There is little chance for the auctioning system as of 2013 under the current arrangements of the Regulation No 1031/2010 to pose any competition for the secondary market as regards the reliability of supply and the hedging needs. The operators which expect to cover their emissions in the third settlement period only with allowances bought in the auction should in advance be aware of certain legal circumstances that could complicate their projections.
Why I underestimate the auctioning system in such a way?
The legal measure commented upon in this post:
Commission Regulation No 1031/2010 of 12 November 2010 on the timing, administration and other aspects of auctioning of greenhouse gas emission allowances pursuant to Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowances trading within the Community OJ L 302, 18.11.2010, p. 1
referred to as “Regulation”)
Certainty of the delivery
The first reason is obvious to everybody who had even cursory look at the text of the Regulation - auctioned target products are two-days spot and five-days futures which per se are not suitable for satisfying long-term needs of the market participants. But users of the auctioning infrastructure could also get stuck when dealing with not so apparent issues. According to the Article 48 of the Regulation where the clearing system or settlement system fails to deliver the whole or part of the auctioned allowances due to circumstances outside its control, the clearing system or settlement system shall deliver the allowances at the earliest opportunity and the successful bidders or their successors in title shall accept delivery at that later date. The said provision also clearly reserves that the remedy mentioned above is the sole remedy to which a successful bidder or its successors in title are entitled to in case of any failure to deliver auctioned allowances, due to circumstances outside the control of the clearing system or settlement system concerned.
The above cited provision of the Regulation gives rise not only to the threat that he participation in the auction does not guarantee for the bidder the delivery of the carbon credits in the right time but also imposes on the bidder an important obligation to take the delivery at the later (not specified) date - when it could already be not needed (since the bidder covered its demand, in the meantime, from some other sources).
If somebody wish to have more certainty as to the agreed date for the delivery of carbon credits as well as the consequences of the counterparty’s potential default (the right to damages) it seems the more appropriate way and strategy would be adequately formulated contract on an OTC market along with the carefully designed collateral. These are offered by the secondary market – not the auctions.
Collateral posted by an unsuccessful bidder – when refunded and what interest rate applied?
The problems of the lesser weight, but nevertheless important for some categories of bidders, may be the lack of the certainty with regard to the Regulation arrangements related to the term for the refund by the auction platform of any unused collateral posted by an unsuccessful bidder (together with any interest accrued on cash collateral).
Pursuant to the Article 49 of the Regulation prior to the opening of the bidding window for the auctioning of two-day spot or five-day futures, bidders or any intermediaries acting on their behalf, are required to give collateral. This in itself is some sort of imbalance in mutual relations between the bidders (which are required to give collateral and are subject to remedial measures in the event of default) and auction platform (which are not). This imbalance can be further observed in specific arrangements on, so important, time limits and interest rates.
The Regulation only states in that regard that any unused collateral shall be released ‘as soon as practicable’ after the close of the bidding window – that is exactly when? The legal measure at issue unfortunately does not specify how many days the auction platform can maximally retain the unsuccessful bidder’s monies. When it comes to big volumes, very active bidders can be in this way exposed to liquidity risks. This risk is, furthermore, exacerbated by the ambiguity as to the interest rate to be applied on such refunded cash collateral.
Let’s hope that these uncertainties will be cleared in the future contracts appointing auction platforms.
Default of the bidder
As opposite to the maximally safe position of the auction platform and the auctioneer, the consequences of late or non-payment for the allowances by the bidder in the auction are quite severe – as in the mere contract concluded on an OTC market.
In the first place delivery versus payment arrangements are applied – which per se is the most advantageous for the seller option. Pursuant to the Article 45 of the Regulation a successful bidder shall only be delivered allowances, if the entire sum due is paid to the auctioneer.
A successful bidder that fails to meet its obligations in full by the due date shall be in default of payment and may be, furhermore, charged either or both of the following:
(a) interest for each day beginning with the date on which payment was due and ending on the date on which payment is made at an interest rate set out in the contract appointing the auction platform concerned, calculated on a daily basis;
(b) a penalty, which shall accrue to the auctioneer less any costs deducted by the clearing system or settlement system.
Without prejudice to the above where a successful bidder is in default of payment one of the following shall occur:
(a) the central counterparty shall interpose to take delivery of the allowances and effect payment of the sum due to the auctioneer;
(b) the settlement agent shall apply collateral taken from the bidder to effect payment of the sum due to the auctioneer.
In the event of a failure of settlement, the allowances shall be auctioned at the next two auctions scheduled on the auction platform concerned.
As follows from the recitals to the Regulation, the above-described arrangements for the delivery and payments for allowances in the auctions are the reflection of the a priori adopted legislative assumption not to design auctioning system as a competitor to the secondary market. Allowances sold in the auctions should only complement pre-existing market structures. The above-described provisions of the Regulation prove that this intention was consequently implemented.
When we already established that buying allowances in the auctions is burdened with significant shortcomings for acquirers seeking certainty when it comes to the terms of supply and potential indemnity for default in the supply it is worth considering now whether auctions have any advantage over OTC market from a demand side participants point of view.
In that context it should be written down that in the effect of the operation of the Article 7(2) subparagraph 2 of the Regulation, the bidder is able to buy emission allowances for the clearing price, which, in principle, could be lower than the price offered in the bid. The said provision stipulates that ‘The price of the bid at which the sum of the volumes bid matches or exceeds the volume of allowances auctioned shall be the auction clearing price’. This mechanism generally is for the benefit of the bidders, especially the small and inexperienced ones, which are able to buy carbon credits cheaper than they earlier evaluated their bid. In that aspect the auctions offer for the SME the opportunity which is rather hard to exploit on the OTC market.
The potential disproportional impact of this rule is, however, alleviated by mitigating mechanism contained in Article 7(6) which reads: ‘Where the auction clearing price is significantly under the price on the secondary market prevailing during and immediately before the bidding window when taking into account the short term volatility of the price of allowances over a defined period preceding the auction, the auction platform shall cancel the auction’.
The above legal circumstances lead to the conclusion that theoretically it is possible to buy emission allowances in the auction cheaper than the price on the secondary market, but not ‘significantly’ cheaper (when big volumes are at stake this deal might, however, seem interesting).
The question what does it mean price ‘significantly under’ the price on the secondary market remains to answer. Clearing this issue up will in effect delineate the scope for potential benefits for auction participants - being the price on the secondary market (prevailing during and immediately before the bidding window) at one end of the spectrum of possible situations and the price ‘significantly under’ the said price at the other end of the spectrum (situation in which the auction will be cancelled).
In between those extremes are the fruits to be picked in the auctions.
It’s no wonder that information on the methodology to define what constitutes an auction clearing price ‘significantly’ under the prevailing secondary market price before and during an auction is listed as confidential data not disclosed to bidders (Article 62(1)(i) of the Regulation).