entities could attempt to manipulate markets 

without worrying about compliance. Such manipulation 

has not occurred in U.S. cap-and-trade programs since 

2001, but it has occurred more recently in the European 

Union’s GHG cap-and-trade program.11

Unlike the other areas of concern discussed in this report, 

market manipulation is illegal. Although the potential for 

manipulation is reduced when markets are active and 

competitive, some manipulative threats can be countered 

only through diligent regulatory oversight. However, as 

seen in Europe, such oversight could prove difficult in the 

early years of a nationwide U.S. cap-and-trade program 

for greenhouse gases, when regulatory tools would not yet 

be well established and regulators would lack experience 

managing the markets. 

Limits on Market Participants 

The extent to which any of the problems described above 

could destabilize allowance markets is unknown, but one 

approach to reducing concerns about systemic risk, price 

decoupling, and manipulation would be to impose 

restrictions on participation in allowance markets. Possible restrictions include an outright prohibition on certain 

participants, less stringent “position limits” that specify 

the total amount of trading in which any one participant 

can engage, and “circuit breakers” to limit swings in 

allowance prices. Existing cap-and-trade programs for 

greenhouse gases have not implemented prohibitions on 

certain participants, but some programs have stipulated 

position limits. In addition, recently enacted legislation 

expands the use of position limits in various markets, and 

circuit breakers are becoming increasingly common for 

exchange-traded securities and commodities.

Prohibition on Traders 

Banning entities not covered by the cap on emissions 

from owning or trading allowances would represent 

the most aggressive limit on participation in allowance 

markets. Under such a restriction, participation would 

be limited to electric utilities, oil and gas importers and 

refiners, emissions-intensive manufacturers, and other 

entities that would be required to comply with the cap; 

investment banks, firms that use emissions-intensive 

goods and services, and other common traders in similar 

markets would not be allowed to buy or sell allowances.12

Prohibiting those participants in an effort to reduce concerns about systemic risk, decoupling, and manipulation 

would make it more expensive for covered entities to 

comply with the cap-and-trade program. Such a prohibition could also prompt the remaining market participants 

to respond in ways that would exacerbate the original 

concerns by giving them a greater incentive to engage in 

speculative trading or manipulation.

Benefits of Having Many Traders. Limiting allowance 

trading to covered entities would mean forgoing the 

advantages that result from broad and diverse participation in a market. The main such advantage in allowance 

markets—as in markets for agricultural, energy, and 

financial products—would be to lower trading costs for 

all participants by increasing liquidity. In a more liquid 

market, covered entities that wanted to buy or sell allowances, particularly in large numbers, could more quickly 

identify another party with whom to trade without 

affecting the market price of allowances. Prohibiting 

some entities from taking part in allowance markets 

would reduce liquidity and thereby increase the cost to 

covered entities of complying with the cap-and-trade 

program. 

A second benefit of broad participation would be to 

improve the likelihood that allowance prices accurately 

reflected the incremental cost of cutting emissions. As in 

any market, active traders in an allowance market would 

have a financial incentive to study the market and the 

industries underlying it, because their profits from providing liquidity would depend on the quality of their 

information about the cost of reducing emissions and 

about the future supply of and demand for emissionsintensive goods and services. Furthermore, active traders 

would have a financial incentive to buy when prices are 

low and sell when prices are high, which would lead them 

11. Between 2000 and 2001, an individual active in southern California’s Regional Clear Air Incentives Market (a cap-and-trade program for nitrogen oxides and sulfur oxides) engaged in manipulative fraud, stealing millions of dollars from covered entities and 

other traders. For information about recent cases of manipulation 

in the European cap-and-trade program, see Government 

Accountability Office, Carbon Trading: Current Situation and 

Oversight Considerations for Policymakers, GAO-10-851R (August 

19, 2010), www.gao.gov/products/GAO-10-851R.

12. Under such a ban, noncovered entities that received allowances 

from the government might be permitted to sell them (either 

directly or through the government) but would not be permitted 

to buy allowances.
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to put pressure on allowance prices to reflect the most 

accurate, up-to-date information about market fundamentals. As a result, with more-diverse participation in 

the market, the quality of information reflected in market 

prices would be higher, which in turn would minimize 

the cost to the U.S. economy of meeting the cap. 

A third advantage of broad participation is that traders 

would be expected to hold an inventory of banked allowances (those not used during the current compliance 

period but saved for some future time when cutting emissions might be more expensive). Covered entities too 

could hold banked allowances, but doing so would be 

more costly for them because it would tie up capital they 

could invest in other ventures. In contrast, some types of 

traders would have access to less expensive capital than 

many covered entities would, making the expected return 

from holding inventories a more attractive investment for 

them.13 If traders could reasonably be expected to hold 

inventories, a covered entity could use the capital that 

would otherwise be dedicated to banking allowances for 

other purposes.

Unintended Consequences of Prohibiting Traders. 

