Carbon Market Development and Oversight. June 26, 2009 De Ana Dow, Managing Director, CME Group

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1 Carbon Market Development and Oversight June 26, 2009 De Ana Dow, Managing Director, CME Group

2 Contents I. CME Group and the Green Exchange Initiative II. Fundamentals of a Successful Carbon Market III. Carbon Market Oversight Considerations IV. Appendix: Additional Background 2

3 CME Group Overview Largest, most diverse financial exchange in the world for trading futures and options for both individual and institutional traders Formed by the 2007 merger of the Chicago Board of Trade and Chicago Mercantile Exchange; followed by the 2008 acquisition of New York Mercantile Exchange (The oldest of the three, CBOT was founded in 1848.) 1. In this presentation, pro forma results for CME Group assume the acquisitions of CBOT and NYMEX were completed as of the beginning of the period presented. See the CME Group Inc. Reconciliation of GAAP to Pro Forma Non-GAAP Measures available on our Web site under the Investor Relations section for detail related to the adjustments made to reach the pro forma results. 3

4 CME Group Overview CME Group provides deep liquidity through a fast, reliable, scalable and widely distributed electronic trading platform (CME Globex ) CME Group connects buyers and sellers at their agreed price and distributes market data to all market participants Diverse and global product mix: Equity Indexes Foreign Exchange Energy Metals Agricultural Commodities Interest Rates Alternative investments (weather and emissions) 4

5 The Green Exchange Venture Overview Create the premier environmental trading platform through a consortium approach that combines CME Group s world class execution and clearing platforms with the strength of leading market and commercial participants Partnership closed on June 15, 2009 and products will trade on NYMEX and clear through CME Group clearing house The venture is applying to CFTC for Designated Contract Market Status (DCM) for the Green Exchange this is the highest level of regulation for a derivatives trading platform Partners Founding Partners: CME Group, Evolution Markets, Morgan Stanley, JP Morgan, Goldman Sachs, Credit Suisse Commercial Partners: Constellation, Vitol* Broker and Alternative Investment Funds: ICAP*, TFS*, RNK*, Tudor*, Spectron Product Slate: currently available on CME Group through NYMEX European Union Allowances (EUA) Futures and Options Certified Emission Reduction (CER) Futures and Options US Acid Rain Program Sulfur Dioxide (SO 2 ) Futures and Options US Acid Rain Program Nitrogen Oxide (NO X ) Futures Northeastern Regional Greenhouse Gas Initiative (RGGI) Futures and Options * Indicates potential equity partners who have not made a binding commitment 5

6 Contents I. CME Group and the Green Exchange Initiative II. Fundamentals of a Successful Carbon Market III. Carbon Market Oversight Considerations IV. Appendix: Additional Background 6

7 A Price on Carbon: a New Risk that Must be Managed By imposing a GHG emissions cap on utilities and other large stationary sources, Congress creates a new input risk similar to fuel or financial Traditional risks such as fuel or financial have been historically managed through a combination of over-the-counter and exchange traded risk management tools with standardized risks hedged on exchange and customized risks hedged over-thecounter To achieve the greatest reductions at the lowest possible price, emitters and builders of low carbon infrastructure must be able to efficiently hedge their carbon (and other) risks 7

8 Exchange-Traded and OTC Risk Management Tools Transaction Type Exchange- Traded Over-the- Counter (OTC) Definition Standardized derivatives that trade between two anonymous parties through a CFTC regulated trading platform Bilateral contract that meets the unique needs of the counterparties Benefits Liquidity Transparency Price discovery Counter-party credit risk management New product development Terms and conditions are customized to meet unique hedging needs Smaller lots (e.g. 67 v units specified in exchange contract) Unique hedging time-frames may be needed to secure project specific financing 8

9 What Types of Instruments Will Likely Trade? Spot Allowance Allowance or offset transactions for immediate delivery and payment. The transfer is not completed until the regulator (e.g., EPA) has received confirmation from both the seller s and the buyer s account representative. Forward Sales/Contracts Cash sales of allowances, or offsets, where delivery is to be made at a future date, but at today s price or another specified price. This can benefit emitters and clean developers who may need a degree of certainty to manage compliance costs or secure financing for clean energy projects. Futures Standardized contracts involving an established quantity of an underlying asset (e.g., 1000 allowances to emit one ton of carbon per allowance) which will be delivered or cash settled at a known future date. Buyers and sellers participate in a liquid and transparent marketplace. Options The right, but not the obligation, to purchase or sell a given quantity of allowances or offsets at a given price within a specified time frame. Swaps Derivatives where two counterparties exchange streams of allowances, offsets or cash-flows with each other. 9

