Designing a U.S. Market for CO2

Posted: 19 May 2009

See all articles by John E. Parsons

John E. Parsons

Massachusetts Institute of Technology (MIT) - Sloan School of Management

A. Denny Ellerman

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Stephan Marvin Feilhauer

Massachusetts Institute of Technology (MIT)

Abstract

In 2005-2006, the U.S. SO market experienced a surprising price spike attributable to a combination of changing fundamentals and institutional features (notably, the tax treatment of “longs”) that undermined the flexibility of the bank. The U.S. SO market's transition to a tighter system in 2000 avoided such a divergence by allowing unlimited banking of allowances into the second phase. The 2007 close of the first phase produced a sharp divergence between the spot price at the end of 2007 and the futures price for 2008, reflecting the restriction against carrying over (or “banking”) allowances from one phase to the next. The 2005 opening of the EU CO market was marked by a surprisingly high price, one that resulted from a delay in institutions with long positions in allowances (“longs”) bringing supply to the market. This article reviews the historical performance of these two markets, with particular focus on how the flexibility afforded by, as well as restrictions on, the “banking” and borrowing of allowances has affected the evolution of prices. While both markets have generally functioned well, four episodes are used to illustrate the importance of designing the rules to encourage such flexibility. The United States may soon have a market for carbon. If so, that market will grow out of a cap-and-trade system like the EU's Emissions Trading System for CO or the U.S. Acid Rain Program for SO.

This article reviews the historical performance of these two markets, with particular focus on how the flexibility afforded by, as well as restrictions on, the “banking” and borrowing of allowances has affected the evolution of prices. While both markets have generally functioned well, four episodes are used to illustrate the importance of designing the rules to encourage such flexibility.

The 2005 opening of the EU CO market was marked by a surprisingly high price, one that resulted from a delay in institutions with long positions in allowances (“longs”) bringing supply to the market.

The 2007 close of the first phase produced a sharp divergence between the spot price at the end of 2007 and the futures price for 2008, reflecting the restriction against carrying over (or “banking”) allowances from one phase to the next.

The U.S. SO market's transition to a tighter system in 2000 avoided such a divergence by allowing unlimited banking of allowances into the second phase.

In 2005-2006, the U.S. SO market experienced a surprising price spike attributable to a combination of changing fundamentals and institutional features (notably, the tax treatment of “longs”) that undermined the flexibility of the bank.

Suggested Citation

Parsons, John E. and Ellerman, A. Denny and Feilhauer, Stephan Marvin, Designing a U.S. Market for CO2. Journal of Applied Corporate Finance, Vol. 21, Issue 1, pp. 79-86, Winter 2009, Available at SSRN: https://ssrn.com/abstract=1394691 or http://dx.doi.org/10.1111/j.1745-6622.2009.00218.x

John E. Parsons (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
United States

HOME PAGE: http://www.mit.edu/~jparsons/

A. Denny Ellerman

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

Stephan Marvin Feilhauer

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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