JONES DAY TALKS®: Carbon Markets are Booming, and Regulators are Watching

Efforts by government agencies, companies, and investors to limit the effects of climate change continue to influence activity in the financial markets. Interest in carbon markets, where emission credits are purchased and sold─and also where derivatives on those credits are traded─is growing rapidly, and that trend is expected to continue. Some estimates predict the cost of carbon could eventually double, due to the increased focus on climate issues and the tightening of greenhouse gas standards by global regulators.

The increase in trading volume has attracted the attention of regulators and enforcement agencies. Jones Day partner Josh Sterling explains how the carbon markets work, details the risks participants face, and describes what companies using these markets should do now.

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A full transcript follows:

Dave Dalton:

As governments, companies, and investors attempt to curtail the impact of climate change, interest in carbon markets, where units representing emissions reductions are traded, is growing at an astounding pace. One recent news item quoted a carbon trader saying the global carbon market has the potential to be 10 times the volume of crude oil trading. Jones Day's, Josh Sterling is here to talk about who's active in the carbon markets, how those markets are regulated and the potential opportunities and risks for companies and other participants. I'm Dave Dalton. You're listening to Jones Day Talks.

Jones Day's Josh Sterling has 20 years experience in the derivatives and security markets, both as lead counsel to major companies and as a Senior Federal Financial Regulator. Josh represents clients that are active in the derivatives markets with matters before the US Commodity Futures Trading Commission or CFTC, the US Securities and Exchange Commission, that's the SEC, and various self-regulatory organizations. Josh has particular experience assisting clients with examinations and investigations relating to their trading practices and compliance with related registration reporting and other real requirements. Well, Josh, welcome back. Thanks for being with us today.

Josh Sterling:

Thanks Dave. It's great to be here. Appreciate it.

Dave Dalton:

This is, I believe our fourth program that you and I have done regarding these issues. Every time, I learn something and every time ... well, obviously I learned something. I learned a lot of things, but every time I'm surprised by something, the way the conversation goes, the issues. We're talking about carbon trading, and this is something, I was maybe very vaguely aware of, but I didn't realize how big this is, what the potential is. But I'm getting ahead of myself. Let's go back. Josh, tell us what is carbon trading when we're referring to this in these markets? Tell me what that is.

Josh Sterling:

Sure, absolutely. Carbon trading generally refers to trading of credits that allow a business to emit or use some amount of carbon in their day-to-day activities, and you can buy and sell credits. They're issued, say, by a governing body in one of these markets, or you can also enter into a derivatives trade, a futures contract, let's say, or an options contract to acquire those credits or to sell them on in the future as well. So there's sort of a cash market for them, and there are also derivatives contracts based on these credits, as well. The idea being it's a tool companies can use if they're in a transition of their energy mix or their output mix, they can use these to have a net effect of reducing their output of carbon because they're relying on credits that already exist. Which if they use, someone else can't, the theory goes.

Dave Dalton:

Okay. Let's talk about why carbon trading is becoming so important right now. Why is this suddenly topical?

Josh Sterling:

Certainly. Well, I've been back in private practice about four months now. Since I've back, there's been a steady drum beat with the change in administration here in the United States, of climate regulation and increased focus on it. That is certainly true here in the States. The European Union is ahead of the United States. There's going to be an upcoming meeting of the UN sponsored body. I think it's called COP26, I'm not quite up on that, to talk more about the Paris Climate Accord, which the United States has rejoined and everything coming out of our financial regulators, where a lot of it, I should say, has been focused on climate risk in the financial system. So it is picking up. I'll even note that today it's June 21st. And I believe that the US financial regulators are meeting with the president and his team to talk about, among other things, their efforts to address climate change in the financial system. So all of those things contribute to an increased focus on ways to manage climate risk.

Dave Dalton:

Yeah. Okay. So obviously this a big issue, a front burner issue, no pun intended there, a burning issue, I will say that. For a lot of people playing these markets, but who is active here, who are the players in the carbon trading markets right now, as we speak?

