Ensuring the integrity of the European carbon market
Frequently Asked Questions: General (April 2014)
The lion's share of transactions in emission allowances is in the form of derivatives (futures, forwards, options), which are already subject to EU financial markets regulation (including the current MiFID). However, transactions for immediate delivery of allowances (also called "spot" transactions) are currently not subject to equivalent rules at the EU level and are not supervised. In the past, some carbon exchanges even "packaged" emission allowances as financial instruments (futures with a few days delivery period) which showed that many market participants expected protections and benefits of trading in financial instruments and had a clear preference for allowances offered in such form over instantly available allowances (spot) traded on other venues.
To address this gap, the Commission has decided to come forward with proposals for a suitable regulation of this segment of the carbon market, which have now been politically agreed by the Council and the European Parliament. Under the reviewed MiFID, spot transactions will also be subject to EU financial markets regulation (for more information see MEMO/14/305 on the reviewed MiFID).
What is the expected benefit of applying financial markets rules to all segments of the carbon market?
The carbon market has experienced significant growth in size and sophistication. The European carbon market is the EU's flagship policy to reduce greenhouse gas emissions and has a crucial role to play over the coming decades in the transition to a low-carbon economy. As the Commission's analysis for the 2030 climate and energy framework has indicated, this transition requires significant investments in the coming decades. The carbon market therefore needs a robust level of oversight in order to facilitate investments in this low-carbon transition.
The rules also aim to provide a safe and efficient trading environment to enhance confidence in the carbon market in the wake of a series of unfortunate fraudulent activities which the market has experienced a few years ago.
The rules will enhance this market's overall transparency both in terms of data publicly available to all participants and the information submitted to supervisors. They will also ensure the ability of supervisors to act swiftly and decidedly on cases of misconduct, unfair treatment of clients and threats to orderly functioning of the market. All this will be to the benefit of other market participants and clients of professional traders and intermediaries (often EU Emissions Trading Scheme (ETS) compliance buyers relying on professional help to buy and sell emission allowances). The rules of the Markets in Financial Instruments Directive (MiFID) and Regulation (MiFIR) will deal with all those matters.It is furthermore necessary to minimise the risk of market abuse – comprising both insider dealing and market manipulation - in the carbon market. By virtue of cross-references to the reviewed MiFID, the politically agreed rules on market abuse – more specifically the Market Abuse Regulation (MAR) and a Criminal Sanctions for Market Abuse Directive (CSMAD) – will deliver that (for more information see MEMO/13/774 on MAR and MEMO/14/78 on CSMAD).
For further references new MAD regime or rules shall comprise the Market Abuse Regulation (MAR) and the Criminal Sanctions for Market Abuse Directive (CSMAD).
New MiFID regime or rules shall comprise the new Markets in Financial Instruments Directive (MiFID) and the Markets in Financial Instruments Regulation (MiFID).
Last but not least, professional intermediaries in the carbon market will be required to apply customer due diligence measures as provided by the Anti-Money Laundering Directive . Such verification will complement the measures foreseen already at the level of the EU ETS registry and will contribute to overall enhanced protection of the market from money laundering risks.
The Commission has duly considered the impacts of classifying emission allowances as financial instruments and submitting them to financial markets rules. Those impacts were presented in the impact assessment report accompanying the MiFID/MIFIR review proposals.
Why has the EU opted for coverage of all segments of the carbon market by financial market rules instead of proposing a separate, tailor-made regime or the coverage of the carbon market by energy market rules?
Any emerging regime for the spot carbon market would need to be fully coherent with the regulation of financial markets, in particular as the lion's share of the carbon market today consists of derivatives trading and is hence covered by financial market rules. Furthermore, the regulatory framework for the auctioning of emission allowances is closely aligned in key respects with the rules applicable for the secondary market in financial instruments. Any regime would also need to embrace adequate measures against market abuse, based on the MAR/CSMAD.
Coverage by the financial market rules further stabilises the carbon market and ensures its robustness. It also gives a clearer regulatory status to emission allowances. In eight years, the European carbon market has grown from around €6 billion annual turnover to up to €90 billion. According to analysts, it is expected to continue to grow. As the market grows, the coverage by financial market rules will provide a comprehensive regulatory framework that will still be adaptable to carbon market specificities.
