The Discussion paper in view of a European Climate Change Programme (ECCP) stakeholder meeting on carbon market oversight organised by the Commission services Brussels, 4th May 2011 considers the implications of classifying emission allowances and other EU ETS compliance units as financial instruments under MiFID. It seems, however, not probable taking into account arguments of many participants of various market sectors and branches in their responses to the MiFID review consultation.
Spot trading in emission allowances (“EUA”) is currently not regulated at the European level. The general approach consists in excluding emission allowances as financial instruments under Markets in Financial Instruments Directive (MiFID), but capturing derivative contracts based on such allowances (with the exception of Romania, where EUA’s were classified as financial instruments).
Pivotal elements of the European Commission proposal on MiFID II/MiFIR released on 20 October 2011 as regards emissions market are analysed in brief in “MIFID II and emissions – consequences under preliminary investigation”.
Concurrently, the Commission obtained stakeholders feedback on the question: “What is your opinion on whether to classify emission allowances as financial instruments?” in the Public Consultation: Review of the Markets in Financial Instruments Directive (MiFID) recently concluded (http://ec.europa.eu/internal_market/consultations/2010/mifid_en.htm) and a legislative proposal to amend MiFID is expected to be adopted by the Commission in the coming months.
Under the considered approach, according to the Discussion paper, the scope of the EU financial markets legislation would be extended to apply to the spot segment of the carbon market. This would be achieved by classifying emission allowances (and other ETS compliance units) as financial instruments under MiFID (i.e. by listing them as a new class of financial instruments in Annex I Section C of that Directive).
It seems that such a legislative concept met with a cold reception in responses to the MiFID review consultation from market participants.
The Union of the Electricity Industry–EURELECTRIC, in its response, raises, for instance, that the classification of emission allowances in the context of secondary spot trading as financial instruments is not appropriate for a number of reasons:
1) From a technical point of view, spot emission allowances:
- do not confer financial claims against the public issuer of such allowances;
- do neither represent titles to capital (with voting rights) or title to debentures;
- nor constitute forward contracts;
2) From a personal application scope, spot emission allowances are meant to serve climate change objectives and are therefore designed to apply to industrial operators. Their primary purpose is not to serve as an investment product proposed and managed by;
3) The classification of spot emission allowances as financial instruments would imply:
- legal obligations under MAD and MIFID that would not prove always relevant (e.g. prospectus in case of take-over bid) and would require the creation of an exception sub-regime;
- some legal obligations would be too burdensome to comply with especially for industrial SMEs as well some small power utilities;
4) Classifying emission allowances as financial instruments could cause a requalification under IFRS 9, triggering the application of fair value accounting.
EURELECTRIC concluded that the European Commission should design an appropriate regime for emission allowances and such a regime should adapt a selection of the most relevant provisions from the financial regulation to the characteristics of industrial market participants, and should classify emission allowances in a new sui generis category.
Also International Swaps and Derivatives Association, Inc. (ISDA) contend that:
a) EUAs are not in themselves financial instruments;
b) the role and purposes of the “physical” EUA markets are different from those of financial markets;
c) the financial capture of a large number of non-financial companies would be inappropriate, bearing in mind that they do not carry on “investment business” and, in the context of EUAs, do not have retail customers;
d) the quantum of systemic risk is extremely low.
ISDA made an observation (I consider crucial from the systemic point of view) that extending the scope of financial regulation to include non-financial underlying products/instruments could create a precedent in relation to other non-financial assets.
As a result, ISDA view on the issue, expressed in MiFID review consultation, is similar to that of EURELECTRIC. ISDA does not believe it is appropriate for dealings in emission allowances to be subject to financial regulation, but by the physical regulatory authorities.
European Federation of Energy Traders (EFET) generally shared the views of the above mentioned organisations and added that the primary reason for emission allowances was to provide the means to industrial operators to meet obligations under an emissions trading scheme – their primary purpose was not to serve as an investment product.
In that sense also French financial regulator raised the circumstance of absence of an issuer in the usual meaning of the word in relation to the EUA’s.
The view that it is neither suitable nor proportional to consider emission allowances as financial instruments and making them an integral part of the MiFID framework GDF SUEZ supported with additional arguments. According to its response, energy companies, especially those that are active in generating electricity, increasingly consider emission allowances as an integral part of their production ‘inputs’, next to the “real” fuels used in the electricity generation process. Such purchases or sales are part of the industrial activity of such companies, and these are not at all intended as speculative activity.
Their classification as financial instruments would also imply significant additional capital requirement costs for an energy companies and even more for smaller companies which could significantly reduce their activities in emissions markets.
GDF SUEZ also observed that emission allowances were hybrid instruments that consisted both in an administrative authorization (to emit carbon dioxide) and a commercially exchangeable commodity. Irrespective of the classification of some derivative contracts on emission allowances as financial instruments under MiFID (section C (10) of Annex I), there was no consensus at European (and international) level on the legal qualification of such instruments.
