by Roger Feldman --
Andrews Kurth, LLP
Casablanca is really the ultimate movie about energy. Rick plays “As Time Goes By”; the markets, for good or ill, lurch along. So, too, do climate change regulation proposals. It is easy to believe, especially at this time of year when energy legislation shimmers like the Northern Lights, “Louis, I think this is the beginning of a beautiful friendship.”
But it would be unwise to forget that Casablanca, after all, was nothing more than a big Moorish bazaar, the culture of genies granting wishes, filled with greed and superstitious hope. America’s particular energy bazaar also has two very different genies hovering over it. One is the volatile price of oil, whose price movements appear to be beyond our control, and which inevitably affects the price of other energy commodities, notably natural gas. The sour smell of possible market manipulation is always in the air. The other is a new unknown genie: the still-mysterious price of carbon offsets, whose impacts on the marketplace promise to significantly rearrange the relationships of traditional energy commodities and alternative energy sources.
These two genies, natural gas and carbon, have something else in common, besides their ability to impact the stability of the energy prices and roil the shaky economic health of our country. This is the current status of the regulation of their trading markets.
Ever since 2000, natural gas has been permitted to trade as an “exempt commodity,” on lightly regulated “ECMs” — exempt commodity markets. (The Commodity Exchange Act, as amended extensively by the Commodity Trading Modernization Act, provides for three tiers of regulation of the exchanges by the Commodity Futures Trading Commission.) You may remember that a company called Enron (which thought itself the mother of all genies) was a proponent of natural gas trading of this type; that at the time of the California deregulation meltdown there was an incomplete effort to rectify this situation in recognition of the havoc which the potential for manipulation had wrought. It was so sufficiently incomplete that there have, in the very recent past, occurred meltdowns of hedge funds like Amaranth resulting in misguided speculation in the market, which caused a minor financial crisis and post-hoc FERC apoplexy. “It’s time to round up the usual suspects,” as they say in Casablanca: stuff that genie back in the bottle. Recently, Senator Levin introduced the not-so-subtly named “Close the Enron Loophole Act,” which would revoke the earlier regulatory exemptions, and at least require the Commodities Futures Trading Corporation to apply its more stringent rules to supervising gas trading markets. The underlying policy hypothesis — which may have some merit (although it turns a blind eye to the overarching impact of the oil genie) is that such regulation will “prevent price manipulation and dampen the excessive speculation that [has] unfairly increased the cost of energy in the United States.”
But the Enron Loophole bill would go further than that, extending CFTC regulation to a class of derivative contracts related to assets not previously treated as jurisdictional: emissions from hydrocarbon combustion, including not only sulfur dioxide (SO2) and NOx which have been subject to a cap and trade regulatory scheme for well over a decade, but also carbon dioxide (CO2), the greenhouse gas whose regulation is still the subject of nascent statutory schemes on a regional and state basis, as well as a variety of voluntary programs which have spurred the creation of contracts which can be traded in new as-yet-un-codified rights. Note: It is not the environmental credits themselves, but the trade in futures, that would be regulated.
The initial reaction to the overall Levin proposal must be similar to that of Captain Renault in Casablanca upon discovering that illegal gambling is rife at Rick’s place: “I am shocked, shocked--.” Or as a CFTC commissioner riffed at a recent hearing on the subject: “Who’s in charge?”
The need for regulating the trade of established energy commodity futures could not be more clear. There continue to be issues as to who is best equipped to do it: The FERC (because of its natural gas regulatory responsibilities), the SEC (because of its superior compliance capabilities -- albeit not generally applied in CFTC turf), or the CFTC (which has developed significant experience in the regulation of other types of commodity futures trading).
As to regulation by the Levin legislation of environmental emissions affects - what might best be called “markets in gestation,” the issue is not that we would be shocked that the emergence of the potentially huge new market could produce manipulation. The only question for most observers is: How should regulation evolve? Richard Sander and the Chicago Climate Exchange have suggested that climate futures are so recently developed a commodity that an exchange dealing with them ought to incur the burdens of heavy CFTC regulatory oversight. Some observers might suggest that this position is not a wholly disinterested one, as that is one of the CCX’s products. But that is not really the point.
There is a more basic issue, which may well receive greater attention in the coming months as carbon regulation takes shape: whether trading in carbon futures is a subject which deserves oversight not just by the CFTC from a trading manipulation standpoint, but as matter whose collateral energy policy ramifications are so great that there also ought to be a formal Energy/EPA coordination of policies and oversight.
The first reaction of many is to shrink in horror from this anachronous thought. Have we taught ourselves nothing over the vast two computer-powered decades of the speedy potential of markets to do valid price discovery, as opposed to the bungling politically-influenced decisions of bureaucrats? (See “The Horrid Case of Natural Gas Before Deregulation” vols. 1960-1990.) After all, as Casablanca says, “a kiss is just a kiss.” A trade is just a trade. Markets are an article of faith of our libertarian age.
There is obviously some truth in that position. Still a small voice is heard: have we learned nothing from Enron? When there are interrelated market commodities whose prices or delivery can be arbitraged and/or manipulated, societally counter-productive things can happen (and have happened). And is not astute manipulation of the currently unregulated commodities, such as the twin genies, capable of similar mischief and collateral impact on our electric power markets? Should we really believe Treasury Secretary Hank Paulson who, musing on subprime loan regulation, exclaims that nevertheless it is a good thing that traders and bankers stay one step ahead of regulation?
There is a wise middleground position between free markets and command-and-control, based not in trading regulation but in the definition of how the carbon markets will be structured, allowances allocated, trades verified, transactions monitored and, above all, whether unforeseen perturbations in the cross-fuels and energies markets could result. Once public law turns lose the “Invisible Hand” in a gasp of green excitement (combining environmental virtue with market secularity) without first considering its energy price and policy implications, the genie of speculative future markets is out of the bottle. (Perhaps there is something to be gleaned from the post-Enron FERC and Congressional analyses of what went wrong, in terms of the establishment of some on-going energy/environment market monitoring team, which leaves commodity regulation to the commodity regulators.)
At the opening of the movie, Casablanca is characterized by insulated
introspective thinking. Rick thought only about himself. The resistance
leader, Victor Laszlo, thought only about the needs of the movement.
Ilsa thought only (most of the time) about love. By the arrival of the
closing credits, there has been growth to broader thinking. This is the
spine of the story, the power of Casablanca. Is there a lesson for our
Energy Casablanca? Perhaps too much to hope for. Welcome to 2008.
“Here’s looking at you kid.”