The Commission has examined the merits of a tailor-made regime. However, as all stakeholders acknowledge, even a tailor-made regime would have to reproduce the overall approach and most of the technical solutions already found in the MiFID/MAD. It is also questionable whether the coverage of the spot segment (currently a very small part of the overall carbon market activity) would actually justify development of a fully separate regime, which would also bear the risk of inconsistencies with the rules that already govern the largest part of the market.
Lastly, placing the spot carbon trade under a potentially less stringent set of rules than is the case for carbon derivatives trade may eventually be detrimental to the spot segment's prospects.
The proposed rules are coherent with the Regulation on Energy Markets Integrity and Transparency (REMIT), where appropriate, for example as regards the duties to disclose inside information. The REMIT established a suitable framework for transparency and integrity in the electricity and gas markets. However, there are many quite specific elements in the REMIT which build on past legislation developed exclusively for the energy sector. Although there is a strong interplay between the energy and carbon markets, there are many additional sectors covered by the EU ETS. The application of energy markets specific rules would not be appropriate in their case.
Individual ETS compliance buyers buying and/or selling emission allowances on own account will be exempted from authorisation and compliance duties under the new MiFID, as well as entities like trade associations which will provide investment services in emission allowances as long as (i) this activity will be ancillary and (ii) they are not part of a financial group. If those two conditions are fulfilled, this exemption will also be available to companies other than financial intermediaries providing investment services to the group they are part of. Another optional specific exemption may be available to joint ventures of local electricity and gas undertakings, and of EU ETS operators under certain conditions.
The position limits regime provided for under MiFID for commodity derivatives does not apply to emission allowances.
Specific pre- and post-trade transparency requirements will be developed in due consideration of the specificities of emission allowance as an instrument of trade and the genuine carbon market features.
The new market abuse regime includes several carbon-specific elements for example, a specific definition of inside information, a tailored inside information disclosure duty, and a complete coverage of the primary market (auctioning).
Joint ventures of local electricity and gas undertakings, and of firms subject to the EU ETS may be exempt if Member States chose to provide this derogation to the participants in their territory. These exemptions may be available as long as these Member States submit such joint ventures to national requirements which are at least analogous to certain requirements under MiFID/MiFIR (authorisation and supervision, conduct of business, organisational requirements on conflicts of interest, participation in an investor-compensation scheme or professional indemnity insurance etc.).
The joint ventures may qualify for the optional exemptions provided that:
- they provide investment services exclusively in commodity derivatives, emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risk of their clients (i.e. local electricity and gas undertakings or firms subject to the EU ETS;
- their clients jointly hold 100% of the capital or the voting rights, exercise joint control and would be exempt themselves under the analogous exemptions under MiFID in relation to own account dealing / market making in emission allowances if they were to carry out these investment services.
The new MiFID/MiFIR and MAR/CSMAD rules will fully apply to emission allowances and derivatives thereof (i.e. as for derivatives with traditional financial underlying and unlike commodity derivatives). They also cover other units recognised for compliance under the EU ETS.
MAR and CSMAD also apply to behaviour or transactions, including bids, relating to the auctioning on an auction platform authorised as a regulated market of emission allowances or other auctioned products based thereon, including when auctioned products are not financial instruments, pursuant to Regulation (EU) No 1031/2010.
The rules cover secondary market transactions in some, but not all, CERs and ERUs – those that are held on an EU ETS registry account. How the credits from a specific project will be treated is determined by the detailed rules of the EU ETS Directive (article 11a) and its implementing measures . As a rule, the registry now holds only units recognised for compliance use under the EU ETS.
The duty to disclose inside information will be placed not on the issuer (as is the case of traditional financial instruments such as shares and bonds), but on the emission allowance market participant. The information to be disclosed – satisfying all essential criteria of inside information set out in MAR – will concern the physical activity of the disclosing party (e.g. on capacity and utilisation of installations).
At the same time, MAR includes an exemption for those participants in the emission allowance market the activity of which (expressed in terms of annual emissions or thermal input or a combination thereof) falls below a certain minimum threshold. That threshold will be determined by the Commission by means of a delegated act.
As a result, the disclosure duty will apply to only those entities, the activity of which on an individual basis can have material impact on the price formation of emission allowances or the (consequential) risks of insider dealing.