Although banning all participants but covered entities 

from allowance markets would aim to lessen the risk of 

market disruptions, the outcome could be different: Such 

a prohibition could reduce liquidity and make allowance 

prices more unstable. Without other traders, covered 

entities would have to rely on each other when they 

wanted to buy or sell allowances. But many covered entities would probably have similar demand for allowances 

at similar times, so the supply of and demand for allowances by covered entities would be unlikely to balance in 

the secondary market at any one time without triggering 

a change in allowance prices. The size of that price 

change would increase with the amount of the imbalance 

and the size of covered entities’ intended trades. If only 

a few participants accounted for a large share of the 

market—as would be expected in a national GHG capand-trade program—those price changes could be even 

larger.14

The combination of an illiquid market and a few very 

large participants could make it easier for one participant 

to profit from cornering or otherwise manipulating the 

market. Thus, the lack of liquidity caused by limits on 

participation could expose the market and its participants 

to the type of manipulation that those limits would be 

intended to reduce. Quantifying the increased risk of 

manipulation or its cost is difficult, however.

In addition, restricting participation to covered entities 

would give some entities a financial incentive to provide 

the services to the market that would otherwise be offered 

by excluded participants. Eliminating traders who were 

paid a risk premium to absorb price changes would not 

eliminate the prospect of earning that premium, because 

it would not remove the risk of price fluctuations. Some 

covered entities would probably expand their capacity to 

play the role of those excluded traders in allowance markets. Eventually, they might support many of the same 

speculative transactions offered by excluded market participants, but from the legal structure of a covered entity. 

Consequently, on average, covered entities would be 

likely to face greater risk of variability in allowance prices, 

either because they had absorbed the risk of such variability from other covered entities or because they could no 

longer enter into some price-insurance contracts. And to 

the extent that the covered entities taking on more risk 

were less effective at managing that risk than the excluded 

participants would be, they would charge a higher premium to bear the risk.

The increased concentration of risk for covered entities—

particularly risk related to their own operating costs—

could leave some firms vulnerable to large shocks in 

allowance prices, which could have negative consequences for the economy. For example, an electric utility 

could miscalculate its risk exposure in such a way that a 

shock to allowance prices could force it into bankruptcy, 

potentially causing disruptions not only to its shareholders but also to individuals and businesses dependent 

on its electricity. The collapse of a risk-bearing covered 

13. One reason that potential traders such as investors, mutual funds, 

and pension funds would have access to less expensive capital is 

that they do not pay corporate taxes on appreciation in their 

investments. Covered entities, by contrast, must pay corporate 

taxes on any earnings before they repay capital loans. All else being 

equal, entities that do not pay corporate taxes can borrow money 

at a lower cost than entities that do pay those taxes. 

14. A consulting firm specializing in oil, gas, and carbon markets 

estimates that 5 oil and natural gas companies are responsible for 

about 25 percent of GHG emissions by covered entities in the 

United States and that 13 power companies are responsible for 

another 15 percent of emissions; see Point Carbon, Carbon Exposure: Winners and Losers in a U.S. Carbon Market (Washington, 

D.C.: Point Carbon, November 2, 2009).
8 EVALUATING LIMITS ON PARTICIPATION AND TRANSACTIONS IN MARKETS FOR EMISSIONS ALLOWANCES

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entity could have greater repercussions than the collapse 

of a risk-bearing investor or speculator. 

Alternatively, limits on participation could induce 

excluded traders to purchase a covered entity, thus allowing them to participate in allowance markets and continue to earn profits by offering liquidity and absorbing 

risk. To some extent, the foundation for that possibility is 

already in place: Several large investment banks own 

electric power generation or transmission facilities in the 

United States. 

If any of the aforementioned responses occurred, successfully enforcing a ban on certain participants would 

probably entail high costs and still not entirely eliminate 

concerns about price decoupling or manipulation.15

However, to the extent that a prohibition was not fully 

enforceable, it would have less impact on liquidity or 

covered entities’ costs of managing risk (assuming that 

the inability to enforce the ban did not have other 

unintended consequences). 

Position Limits 

Another type of restriction on participation—used in 

commodity and financial-product markets as well as in 

the northeastern U.S. cap-and-trade program—is position limits, which stipulate the maximum number of 

contracts that an individual market participant can hold. 

Position limits are increasingly relied on to address concerns about manipulation; however, they tend to decrease 

the speed with which new information is reflected in 

prices and to reduce market liquidity. In addition, setting 

them at optimum levels and enforcing them can prove 

difficult and costly. 

Uses and Benefits. Position limits would address concerns 

about systemic risk and market manipulation at a lower 

cost to the economy than a complete prohibition on certain traders would. The reason is that setting a maximum 

position would still allow broad participation but would 

create an upper bound on the losses of any single participant, including firms that would be a conduit for those 

losses to spill over to other segments of the economy. 

Position limits are commonly used in derivatives markets, 

although variations on them (sometimes called concentration limits) have also been implemented in markets for 

the goods that underlie those derivatives. Typically, position limits are not applied to market participants that 

produce or consume the underlying good but instead are 

used to prevent traders from amassing holdings that 

could be used to manipulate a market and cause prices to 

deviate from market fundamentals. A less restrictive alternative to position limits is position accountability limits, 

which, if exceeded, trigger more-extensive reporting 

requirements (about, for example, the nature and size of 

contracts that a participant holds and the trading strategy 

used by the holder).16

Position limits for agricultural and some energy commodities are currently set by the Commodity Futures 

Trading Commission (CFTC), which regulates derivative 

transactions in various commodity markets. For example, 

a CFTC formula that applies to exchange-traded agricultural derivatives prohibits a market participant from 

holding more than 10 percent of the first 25,000 currently open derivatives contracts in a market and 2.5 percent of any contracts beyond the first 25,000.17 Within 

allowance markets, the Regional Greenhouse Gas Initiative in the northeastern United States limits bidding by a 

single entity to 25 percent of allowances sold in an auction. Other position limits are established by individual 

exchanges. The European GHG cap-and-trade program 

does not include position limits for its allowance markets, 

but some individual exchanges on which European 

allowances are traded have adopted their own limits. 

