Concept Title: Carbon Dioxide Emissions Allowance Futures Contract and Trading Platform
One Sentence Synopsis of Concept: Web-based trading platform to facilitate the trading of a new futures contract based on the expected future price of U.S. Carbon Dioxide emissions allowances. Concept Description (200 Word Maximum): Market Need: Futures contract and web-based trading platform will allow firms and investors the opportunity to hedge exposure to, and speculate on, the future price of U.S. Carbon Dioxide emissions allowances. Size of Market Opportunity: According to Commissioner Bart Chilton of the Commodity Futures Trading Commission, “The potential size and scope of a structured carbon emissions market in the U.S. is unequivocally vast.” However, the size of this new market opportunity will vary based on investors’ expectation of future U.S. cap-and-trade regulations. Assuming a linear relationship between expectations and transaction commissions, the annual size of the market varies between $274,000 at current expectations of zero and $28,800,000 at 100% expectations. More details on these estimates are listed in Appendix 3.
This latter estimate is conservative as it assumes that regulations would cap emissions at current levels. If regulation is approved, emissions will most likely be required to decrease over time, and thus the price of allowances will increase, along with the size of the market and commissions earned. Barriers to Entry: The largest barrier to entry will be the creation of a liquid market that will draw market participants. Market/Customer(200 Word Maximum): Users of this futures contract and web-based trading platform will include both firms and investors who are interested in hedging exposure to, and speculating on, the future price of U.S. carbon emission allowances. Firms are motivated to neutralize themselves from extraneous risks in order to provide certainty to investors regarding overall business performance. Examples of participating firms would be utilities and manufacturers, or other firms who are highly exposed to carbon allowance price risk and wish to hedge their exposure to future price fluctuations of these allowances. Examples of participating investors would include institutional investment funds and retail investors who wish to allocate their capital efficiently in a new asset class and/or speculate on the future price of carbon emissions allowances. Net buyers of this futures contract would differ from net sellers. Net buyers would include market participants who believe their future emissions will be higher than their future emissions cap. Net sellers would be those participants who believe their emissions in the future will be lower than their future cap. Competition(200 Word Maximum): There are no competitors in existence which offer a U.S. exchange-traded carbon futures contract. The Chicago Climate Exchange, which operated from 2003 to 2010, facilitated exchange-based trading for spot carbon emissions contracts, however this market is now defunct. There are several competitors in existence which provide over-the-counter brokerage services on California carbon futures instruments. These companies include the Green Exchange and the Chicago Climate Exchange (ICE). The first California carbon futures contract traded on August 29th, 2011 through the Green Exchange for $17. In the past, the successful launch of a futures contract has attracted competitors into the market with similar contracts. Successful markets are typically the first markets to amass liquidity. A good example of this pattern is the case of live cattle futures. These contracts were introduced by the Chicago Mercantile Exchange (MERC) and their success was quickly noticed by the Chicago Board of Trade (CBOT). The contract eventually launched by CBOT was not successful as liquidity had already attained critical mass at the MERC. In this way, it is crucial to attain a critical mass of liquidity in this new contract before it is attained by a competitor. Sales/Marketing(200 Word Maximum): In order to attain liquidity in this new contract, it is crucial for investors to not only become aware of the exchange, but also to have confidence in its ability to neutralize credit risk. In order to accomplish both of these tasks, the web-based trading platform will be launched with the assistance of the CME Group through its Globex trading platform. The listing of this contract through Globex will provide publicity and credibility for the contract. Also, because trades will be cleared through the CME Group clearing house, traders can be confident that their exposure to credit risk will be neutralized. Partnership with the CME group is essential in the race for liquidity, but it is also expensive. The launch fee for the contract is approximately $100,000 and 50% of the trading commissions will be shared with the CME group. Further promotion of this contract and trading platform will be through business-to-business sales initiatives. Larger traders will be offered a percentage discount on trading commissions in exchange for trading volume. Team (200 Word Maximum): Brian Kerschner will manage the launch of this new futures contract and web-based trading platform under the guidance of experienced market-makers