CCX Carbon Financial Instrument CFI® Contract
April 29, 2010An April 27 ruling by the U.S. Commodity Futures Trading Commission (CFTC) affects the status of carbon emission reduction contracts traded on the Chicago Climate Exchange (CCX) and may be a signal regarding the future of those contracts in any carbon trading scheme that Congress may create. The specific CFTC determination is that Carbon Financial Instrument® (CFI®) contracts traded on the CCX do not satisfy the Commission's significant price discovery (SPDC) criteria and therefore do not trigger regulation. The basis of the finding, however, effectively is that the CCX is not a particularly influential player in emerging U.S. carbon markets and, of particular note, the CFTC is of the opinion that the CCX instruments are relatively unlikely to be folded into any national mandatory carbon reduction program.
What's the CFI?
The CFI® contract is a carbon-based commodity that is traded on the CCX. Each CFI, which represents 100 metric tons of carbon dioxide-equivalent, consists of so-called "exchange allowances" and "exchange offsets." The CCX issues exchange allowances to exchange members based upon each member's emission reduction schedule and baseline. Exchange offsets, on the other hand, are generated by qualifying offset projects.
The CCX is an Exempt Commercial Market (EMC) under the Commodity Futures Modernization Act. Under what has become known as the "Enron Loophole," certain eligible commercial entities (ECE) are largely exempt from CFTC regulation when they trade on ECMs. Traders on the CCX thus must be ECEs.
In the post-Enron era, the CFTC Reauthorization Act of 2008 granted the Commission authority to regulate contract trading on ECMs that perform a significant price discovery function, or SPDC. A contract serves an SPDC if it possesses one or more criteria: (1) price linkage (i.e., whether and the extent to which the contract relies on a daily or final settlement price on a regulated exchange); (2) arbitrage (i.e., whether and the extent to which the contract price is sufficiently related to a contract traded on a regulated exchange to enable arbitrage); (3) material reference price (i.e., whether and the extent to which, on a frequent and recurring basis, transactions in a commodity are based upon prices generated by contracts being traded or executed on the ECM); and (4) material liquidity (i.e., whether and the extent to which traded contract volumes are sufficient to have a material effect on other traded contracts).
The CFTC had previously indicated that the CFI® contract could satisfy the material reference price and material liquidity criteria.
What Did the CFTC Say About the CFI® Contract?
The CFTC concluded that the CFI® contract did not satisfy the material reference price and material liquidity criteria.
With respect to the material reference price criterion, the CFTC determined that the CCX is basically a closed and small market. In particular, "it appears that CCX CFI prices are not widely used as price references in the US carbon market due to the relative small market share of the CCX CFI program in the overall US carbon market and the currently limited potential for the CFI program to be folded into a national mandatory carbon reduction program" (Statement of Richard Shilts, Director, Division of Market Oversight on Meeting to Consider Significant Price Discovery Contract Determinations, April 27, 2010).
With respect to the material liquidity criterion, the CFTC found that each vintage of CFI® contract was only traded, on average, once a day - a trading rate that was well below the Commission's benchmark for active trading. In other words, the CFI® contract is illiquid.
What Does This Mean for the US Carbon Markets?
It's a mixed bag. On the one hand, CCX participants may perceive a benefit to remaining largely unregulated.
On the other hand, in reaching its determination, the CFTC basically concluded that the CCX was not an influential player in the emerging US carbon markets, a determination that might carry some sting for the CCX.