The CFTC often uses position limits to alleviate concern 

about manipulation in agriculture and energy markets. 

For example, in 2006 and 2009, Senate committee 

reports on speculation in commodity markets noted that 

although traders generally benefited those markets by 

increasing liquidity, they were capable of distorting commodity prices by engaging in manipulative practices or 

15. See Western Climate Initiative, Market Oversight Draft Recommendations (April 1, 2010), www.westernclimateinitiative.org/publiccomments/document/27.

16. For a more detailed discussion of position and position accountability limits, see Jeffrey H. Harris, Report on Holdings Limits to the 

Western Climate Initiative Markets Committee (Western Climate 

Initiative, May 6, 2010), www.westernclimateinitiative.org/

public-comments/document/31. 

17. A contract is defined differently for each agricultural commodity. 

A single corn contract, for instance, represents 5,000 bushels of 

corn at a specified grade.
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excessive speculation.18 The CFTC found no evidence 

that speculative activity had caused price changes in the 

instances cited in the reports; nevertheless, it chose to 

implement position limits on four commonly traded 

energy commodities.19

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203), which was enacted in 

July 2010, requires the CFTC to establish position limits 

for exchange-traded derivatives on all energy, metal, agricultural, and other physical commodities. Consequently, 

if an allowance market developed as part of a nationwide 

GHG cap-and-trade program, that law would probably 

require the CFTC to set position limits on holders of 

allowance derivatives.20 In addition, the law directs the 

CFTC and the Securities and Exchange Commission 

(SEC) to establish position limits for swaps, a type of 

derivative not previously regulated, in which parties 

exchange the financial benefits from two underlying 

products. Although many of the new law’s definitions 

and interpretations have yet to be finalized, those requirements represent an expansion and centralization of efforts 

to regulate position limits. 

Challenges and Drawbacks. Establishing and enforcing 

position limits pose two principal challenges. First, the 

optimum level of position limits involves difficult tradeoffs and varies over time as the size and liquidity of a market and the characteristics of participating firms change. 

Adjusting position limits regularly is challenging for 

regulators. At any point in time, setting larger or smaller 

limits involves a trade-off between reducing the potential 

for manipulation and reducing costs for market participants. Position limits set at lower levels help prevent 

manipulation in a market that is illiquid, highly concentrated, or difficult to monitor and regulate. If limits are 

set too low, however, they are likely to reduce or eliminate 

trading by some participants, which can increase costs for 

the remaining participants by reducing liquidity and lessening the diversity and amount of information available 

in the market.

Second, enforcing position limits can be difficult and 

costly for contracts traded on more than one exchange, 

because regulators have to reconcile the entities and trading positions across exchanges. For example, in 2008, 

energy traders in the United States were able to avoid the 

CFTC’s position limits on energy derivatives by holding 

some of their assets at a U.K. exchange. Closing that 

“London loophole” required an agreement between the 

CFTC and regulatory authorities in the United Kingdom 

to impose similar limits and reconcile positions across 

exchanges. In some cases, position limits might prove 

impossible to enforce—for instance, if a large share of the 

trading in a market occurred over the counter rather than 

on established exchanges. 

Circuit Breakers 

Circuit breakers (also known as price limits or trigger 

prices) place limits on the total size of price changes that 

can occur in a specified period. Many commodity markets use circuit breakers, and regulators are considering 

them for broader adoption, although their effectiveness 

varies depending on the causes of the price changes. 

Uses and Benefits. Circuit breakers are intended to stabilize markets when price movements are rapid and large by 

giving participants time to sort out the causes of the price 

changes. As an example, if the price of corn futures on the 

Chicago Mercantile Exchange rises above the previous 

day’s price by 30 cents per bushel (corn was selling for 

about $5.60 per bushel in early December 2010), trading 

at any price above that circuit breaker is prohibited for 

the rest of the day, although trading can continue at lower 

prices. On the following day, the price of corn is limited 

from rising more than 45 cents per bushel above the first 

day’s closing price, and on the third day, from rising more 

than 70 cents per bushel above the second day’s closing 

price. (Comparable circuit breakers apply if the price 

of corn falls precipitously.) Such price limits are not 

18. Senate Committee on Homeland Security and Governmental 

Affairs, Permanent Subcommittee on Investigations, Excessive 

Speculation in the Wheat Market (June 24, 2009), examined 

whether speculators in the wheat market were creating price distortions between the futures market and the spot market. Senate 

Committee on Homeland Security and Governmental Affairs, 

Permanent Subcommittee on Investigations, The Role of Market 

Speculation in Rising Oil and Gas Prices: A Need to Put the Cop 

Back on the Beat (June 27, 2006), concluded that speculation may 

have contributed to increases in oil and gas prices, although limitations on data made it difficult to determine the extent of the 

impact.

