The European Commission has announced that it will hold a stakeholder meeting in Brussels on 4 May 2011 to seek views on policy options to regulate spot trading in emission allowances.
Those active in the secondary (or spot) market for emission allowances need to understand the implications for their businesses.
Under the EU ETS Directive the European Commission is obliged to examine whether the market for emissions allowances is sufficiently protected from insider dealing and market manipulation, and if necessary introduce proposals to ensure adequate protection is provided. On 21 December 2010, the Commission published a Communication setting out its assessment of the level of protection currently available.
Market abuse concerns
In the past, the EU ETS has been subject to VAT fraud, the re-sale of used carbon credits, and a phishing scam. In March 2010, trading was suspended following concerns about Hungarian registered CERs (see our e-bulletin dated 20 April 2010). There have been several thefts of allowances, including the theft of 475,000 allowances, worth around €7 million, from the Czech Republic's registry account, which were then cashed on the spot market within minutes (see our e-bulletin dated 26 January 2011).
Whilst these incidents did not amount to market abuse in the manner regulated by the Market Abuse Directive (MAD), they did give rise to calls for stricter regulation of the carbon market. In its Communication, the Commission concluded that although the majority of the carbon market is subject to appropriate oversight, a gap exists in the regulation and supervision of the spot market.
Spot market regulation: the options
The Communication, and a discussion paper which has been issued ahead of the stakeholder meeting, set out two policy options to address regulatory deficiencies:
- ensuring consistent coverage of all segments of the carbon market, including spot trading, by financial markets legislation (for example, by classifying EU ETS allowances, CERs and ERUs as financial instruments under the Markets in Financial Instruments Directive (MiFID)); or
- creating a tailor-made regime for emission allowances that would build on existing financial markets rules.
Although the Commission's proposed Regulation on Energy Market Integrity and Transparency (REMIT) (see our e-bulletin dated 15 December 2010) was considered as a legislative mechanism to enhance oversight of the carbon market was also considered, but the Commission decided not to pursue this approach.
Neither policy option would be used to provide an exclusive solution to EU ETS registry security issues, which the Commission hopes will be resolved through the introduction of a single EU ETS registry in January 2012. The registry will be run by the Commission and will replace the current registries operated by Member States.
Coverage by financial markets legislation
Bringing spot trading in emission allowances within the ambit of MiFID would mean that intermediaries providing spot trading services would need to be licensed in the same way as investment firms in the absence of an appropriate exemption. This reflects the fact that these services would qualify as investment services under MiFID. Trading venues would need to obtain the appropriate MiFID authorisation to match their profile (for example, as a regulated market or a multilateral trading facility).
Exemptions and proportionality clauses could be used by eligible carbon market participants to mitigate the impact of MiFID requirements if these proved to be disproportionate to the scale or nature of a participant's activity in the spot market. For example, there are existing exemptions under Articles 2(1)(i) and 2(1)(k) of MiFID that are widely used by energy market participants to limit the impact of MiFID on their energy trading activities, particularly as regards the principal to any energy transactions.
However, these existing exemptions are currently under review and it has recently been suggested by the Commission in its public consultation on the review of MiFID (see our e-bulletin dated 13 December 2010) that the Article 2(1)(k) exemption should be removed and that the scope of the Article 2(1)(i) exemption should be narrowed. Therefore, it seems likely that there will be less scope for energy market participants to make use of these exemptions once the review of MiFID has taken place.
In its discussion paper the Commission highlights that not all spot trades in allowances would be covered by MiFID. In particular, bilateral, over-the-counter, spot trades between two carbon market participants outside regulated venues would be beyond the remit of the Directive. However, any such trades, and all carbon market participants, would be subject to MAD, which prohibits insider dealing and market manipulation. MAD also empowers financial regulators to investigate and take enforcement action against market participants found to be in breach of the rules.
Reclassifying emission allowances as financial instruments would mean that in addition to MAD and MiFID, other EU financial market measures (such as the Anti-Money Laundering Directive or the Settlement Finality Directive) could apply. The Director-General for Climate Action is currently mapping out the implications of such a reclassification with regard to other EU measures.
A tailor made regime
This approach would introduce a specific framework to regulate spot trading in emission allowances, by:
- extending the application of MiFID and MAD to spot trading in allowances, but without reclassifying allowances as financial instruments; and/or
- creating a new set of rules to govern:
- intermediaries or trading venues involved in spot trading in allowances;
- related market misconduct;
- related transparency, and provide investor protection (including "know your customer" checks to be carried out by intermediaries);
- the supervision of the spot market, including the investigation of suspected breaches of the rules and the imposition of sanctions.
A key benefit of this approach is that it would provide the flexibility to create a regime specifically tailored to trading in the carbon market. However, consistency with the overall EU approach to financial market regulation (as set out in MiFID and MAD etc) would need to be maintained.
The Financial Markets and Law Committee's 2009 paper "Emissions Allowances: Creating Legal Certainty" also examined some gaps in the legal framework of the EU ETS.
MiFID and MAD reviews
MiFID and MAD are currently subject to comprehensive review by the Commission, with new legislative proposals expected to be adopted during the course of 2011 (our e-bulletin dated 13 December 2010 gives more detail on the MiFID review). The Commission believes that these reviews present an opportunity to enhance oversight of the carbon market using those Directives.
If the option of bringing emission allowances within the scope of MiFID were to be pursued, the MiFID review, and any subsequent narrowing or removal of the exemptions currently available to energy market participants, could affect the impact of regulation on those engaged in spot trading in allowances.
Those active in the spot market for emission allowances should ensure that they understand the implications of both policy options for their businesses, and may wish to respond to the European Commission's discussion paper in order that their views can be taken into account.
The Commission's Communication, the discussion paper, the agenda for the stakeholder meeting being held on 4 May 2011 and details of how to respond are available here.