Emission allowance market participants will typically be EU ETS operators in the sense of the EU ETS directive, but in specific cases this category may also cover other persons like trading entities belonging to a group which also includes one or more EU ETS operators with physical activities above the minimum threshold set.
The overall architecture of the Commission proposals concerning emission allowances remains intact. That is to say that reviewed MiFID rules applicable to traditional financial markets (including emission allowances derivatives trading on leading exchanges) will also apply to the emission allowances themselves. This will put them on equal footing with the derivatives transactions concerning the transparency, investor protection and integrity.
The main difference is that specific exemptions from MiFID/MiFIR for carbon market participants have been recast and two new exemptions added:
- Exemption for all EU ETS operators dealing on own account in emission allowances;
- Optional (nationally decided) exemptions for joint ventures of firms subject to the EU ETS under certain conditions (for more see question above on the optional exemptions).
Impact of the proposal (April 2014)
Once financial market rules are extended to all segments of the carbon market, are we not exposing the carbon market to the risk of increasing speculation, and as a result, price volatility and disorderly pricing of carbon?
The European carbon market has grown substantially from around €6 billion turnover in 2005 to up to €90 billion. Fluctuations in the price of carbon under the EU ETS reflect the balance of supply and demand, driven by market fundamentals. Empirical evidence shows that historically high levels of volatility in carbon prices in 2005 to 2007 are due to some very specific reasons. There is no evidence of any pattern between the influx of investors and volatility in carbon prices.
Furthermore, financial intermediation is a necessary part of a market. Market intermediaries typically fill supply or demand voids by standing ready to buy or sell from market end-users (EU ETS compliance buyers) on a continuous basis. Such participants also may enhance the price discovery process by collecting and bringing information to the market. The lion's share of the carbon market today already consists of futures and other derivatives trading and is hence covered by financial market rules. That dominance of the financial segment has not led to any particular disturbances neither in the carbon market nor for the compliance by the EU ETS compliance buyers. It is the unregulated spot segment that has attracted illicit behaviour a few years ago.
Can we be confident that new demanding rules will not curb liquidity and thus hurt the carbon market?
Yes. Otherwise futures and forwards would not have become the dominant segment of the European carbon market. Stricter regulatory standards will provide for a safer and more reliable trading environment. Carbon market participants already now display a clear preference for concluding transactions in emission allowance derivatives on MiFID-licensed exchanges and mostly have their transactions cleared by a clearing house.
How will the new framework apply to… (April 2014)
The application of MiFID and MAD will not limit the possibilities of ETS compliance buyers to buy or sell allowances on the market, be it on exchange or over-the-counter. In most cases, where their emission allowances trading activity would be for their own account (hence not executing client orders), they will be dispensed from the duty to have a MiFID-licence normally required from investment firms. An additional requirement is that there is no use of high frequency trading technique. Authorisation under MiFID will not be required from those entities that will provide services relating to the emission allowances market exclusively for their group. Finally, joint ventures of ETS compliance buyers may also be dispensed from this duty in those Member States which have provided for an analogous regime at national level. Pursuant to the new market abuse regime, all ETS compliance buyers will need to respect the prohibitions of insider dealing and market manipulation. Emission allowance market participants (entities with emissions or rated thermal input above the specified threshold) will also need to follow additional obligations like disclosure of inside information, holding an insiders' list and notifications of own transactions by managers.
As a rule, entities providing investment services specialising in emission allowances (e.g. reception and transmission of orders and their execution, safe-keeping and administration of clients' assets) would be required to hold a MiFID licence and comply with all MiFID organisational and operational requirements (including know-your customer checks, transactions reporting, record keeping and investor protection rules). It is only normal for companies with this kind of activity to be covered by financial market organisational and conduct of business rules and be subject to the supervision of financial regulators.
Traders in emission allowances may be eligible for an exemption from MiFID authorisation (e.g. on the basis of restricted and ancillary character of a firm's investment services activity relating to emission allowances or derivatives thereof and subject to additional strict criteria). However, in a large majority of cases, these traders also provide services involving derivatives of emission allowances or of commodities, and are hence already required to hold a MiFID licence, independent of the new framework for the spot carbon market.