19. See Interagency Task Force on Commodity Markets, Interim 

Report on Crude Oil (July 2008); and Commodity Futures Trading 

Commission, Office of Public Affairs, “Proposed Rulemaking 

Q&A” (January 14, 2010). 

20. See Government Accountability Office, Carbon Trading: Current 

Situation and Oversight Considerations for Policymakers.
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triggered often, and when they are, they rarely continue 

past a single day. In a recent 20-month period, for example, the Chicago Mercantile Exchange’s price limit for 

corn was triggered only three times, without ever triggering the second day’s limit.21

The SEC adopted a similar circuit breaker strategy after 

the Dow Jones Industrial Average dropped by 1,000 

points on May 6, 2010. That strategy halts trading on 

certain securities for 5 minutes if their prices rise or fall 

by more than 10 percent during a 5-minute period.22

The main reason to halt trading in response to large price 

changes is to give market participants a chance to assess 

whether such changes reflect market fundamentals. In the 

case of allowances, some traders might react to a rapid 

decline in prices by selling their holdings—and thus drive 

down prices further—rather than waiting to sell but risking a continued decline. The temporary halt in trading 

that a circuit breaker offers could reduce the likelihood 

and severity of such episodes. For instance, in explaining 

its new circuit breaker strategy, the SEC stated that there 

was evidence of “irrational prices” (prices that did not 

reflect market fundamentals) in the rapid drop in the 

Dow Jones Industrial Average and that “by establishing a 

set of circuit breakers that uniformly pauses trading in a 

given security across all venues, these new rules will 

ensure that all markets pause simultaneously and provide 

time for buyers and sellers to trade at rational prices.”23

Challenges and Drawbacks. Research suggests that the 

effectiveness of circuit breakers in reducing large price 

swings depends on the circumstances in which they 

are used.24 If a price change is caused by an imbalance 

between buyers and sellers, a temporary halt gives all 

parties, particularly those who were initially absent, an 

opportunity to join the market, evaluate current conditions, and respond accordingly. In that situation, or when 

a halt gives participants who are active in the market but 

uninformed about fundamentals more time to understand the factors underlying a rapid price change, a circuit breaker is likely to improve the functioning of a 

market. 

In other circumstances, however, a circuit breaker may be 

ineffective or even detrimental to a market’s functioning. 

For example, it may have either no impact or an adverse 

impact if a price swing is caused by some change in market fundamentals that will ultimately lead the price to rise 

or fall beyond the range of the circuit breaker. In that 

case, a circuit breaker slightly impedes the market’s ability 

to reflect market fundamentals. If identical circuit breakers are not implemented on multiple exchanges that trade 

the same derivatives contract, trading may shift from one 

exchange to another, limiting the circuit breaker’s effectiveness. Finally, a circuit breaker can reduce liquidity by 

exacerbating an imbalance between buyers and sellers. 

For example, if the price of a security is falling, buyers 

who believe a halt in trading is imminent will be unwilling to buy because they do not want to be left holding the 

security. In addition, sellers may want to speed up their 

trades in order to complete them before trading comes to 

a halt. Such actions produce greater price variability, 

which can harm a market. 

Limits on Derivatives 

Allowance derivatives would give market participants a 

means of reducing their exposure to price risk, as such 

contracts do in existing cap-and-trade programs in the 

United States and Europe.25 The recent financial crisis, 

21. Public statistics regarding the frequency that price triggers stop 

trading are not available; that statement is based on analysis by 

CBO of the difference between each day’s high and low price and 

the previous day’s closing price between January 1, 2009, and 

September 1, 2010. 

22. The new circuit breaker applies to securities that are part of the 

Standard & Poor’s 500 and Russell 1000 indexes. It is in effect on 

a pilot basis, although the Chairman of the SEC has stated that 

circuit breakers are likely to become permanent. See Mary L. 

Schapiro, “Strengthening Our Equity Market Structure” (speech 

to the Economic Club of New York, September 7, 2010), 

www.sec.gov/news/speech/2010/spch090710mls.htm.

23. Securities and Exchange Commission, “SEC Approves New 

Stock-by-Stock Circuit Breaker Rules” (press release, June 10, 

2010), www.sec.gov/news/press/2010/2010-98.htm. Also see 

Commodity Futures Trading Commission and Securities and 

Exchange Commission, Findings Regarding the Market Events of 

May 6, 2010 (September 30, 2010). 

24. See Lawrence E. Harris, “Circuit Breakers and Program Trading 

Limits: What Have We Learned?” in Robert Litan and Anthony 

Santomero, eds., Brookings-Wharton Papers on Financial Services: 

1998 (Washington, D.C.: Brookings Institution Press, 1998).

25. For information about the U.S. markets, see Potomac Economics, 

Annual Report on the Market for RGGI CO2 Allowances: 2009 

(New York: Regional Greenhouse Gas Initiative, August 2010). 