Josh Sterling:

Sure. I can tell you that there are a number of different kinds of companies that are active in these markets. The traditional commodity trading firms are involved in those markets. They trade all manner of commodities. They would trade this as well, carbon is viewed as a commodity. And so a credit for carbon usage will in fact tie to some commodity that comes out of the ground, let's say that's used. I think, like any other financial market, you also have financial services companies, particularly asset managers, hedge funds can be active in these markets as well. I think we mentioned on the last podcast, talking about energy derivatives with David Applebaum.

In any market, you usually have producers and things, and then speculators on things. Speculators in the best sense of the word, meaning people who provide liquidity. If you were to look into, okay, who are the producers or users out there? It is a very mixed group of companies and all manner of industries. And then the asset managers are in there and provide liquidity. And I think that you see increasingly companies exploring these markets because there is an imperative from several institutional investors that hold a lot of their shares, several asset managers that run investment funds and hold their shares to basically get serious or more serious about reducing your carbon footprint and carbon credits. Carbon trading can be one way to do that while you're looking at sort of restructuring the actual business you're running.

Dave Dalton:

Okay. So where there's activity and certainly where there is activity related to the financial markets or derivative markets, there's going to be regulation. So what agencies here in the US and elsewhere would regulate carbon trading?

Josh Sterling:

Sure. Well, in the United States, it would be the Commodity Futures Trading Commission. My old agency. Carbon is a commodity or it's tied to other commodities, let's say. And so it trades contracts on emissions, meaning carbon, do you trade on contract markets that are registered with and regulated by the CFTC? Now those markets themselves have their own rules and their own surveillance teams. So they overlook that too. And as we've talked about before those powers that the exchanges have, or to look for trading misconduct to require our reporting and the CFTC does much the same thing, and sometimes bringing cases against people in parallel with the DOJ. I would also say, and we'll get into this when we start talking about some risks and carbon trading, The Securities and Exchange Commission will have an interest in it, not so much the trading of the credits, but what people say about the trading of it or the impact of it in their annual reports or other disclosures to investors. If those companies happen to be registered with the SEC. And I won't speak with expertise in Europe, but I do know that the trading regime in Europe is, broadly speaking, regulated by the European Union Government apparatus and different agencies there in. So it's pretty comprehensively regulated.

Dave Dalton:

Let's talk about risk and opportunities here in the carbon markets. What are the opportunities for clients?

Josh Sterling:

Sure. The opportunity right in front of them, is to consider ways that they can use carbon credits, carbon trading, to effectively reduce the net output of carbon emissions within a system. I know California has a trading regime. There's obviously a trading regime in Europe and is government controlled. And so programs like this, if there's only a certain number of emissions credits allowed, then anybody who is not otherwise reducing their emissions would want to use the credits to try and come into line with whatever the target is for overall emissions. And so the idea is if there are fewer credits around than there are carbon and you have to follow rules, or you opt into a voluntary scheme, that ultimately the net effect is everyone who participates in those markets or subject to those rules will have lowered their carbon emissions credits, either because they've voluntarily decided to or because that's what the rule says.

Yeah. And so I think that there's an opportunity to sort of use this as a way to try and get an advanced step, let's say, on greening your footprint. And it can complement other activities that a company is undertaking and greening their footprint but perhaps accelerate that. I know in Europe, there's been talk about bringing forward some of their carbon reduction commitments to 2030, perhaps more quickly than had been originally envisioned under their Green Plans. And so because of that, these markets might be particularly powerful tool for some carbon intensive businesses to use it. I think there's an opportunity there. And I think that if you're not in this business, where you're sort of in an industrial or commercial business, but a financial business, there's going to be a lot of price action for carbon credits, let's say, and you can use derivatives, or you can take positions in carbon credits themselves to try and make money off of that. So I think there are opportunities to get a favorable investment return by providing liquidity into these markets. And you might be able to say, for an ESG investment fund that you're doing this, you're sort of helping support a market. And that's something that investors in your funds are very interested in. So I think there are opportunities on both sides of the market. Sure,

Dave Dalton:

Sure. And trust me, we all know 2030 sounds like a long time away. It'll be here before you know it. So there will be some upward price pressure. I'm thinking these things get squeezed. The markets are only so big. So it's going to be fascinating to watch. What's the other side of the coin? Tell me about some risks here. What should we be aware of?

