BOARD MEETING DATE: May 3, 2002
AGENDA NO. 31
Merits of a Centralized Market for RECLAIM
SYNOPSIS:
In May 2001, Regulation XX – RECLAIM was amended to help stabilize RTC prices and address California energy issues. The resolution for the amendments included direction to staff to work with economists and interested parties to evaluate the merits of a centralized trading market. This report summarizes progress in the evaluation and staff’s recommendations.
COMMITTEES:
Stationary Source and Mobile Source, March 22, 2002, Reviewed
RECOMMENDED ACTION:
Receive and file.
Barry R. Wallerstein, D.Env.
Executive Officer
Background
The RECLAIM rules were amended in May 2001 in response to a rapid rise in NOx RTC prices and the California energy crisis. Although the energy issues were the primary cause of the high RTC prices, delayed installation of control equipment by RECLAIM facilities was also a factor. Some parties felt that the RECLAIM trading market mechanisms and a lack of timely and complete trading information may have placed facilities in a situation with inadequate time to install control equipment, thus, necessitating the purchase of RTCs, which were in limited supply. This led to a proposal to study a centralized market for RECLAIM. The AQMD Governing Board adopted a resolution at the time of the May 2001 RECLAIM amendments that directed staff to evaluate the merits of a centralized trading market. The attached report fulfills that requirement.
The price of NOx RTCs has stabilized since the May 2001 rule amendments which removed power producers from the trading market. A RECLAIM Trading Working Group has also worked with industry and other interested individuals to see that trades are processed quickly and timely trading information is available on the AQMD website. Staff continues to work with RECLAIM facilities to make improvements to posting and processing of trades as well as exploring other ways to improve the mechanics of trade processing. Power producers and some of the larger RECLAIM facilities are installing control equipment, which will further stabilize the supply of RTCs.
Originally, the AQMD designed the compliance and trading mechanisms of RECLAIM and then took a hands-off approach to allow the RECLAIM trading market to evolve and develop on its own. The goals were to keep the market structure as simple as possible, insure access to all participants, and insure that actions required by AQMD occurred. The AQMD would register trades and provide information to the market, but would focus its efforts on compliance with program requirements rather than becoming involved in the structure of, or running of, the market. The resulting market is a diverse market, which is a combination of direct trading, brokered trades, and one auction trading forum.
RECLAIM is a thinly traded market. There are currently 335 NOx RECLAIM facilities, with only about 10% of the facilities trading more than 10 times in the last 2 years. In 2001, there were 640 NOx trades with price involved.
Most financial markets are profit-driven. Participants are free to choose when and if they execute a trade. RECLAIM differs due to the underlying compliance basis and regulatory requirements. RTCs have limited lives and trades are often executed to meet specific compliance deadlines.
Centralized Market
The current RECLAIM market is a diverse market where trades occur directly between RECLAIM facilities or with the aid of an intermediary, such as a broker, and prices are negotiated. In an aggregated or centralized market all trading would take place at a single point. This type of market would have an electronic system for matching buyers and sellers and determining a clearing price. All buyers and sellers in the market at a given time would participate at the same price, determined by supply and demand. The market would have a financial partner, such a bank, to hold a buyer’s money in escrow until a trade was finalized. The market software would link with the AQMD database to verify availability of credits. The AQMD or a third party could operate the central market.
A centralized market is one option to provide more complete and transparent market information. Significant efforts would be required to institute such a market for RECLAIM, and the analysis demonstrates that such a change is not advisable. It would entail extensive software development and maintenance including the need to address, to the extent possible, non-conventional trades such as cross-cycle, interpollutant, and business package transactions; increased AQMD involvement; partnering with a financial institution; RECLAIM rule amendments; and potential short-term disruption to the current program. Costs would be passed on to RECLAIM market participants in the form of additional fees. The small size of the RECLAIM market, the underlying regulatory requirements for trading, and preferences of the market participants were considered in the analysis and recommendations.
Public Process
AQMD staff participated in several internal meetings, public meetings, and conference calls to obtain input on the possibility of changing the market structure. A RECLAIM Market Working Group was formed which met twice to discuss effects of the May 2001 rule amendments, trade processing and posting improvements, issues leading to the suggestion to investigate a centralized market, and alternative market structures. The working group included economists, brokers, RECLAIM facilities, and other interested individuals. Staff also conducted a survey of RECLAIM facilities that trade frequently regarding trading issues and information availability. Almost all the working group members and the survey respondents (28 individuals representing 45 RECLAIM facilities) felt the May 2001 RECLAIM program changes had adequately addressed the high NOx prices and were opposed to changing the current market structure. Comments received during the survey regarding further trading improvements, such as simplifying paperwork for intra-facility RTC transfers, that are not related to the change in market structure will be addressed through the ongoing RECLAIM Trading Working Group effort. The working group members and 4 outside economists also reviewed and provided comments on the draft report.
Conclusions
While a centralized market could provide certain advantages over the current diverse market structure, staff has evaluated pros and cons of the existing market structure and a centralized market and is not recommending the centralized market approach. There are significant costs to set up and maintain a central market (initial software costs over $700,000). The costs would be passed on to traders in the form of additional fees. AQMD is limited by state law to recovering only the costs of the program and cannot generate revenues from licensing the exclusive right to operate a centralized market, but the additional fees could be significant, particularly if trading volume is low. A central market would also necessitate greatly increased involvement and oversight by the AQMD and could cause temporary disruption to the current program during the transition period. In addition, no cost transactions (e.g., cross-cycle trading) or RTC trades as part of other business transactions often taking place in the current market may become more complicated under a centralized market.
Most of the input, both from the working group members and survey respondents, is that the current RECLAIM market structure works satisfactorily and meets the needs of the participants. The May 2001 rule amendments and enhancements to trade processing and posting have largely addressed the issues of the NOx RTC price increase and there is no urgency to change the market structure. An economist from Massachusetts Institute of Technology who reviewed a white paper from the centralized market proponent advised that other, less costly solutions should be explored before going to a centralized market. Staff’s independent analysis of the technical information agrees with the suggestions from these sources. Four economists were requested by staff to comment on the report regarding a centralized market. All four concurred with the conclusions of the report that AQMD should focus on continued improvements to the existing system.
Recommendations
Maintaining the current RECLAIM trading market is recommended. Time should be allowed to see the effects of the May 2001 RECLAIM rule amendments and the on-going improvements to trade posting and processing. AQMD will continue to work with RECLAIM facilities and other interested parties to make any additional changes needed to improve posting and processing of trades and information availability.
Merits of a Centralized Market for RECLAIM
Appendices
/ / /