For information about the European market, see Jonas Monast, 

Jon Anda, and Tim Profeta, U.S. Carbon Market Design: Regulating Emission Allowances as Financial Instruments (working paper, 

Duke University, Nicholas Institute, February 2009).
EVALUATING LIMITS ON PARTICIPATION AND TRANSACTIONS IN MARKETS FOR EMISSIONS ALLOWANCES 11

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however, highlighted some concerns about the role that 

mortgage-related derivatives played in reducing transparency and creating systemic risk. The Dodd-Frank law 

responded to those concerns with an array of regulatory 

changes aimed at increasing transparency and improving 

how markets operate. Those changes are designed to 

reduce systemic risk in all markets, although the extent 

to which they will achieve that goal—and the nature 

and significance of their unintended consequences—is 

unclear. In any event, some observers have called for 

more-aggressive limits on derivatives linked to potential 

GHG allowances. 

Restrictions on allowance derivatives can range from an 

outright ban to less stringent limits similar to the ones 

contained in the Dodd-Frank law. Those limits include 

placing greater reliance on transparent and risk-reducing 

trading platforms (such as centralized clearing houses or 

exchanges) and increasing costs for transactions (such 

as over-the-counter trades) that do not occur in those 

settings. 

Prohibition on Derivatives 

Banning allowance derivatives would constrain market 

participants to trading only allowances in the secondary 

market. Such a prohibition would be likely to increase the 

costs for covered entities to comply with a cap-and-trade 

program. And although a ban would be aimed at addressing concerns about systemic risk and lack of transparency 

in allowance markets, it could end up creating a less 

transparent market that was harder to regulate and had 

a greater likelihood of contributing to wider economic 

disruptions.

Benefits of Derivatives. The availability of derivatives 

would lower a covered entity’s compliance costs by providing increased convenience and flexibility in managing 

price risk. A covered entity that could lock in a future 

purchase price for allowances with a forward contract 

would reduce uncertainty about its future expenses and 

avoid the costs associated with that uncertainty—just as 

firms do in various other markets. The main alternative 

to using derivatives to protect against future price uncertainty would be to buy allowances in the primary or secondary market and hold them until they were needed. 

Derivatives contracts, however, would typically involve 

much lower transaction costs than borrowing to buy 

allowances would. Those lower transaction costs would 

be likely to attract a wide variety of participants, as has 

happened in derivatives markets for agricultural, energy, 

and financial products. Wider participation would 

increase liquidity, which would further reduce costs for 

covered entities.

Certain types of derivatives—such as short sales—that 

allow market participants to profit from a decline in 

prices provide a critical mechanism for keeping prices 

linked to market fundamentals and thus for keeping price 

bubbles in check. When market participants are seen to 

make many short sales, they send a signal to other participants that they believe prices should be lower. Short sales 

were temporarily banned in several markets in the United 

States and the United Kingdom during the financial crisis 

in an attempt to reduce price variability. Studies of those 

events concluded that eliminating short sales actually 

increased price variability because prices were more likely 

to become decoupled from market fundamentals.26

Unintended Consequences of Prohibiting Derivatives. 

Without access to allowance derivatives, covered entities 

would look for other ways to satisfy their desire to protect 

against uncertainty about allowance prices. One response 

might be the development of loosely related financial 

products that could trade legally on other derivatives 

markets in the United States but whose value would not 

be directly derived from allowance prices. For example, 

the price of natural gas has sometimes moved in the same 

direction as the price of allowances in the European 

GHG cap-and-trade program. If the price of allowances 

in a similar program in the United States also moved with 

natural gas prices, and if allowance derivatives were prohibited under such a program, market participants might 

buy or sell derivatives contracts related to natural gas to 

protect themselves against variability in allowance prices. 

Although that approach of using derivatives on correlated 

commodities could provide some protection, it might 

also increase price variability in allowance markets. For 

26. See Ekkehart Boehmer, Charles Jones, and Xiaoyan Zhang, Shackling Short Sellers: The 2008 Shorting Ban, Research Paper 34-09 

(Ithaca, N.Y.: Cornell University, S.C. Johnson Graduate School 

of Management, September 25, 2009); and United Kingdom 

Financial Services Authority, Short Selling, Discussion Paper 09/1 

(February 2009), www.fsa.gov.uk/pubs/discussion/dp09_01.pdf. 

Likewise, the Securities and Exchange Commission, in Economic 

Analysis of the Short Sale Price Restrictions Under the Regulation 

SHO Pilot (February 6, 2007), concluded that the presence of 

short selling reduced price variability for large securities and 

increased liquidity. 
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instance, during a period of high variability in natural gas 

prices, covered entities that used natural gas derivatives to 

protect against allowance-price uncertainty would be 

exposed to the high variability in gas prices. That exposure might affect trading in allowance markets—and thus 

the price of allowances—even if the sources of the variability in natural gas prices had no direct implication for 

the cost of cutting GHG emissions. Thus, although using 

correlated assets instead of allowance derivatives might 

prove cost-effective for covered entities at times, over the 

long term, the indirect basis of the correlation would be 

likely to raise the cost of a cap-and-trade program and 

could contribute to systemic risk.

