CME Revs Up for Surge in Carbon Credit Trading

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As the Senate debates the American Clean Energy and Security Act recently passed in the House that attempts to create a cap-and-trade scheme for carbon emissions in the U.S. similar to Europe’s, the Chicago Mercantile Exchange has been ramping up its efforts to prepare for an expected surge in carbon credit trading.

The climate-change bill would put a limit on the amount of carbon emissions a company can generate, but allow over-limit companies to meet their requirements by purchasing credits from those emitting less pollution than they’re allowed. A voluntary carbon credit market already exists in the U.S.; the bill under debate would broaden the market to those who must buy carbon credits or face penalties (or drastically reduce their carbon emissions).

“It’s very early days, but once the Senate has taken it up and it’s clear what the bill will look like, then the U.S. carbon credit market will start to grow quickly and trading will go up,” says Randy Warsager, director of green products at CME Group. “The voluntary market in the U.S. is also growing nicely.” About $118 billion worth of carbon credit contracts were traded in the U.S. 2008 and the market is expected to reach $150 billion in 2009. But Europe’s market is many times larger, Warsager says. In the U.S., “There’s a lot of anticipation of what compliance will look like, people are waiting until they get a little more clarity.”

The CME Group and several partners — Evolution Markets, Morgan Stanley, Credit Suisse, Goldman Sachs, JPMorgan, Merrill Lynch, Tudor Investment, Constellation Energy, Vitol, RNK Capital, ICAP, and TFS Energy — are building a Green Exchange that currently awaits CFTC approval. Upon approval, this exchange would trade all the environmental products the CME currently trades, including carbon emission reduction futures contracts and sulfur dioxide futures and options.

Why the need for a separate exchange for environmental products? “The underlying rationale for having a separate exchange was partly to create a partnership structure that would draw people’s interest and provide an incentive for them to grow with us,” says Warsager. “Also, there’s a certain logic to putting all the environmental contracts together on one platform.”

Yesterday, the CME Group launched new sulfur dioxide futures and options contracts. Sulfur dioxide is a chemical compound produced by the burning of coal and petroleum; it’s also used in wine-making. The Environmental Protection Agency’s Clean Air Act Amendments of 1990 set a goal of reducing annual sulfur dioxide emissions and reductions in sulfur dioxide emissions that are facilitated through a market-based cap and trade system under the EPA’s Acid Rain Program.

In recent weeks, CME Group announced that it will trade European Union Allowance and Certified Emission Reduction futures contracts. These contracts are used by European companies that have more allowances for carbon dioxide emissions than they need, and therefore can sell their leftovers.

The CME currently trades these and other environmental products through its New York trading floor and its ClearPort and Globex trading platforms.

The U.S. sulfur dioxide-related contracts market struggled in 2008, Warsager acknowledges. “The sulfur dioxide emissions market was challenged last year when the cleaner interest rate rule was vacated in a court decision, so that was hard for those markets, they’re rebuilding slowly,” he says. “That has an obvious impact on any derivatives related to those markets.”

Assuming environmental contract trading accelerates this year, the way the Green Exchange will attract order flow will be through liquidity, Warsager says. “We’ll have to develop a liquid market across different platforms,” he says. “Once we have a critical mass of liquidity, then we present a viable alternative or complement to what other people are doing.”