Trading venues offering contracts for spot trade in emission allowances and not currently subject to the MiFID, would be expected to obtain a MiFID authorisation in accordance with their specific profile (as a regulated market, a multilateral trading facility (MTF), or the new category of organised trading facility (OTF)).
The application of the revised MiFID in their case would mean that in order to continue spot trading activity they would need to make necessary adaptations to be in a position to seek a MiFID authorisation.
Relation with other measures (April 2014)
Will financial services legislation cross-referring to MiFID also apply to the spot trade in emission allowances?
A number of other EU financial-market measures cross-referring to the MiFID would also be applicable to transactions and other market activity involving emission allowances. Those impacts would include, for example:
A number of other EU financial-market measures cross-referring to the MiFID would also be applicable to transactions and other market activity involving emission allowances. Those impacts would include, for example:
Market Abuse Regulation and Criminal Sanctions for Market Abuse Directive ;
Anti-Money Laundering Directive;
Settlement Finality Directive;
At the same time emission allowances trade would fall outside the scope of the following EU financial market measures:
Legislation on capital requirementsonly applies to credit institutions and investment firms. Most ETS compliance buyers which have limited trading activity, ancillary to their main business will be exempt from the MiFID and thus also exempt from such capital requirements.
Professional traders with investment services or activities involving emission allowances are typically also active in the trading of derivatives of emission allowances or of commodity derivatives. As a result, and without prejudice to currently applying transitional exemptions, they are therefore anyhow covered by capital requirements stemming from the MiFID and the Capital Requirements Directive. This means that any future coverage of emission allowances by the MiFID would not impact their treatment under the Capital Requirements Directive. Such impacts could materialise in the unlikely case that a professional trader specialises solely in the spot trade of emissions allowances and is covered by the MiFID registration duties only on those grounds.
No, the system of EU ETS registries will not be redundant as a result of coverage of emission allowances by financial markets rules. Clearing houses and settlement systems will continue to provide support services to the trading pursued on- or off-exchange and will be complementary to the functions performed by the single Union registry. The registry does not record market transactions, but does record any resulting physical delivery of allowances. Furthermore, it also performs other (supporting) functions, such as recording the creation of allowances, surrendering for compliance with the EU ETS and their deletion, as well as free allocation and auctioning.
Will classification of emission allowances as financial instruments mean that they are to be treated as financial assets?
The proposals on carbon market oversight will not alter the fundamental purpose of the emission allowances. Their classification as financial instruments is made for the purposes of application of the EU financial markets regulation and is not aimed to deal with the legal nature of emission allowances (on the grounds of private law) or their accounting treatment.
No, the classification of allowances as a financial instrument would have no direct impact on the accounting treatment of emission allowances under the Union law. Classification of emission allowances for accounting purposes depends on the criteria set by accounting standards only, which are under the authority of the International Accounting Standards Board (IASB).
The IASB currently lists emission trading systems as of its research projects. However, there are currently no harmonised accounting standards for emission allowances at international level. National approaches in a few Member States may already require companies to recognise them as regular (financial) assets. In absence of a harmonised accounting treatment of emission allowances at international level the Member States take individual responsibility in this regard.
In the specific case of emission allowances (and auctioned products based thereon) the new MIFIR/MiFID and MAR/CSMAD frameworks will enter into application on the same date, 30 months after the entry into force of the new MIFIR/MiFID which in turn is envisaged on the 20th day following its publication. Thus the start of application is expected towards the end of 2016. The delayed application of MAR/CSMAD in the specific case of emission allowances is due to the fact that the new MIFIR/MIFID rules classifying emission allowances as financial instruments will not be in application until 30 months after the entry into force of MIFIR/MIFID.
Corresponding measures currently applicable to the carbon market by virtue of Union law (e.g. the Auctioning Regulation) or of the law of the Member States can remain in application until that date.
- Regulation (EU) No 575/2013 (Capital Requirements Regulation – CRR) and Directive 2013/36/EU (Capital Requirements Directive IV – CRD IV), repealing Directives 2006/48/EC and 2006/49/EC.
-  The application of capital requirements does not automatically flow from being caught under MiFID. There is an exemption for commodity dealers in the Capital Requirements Regulation (CRR) applicable until the latest end of 2017 (review due before end of 2014). As a result the capital requirements these firms should be subject to will be dealt in a separate review of the CRR exemptions. See Article 498 (1) of the CRR.