Josh Sterling:

Right. Well, I was reflecting on a recent piece and I think it was Bloomberg, Dave, talking about developments in the carbon markets. And some of the statistics there got me thinking about the opportunities we just discussed, but as well as the risks, and there has been speculation or thought that the carbon market could exceed the size of the crude oil market. Maybe up to 10 times. That the cost of carbon could be increased dramatically, in Europe it could double, I read it's up 60% on the year per metric ton from 50 Euros to 100 Euros is where it might go. And that apparently only 20% of the potential market of carbon is covered by trading in regulated markets. And so you have the other 80% could come online. The market could get very big. So that points to opportunity, but it also points to risk.

If you'll bear away from you, there are really five key risks to think about, and they're common to commodities generally. But the first one is volatility risk. Volatility is basically large swings, or any swings, in price up and down. And there are ways, let's say, in a derivatives market for price swings, to be managed with daily price limits. That's in place for a number of commodities contracts in the futures markets that might not exist in every market for carbon credits out there. And the one way you would deal with price swings, let's say, if there's great degree of demand would be to increase supply. And if a regulator has to bring the supply online more credits, let's say, that might not be timely if you're already in the market. One of the challenges of volatility is if you're trying to manage your trading positions to line up with your underlying business, and you have an idea how many credits you need, the amount of cash you have to commit to buying credits or having margin oppositions to acquire credits in the future, say you use a futures and option contract, could go way up. And so it could become more capital intensive than you thought getting into it. So volatility risk is one.

The other one which is related is basically adoption risk. This is the risk if the markets are going to be thin initially, not very many traders. That too can lead to large price swings, price dislocations, which is volatility, but the flip side of that, where it can go bad, is if there's market manipulation. Let's say a few traders take outside positions and they do so to drive the price up or down to fit their own needs. The other thing too about adoption is this might be a very thin market, but it might get thick or deep very quickly. When that happens those markets, wherever they may be in the world, might lack tools to monitor effectively for manipulative and disruptive trading. So if you are getting in midstream, late-stream into a market and it's moving quickly, the regulators might not yet have a grip on things like wash trading, or spoofing, or disrupting the closing of a market. So there can be real challenges around that as these markets mature.

Also the third risk I would say is regulatory and political risk. There's the risk of governments around the world might adopt different standards to address climate risk that are not aligned with given company's global footprint. So carbon trading in the EU might not align with standards adopted in the United States, for example. I think there will be an effort at global harmonization in this respect, at least amongst major money center jurisdictions, that's far from guaranteed. So I guess in some ways it's not different from managing different securities or derivatives portfolios in different countries, under different rules, or different currencies. If you're a global company, you need to have access to different currencies and they're all going to be different. But what's key here though, is if you're trying to get company's carbon footprint, way down, different measurements or progress towards that goal might make it really hard to show. It could be trying to write a whole sentence using words from different languages when you're trying to say just one thing.

So the fourth risk I would highlight Dave, is disclosure risk. What you tell your investors and other stakeholders about your approach to climate, matters greatly. And we might have a new rules proposed by the SEC, according to the Wall Street Journal this morning on climate disclosure, as early as this October. And that will obviously weigh into what people think about what they should disclose to investors. If you're using carbon credits to address your carbon footprint and you are subject to regulation, let's say, by the SEC, as a public company, you should be very careful and very clear as you think through, to what extent you make representations already to investors about your carbon footprint.

