Isra-Mart srl: US cap-and-trade: efforts to standardise agreeements

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California’s carbon cap-and-trade scheme is powering ahead despite early opposition and is now on course to begin in 2012. Pauline McCallion looks at efforts to standardise trading agreements and provide hedging capabilities ahead of the start date

After beating a legal challenge that threatened to end its carbon cap-and-trade scheme before it had even started, California has refocused on its efforts to establish what will be the largest carbon emissions market in North America and the second largest in the world after the European Union Emissions Trading Scheme (EU ETS). The eight-year, state-wide scheme will cover 85% of California's greenhouse gas emissions and be regulated by the California Air Resources Board (Carb). It is due to start in January 2012, with the first compliance period running from 2013-14. This will cover electricity generators and industrial emitters of more than 25,000 metric tonnes of carbon dioxide equivalent (MT CO2e) per year. Other sectors, such as transportation fuels, will be brought into the scheme for the second compliance period, which is due to start in 2015.

It is widely hoped this scheme will form the blueprint for a future federal carbon cap-and-trade scheme in the US. But the recent announcement by Carb chairman Mary Nicols in June that the compliance start date will be delayed by a year until 2013 has reminded market participants of the somewhat precarious nature of such regulation-based markets. The major concerns for the future are regulatory: could the programme fall prey to another delay, or even abandonment, before or soon after it starts? If so, what will happen to transactions that are already on the books? As the market struggles to find a firm footing, standard documentation is generally seen as a must to mitigate such risk.

So far several contracts have been developed, or are in the process of being created, to address these key concerns for participants. Whether or not current contracts will eventually merge into one standard agreement remains to be seen, but market participants agree that developing a standard set of terms and conditions, at the very least, will ensure carbon trading in this part of the world starts off on the right foot.

Man-made market

The fact that the carbon market is essentially man-made - based on regulation - creates bumps on the road to development. "All of the rules are created by regulators and, importantly, supply and demand is created by regulators via the limits put on emissions," notes Christopher Norton, London-based head of the environment and climate change practice at Hogan Lovells. If the regulator issues allowances on a five-year cycle, for example, it would have to respond quickly to ensure the scheme remains in play in the face of any event during that period that significantly lowers emissions - for instance, a natural disaster that shuts in a significant portion of a region or country's power generation, which would send the carbon price plummeting and potentially jeopardise carbon trading. "The fact the regulator might find it difficult to respond to that type of situation quickly and accurately is one of the differences between the emissions markets and other commodities markets," Norton says.

As it advances towards its start date, potential participants have been eyeing the market, particularly in the absence of a federal carbon trading programme in the US. By preparing at an early stage, they can ensure they are ready to participate and have all their bases covered when it comes to hedging any risks associated with the scheme. Shell Energy North America, for instance, got involved fairly early on in helping to develop standard documentation for over-the-counter trading in California carbon emissions alongside the International Emissions Trading Association (Ieta). According to director of environmental products at Shell Energy, Graeme Martin, it wanted to encourage the industry to get standard terms and conditions in place. It created a draft, standalone California allowance agreement for Ieta as a ‘straw man' for its development process.

"Many participants – and I'm sure we'll be one of them – will use multiple channels to try and hedge their exposure in this market," says Martin. "So one of the major goals of the process of developing standardised documentation is to make sure the different contracts deal with potential issues in similar ways in order to limit basis risk or contract difference risk."

The routes to market for Californian carbon traders will include both exchange-traded products and bilateral transactions. The latter will likely often be completed under standard contracts developed by industry associations and market participants. Ieta and the International Swaps and Derivatives Association (Isda) have already developed versions of standard documentation for the EU ETS. Ieta is now working on a global initiative to develop a less "euro-centric" framework, according to Peter Zaman, a London-based partner at Clifford Chance and chair of Ieta's emissions trading agreement drafting group. The International Emissions Trading Master Agreement (IETMA) will be a general document covering typical buyer and seller obligations, irrespective of transaction location. This will be supplemented by individual scheme schedules relating to specific markets, for example, those trading EU allowances will use a confirmation that links into the EU ETS schedule.

The sub-working group for the IETMA plans to circulate a draft to Ieta members for comment in August. If it is finalised on schedule, Zaman anticipates that a separate sub-group could start looking at developing a California annex in the third quarter, finishing by the end of the year, provided all goes to plan. "It depends a little on how controversial any aspects in that drafting process might be," he says. "If we don't have any controversies, then it should be done relatively quickly."

Financial players

The participation of financial institutions in such markets also often spurs efforts to develop standardised contracts, according to Norton. "When the financial community is involved, they often push for standardised trading documents because of an understanding of their importance developed from their commodity trading activity elsewhere," he says. "And as the market becomes more liquid and there is more trading, there will be a greater push towards standardisation because participants do not want to pay a lawyer every time they trade. That's the whole point of standardising the contracts, to help liquidity in the market."

In November 2010, Barclays Capital announced the first forward trade of California Carbon Allowances using its Carbon Allowance Forward Trade Agreement (Cafta).

It has plenty of experience in this area, having already developed similar documentation for OTC trading in the EU ETS in October 2006, again ahead of the finalisation of market infrastructure. When it transferred this knowledge and experience to the US market in early 2010, the bank was initially focused on developing documentation for an anticipated US federal carbon trading scheme. It shifted its focus to California by the third quarter once a federal scheme looked unlikely in the near-term.

