It could presumably contribute to strengthening the liquidity in the emission allowances market and prop-up ailing prices if the safeguards provided for in the Financial Collateral Directive were extended to carbon instruments.
Also emitters could gain advantage from such a legislative action.
Financial Collateral Directive and MiFID II review - spot emission allowances trade excluded
MiFID II Directive classifying emission allowances as financial instruments is currently the subject of negotiations between European Parliament and the Council. The effects of such regulatory change will be far-reaching (see: MIFID II and emissions – consequences under preliminary investigation and Consequences of the new MAD Regulation regime for inside information for the emission allowances market – the threshold decisive).
It is noteworthy that while there is intention that the EU financial-market measures cross-referring to the MiFID like:
- Market Abuse Regulation and Criminal Sanctions for Market Abuse Directive;
- Anti-Money Laundering Directive;
- Settlement Finality Directive
also be applicable to transactions and other market activity involving spot emission allowances potentially classified as financial instruments, concurrently spot emission allowances trade would fall outside the scope of:
- Prospectus Directive,
- Transparency Directive,
- Undertakings for Collective Investment in Transferable Securities (UCITS) Directive;
- Financial Collateral Directive (see the answer to the Question 14 - MEMO/11/719 of 20 October 2011).
Especially with respect to Financial Collateral Directive (Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements (OJ L 168, 27.6.2002, p. 43 as amended) – hereinafter ‘Financial Collateral Directive’) this approach seems to be lacking in consequence.
Possible extension of the Financial Collateral Directive and its safeguards to emission allowances would be particularly important to clearing houses that accept emission allowances as collateral.
Mechanisms provided for in the Financial Collateral Directive can be seen as introduced in the interest of collateral takers and generally favouring them but from the other point of view they can foster liquidity in the emissions market and facilitate collateralisation of transactions by smaller market participants lacking in possibilities for more costly ways of collateralisation.
Emitters of greenhouse gases could use their EUAs resting unproductively on the emissions accounts in the registry till the EU ETS settlement date (30 April) for safeguarding transactions in different products, amongst others energy. Some of them are doing this already.
The problem in question gains particular importance in view of incoming EMIR requirements for risk mitigation measures in OTC derivatives market (see: ‘Contentious collateral in EMIR draft technical standards’).
Review of the provisions of Financial Collateral Directive against carbon-collateral usability
Reviewing the provisions of Financial Collateral Directive against carbon-collateral usability criteria indicates that the majority of body of this legal act could be applied (in particular Article 4 Enforcement of financial collateral arrangements, Article 5 Right of use of financial collateral under security financial collateral arrangements, Article 6 Recognition of title transfer financial collateral arrangements, Article 7 Recognition of close-out netting provisions, Article 8 Certain insolvency provisions disapplied and Article 9 Conflict of laws).
Among the effects of the existing non-applicability of Financial Collateral Directive to the market activity involving spot emission allowances is the diversity of the national approaches in that regard and difficulties in assessing legal environment for cross-border transactions.
Conflict of laws
1. Any question with respect to any of the matters specified in paragraph 2 arising in relation to book entry securities collateral shall be governed by the law of the country in which the relevant account is maintained. The reference to the law of a country is a reference to its domestic law, disregarding any rule under which, in deciding the relevant question, reference should be made to the law of another country.
2. The matters referred to in paragraph 1 are:
(a) the legal nature and proprietary effects of book entry securities collateral;
(b) the requirements for perfecting a financial collateral arrangement relating to book entry securities collateral and the provision of book entry securities collateral under such an arrangement, and more generally the completion of the steps necessary to render such an arrangement and provision effective against third parties;
(c) whether a person's title to or interest in such book entry securities collateral is overridden by or subordinated to a competing title or interest, or a good faith acquisition has occurred;
(d) the steps required for the realisation of book entry securities collateral following the occurrence of an enforcement event.
Notably the current absence of uniform safeguards at a EU level against bankruptcy proceedings (Article 4(5) – ‘Member States shall ensure that a financial collateral arrangement can take effect in accordance with its terms notwithstanding the commencement or continuation of winding-up proceedings or reorganisation measures in respect of the collateral provider or collateral taker’ could be seen as an important handicap of collateral provided in the form of carbon credits.
Interesting observation is, moreover, that Article 9 (Conflict of laws) of the Financial Collateral Directive (see: box) is partly consumed by the newly inserted Article 10(5) of the Commission Regulation No 1193/2011 (the Registry Regulation). This provision foresees that ‘Accounts shall be governed by the laws and fall under the jurisdiction of the Member State of their administrator and the units held in them shall be considered to be situated in that Member State’s territory.’ The two regulations are visibly two different manifestations of the same legislative direction.
And why do I suggest that extending Financial Collateral Directive to spot emissions allowances trade could prop-up prices in the emission markets? Its rather simple casual link – while emission allowances are covered by the safeguards contained in the said Directive, EUAs will become more valuable collateral and it is probable that the demand for these instruments will rise (with effect on prices).
‘Good faith’ issue, perfection requirements and liquidation of the collateral
‘Good faith’ issue, perfection requirements and liquidation of the collateral are the points that can cause real trouble when spot emission allowances are today used as collateral in cross-border transactions.
It was observed in MEMO/01/108 of 30 March 2001 that the purpose of the bankruptcy legislation is the same in each Member State, but there are important differences concerning the definition of whether a transaction favours a creditor and whether it should therefore be invalidated. In some countries, it depends on whether or not the creditor has accepted the collateral in “good faith”; (i.e. he was unaware that the company was about to go bankrupt). In other countries there are objective rules, according to which all such transactions securing old debt can be invalidated if the transaction was carried out in a certain period before the bankruptcy occurred. Such differences make it difficult for market participants to agree on cross-border transactions, because foreign bankruptcy legislation could have an impact on the validity of an agreement with a foreign counterparty. Thus, market participants have to be aware of the whole range of bankruptcy legislation applied throughout the Community.
The above remarks relate to the situation in which a creditor has been “favoured” shortly before the moment when the bankruptcy occurs. According to bankruptcy legislation this transaction is normally declared invalid by the liquidator (e.g. where an already existing loan has been secured with collateral shortly before bankruptcy, the liquidator can declare that the offering of collateral was invalid).
There are also rules concerning the procedures a creditor must follow to ensure their right to the collateral in the event of bankruptcy of the debtor (and how to ensure priority over other creditors in accordance with the agreement). These procedures are called “perfection requirements” and exist to ensure that the creditor does not illegally benefit from the collateral and to prevent further use of the collateral by the debtor. But collateral takers today must comply with impractical publicity requirements, to ensure that third parties are aware that the assets being provided as collateral would not be generally available in an insolvency situation. Failure to comply can result in the invalidity of the collateral. In addition, the circumstances under which the creditor would be allowed to liquidate the collateral differ substantially from one Member State to another. In some jurisdictions, the collateral can be liquidated immediately, but in others the creditor can be obliged to wait several months.
So regulators, don’t wait, extend Financial Collateral Directive to spot emissions allowances trade immediately!