If you're relying on these carbon credits this is entirely possible, I don't know this, but someone could say, "Well, buying a credit, it doesn't mean you're actually really reducing the amount of carbon you put out. You're just buying a credit." And that seems to me, obviously, to be a perfectly fine way to manage your climate transition. Governments allow that to be done, but investors might not read it just the same way. So there's a need to be careful about that. I also think that if you're making disclosures already about climate transition, your carbon footprint, and your use of carbon markets, but like anything else, a company should have a very deep understanding of the specifications for the carbon credits or the derivatives based on them and understand the validation of their specifications. So they have confidence that the measure is accurate, reliable, and meaningful. And so I think that's an important consideration.

The fifth risk I'll mention is a verification risk. Basically, this exists for any commodity I think. It's the risk of whether you're getting what you pay for with the carbon credit. In some ways, this is no different than the verification risk you face with a physical commodity. For example, when you're taking delivery of coffee beans, do they meet the specifications to the futures contract under what you bought? At least I think carbon credits could relate to things that may be more difficult to measure, like the amount of carbon used in a fleet of commercial vehicles, or the amount of carbon dioxide released by a companies factories or retail outlets. The point is this the carbon credits are for a fixed amount of emissions, it's an allowance, generally speaking. But the amount of carbon you expend in your business could be variable, maybe a challenge to track that. And it could be difficult to sort of verify your progress and how much of a dent carbon credit would put in your actual carbon output. So those are things to be considered carefully.

Now, Dave, I know I said five risks, but I have a sixth risk bonus and it wouldn't be a podcast I'm on without talking about it, enforcement risks. So I think regulators particularly here in the states are getting up to speed quickly on carbon markets. That might mean there'll be slower to react to developments. That means further that adoption of consistent standards and a consistent application of those standards might be some way off. And I think regulators could face political pressure, based on what we're seeing out of the hill, to create those standards through enforcement action, even in the absence of final rules. I know the SEC, for example, has a climate task force already stood up that includes members of the enforcement division over there.

So if you're already active in trying to address climate risk, you're already saying things in the public about what you're doing. I think you should bear enforcement risk in mind, even if you're meaning to do well. And suggestions I would make on how deal with this enforcement risk, which embodies the other five, are really these, first of all, run diligence on the markets you're going to use. Make sure you understand the contracts for carbon credits and the standards.

If you're going to use carbon markets, the second thing I'd say is document your decision making on how, why and the extent to which you rely on those markets.

Third, like trading anything else, you should have effective tools within your organization to monitor your trade, make sure you're following the market rules. Make sure you're getting what you paid for. Make sure that it matches what you need the credits for.

Fourth, I would say is consider the effectiveness of that trading on addressing your wider climate commitments. It's probably not a total solution, but it's part of a solution and that may change over time. So don't lose sight of how that changes.

And then fifth, I've talked about this before, the final suggestion I make for companies to consider, is if you're a public company SEC registered, make sure your climate related disclosures reflect a fully considered assessment if you're trading in carbon markets and its impact on your footprints you might be looking at global standards and saying, you're doing a great job. Just bear in mind, regulators, investors, and dare I say, the plaintiff's bar, might have a different view of how effective you're actually being. So those are some thoughts I had on the big issue of risk. I know I went on for a long time, but I think they're all worth saying.

Dave Dalton:

Absolutely great summation. This is all so new. Isn't it? Regulators, enforcement agencies, et cetera, in the real world, to dumb it down, are regulators and enforcement agencies likely to be accommodating, forgiving? Like you mentioned, okay, what if you misallocate, what if you miscalculate how many credits you're going to need, you run over. Okay. Things like that. The, SEC wants your reporting to be straight or they will, they're going to come down, but in reality, do regulators get it? In terms of, look, everybody's trying to figure this out, and this company seems to be on path to doing it right, they're trying. This is a very naive way of looking at it, Josh. I'm just wondering how much runway does responsible company get while trying to comply, even if they're not right, as all this is coming out and it's so new?