Simplicity and standardisation are key to addressing transaction risk issues, according to Kedin Kilgore, head of US emissions trading at Barclays Capital. In the early days of any market "we tend to see a lot of independent contracts developed bilaterally by counterparties, but which are incompatible with bespoke agreements used elsewhere in the market", he explains. "The Cafta addressed this issue by providing a single standard around which all parties could agree."

Furthermore, to keep it simple, Barclays developed the Cafta as a plain-vanilla forward purchase -and -sale agreement with only two non-standard parts. First, a ‘roll' that allows for a delay in system start, as well as an eventual no-fault tear-up in case the system fails to come on line. "Our Cafta helped avoid the problem of too many incompatible contracts by getting everybody on consistent terms from the beginning."

Kilgore says this approach addresses the two biggest risks to the California scheme right now: when and if the scheme is actually going to start. "Getting everyone on the same page" as soon as possible will help address transaction risk and cost issues, he says.

Anticipating regulatory risk

The Cafta is generally viewed as a welcome addition to the market. Andy Kruger, vice-president of the emissions credit and greenhouse gas desk at brokerage CantorCo2e, says Barclays Capital did a good job in anticipating regulatory risk, such as a programme delay, within the Cafta. "It lays out a method for dealing with the possibility that the programme isn't in place in 2012 and that the contract can't settle in December 2012 by including an automatic roll to the following year," he says.

The exchange-traded market has taken a leaf out of the OTC market's book in this respect. On July 18, Green Exchange (GreenX), a consortium of financial organisations that includes the CME Group, Goldman Sachs, Vitol and Icap Energy, announced it will launch a California carbon futures contract in September 2011. The contract will include a provision for open interest to roll one year so that if the California scheme does not start in time for the December 2012 contract expiration, all positions will be transferred to the corresponding December 2013 contract. If the scheme is still not in force by December 2013, all contracts with open interest after the last day of trading will settle financially at the auction reserve price for that year.

Martin adds that the draft Shell Energy has developed also addresses delays to the programme by allowing transaction delivery dates to be rolled. "Some things are reasonably straightforward to build into a contract, while others are a little more difficult, such as a programme ban," he continues. "For example, if the programme starts but is later abandoned, what happens to everybody's trades? That was really the reason for putting something on paper, to try and get people thinking about such issues and to ensure that whatever is ultimately created has support across different market participants. So it is not just one view, everybody has a chance to comment and participate in the development."

If by December 2013, the scheme is still not in operation, there is an additional nine- month interval after which the Cafta contract is simply torn up. "At the outset that was a concern for some people because they didn't know how they could possibly settle their books, especially if they were active traders," Kruger continues. "On the one hand a compliance buyer would simply view this as a call option, whereby if the worst happens the contract is torn up and there is no obligation. However, compare that with a trader who might be buying that contract and reselling it or buying a contract that's already been resold and it has to settle – some were reluctant to participate without the agreement stating that, even if the programme is abandoned, the transaction would still settle, even if it's at zero. As a result, the market spoke and a number of subsequent contracts have modified the Barclay's format to include a settlement trigger."

And there are other options available, albeit at a price. "There are other structures with a lower cost, but the buyer takes on a much higher risk - if there was no programme in 2013 or 2014, they would just lose their money. It becomes a question of what you are trying to achieve in the transaction and how much risk you are willing to take - it's a risk/reward calculation," says Gregory Arnold, managing partner of CE2 Capital Partners, a California-based environmental investment management company.

Growing activity levels

Given the youth of the market and these concerns over how transactions would be settled in the event that the programme stalls or is scrapped, activity has so far been thin. According to Barclays Capital, the size of some bilateral trades under its contract has reached 100,000 tonnes or more and a conservative estimate of open interest is around two million tonnes per day.

But Kruger adds that many of the entities due to be regulated under the Californian scheme are ready to go as soon as they have reassurance that their allocation will land in their account. "It is primarily the power providers, as well as the industrials and the fuel entities, who are very much focusing on this daily and gearing up, if they haven't already, to respond," he says.

CE2's Arnold adds that more participation from compliance players could further shape current standardised documentation. "The utilities, refiners, oil companies and so on are going to have their own perception of what a standard contract looks like," he says. "The big buyers and sellers will ultimately define the standards and certainly there will be people who will use Isda [master agreements] for a lot of this. My guess is that there will be standardised terms, but different contracts."

Ieta is likely to push for full standardisation with one contract, according to Arnold, but he adds that "this is the first inning of a very long ballgame", so what the final shape of the market is likely to be remains difficult to predict. "For us, 90% of our contract might be the same as everyone else's, and 10% or even 20%, might be different because of the particular needs of our firm. I think other firms might end up being the same way," says Arnold.

In this respect, a move towards more clearing of OTC derivatives under the impending regulatory reach of the Dodd-Frank Wall Street Reform and Consumer Protection Act is likely to have an effect on the outcome. Arnold says: "The exchanges will offer contracts and if you want to clear [through them], you're going to have to basically accept the exchange's contract and agree to convert your contract to clear, which will be another force towards standardisation."

Emerging markets such as this tend to experience teething problems. All eyes will be on the California scheme as it gears up for its launch next year, to see how the infrastructure that is currently being built for carbon trading in the region copes with problems, as well as the impact on trading entities participating in the market. Experts generally believe that participants will cover all possible bases by using a standardised trading agreement, or at least standard terms and conditions. While there is always the chance of a curveball that could throw the market out of whack, it is hoped that the use of a solid trading agreement will prevent any upsets from derailing the market completely.