Prohibiting derivatives in a U.S. allowance market could 

also give participants an incentive to move their transactions to overseas markets beyond the oversight of U.S. 

regulators. As an example, the Eurodollar market (where 

dollar-denominated deposits trade outside U.S. banking 

regulation) developed overseas in the 1960s to skirt U.S. 

regulations intended to limit dollar-denominated loans to 

foreign entities.27 In that case, the effect of prohibiting a 

certain type of transaction was not to eliminate those 

transactions but only to reduce the United States’ ability 

to regulate them. As with the Eurodollar experience, if 

the market for allowance derivatives was eliminated in the 

United States, similar derivatives might appear on a foreign exchange, such as IntercontinentalExchange Futures 

Europe—a derivatives market regulated by the U.K. 

Financial Services Authority that already trades U.S. 

energy derivatives. 

If a new offshore market satisfied covered entities’ 

demand for additional sources of liquidity and for opportunities to reduce price risk, the immediate result of a ban 

on allowance derivatives would only be increased costs for 

market participants to learn and transact business in a 

new overseas market under a different regulatory environment. Over the long term, however, the loss of U.S. oversight and the reliance on foreign regulatory agencies 

would probably increase program and compliance costs, 

relative to a U.S. allowance market that permitted derivatives, for several reasons. First, foreign regulatory agencies 

might be less effective at identifying manipulation 

because underlying market fundamentals would involve 

conditions specific to the United States. Second, U.S. 

regulators would be unlikely to respond quickly if the 

price of allowance derivatives changed to a large degree or 

appeared to be manipulated. Preventing such offshore 

activity would pose a difficult enforcement challenge 

(although to the extent that enforcement was unsuccessful, cost increases for covered entities would be smaller, 

unless partial enforcement produced other unintended 

consequences).

Reliance on Centralized Clearing 

Instead of prohibiting all derivatives, the Dodd-Frank 

law expands the use of centralized clearing houses—

institutions that facilitate the settlement of transactions 

between two parties. Centralized clearing has benefits for 

the stability and transparency of markets, but greater reliance on it could raise transaction costs for participants 

while not entirely eliminating systemic risk.

Uses and Benefits. Centralized clearing is designed to 

address concerns about systemic risk and market transparency at a lower economic cost than banning derivatives would. The benefits of a clearing house stem from 

its primary functions: 

 Serving as a conduit between the two parties in a 

transaction (the counterparties), and 

 Accepting legal responsibility for resolving any liabilities if one party defaults on its commitments. 

Those functions can be especially important to market 

stability if a defaulting party has many counterparties, in 

which case the clearing house can combine offsetting 

gains and losses among counterparties to determine the 

defaulting party’s net liability. The presence of a clearing 

house means that market participants do not need to 

spend resources to determine the financial strength of 

their counterparty in a transaction, and thus they can 

more easily enter into transactions with unknown parties 

on the basis of evaluations by the clearing house. To be 

effective, clearing houses must assess the financial viability of each transacting party and set appropriate margin 

requirements (deposits that traders make to a clearing 

house on a daily or more frequent basis to cover some or 

all of the risk that they will not be able to pay their counterparties). In providing those services, a clearing house 

maintains a centralized data repository where details 

about the holdings and liabilities of market participants 

27. See Hal B. Heaton, “The Euromarket” (working paper, Brigham 

Young University, Marriott School of Management, 2009); and 

J. Orlin Grabbe, International Financial Markets (Englewood 

Cliffs, N.J.: Prentice-Hall, 1996).
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are stored. That repository makes regulatory oversight 

easier and reduces counterparty and systemic risk.28

Challenges and Drawbacks. The services provided by 

clearing houses can result in higher costs for traders than 

would otherwise be the case in bilateral transactions. For 

example, two parties that frequently traded allowances 

with each other could determine without a clearing 

house, and with a high degree of confidence, that the 

other party was sufficiently creditworthy to waive any 

margin requirements. In that case, having to pay the costs 

associated with the credit evaluation, margin requirements, and settlement procedures imposed by centralized 

clearing would increase the overall cost of those transactions. However, for transactions in which a pair of 

counterparties did not know or have experience trading 

with each other, a clearing house could reduce both parties’ overall costs by coordinating the transaction, performing credit analyses, and determining appropriate 

margin requirements and settlement procedures given the 

specific nature of the transaction and the parties involved. 

In addition, some researchers have suggested that centralized clearing could increase systemic risk in several ways. 

The settlement assurances offered by a clearing house 

could encourage some market participants to engage in 

riskier transactions because they would know that the 

costs of potential defaults on those transactions would be 

absorbed by the clearing house and distributed over all 

transaction fees.29 Similarly, because clearing houses serve 

as a central counterparty to each trading entity, they 

could increase systemic risk by concentrating market risk 

rather than diversifying it throughout the economy. That 

is, the clearing house would bear the totality of the market’s overall risk, and thus, if it lacked sufficient capital or 

was slow in reconciling accounts, and counterparties lost 

faith in the settlement process, market liquidity could be 

reduced dramatically and the market could become 

unstable.30 Although that concern could be partially 

addressed by having multiple houses provide clearing 

services for the same type of derivative, such an arrangement would be less effective at protecting against counterparty risk, because counterparties would be spread 

across those multiple clearing houses.31

Trading Through Formal Exchanges 

The Dodd-Frank law complements the use of clearing 

houses to reduce systemic risk with the increased use of 

exchanges—organized markets where standardized financial transactions take place. Exchanges can offer many of 

the same benefits as centralized clearing as well as additional advantages, but those benefits generally arise only 

for contracts with large trading volumes. 