Josh Sterling:

Yeah. I'm of two minds on this. The first one I would say is that the government particular agency, like the SEC, let's say, or the CFTC, may be forgiving in areas of lesser offense, let's say. There's no overt ill intention. It's just that you didn't get your disclosures quite right. Something like that. And I think that they'll be prepared to be more forgiving in the sense that you will be in an enforcement proceeding for violating the laws. But if you sort of hit the trifecta, that you self-report the violation, you cooperate with the investigation, and you're ahead of the regulator in your plans for remediation, you can get a meaningful reduction in penalty. Maybe a decision not to bring an enforcement action at all, I should say. That's entirely possible, but I do think the framework you should expect going in will be one of enforcement.

So that's sort of the lighter case, the more serious case. And this is more on the CFTC side of things, as I see it. Talking about carbon markets is sort of trade practice violation. If you're manipulating or disrupting markets, affecting the price in the market, I think, in for a walloping. And I think that's the approach the CFTC would take because one of the prime directives that that agency is to make sure the markets accurately price the underlying commodity. And so if you frustrate price discovery, that is where the CFTC has been particularly unforgiving. And I would not expect that to change at all.

Dave Dalton:

All right, Josh, to kind of wrap this conversation up, talk about the CFTC and where you think they're going on climate rulemaking, pertaining to the carbon markets or otherwise, what do you see coming down the road here?

Josh Sterling:

Yeah, Dave, there was a meeting a week or two ago now of a committee of the CFTC, one of their market committees with market participants involved. And in that meeting, there was some discussion about paths the CFTC could go down. And I think that there are a number of steps they may take. There are disclosure steps. They can require an enhanced climate disclosure by the kinds of investment pools that they regulate, maybe climate risk disclosures to customers, futures brokers, or swap dealers, something like that. I think as well, the CFTC may take some cues from the banking regulators on what sort of quasi-prudential standards they might adopt to address climate risk in the system. That could be incorporating climate or climate benchmarks into risk management programs. And there could be an increased focus on covering climate risk and climate mitigation as part of compliance programs, within swap dealers or futures brokers, firms like that.

And it's entirely possible, they might go with a firmer hand in this. I would hope this is someone down the line, but they could explore different treatments on margin requirements, and as well as capital requirements, depending upon the climate sensitivity of a futures broker or a swap dealer, or ultimately their client base. That if there's sort of more climate risk you're introducing into the system, maybe you should have to hold more capital. Maybe the trades that do that should require the posting of more margin, it could be an approach as intensive as that. And I'll note that some of the final margin rules are about to roll out at the CFTC and the capital rules got done last year. I had a bit of a role in that. So I like to think that those things would be untouched and we're sort of focusing on more processed and then sort of substantive cash on the barrel.

But I think it's all on the tables, the bottom line. And I think that if you are a global financial institution, you are obviously in the cash markets where climate is going to have to be dealt with. And that means as a corollary, you're in the derivatives markets too, and the CFTC will focus on that. And I think the best we can hope for, and leadership there has indicated they will, they will try to coordinate with banking regulators and look at the global standards that get implemented to make sure that you're going to have cash market risk, let's say, and that it's climate focused, that the derivatives markets can help lay off that risk because that's how they're supposed to work. They often don't work in a vacuum. So that's what I found.

Dave Dalton:

Josh, as usual great summation. My prediction is you're going to be very busy the next couple years if this stuff gets fleshed out, if these processes and regulations or are put into force. It's a fascinating part of the law. And obviously we're glad you're here with us at Jones Day. It's going to be interesting to watch that's for sure. Josh, your great as always. We'll do this again soon, I'm sure.

Josh Sterling:

All right, Dave, thank you very much.

Dave Dalton:

Awesome. Josh, thanks for being here today. For complete biography and contact information for Josh Sterling, go to and while you're there, visit our insights page. You'll find more podcasts like this one, videos, white papers, newsletters, commentaries, and other valuable content. Subscribe to Jones Day Talks at Apple Podcasts and wherever else podcasts can be found. Jones Day Talks was produced by Tom Kondilas, I'm Dave Dalton. We'll talk to you next time.

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