10 Hedging with Futures Contracts Carbon Price per Ton In this scenario, an emitter may have a view that allowance prices will be higher at the end of the emitter s compliance period so a futures contract is used to hedge. Cash Price *Hypothetical scenario of carbon credits with futures Years 10

11 Fundamentals of an Effective Carbon Market Price Discovery Centralized trading results in transparent market-based prices for market participants: signals supply and demand of carbon allowances into the future Transparency Continuous publication of prices as well as trading volume for each compliance period (i.e., carbon vintage) allows market participants and regulators to make informed decisions Liquidity Offers all market participants the highest likelihood that they will find a match (a buyer for every seller and seller for every buyer) and therefore results in a more efficient market Credit Risk Management Central Counterparty Clearing virtually eliminates default risk of counterparties and ensures that the carbon market will not be crippled by a small number of actors The Exchange model provides fundamentals of a Successful Carbon Market 11

12 Reducing Risk: Central Counterparty Clearing In the Bilateral Model customers are at risk when one default occurs as customers are exposed to each other In the Counterparty Clearing Model customers are protected from risk of default as a Clearing House manages the risk 12

13 Contents I. CME Group and the Green Exchange Initiative II. Fundamentals of a Successful Carbon Market III. Carbon Market Oversight Considerations IV. Appendix: Additional Background 13

14 Market Oversight Objectives Ensure reporting of high quality environmental data related to emissions objectives Ensure that allowances and offset credits are accurately tracked Monitor derivatives trading for market abuse Eliminate opportunities for market manipulation Mitigate systemic risks associated with carbon and related markets 14

15 Recommended Regulatory Approach Allowance and Offset Market Optimal Regulators: EPA & USDA Regulatory duties: Allowance issuance Verifications of emissions data Tracking of allowance and offsets credits* Issuance of fines for noncompliance Derivatives Market Optimal Regulator: CFTC Regulatory duties: Oversight of Designated Contract Markets (DCMs) Review data on OTC transactions Market surveillance Enforcement authority 15

16 CFTC Market and Trade Surveillance Programs Market Oversight Well-developed, effective programs to monitor markets for manipulation, price distortion and disruptions of the delivery or cash settlement process Experienced personnel Employees with expertise on futures markets, including trading, clearing, and delivery mechanisms Large trader reporting system Rule Enforcement Reviews CFTC effectively monitors large market positions for evidence of position concentration in one entity or related entities or other indications of market power Regular reviews of each DCM s ongoing compliance with core principles; Exchange self-regulatory programs reviewed to ensure enforcement of its rules designed to prevent market manipulation and customer and market abuses 16

17 ACES Act Market Oversight Considerations Legislation should clearly establish CFTC as the regulator of the environmental derivatives market Rather than select the regulator, an interagency working group of USDA, EPA, FERC should be available to provide input to CFTC as the Commission develops regulations to achieve the requirements set forth in the bill (prevent fraud, excess speculation, etc.) Default rules for market oversight which mandate that all transactions be done on exchange and set position limits should be stricken Regulation of energy derivatives provisions should be removed and addressed through broader derivatives oversight proposals Transaction fee should be eliminated: would undermine Administration s proposals to encourage central clearing and could drive transactions overseas 17

18 Proposed Regulatory Approach for Carbon & Environmental Derivatives ACES Act Proposal An interagency task force will recommend the agency to regulate the derivatives market and the regulator must develop regulations within 18 months of enactment of the bill The regulations must limit or eliminate counterparty risks, market power concentration risks, and other risks associated with over-the-counter trading If the regulator does not meet the deadline, then default rules come into effect which: Require all derivatives to be executed through a designated contract market Limit individual market participant from controlling more than 10% of open interest in any regulated allowance derivative Recommended Approach Name CFTC as the derivatives regulator and eliminate the default rule. Permit trading on a Designated Contract Market, the highest tier of regulation subject to the full panoply of CFTC rules and regulation Permit trading of over the counter transactions (OTC) Permit OTC transactions to be cleared through a DCO Establish reporting and capital requirements for non-cleared transactions 18