Uses and Benefits. Trading derivatives on exchanges, 

when possible, can increase market transparency and 

lower costs relative to centralized clearing. Exchanges 

such as the New York Stock Exchange and the Chicago 

Mercantile Exchange often incorporate the services of a 

clearing house, but they also establish standardized margin requirements and enable market participants to 

observe the current market price and trading volume 

both before and after a trade is executed.32

The increased transparency and standardization offered 

by exchanges make trades easier to execute, reduce the 

costs and risks of trading, and help participants see the 

effects of market fundamentals on prices. In the case 

of an allowance derivatives market, such increases in 

transparency would reduce the likelihood that allowance prices could become decoupled from market 

fundamentals.

28. See Craig Pirrong, Market Oversight for Cap-and-Trade: Efficiently 

Regulating the Carbon Derivatives Market, Energy Security Initiative Policy Brief 09-04 (Washington, D.C.: Brookings Institution, 

September 2009).

29. See Craig Pirrong, “Mutualization of Default Risk, Fungibility, 

and Moral Hazard: The Economics of Default Risk Sharing in 

Cleared and Bilateral Markets” (working paper, University of 

Houston, February 2010).

30. See John W. McPartland, “Clearing and Settlement of Exchange 

Traded Derivatives,” Chicago Fed Letter, no. 267 (October 2009); 

and John Kiff and others, Credit Derivatives: Systemic Risks and 

Policy Options, Working Paper 09/254 (Washington, D.C.: 

International Monetary Fund, November 2009), www.imf.org/

external/pubs/ft/wp/2009/wp09254.pdf.

31. See Darrell Duffie and Haoxiang Zhu, Does a Central Clearing 

Counterparty Reduce Counterparty Risk? Research Paper 2022 

(Stanford, Calif.: Stanford University Graduate School of Business, June 5, 2010), www.stanford.edu/~duffie/DuffieZhu.pdf.

32. Information about price and trading volume after trades are executed is an example of posttrade transparency. Some exchanges 

also offer pretrade transparency: information about the best prices 

at which buyers and sellers are willing to transact business. The 

Dodd-Frank law also creates swap execution facilities, which are 

not exactly exchanges according to the CFTC’s definitions but 

contain many similar features in terms of transparency, margin 

requirements, and clearing.
14 EVALUATING LIMITS ON PARTICIPATION AND TRANSACTIONS IN MARKETS FOR EMISSIONS ALLOWANCES

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Exchanges are best suited to contracts that are liquid (frequently traded) because such contracts would be expected 

to capitalize on all of the benefits offered by an exchange. 

Illiquid contracts might not be traded often enough for 

market participants to benefit from the transparency that 

an exchange provides. For example, an allowance derivative that traded once a day would display a day-old price 

that did not incorporate new information made available 

to the market since the previous transaction; therefore, 

the most recent transaction price could not necessarily be 

relied on as a basis for the next transaction price. Illiquid 

contracts could still benefit, however, from the clearing 

functions and margin requirements offered by exchanges. 

Liquidity is improved when contract terms, such as delivery dates and quantities, are standardized. But standardization does not guarantee liquidity, as evidenced by the 

many standardized contracts available on the Chicago 

Mercantile Exchange (such as for pork bellies and crude 

palm oil) that have little trading activity.33

Many of the derivatives likely to be used in a U.S. allowance market would be standard and thus amenable to 

exchange trading. (Some $71 billion in European allowance derivatives were traded on exchanges in 2009, as 

shown in Table 1 on page 3.) Standardization is not possible for some types of derivatives, such as many mortgage derivatives, because of the complex nature of the 

underlying product. (Mortgages vary by the terms of the 

loan, the condition of the property, and the characteristics of the borrower, all of which can affect how quickly 

the loan is repaid and thus the value of derivatives to the 

buyer and seller.) But allowances would be a homogeneous commodity, meaning that all allowances from a 

particular year would be equivalent in value. That homogeneity would reduce traders’ ability to construct complex allowance derivatives that could not be standardized. 

Challenges and Drawbacks. Analysts have many of the 

same reservations about exchanges that they have about 

centralized clearing. Concentrating transactions in a 

small number of exchanges could create systemic risk. In 

addition, to reap all of the benefits of exchanges, allowance markets would need to be regulated in ways that discouraged traders from moving derivatives transactions 

away from exchanges. For example, exchanges charge 

fees to offset the services they provide, and those fees give 

participants an incentive to move transactions off 

exchanges to over-the-counter markets. Further, market 

participants that had an information advantage might 

shift to OTC or other markets that lacked transparency 

so they could earn higher profits from their information 

advantage. Such a shift appears to have occurred after the 

transparency of the corporate bond market was increased, 

when many traders and their counterparties moved to the 

OTC market.34 Consequently, to preserve the benefits of 

centralized clearing and exchange trading in reducing systemic risk and increasing transparency, the OTC market 

would need to be regulated to a similar extent. 

Increased Regulation of Over-the-Counter Trading

Like markets related to agricultural and energy commodities, the secondary allowance market and the market for 

allowance derivatives would probably contain customized 

and unique contracts that were neither liquid nor standardized but were still an important part of a covered 

entity’s strategy to hedge against variability in prices. 

