MEMORANDUM

To:	Kevin Culligan, Erich Eschmann, Scott Benolkin, EPA/CAMD

From:	Barry Galef, Bansari Saha, Jason Lee, Bickey Rimal, ICF
International

Subject:	Transaction Costs in Allowance Trading Markets

Date:	September 17, 2008



This memorandum summarizes ICF’s interim findings on the magnitude of
transaction costs in allowance trading markets.  These findings are
primarily based on limited conversations with brokers and consultants,
review of literature on transaction costs, and information available on
broker and exchange websites. 

Our findings suggest that the costs are fairly standardized and are
generally low compared to the value of allowances.  We found that
transaction costs are usually well below the 1- to 2-percent range of
allowance values typically quoted in the economics literature.  From our
discussions with the industry consultant, we also learned that there is
enough competition amongst the approximately fifteen brokerage houses
that any attempt at charging fees in excess of market standards will be
bid down through competition and entry.  In many instances, larger
clients can negotiate fees even lower than market averages.  Moreover,
we recently saw exchanges such as Chicago Climate Exchange and New York
Mercantile Exchange adding the SO2 and NOx allowances to their list of
commodities.  

In this memorandum, we first present the textbook definition of
transaction costs discussing the components that constitute the costs. 
We then present our findings on the magnitude of transaction costs in
the allowance trading markets, based on the information we were able to
collect in the last few days.  In the third and final section, we
quantitatively analyze the magnitude of the costs in the CAIR NOx
Program.   

Definition of Transaction Costs

Transaction costs are costs associated with the exchange of goods or
services.  In the allowance trading market, transaction costs are often
considered to be the fees charged by brokerage firms.  These fees are
the direct costs associated with buying and selling allowances.  In
addition to these direct costs, there may also exist indirect costs (or,
as one broker we spoke with called it, costs for “quasi-consulting
services”).   If a company needs some expert analysis or opinions to
maximize the value of its allowances, the cost of that analysis can be
considered an indirect transaction cost because it is indirectly related
to actual execution of the trades.  In most cases, costs for these
analytical services are not included in the standard fees, but brokers
pointed out that these services are only required only in a relatively
small fraction of trades (perhaps in the range of 5--10 percent of all
trades).     

    

In economic theory, transaction costs have three components: 
information and search costs, bargaining costs, and policing and
enforcement costs.   The first two components—information and search
costs, and bargaining costs—are standard services provided by
brokerage firms.   These firms facilitate transactions through price
discovery and matching buyers with sellers. Once the potential
counterparty is identified, the buyers and sellers usually complete the
transaction with each other (see Footnote #6 for a variant to this
situation).  The identities of buyers and sellers are protected during
this process.  

Brokerage firms also provide various consulting services or other
analytical support based on client needs.  In most cases, it appears
that they provide these services at no extra charge provided that the
clients enter into an agreement to trade exclusively with them.  In some
cases, though, there seem to be an additional fee, as discussed below. 
These types of services could include analyzing, advising, and
strategizing based on the client’s needs.  Our discussions with the
industry consultant confirmed that these indirect services are typically
for short-term (i.e., a few months to a year) market projections based
on brokers’ anticipation about various market parameters (for e.g.,
studying what demand might be based on coal use, expectations about the
degree to which the next summer months can affect electricity demand,
etc.).  These expert opinions do not involve any sophisticated modeling
by the brokerage firms and large EGUs are unlikely to rely on them
because of doubts about their unbiasedness.  Given that most firms may
not require added payments for conducting these services and these
services seem to be of low relevance to compliance behavior, costs for
these quasi-consulting services appear to be trivial in relation to
overall transaction costs.

The third component, the cost of policing and enforcement, is somewhat
difficult to interpret because the cost to prevent a potential conflict
between the seller and the buyer is included in the fees charged by the
brokerage firms.  For example, if a buyer or seller does not have good
credit, then the brokerage firm can work as an intermediary in the
process of exchanging funds by opening an escrow account.  Moreover, a
seller or buyer occasionally may wish to conduct the transaction using
an exchange.  In that case, the cost of using the exchange is an added
cost but it does prevent any conflict that could occur from the
transactions. Though the costs of policing and enforcement to prevent a
conflict between the seller and the buyer are included in the fees
charged by brokerage firms, a conflict between a seller/buyer and the
brokerage firm is not.  However, we think a possibility of the brokerage
firm counterfeiting allowances is very small given that maintaining a
good reputation is essential for client-oriented businesses.        

Fees Charged by Brokerage Firms

The fees charged by brokerage firms seem to be standard and fairly small
compared to allowance prices.  We conducted interviews with two
brokerage firms and both quoted fees in the same range.  Moreover, when
asked the same question during our interview with the industry
consultant, his response was strikingly similar to those given to us by
the brokers, providing confirmation that these fees are well
standardized due to the competitive nature of the brokerage business. 
Finally, the range for these fees is also comparable to the range we had
found in our literature review.

