While the EU is preparing for the commencement of “Phase IV” of the EU emission allowance trading scheme as of 1 January 2021, the linking of the emission trading systems between the EU and Switzerland recently became effective. We will cover these recent developments, as well as some general background on the cornerstones of EU allowance trading and EU emission allowances as such.

What is the ETS?

Directive 2003/87/EC (“ETS Directive”) established a scheme for greenhouse gas emission allowance trading within the EU (the “EU Emissions Trading System” or “ETS”) aiming to promote the reduction of greenhouse gas emissions in a cost effective and economically efficient manner. Until recently, the ETS was operating in the EU countries as well as Iceland, Liechtenstein and Norway. It covers around 45% of the EU’s greenhouse gas emissions.

The ETS operates as a “cap and trade” system: the total amount of (certain) greenhouse gases is capped and this cap is reduced over time. Within the cap, the ETS creates allowances (meaning rights to emit a certain amount of greenhouse gases). Companies receive emission allowances either by means of free allocation or via auctions and may trade with one another. After each year, each company must surrender sufficient allowances to cover its emissions or fines will be imposed. While only certain companies may become subject to fines, private individuals and companies, which do not emit greenhouse gases, may also participate in the trading of EU allowances.

Emission allowances in a financial market regulatory framework

Directive 2014/65/EU (“MiFID II”) classifies EU emission allowances as financial instruments. By bringing emission allowances fully into the scope of MiFID II and Regulation (EU) 600/2014 (“MiFIR”), the European legislator has reacted to fraudulent practices in spot secondary markets in emission allowances.

As a result, certain services and trading in emission allowances might be subject to licensing requirements (investment firms) and/or subject to the MiFID II / MiFIR regime more generally. There are, however, certain exceptions relating to participants of the ETS, in particular applying to operators subject to the requirements of the ETS Directive who merely deal on their own account, persons providing services exclusively for affiliates and persons trading in emission allowances as an ancillary activity.

In a similar manner, Regulation (EU) 596/2014 (“Market Abuse Regulation” or “MAR”) also applies to emission allowances. Participants trading in emission allowances are therefore subject to the prohibition of insider dealing and market manipulation. Furthermore, disclosure obligations as well as managers’ transactions provisions and insider lists obligations apply in a similar way than for any issuer of listed financial instruments.

Commencement of Phase IV of the ETS on 1 January 2021

Since the ETS started operating in 2005, a step-by-step plan in the ETS Directive provides for a changing environment of emissions trading and allocation through the implementation of trading periods.

Phase IV will commence on 1 January 2021. In 2018, the legal framework for the ETS was revised in order to meet the EU’s emission reduction targets for the year 2030:

  • During the term of Phase IV, the percentage of freely allocated allowances should progressively be reduced. While prolonging the system of free allocation for another decade, the free allocation will only focus on sectors with the highest risk of relocating production outside of the EU. For less exposed sectors, free allocation is phased out gradually until the end of Phase IV (2030). Also, a significant number of free allowances is set aside for new and growing installations.
  • Further, the linear reduction factor, at which the overall emissions cap is gradually reduced, increases from 1.74% to 2.2%.

Notably, new mechanisms will be introduced to support energy-intensive sectors and the power sector in meeting the innovation and investment challenges of the transition to a low-carbon economy. These include two new funds: The Innovation Fund aims to support innovative technologies and will provide for a funding amount of approx. EUR 10 billion from 2020-2030. The Modernisation Fund is designed to support the modernisation of the power sector in lower-income Member States and will provide for a funding amount of approx. EUR 14 billion in 2021-2030. Both funds are financed through the auctioning of allowances.

We will shed further light on these funds in our next blog post in due course.

Together with Phase IV the new EU Emission Trading System State aid Guidelines which have been published by the European Commission on 21 September 2020 will enter into force - please click here for further information.

If you are interested in how the transmission to Phase IV might affect your business, please get in touch!

Recent changes to the CRR relating to emission allowances

Regulation (EU) 575/2013 (“CRR”) – in a nutshell – applies to banks and investment firms and sets out prudential requirements for capital, liquidity and credit risks in order to decrease the likelihood that banks go insolvent.