Such nonstandard contracts would benefit less from trading through centralized clearing houses or exchanges and 

thus would tend to trade on the OTC market. Concerns 

about allowance markets could be addressed by designing 

regulations to further two aims:

 Increase the transparency of OTC trading, which 

would improve regulatory oversight; and 

 Encourage participants to move OTC transactions to 

exchanges or clearing houses, which could reduce 

systemic risk.

Uses and Benefits. In the case of OTC trading of allowances themselves (rather than derivatives), one way to 

simplify regulatory oversight would be to increase the 

tracking of such trades and reconcile them with similar 

transactions occurring simultaneously under the oversight of exchanges or centralized clearing houses. That 

could be done in the secondary market by using a registry 

(a list of allowance owners and their holdings). Important 

33. See CME Group, “Volume and Open Interest Report, 8:00 A.M. 

Final Report” (updated daily), available at www.cmegroup.com/

market-data/volume-open-interest.

34. See Hendrik Bessembinder and William Maxwell, “Transparency 

and the Corporate Bond Market,” Journal of Economic Perspectives, 

vol. 22, no. 2 (Spring 2008), pp. 217–234. That paper analyzed a 

sample of corporate bonds before and after the implementation of 

the Transaction Reporting and Compliance Engine (TRACE) system, which substantially increased publicly available information 

about the prices and volume of bond trading. TRACE was found 

to reduce traders’ costs but also to spark a shift of transactions to 

other, less transparent markets.
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design features for such a registry include ensuring that it 

is updated frequently enough, such as daily or weekly, to 

capture the flow of allowances between owners, and making sure that it assigns allowances to the “beneficial 

owner” (the entity that controls the decision to buy or sell 

the allowances, independent of who has actual title to 

them). Several registries for GHG allowances are currently active in the United States, including the Climate 

Registry and the California Climate Action Registry. Following adoption of one of the current registries or development of a new nationwide OTC registry for allowances, regulators could combine registry information 

with information about allowance transactions available 

from exchanges and clearing houses to more easily monitor allowance markets for manipulation or other threats 

to stability. 

Tracking could also be used to improve regulatory oversight of the OTC market for allowance derivatives. For 

example, the Dodd-Frank law establishes several new 

approaches for regulating OTC derivatives that would be 

applicable to allowance derivatives (although how those 

approaches will be implemented is still unclear). The law 

defines many derivatives not previously traded on an 

exchange as a type of swap that would have to be traded 

in an exchangelike setting (called a swap execution facility) or, if not suited to that, would have to be registered 

with a swap data repository (a list similar to a registry but 

exclusively for swaps). The law also establishes mechanisms to aggregate OTC transactions so that regulators 

can more easily observe beneficial owners and trading 

volumes. 

Another approach to regulating the OTC market for 

allowance derivatives would be to increase the cost of 

OTC transactions in the hope that participants would 

shift them to exchanges or clearing houses. The DoddFrank law does that by raising capital requirements for 

banks and other institutions that hold deposits and by 

increasing margin requirements for institutions that trade 

in OTC contracts. Specifically, the law requires the 

CFTC to impose higher capital and margin requirements 

on institutions (typically banks or investment banks) that 

carry out a sufficient volume of OTC transactions to be 

called dealers, as well as on firms that have large enough 

OTC holdings that they are considered important to the 

stability of the financial system. As a condition for operating in the OTC market, dealers and large institutions 

alike must comply with those capital and margin requirements, subject to periodic audits. The resulting increase 

in compliance costs for OTC transactions is designed to 

serve as an incentive to standardize contracts and move 

them onto exchanges or clearing houses. (Regardless of 

the effects on any particular market, capital and margin 

requirements are intended to decrease systemic risk by 

reducing the chance that the bankruptcy of a single entity 

will trigger the bankruptcy of any counterparty or bank 

from which it has borrowed.) 

Challenges and Drawbacks. Increasing regulation of 

OTC transactions could result in some unintended 

behavior on the part of banks and market participants 

that might undermine the intent of such regulation. For 

example, if regulations differed between jurisdictions 

(such as between the United States and the United Kingdom), banks and their covered-entity counterparties 

could shift transactions to less regulated or less costly 

jurisdictions. In addition, higher capital requirements 

would probably prompt banks to reduce their lending or 

raise more capital. Historical evidence suggests that 

higher capital requirements cause banks to shift toward 

riskier investments (within a given class of investment) to 

compensate for the higher costs imposed by those 

requirements. At the same time, banks have sometimes 

reduced their lending to small businesses and individuals 

in response to such requirements.35

35. For a more thorough discussion, see Patricia Jackson and others, 

Capital Requirements and Bank Behaviour: The Impact of the 

Basel Accord, Basel Committee on Banking Supervision Working 

Paper 1 (Basel, Switzerland: Bank for International Settlements, 

April 1999), www.bis.org/publ/bcbs_wp1.pdf; and Basel Committee on Banking Supervision, An Assessment of the Long-Term 

Economic Impact of Stronger Capital and Liquidity Requirements

(Basel, Switzerland: Bank for International Settlements, August 

2010), www.bis.org/publ/bcbs173.pdf.