UK HM Treasury and FSA raised the same issue as ISDA that a benefit of classifying emissions allowances as financial instruments would be the resulting unified treatment of the entire emissions market (i.e. spot and derivative), although there would be a corresponding divergence in treatment to the closely linked markets just mentioned. This could pose difficulties for participants active in all of these markets because of the differing approaches.
UK HM Treasury and FSA were also mindful of the problem of SMEs participants in the emissions spot market which had the nature of “compliance only” participants, i.e. they had no financial services motive associated with their participation.
These types of participant are likely to find the burdens of financial regulation onerous, yet the UK considers them unlikely to pose significant systemic risk as a group. In view of the wider agenda to minimise administrative burdens on SMEs and facilitate their growth, the UK emphasises therefore that if it is decided to classify emissions allowances as financial instruments it would be essential to craft an appropriate regulatory treatment for this type of participant. This could be achieved either by exemptions or by integrating within financial services legislation an appropriate bespoke approach.
Also IETA - International Emissions Trading Association – considers as a more appropriate option to enhance oversight of EUA markets through REMIT or a specific market integrity regime for EUA markets, “although caution must be taken to ensure there is no regulatory overlap”.
The opposite view presented the Deutsche Borse. It reminded that emission allowances had aspects of both administrative grants or licences and of private property, and different conclusions as to their legal classification were reached in a number of Member States.
Deutsche Borse was of the view that the integrity of the European carbon market would benefit from a legislative recognition of the fact that emission allowances are handled as financial instruments and that carbon market participants could expect their holding to be afforded the same level of organisational safeguards and investor protection on their emission allowances transactions and holding as they enjoy on their emission derivatives. Further to these benefits, classifying emission allowances as financial instruments would lead to avoiding issues like tax fraud (tax carousel) and VAT differences between Member States. Also the uncertainty of regulation of emission allowances still leads to missed opportunities in the EU ETS as potential traders, especially from the US, are not sure if they are legally enabled to trade emissions allowances. Finally, as a financial instrument emissions allowances would be regulated under the financial directive for collaterals, which would enable clearing houses to offer using emission rights as collateral.
In the Discussion paper in view of a European Climate Change Programme (ECCP) stakeholder meeting on carbon market oversight organised by the Commission services Brussels, 4th May 2011 the European Commission does not refer to the outcome of the MiFID review consultation. It mentions however some implications for the considered approach extending the scope of the EU financial markets legislation to the spot segment of the carbon market (and, consequently, classifying emission allowances and other ETS compliance units as financial instruments under MiFID).
The said implications pursuant to the Discussion paper are:
1) Since intermediation in spot trade of emission allowances would qualify as an investment service under the MiFID, entities providing such services would be required to hold a MiFID licence for investment firms and to comply with all ensuing organisational and conduct of business requirements in the course of that activity.
2) Trading venues specialising in spot trade in emission allowances and thus 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 envisaged in the MiFID review if finally approved by the European Parliament and the Council).
3) Under the revised MiFID several exemptions currently provided under that Directive would be eliminated or narrowed down significantly. Nevertheless, the remaining exemptions and proportionality clauses, as well as any implementing measures developed by the Commission to give effect to the revised MiFID, could be used by eligible carbon market participants to mitigate the impact of the requirements of that Directive should those be inadequate or disproportionate to the scale or the nature of their activity in the spot carbon market.
4) Unlike professional intermediaries or market venues, ETS operators dealing on their own account in emission allowances would not be subject to the compliance duties stemming from the MiFID, as long as their trading activity remains ancillary to their main business and they are not a part of a financial group.
5) All carbon participants would be subject to the rules of the Market Abuse Directive (MAD) which prohibits insider dealing and market manipulation, introduces preventive measures against those types of abuse and empowers financial regulators to investigate and take enforcement action against market participants in breach of its rules.
6) The coverage by the MiFID of transactions in emission allowances would not be complete: transactions between two exempt market participants outside regulated venues (so-called purely bilateral spot OTC trade in emission allowances) would be beyond its remit; even so, such transactions could be examined on the grounds of market abuse pursuant to the MAD rules.
7) As a result of the classification, not only would the MiFID rules apply. A number of other EU financial-market measures cross-referencing to the MiFID would also be applicable to transactions and other market activity involving emission allowances.
In the Discussion paper DG CLIMA added that is currently mapping out (with support of external consultants) the implications the said classification will have on the grounds of the various other EU measures. On a preliminary basis, those impacts should be examined, for example, under the Anti-Money Laundering Directive and Settlement Finality Directive.
It seems to me, however, that classifying emission allowances and other ETS compliance units as financial instruments under MiFID, is not probable. Such a conclusion is supported by the above mentioned considerations of operators of various market sectors and branches in their responses to the MiFID review consultation.