Although the climate bill that passed the House of Representatives in June went through many changes on its way to securing a majority of support, the final version still included a carbon emission cap and trade program as a key component. Although just what compromises will be required to get passage in the Senate remain to be seen, most observers are confident that whatever legislation ultimately reaches President Obama’s desk will include cap and trade.

Last month we looked briefly at how a cap and trade program initiated in the 1990s has successfully reduced the levels of sulfur dioxide. That program certainly gave the lie to those who claimed that the program amounted to a new level of crippling taxation that would surely destroy the economy. Those same arguments are being bandied about in the current debate, but it appears that many of the critics have failed to look at the carbon cap and trade market that is already functioning in this country on a voluntary basis.

Cap and Trade Is Real

“You may be surprised to know that the biggest cap and trade market in the world is here in the United States and in Chicago,” Dr. Richard Sandor told an audience at the Gabelli Cap and Trade Symposium in New York in June. He was referring to the Chicago Climate Exchange (CCX), which launched trading operations in 2003 with 13 charter members including American Electric Power, DuPont, Ford Motor Company, and International Paper. That number has since grown to more than 300 members in several different categories from all sectors and offset projects worldwide.

CCX emitting members make a voluntary, but legally binding, commitment to meet annual greenhouse gas (GHG) emission reduction targets. Those who reduce below the targets can bank or sell their surplus allowances and those who fail to reach the targets reach compliance by purchasing CCX Carbon Financial Instrument (CFI) contracts. Each contract represents 100 metric tons (110 U.S. tons) of CO2 equivalent emissions is composed of Exchange Allowances, which are issued to emitting members according to their emission baselines, and Exchange Offsets, which are generated by qualifying offset projects. The price of the CFI contracts is set by the market and the more members there are looking to buy credits, the higher the cost of each contract.

All members with exchange allowances and exchange offsets are monitored continuously and report their emissions each year via procedures set up by the CCX and by the World Resources Institute/World Business Council for Sustainable Development initiative. Another layer of monitoring happens through the Financial Industry Regulatory Authority (FINRA). FINRA also verifies offset projects proposed and registered by members and offset providers and aggregators.

CCX emitting members directly generate and emit GHG through activities such as energy production, manufacturing, or travel. Associate members do not directly create GHG emissions, but agree to a 100% offset of the indirect emissions for which they are responsible, such as use of electricity and other energy and business travel. The third category–participant members–includes offset providers and aggregators who own projects that offset GHG emissions by storing, eliminating, or reducing those emissions.

These projects can generate exchange offsets that can be traded. Liquidity providers are companies and individuals who join because they want to trade on the CCX Market Exchange. These include hedge funds, professional traders, and proprietary trading groups. Lastly, there are exchange participants, such as the Clean Air Conservancy, who do not have GHG emission reduction commitments of their own, but who buy carbon financial instruments with the sole purpose of reducing emissions by retiring the contracts.

“These companies have stepped up, have been the first movers, and although they were required under our reduction cap to reduce by 4%, they’re up to 11% and their aggregate emissions have been reduced by 400 million tons, twice what Great Britain’s emissions rates are,” says Sandor.

In 2005 CCX launched the Chicago Climate Futures Exchange (CCFE), a Commodity Futures Trading Commission-regulated (CFTC) futures exchange that offers standardized and cleared futures and options contracts on emission allowances and other environmental products and which claims to be the world’s first environmental derivatives exchange. Sandor thinks the future is bright for his exchanges and for trading in these new commodities. “Whatever happens [with the pending legislation in Congress], I fundamentally believe we’re going to see a drive in favor of the kinds of things we do. The only part of the financial sector that didn’t go begging to the U.S. government was regulated exchanges,” Sandor noted. “Wealth creation follows patterns over history, and air and water, when you think about it, are our most precious commodities. They can be traded and we need to ration them. The cap and trade system has functioned with great efficacy.”

An East Coast Initiative

In addition to the CCX voluntary cap and trade program, there is also the Regional Greenhouse Gas Initiative (RGGI), a cooperative effort by 10 states (New Jersey, Vermont, Connecticut, New York, Massachusetts, Rhode Island, Maryland, Delaware, Maine, and New Hampshire) to limit GHGs through a mandatory, market-based CO2 emissions reduction program aimed at the power sector. The participating states first set a cap on emissions and then require a 10% reduction in those emissions by 2018.

RGGI is composed of individual CO2 Budget Trading Programs in each state implemented through state regulations, based on a RGGI Model Rule, and linked through CO2 allowance reciprocity. Regulated power plants can use a CO2 allowance issued by any of the participating states to demonstrate compliance with the state program governing their facility. Together the 10 state programs function as a single regional compliance market for carbon emissions.

Emission allowances under RGGI are obtained at auction, the first of which was held in September 2008. Since that time more than 110 million allowances have been purchased for $366.5 million. Participating states have earmarked the proceeds to fund a number of green projects including weatherizing homes, hiring and training energy efficiency auditors, and subsidizing energy efficiency upgrades for small businesses.

At the most recent auction in June all 30.8 million allowances were sold at an average price of $3.23, down from $3.51 in the March auction.

“RGGI proves that auction-based cap and trade works and can lead us to a new economy with green jobs, a clean energy infrastructure, and a better environment,” said Pete Grannis, New York’s environmental commissioner and chairman of the RGGI board, at the time of the June auction.