Annex II CRR sets out certain types of derivatives agreements for which specific rules under the CRR apply. In May 2019, Regulation (EU) 2019/876 amending the CRR was adopted and will (to a significant extent) apply from 28 June 2021. From such date, Annex II of the CRR will expressly refer to MiFID II clarifying that “contracts of a similar nature” relating to emission allowances fall in the ambit of Annex II of CRR (noting that a convincing argument can be made that this applies already under the current version of the CRR, even though not expressly stated).

The aforesaid changes have implications also beyond the CRR regime. Annex II CRR is frequently cross-referenced in other laws and regulations (e.g. the Austrian Insolvency Code refers to certain agreements covered by Annex II of the CRR for purposes of its netting rules).

Linking of the emission trading systems of the EU and Switzerland

The ETS Directive offers the possibility to link the ETS with other compatible and mandatory emissions trading systems with absolute emissions caps.

With the perspective that the linking of emissions trading systems will further contribute to reducing emissions, the EU and Switzerland entered into a linking agreement in November 2017 (“EU-Swiss Linking Agreement”), which was approved and ratified in 2019 and entered into force as of 1 January 2020. The EU-Swiss Linking Agreement is the first of its kind for the EU and also covers the aviation sector.

Pursuant to the EU-Swiss Linking Agreement, emission allowances compliant under the EU ETS are recognised under the Swiss emissions trading scheme and vice versa. However, subject to the provisions of the EU-Swiss Linking Agreement, both the EU and Switzerland will continue to apply their own legal framework to their relevant emissions trading system; key aspects of the legal framework and essential criteria applying to the respective emissions trading system are reflected in Annex 1 to the EU-Swiss Linking Agreement with a view to establish “compatibility” of the emission trading systems. A Joint Committee was established to ensure the EU-Swiss Linking Agreement’s proper implementation, for purposes of dispute settlement and to monitor ongoing developments. In the context of linking the emissions trading schemes, the applicability of MiFID II in a cross-border context must be carefully considered.

The technical implementation of linking the EU and Swiss emissions trading systems required the relevant registers to be electronically linked. Due to the COVID19-pandemic, the electronic linking was postponed by the Joint Committee from May 2020 to September 2020. Since 28 September 2020, the electronic link has been in place and transactions between the emissions trading systems can be initiated.

The linking of the emission trading systems certainly brings new business opportunities for operators and businesses in both the EU and Switzerland. At the same time, trading of allowances under the interlinked trading systems might entail some uncertainties, in particular regarding the application of EU and/or Swiss legal frameworks and related regulatory requirements. Also, the EU-Swiss Linking Agreement (together with the existing cooperation between the EU and several third countries in relation to the carbon markets and the EU’s membership in the International Carbon Action Partnership ICAP) demonstrates the EU’s ambitions and its “bottom-up approach” in promoting a global network of emission trading systems.

The “European Green Deal” and its implications on the ETS

The European Green Deal combines a set of policy initiatives by the European Commission with the aim of making Europe climate neutral in 2050. By 2030, a 55% cut in emissions (compared to 1990 levels) should be achieved. In this respect, the European Commission presented its “2030 Climate Target Plan” in September 2020 on the basis of which detailed legislative proposals are expected to be presented by June 2021. According to the 2030 Climate Target plan, the legislative proposals will (among other things) focus on the ETS by:

  • introducing a strengthened cap on overall emissions;
  • aiming to expand the use of emission trading to the maritime, buildings and road transport sectors;
  • looking into the integration of all emissions from fossil fuel combustion.

Consultation on updating the ETS

On 13 November 2020, the European Commission opened a number of consultations in the framework of the European Green Deal. One of these consultations refers to the revision of the ETS Directive which shall be reviewed against the targets of the European Green Deal.

The consultation gives interested parties the opportunity to express their view and contribute to the law-making process. Citizens and organisations may submit their feedback until 5 February 2021.

The EU emissions trading system is the world's largest carbon market and it is constantly evolving to combat climate change.