at the CME group and elsewhere. Mr. Kerschner’s professional background is ideally suited for this management position due to his extensive experience in the process of new market development. While working at Sysco Corporation, Mr. Kerschner developed a new geographic market from zero to $2.4 million in annual revenue within one year. These market development skills are directly applicable to the development of liquidity for the new futures contract and web-based trading platform. Financial Projection(200 Word Maximum): The cash flows generated by this futures contract and web-based trading platform will vary based upon investors’ expectations of future U.S. cap-and-trade regulation. The revenues forecasted within the discounted cash flow analysis within Appendix 1 are based on mean cap-and-trade system passage expectations of 10% in 2012 and 30% thereafter. These estimates are based on expectations made public through crowdsourcing website Intrade.com. The distribution of these revenues is assumed to be triangular and the upper and lower revenue limits are listed within Appendix 2. Operating margins and the corporate tax rate are assumed to be normally distributed and equal to those of the CME Group, with mean rates of 61% and 45%, respectively. The standard deviation of these rates is assumed to be 1%, and 2%, respectively. Development costs are assumed to be $125,000, which includes a $100,000 contract launch fee and legal fees of $25,000. Based on a simulation containing 1000 iterations, the mean NPV generated by this futures contract and web-based trading platform is $12.1 million. Based on this simulation, this is a positive NPV opportunity with 99% certainty. 
Implementation Plan(200 Word Maximum): There are several active U.S. patents on file for forward contracts which are similar in structure to the new contract which I plan to introduce. As a defensive measure, in order to protect myself from legal challenges, the first step I take towards implementation will be to file a patent on the new contract. Should I be selected as the recipient of a monetary award from the IU Best competition, I will use these funds to immediately begin the patent filing process. I assume this process will take four years to complete. During this time, I will move forward with the formation and listing of the new futures contract on the web-based Globex trading platform made available through a partnership with the CME group. I anticipate that the contract will be launched within eighteen months of the patent filing.
Appendix 1: Discounted Cash Flow Analysis
Note: Net Present Value listed above is the expected NPV with no randomness.
Appendix 2: Regulation Expectation Forecast Assumptions
Appendix 3: Expectations vs. Contract Trading Commissions Revenue
Source: Chilton, Bart. (2008). “The Most Important Thing.” New York, New York: http://www.cftc.gov/PressRoom/SpeechesTestimony/opachilton-14
Good luck with this!
ReplyDeleteCan you explain how this will impact sustainability? I don't understand if this has any direct connection with the amount of carbon emissions in the atmosphere or if it is merely speculation on the price or carbon.
Hi Professor Brown – Thanks for your question. I think you might agree that placing a price tag on carbon emissions would motivate businesses to emit less carbon. This business venture aims to do exactly that. Let me explain.
ReplyDeleteThis futures market, if successfully implemented, would allow businesses the opportunity to buy “insurance” (futures contracts) against rising carbon emissions allowance prices. Businesses very commonly buy futures contracts as a form of insurance. For example, importers regularly buy futures contracts on foreign currency. They do so just in case the price of the goods they plan to import increase between the time of purchase and time of delivery (payment). In this way, even if the dollar depreciates against the foreign currency denominated good between the time of order and payment, the risk-neutralized firm has already locked-in a foreign currency price which they are comfortable with.
Now, instead of an importer, let’s talk about an extremely carbon intensive business, such as a coal-fired power plant. A coal-fired power plant might want to buy “insurance,” just in case the price of the carbon they emit increases in the future. In order to do so, they could buy a futures contract, just like the importer. However, instead of buying a futures contract on currency, the power plant would buy a futures contract on the price of a carbon emissions allowance. If the price of emitting carbon increases, so would the value of the futures contract owned by the power plant, thus the plant is neutralized from this price risk.
However, the price of this futures contract is an additional cost of doing business, which the power plant would like to avoid if possible. And as the price of this “insurance” increases, as it would with an increased expectation of the passing of emissions regulations, the power plant would be motivated to emit less carbon. By placing a price tag on carbon emissions, you bring this cost into the business plans of carbon emitters, and thus incentive a reduction in emissions and increase the overall sustainability of the U.S. economy.