The typical fees charged by brokerage firms for each allowance market
are shown below.

Exhibit 1: Transaction Fee as a Percentage of Allowance Price

Allowance Type	Allowance Price ($/ton)	Broker Fee ($/ton)	Broker Fee as
a percentage of Allowance Price

SO2* 	300	0.50	< 0.2 %

Seasonal NOx*	850	10-15	< 1.8 %

Annual NOx*	5000	20-25	< 0.5 %

Note: The allowance prices are prices before CAIR was vacated by the DC
circuit court. 

*The allowance price for SO2, Seasonal NOx, and Annual NOx are the spot
price, seasonal NOx 2008 price, and annual NOx 2009 price, respectively.

Source: Evolution Markets ( HYPERLINK
http://new.evomarkets.com/index.php?page=Resources-Market_Updates-Monthl
y_Market_Updates 
http://new.evomarkets.com/index.php?page=Resources-Market_Updates-Monthl
y_Market_Updates )



Given that the SO2 allowance price was about $300/ton just days before
the CAIR vacatur, the transaction costs appear to be less than 0.2
percent of the allowance value.  Considering the fact that SO2 allowance
price was hovering around $550/ton in the second half of 2007 and
gradually came down to the $300/ton level, transaction costs for SO2
allowances could have been significantly lower than 0.2 percent of the
allowance value if CAIR had not been vacated.  For seasonal NOx
allowances, the price was $850/ton, so these costs are less than 1.8
percent.  For CAIR annual NOx allowances, the allowance price was
$5,000/ton before CAIR was vacated by the court, which translates to
less than 0.5 percent.               

Exchange Fees 

According to our research, costs of using exchanges are much lower than
the fees charged by brokerage firms, as shown in Exhibit 2 below.  On a
per ton basis, these exchange fees translate to less than 10 cents/ton
for SO2, less than a dollar/ton for seasonal NOx and up to $2.50/ton for
annual NOx, which are much lower than the broker fees shown in Exhibit 1
above.   

Exhibit 2: Summary of Trading Fees per Contract at CCFE and NYMEX

Product	CCFE	Green Exchange (NYMEX)

	Contract Size	Member Fee (per contract)	Non-Member Fee (per contract)
Contract Size	Transaction Fee (per contract)

SO2 Futures	25 tons	$1.60	$2.00	100 tons	$6.00

Seasonal NOx Futures	5 tons	$2.00	$2.50	10 tons	$7.00

Annual NOx Futures	1 ton	$2.00	$2.50	10 tons	$7.00



The actual transaction fees for using exchanges are thus less than 0.1
percent of the allowance values, as shown in Exhibits 3 and 4 below. 
Exhibit 3 presents exchange fees related to the US SO2 and NOx markets
while Exhibit 4 presents comparable numbers for the EU CO2 market.  

Exhibit 3: Summary of Trading Fees per Contract in terms of percentage
of Allowance Price

Product	CCFE	Green Exchange (NYMEX)

	Member Fee	Non-Member Fee	Transaction Fee

SO2 Futures	0.02%	0.03%	0.02%

Seasonal NOx Futures	0.05%	0.06%	0.08%

Annual NOx Futures	0.04%	0.05%	0.01%

Note: This table has been corrected to take into account the size of
each contract.

Exhibit 4: Transaction Fee at selected Exchanges for CO2 Allowance

Exchange	Transaction Fee ($ per 1,000 metric tons)	Transaction Fee as a
percentage of CO2 Allowance Value

ECX	2.8 - 3.5	0.01%

NordPool	4.2	0.01%

EEX	1.4 - 4.2	0.01%

Green Exchange (NYMEX)	2	0.01%

The CO2 Allowance price was $34.28 (as of 09/05/08)

Source: Point Carbon ( HYPERLINK
http://www.mfe.govt.nz/publications/climate/issues-international-carbon-
market-oct07/html/index.html 
http://www.mfe.govt.nz/publications/climate/issues-international-carbon-
market-oct07/html/index.html ), NYMEX ( HYPERLINK
http://nymex.greenfutures.com/markets/ 
http://nymex.greenfutures.com/markets/ )



There are additional fees associated with using the exchanges, such as
annual fees and application fees, but we assume those are paid by
brokers annually, and are minimal costs of doing business for brokerage
firms.  

Estimating Transaction Costs for the NOx Program

We quantified the total transaction costs under the CAIR NOx program by
using emission projections from IPM.  We also estimated the number of
allowances that each fossil unit could get by assigning the allowances
given to each state in proportion to the heat input in 2010, adjusted
for fuel type.  This fuel type adjustment counted only 60 percent of the
heat input for oil units and 40 percent for gas units, paralleling how
the allowances are calculated for each state.  Once the NOx allowances
for each unit under CAIR are estimated, we calculated the number of
allowances each unit would need to sell or buy.  These make up the
number of allowances that need to be transacted.  We then applied the
$20 to $25 per ton for the transaction fee to estimate the overall
percentage of transaction costs as a share of total allowance
transactions.  Results indicate that transaction costs for the NOX
program were generally very small at less than one-half of one percent. 


