The very flexibility measures that make a tradable permit system efficient also make it vulnerable to fraud and manipulation. Market oversight provisions work to prevent these issues and facilitate price discovery by increasing transparency, containing risk, maximizing liquidity, and ensuring fair competition. Emission allowances can be seen as commodities or financial products, and existing structures for financial market regulation can then be applied to allowance trading.
As the supply of allowances in a trading scheme with an absolute cap is fixed, allowance prices are especially sensitive to demand and thus vulnerable to external shocks and abuses of market power. To limit market power, regulators may impose limits to restrict the number of allowances held by any single participant (position limits) or other measures to prevent groups from colluding to manipulate price levels. Market oversight provisions cover primary markets (see allocation) and secondary markets and help ensure that all participants have equal opportunity to buy allowances at a price based on market fundamentals. In addition to allowances themselves, derivatives or financial contracts for future transactions which ‘derive’ their value from allowances can also be bought and sold. Buyers and sellers can seek each other out and trade over-the-counter (OTC), or go to an exchange where buyers’ bids and sellers’ offers are centrally agglomerated. In OTC trading, there is some ‘counterparty risk’ that the various actors trading cannot or do not fulfill their obligations, which can lead to potentially significant financial losses. To help mitigate this risk, market oversight provisions can promote trading on exchanges or at least through a central clearing party (CCP) which helps to pool risk and minimize the effects of any single unfulfilled contract. Registries and trade repositories can serve similar functions, in increasing transparency and helping to identify potentially market relevant dangers.
In addition to manipulation, outright fraud may be an issue to be addressed by market oversight. Electronic registries that are robust to hacking and know-your-customer rules imposing requirements on who can open a registry account to participate in the market can help guard against phishing attacks (personal information gathering leading to allowance theft) and carousel fraud (cross-boundary trade leading to tax evasion).