The received wisdom is that, after the new president is installed, the desire to establish a “cap & trade” system for carbon regulation will resume. 

If so, among other things, the nation will have embarked on a great computer video game, with carbon credits as avatars, electronic images manipulated on a screen.  A new kind of “currency” to be played online will be official.  The Simms game will be old news.  The result will be even more sweeping than the last game we played, called “Deregulation,” which was intended to use trading in the service of more efficient industry structuring.  Indeed, the social and technological fervor for cap and trade is great.  It is effectively the energy policy cornerstone of the McCain campaign and a preeminent plank in the Obama platform as well.  We are on the Road to Avatar.

This is not to say that establishing some global climate change management system is not a vital objective.  It is to emphasize the need to shine the spotlight on these key questions of how its governance will work.  In particular it requires examination of the ramifications of the allowances/offset methodology, explicit in Kyoto and proposed for the U.S. (for example in the recent. Lieberman-Warner legislation):  The key questions are:

(1)        What offsets may be generated -- where and by who?

(2)        How are these “offsets” differentiated from “allowance”?

(3)        Who’s in charge of overseeing the trading of these new virtual embodiments of real value?

If the answers to these questions are not reasoned and effective ones, a cap and trade program is subject to the possibilities of practical non-functionality, fraud, and ultimately loss of public respect. 

First, some context.  Offsets reduce the need for “allowances,” or authorized pollution rights.  They are purchased from third party providers to reduce cap compliance requirements, i.e., they are payments for the privilege of continuing to emit greenhouse gases.  Under Kyoto, offset projects are located only in listed developing (presumptively poorer) nations.  Building windmills there instead of coal-fired power plants is deemed to net--from a global perspective--reduction of GHGs.  One key problem is that, until 2012, at least, those “poorer” nations, with pollution productive offset capability include some fairly non-intuitive locations:  China, India, South Korea, Brazil.  Nevertheless, or perhaps because of this fact, not insignificant product finance businesses have arisen to exploit opportunity to meet the defined “need.”

With that development has come criticism of the offset scheme’s imbalances.  We find Wall Street Journal articles with headlines like “French Firm Cashes in Under UN Warming Program,” highlighting destruction of GHG nitrous oxide (laughing gas)--which is a byproduct of nylon manufacture--in South Korea producing more money for the manufacturer than the product itself, at a capital cost far below the offsetter’s  allowed Kyoto market revenue return.  And other such articles about special-purpose securities firms, set up to generate offset credits, shaking the foundation of trust in the Avatar by promising more credits than the UN administered system had, in fact, been able to provide them.

We’d like to believe that can’t happen here.  The U.S. model seems slated (based on models to date) to have narrower identification of permissible offset production sources, to limit utilization of non-U.S. offset credits significantly, and to establish parameters for use of pre-legislative voluntary credits.

All that said, it will have one new notable flaw;  it will make it harder for the potential producers of emissions to also be producers of offsets.  That is because the capped points of emissions baselines per Lieberman-Warner will be coal-fired electric plants (downstream), natural gas/NGL processors or importers (upstream), petroleum or coal-based liquid producers or importers (upstream).  It is these producers who will receive the allowances which are the primary currency of “cap and trade,” and purchasers from these primary sources cannot create carbon offsets by installation of further abatement devices.  This is intended to prevent double counting.  It also promises to shrink the possible sources of offsets considerably, and the range of opportunities for third party capital offset development.  Investments by regulated producers in pollution abatement will be confined very likely to be applied against the requirements of their own facilities.

A number of questions remain to be answered definitively.  Will a secondary market for allowances that are received (or acquired in auction), but not applied to emission reductions, be tradable?  (And, assuming so, regulated?  By whom?)  As a practical matter, will emission caps be set so that allowances are, in fact, available for that purpose?  Could there develop a “mega-allowance” market specially for firms financing “excess” GHG reductions (the value of which could be measured in terms of displacement of the costs of emission reductions that otherwise would have to be achieved by a third party to comply with the emissions cap? 

Whatever the ultimate resolution of these questions, it is clear that two key distinctions will be important in Avatar-land:  (i) the line between qualifying offsets and allowances, as well as (ii) which entity is responsible for the trading of each of the commodities.

Responsibility for fine tuning the allowances/offsets distinctions could be, as some proposed legislation has suggested, the bailiwick of a new “Carbon Board,” the same entity slated to be responsible for decisions related to the administration of the allocation of allowances.  It doesn’t take imagination to recognize that many other agencies would like to weigh in, in this regard.

The issue of jurisdiction over trading is generally perceived as the largest one, because the possibility of another “Enron” fraud situation looms over it.  There is no shortage of proposals for regulation in this regard, or hunger on the part of agency empire-builders.  The definitional questions “merely” raise issues as to whether the regulatory system will efficiently generate means of dealing with the planning problems which the definitional questions will present. 

One category of anti-manipulation approach reflected in proposed legislation would thrust the EPA into the business (although perhaps limit its role to the regulation of initial emitters).  Other proposals would focus on adapting and imposing the discipline of the SEC’s and FERC’s respective anti-manipulation rules, and involve those agencies in the regulatory process.  However, GHG credit futures contracts are still, by many common reckonings, a Commodities Future Trading Commission (“CFTC”) bailiwick--as distinguished from “securities” regulated by the SEC.  Tortuous lines have been worked out over time between those two agencies.  CFTC currently regulates the commodities exchanges, like NYMEX, which offer emission allowance futures, options, and swaps contracts. 

This clearly represents an issue which is being debated.  One Congressional response is the Lieberman-Warner legislation for a “Carbon Market Working Group,” wherein wise agency heads confer and allocate jurisdiction over aspects of the overall problem.  This, however, is a board game solution for the largest and fastest moving potentially global video game ever invented. 

In reality, the two substantive problems regarding the creation of the new carbon trading market--what will be traded and how it will be regulated--have significant substantive impact on each other.  Overall system regulation needs to be thought through and executed as a whole.  The impacts on the overall U.S. economy of the imposition of GHG cap and trade are too great for patchwork repair of jurisdictional authority over time. 

“The Road to Ishtar” was a colossal comic movie failure, with a host of the greatest stars, and a plot that left the studio heads doubled over and willing to absorb horrendous budget overruns.  Particularly at this time in the U.S. financial and industrial history, the country cannot afford a video game rerun of that  movie:  “The Road to Avatar” which reviewers ruefully dismiss as a madcap romp. 

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ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.