Exhibit 5: Summary of Transaction Costs under CAIR Annual NOx Program in
2010

Fee for Transacting NOx Allowance	$20 - $25/ton

Total Transaction Costs	$21 – $26 million

Total Value of Transacted Allowances	$5.28 billion

Transaction Costs (%)	0.4 – 0.5%

Note: We used $5,000/ton for the NOx allowance price since that was the
market price before the CAIR vacatur. Even if we use the IPM projected
price of $1,079/ton for CAIR NOx allowance in 2010, the percentage of
the transaction cost is only about 2 percent.

Using information gathered from our discussions with brokers, we also
quantified the costs for advisory services charged by brokerage firms
for their market analyses.  We estimated the number of utility operators
to be about 360 and assumed that 5 to 10 percent of them could seek some
sort of advisory services each year (using approximate figures quoted by
a broker).  We then multiplied the resulting operators seeking
consulting services by $5,000 - $10,000, which was the fee range also
suggested by the broker in our conversation.  As shown in Exhibit 6
below, the resulting estimated cost of advisory services are very small
compared to the transaction costs charged by the brokerage firms.  When
these advisory service costs are added to the transaction costs, the
overall transaction cost percentages remain very close to the 0.4 –
0.5 percent of the total NOx allowance value.  

Exhibit 6: Summary of Advisory Service Costs under CAIR Program in 2010

Fee for Each Advisory Service	$5,000 - $10,000

Number of Operators	360

% of Operators Seeking Advisory Service	5% -10%

Total Costs of Advisory Service	$90,000 - $360,000



These costs appear on their face to be too small too discourage the
affected units from seeking a distribution of emissions close to the
least-cost outcome.  Moreover, these low transaction cost estimates also
seem to validate the industry consultant’s opinion that transaction
costs are generally very small and are not expected to affect program
outcome.  As we have already discussed with you, it should be possible
to strengthen this tentative conclusion, though, using a simple modeling
approach.  

 We called various brokerage firms listed on the CAMD website,  
HYPERLINK "http://www.epa.gov/airmarkets/trading/buying.html" 
http://www.epa.gov/airmarkets/trading/buying.html , and were able to
interview representatives from two brokerage houses in the last week or
so.  At their requests though, we would like to keep broker identities
and their affiliations confidential. 

 Transaction costs in some “thin” markets--such as those for
renewable energy credits—could be higher at 3 to 3.5 percent,
according to the industry consultant we spoke with.    

 North and Thomas (1973). 

 These costs also include any profits a participant in a transaction
needs to secure.

 One broker we spoke with suggested that the average fee for these
services range between $5,000-$10,000 and that they typically provide
these services for very few trades.  Thus, these costs appear to be
fairly small and unlikely to make a significant difference to our
conclusions.  

  Brokers told us they do not generally handle the monetary exchanges
and prefer that buyers and sellers directly conduct the financial
transaction.  If there are credit concerns, however, some brokerage
houses will undertake the “clearing functions”.  These clearing
functions may include the use of escrow accounts or ensuring allowances
get delivered on time.  If brokers are asked to provide these services,
they typically provide them as complimentary services as long as their
brokerage firm is the exclusive agent in the transaction (i.e., to
maintain long-term client relationships).  Moreover, costs for these
clearing services tend to be fairly small, according to the industry
consultant we spoke with.     

 The cost of using the exchange is an added cost but this cost is also
trivial at less than 0.1 percent of allowance price.

 In 2002, Calpine sued its broker when the company learned that some
allowances it had purchased were not available. 

 One industry expert, Gary Hart, had stated that the typical fee charged
by brokerage firm is $0.50 for each SO2 allowance.  His statement is
presented in “The U.S. Acid Rain Program: Key Insights from the
Design, Operation, and Assessment of a Cap-and-Trade Program.”

 “SO2 Markets – July 2008 Monthly Market Update,” Evolution
Markets,
http://new.evomarkets.com/index.php?page=Emissions_Markets-Markets-NOx_S
easonal_Allowances

 The seasonal NOx price of $850/ton and the annual NOx price of
$5,000/ton were in effect days before the CAIR ruling. In general,
prices were in the range of $750/ton to $850/ton for seasonal NOx
allowances and in the range of $3,000/ton to $5,000/ton for the annual
NOx allowances in 2008, according to the “NOx Monthly Market Update
(07/08)” published by Evolution Markets. 

 From the units we projected to be participating in the transactions
under CAIR in 2010, we matched their ORIS codes with the Operator ID
numbers in the latest eGRID database to identify the unique number of
operators under CAIR.

 The consultant felt that high transaction costs, if present, might
discourage speculators but are unlikely to affect those who need to
trade for compliance purposes.  

 PAGE   

 PAGE   2 

		  PAGE  1 

 