19 CME Group Has a Long History of Building the Fundamentals that Make Markets Work CME Group has served a critical roll in successfully developing new and emerging markets for over 125 years through promoting and creating strong Exchange fundamentals The carbon market must possess the successful market fundamentals: Price discovery Price transparency Liquidity Counter-party risk management Proper regulatory oversight through appropriate regulatory agencies will protect the carbon market from abuses and ensure the transparency that is needed for a market that is designed to create environmental, economic, and public benefits 19

20 Disclaimer Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All references to options refer to options on futures. The Globe Logo, CME, Chicago Mercantile Exchange, and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT, NYMEX and CME Group rules. Current rules should be consulted in all cases concerning contract specifications. Copyright 2009 CME Group. All rights reserved. 20

21 Questions 21

22 Contents I. CME Group and the Green Exchange Initiative II. Fundamentals of a Successful Carbon Market III. Carbon Market Oversight Considerations IV. Appendix: Additional Background 22

23 GOAL: Develop a Carbon Market that Supports Economically Viable and Meaningful Emission Reductions Drawing on our experience in designing and running markets for more than 125 years across a diverse mix of commodities and financial instruments CME Group believes that price discovery, price transparency, liquidity, and counter-party credit-risk management are fundamental to creating and sustaining a robust carbon market that will meaningfully reduce emissions. 23

24 Price Discovery Prices generated in highly liquid and transparent markets represent the views and expectations of a wide variety of participants from every sector of the marketplace (the power sector, the transportation sector, project developers, offset providers) Price signals are the most efficient transmitters of economic information They indicate when carbon allowance or offset supplies are short or in surplus, when demand is robust or weak, or when we should take notice of longer-term trends The exchange facilitates price discovery by connecting buyers with sellers Carbon market participants will be able to rely on the futures markets to protect their business against volatility in the cash market by hedging via the futures market 24

25 Transparency Continuous market data including: Price reporting during the trading session Daily reporting of trading volume and open interest Monthly reporting of deliveries against futures contracts Customers from around the globe can place buy and sell orders; the price agreed upon for sale of any futures contract trade is immediately transmitted to the public The widely disseminated futures prices become references for cash market transactions A transparent carbon market will provide timely and critical information to market participants and regulators 25

26 Liquidity Liquidity provides a broad and diverse group of key market players the ability to monetize their carbon assets and liabilities Regulators have visibility into the supply and demand of carbon allowances and actual emissions and therefore can efficiently manage reduction levels Emitters are incentivized to reduce their emissions and invest in clean alternatives Market Participants will be able to efficiently hedge their carbon-related price exposure, either as buyers or sellers A simple example: If an emitter with a compliance obligation believes allowance prices will be higher at a future time when it may need additional allowances, it can purchase allowance futures at prevailing prices as a hedge against an increase If allowance prices rise, their increase in value will offset the increased cost of securing those allowances by other means. The firm can also elect to take delivery of the allowance contracts at maturity Project developers can make informed investment decisions 26

27 Counter Party Credit Risk Management The Clearing House acts as the counterparty to every trade: it is the buyer to each seller and the seller to each buyer CME Clearing has never had a default in over 100 years of operation Requirement of cash or cash-equivalent collateral foundation of clearinghouse stability. OTC derivatives accept less liquid collateral like liens on power plants. Positions are marked-to-the market at least twice a day CME Clearing handles more than 98% of all futures and options traded in U.S. more than 2.8 billion contracts are cleared annually with a notional value of over $1 quadrillion annually CME Clearing sets the standard used by the global financial services community to manage risk The Standard Portfolio Analysis of Risk (SPAN), developed by CME Clearing now helps 50+ exchanges and market participants all over the world evaluate the risk of their portfolios Segregation of Customer Funds Funds are not subject to creditor claims against the buyer s clearing firm, should it become financially unstable or insolvent, and can be transferred to another clearing firm if needed 27

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