On 14 July 2021, the European Commission adopted a series of legislative proposals setting out how it intends to achieve climate neutrality in the EU by 2050, including the intermediate target of an at least 55% net reduction in greenhouse gas emissions by 2030. The package proposes to revise several pieces of EU climate legislation, including the EU ETS, Effort Sharing Regulation, transport and land use legislation, setting out in real terms the ways in which the Commission intends to reach EU climate targets under the European Green Deal.
The European carbon market has grown substantially since its start in 2005. As it gets more sophisticated, it is important that the rules governing oversight of the market keep pace with its development and adequately address risks that may arise.
In order to foster confidence and ensure a safe and efficient trading environment, the European carbon market is subject to a robust oversight regime designed along the lines of the regime applicable to the European financial markets.
The main traders in the European carbon market are energy companies and industrial companies that have obligations under the EU Emissions Trading System (ETS). Financial intermediaries such as banks also trade, usually on behalf of smaller companies and emitters.
To better examine trading behaviours and the potential need for targeted actions, the Commission asked the European Securities and Markets Authority (ESMA) to analyse the trading of emission allowances. ESMA’s preliminary report on the EU carbon market confirms that it functions in an orderly manner, comparable to other financial markets, and that no specific cases of market manipulation have been detected by the relevant market authorities.
On 28 March 2022, ESMA published its final report regarding trading in the EU carbon market. The conclusions of ESMA’s comprehensive analysis are reassuring and confirm the conclusions brought by the preliminary report. Overall, ESMA considers that the data analysis has not unearthed any abnormality in the functioning of the EU carbon market from a financial supervisory perspective.
The observed evolutions of carbon prices and volatility are in line with market fundamentals. It is also reassuring that the national competent authorities have not reported any cases of market abuse. The Commission continues to work closely with national authorities. It is important that regulators keep a watchful eye on the market to ensure its integrity.
Preventing market abuse and other market misconduct
As from January 2018, emission allowances are classified as financial instruments by the revised Directive on Markets in Financial Instruments (MiFID2). Previously, only the derivative contracts of emission allowances were in the scope of financial market rules.
This classification constitutes an important element in safeguarding the carbon market from market abuse and other types of market misconduct regulated under the Market Abuse Regulation (MAR).
Financial market rules applicable to the carbon market mean that:
- High integrity standards apply to all market participants, who are prohibited from engaging in manipulation through practices such as spreading false information or rumours;
- Companies with large installations regulated by the EU ETS are subject to stricter rules on inside information to prevent unfair advantages among market participants;
- Better transparency and simpler access to information (e.g. how much is traded and at what price on carbon exchanges) is available to all market participants;
- Anti-money laundering safeguards (e.g. know-your-customer checks) are extended to all segments of the carbon market.
Relevant financial market legislation
The legislation relevant for the oversight of the European carbon market includes, in particular:
- Directive on Markets in Financial Instruments (MiFID2)
- Regulation on Market in Financial Instruments (MiFIR)
- Market Abuse Regulation (MAR)
- Criminal Sanctions for Market Abuse Directive (CS-MAD)
- Anti-Money Laundering Directive (AMLD)
- Capital Requirements Directive and Regulation (CRD/R)
- Settlement Finality Directive
- Central Securities Depositories Regulation (CSDR)
- Regulation on OTC Derivatives, Central Counterparties and Trade Repositories (known as "EMIR" - European Market Infrastructure Regulation)
- Short Selling Regulation Some elements of the
- Capital Markets Union (CMU) (in particular clarifying the applicable securities law in cross-border transactions)
At the same time, trade of emission allowances falls outside the scope of the following EU financial market measures:
- European Securities and Markets Authority's consultations on financial market rules
- 01/2015 - Interplay between EU ETS Registry and Post Trade Infrastructure: Consolidated Report
- 22/05/2014 – Analysis by consultants Europe Economics and Norton Rose Fulbright for impact assessment on threshold for disclosure of non-public information on emission allowances
- 21/12/2010 - Communication on enhanced market oversight framework for the ETS
The emission allowances are sold via auctions and traded on the secondary market. Auctions of emission allowances represent the primary market, as they are the first event where the allowances are put on the market. The secondary market is comprised of all subsequent transactions. These transactions can take place on a trading venue or outside of it (so-called over-the-counter or OTC transactions). The secondary market is much larger in size than the primary market.
Allowances can be sold in the form of “spot” contracts, meaning that delivery takes place (almost) immediately. However, the lion's share of transactions in emission allowances is in the form of derivatives (including futures, forwards, options). Derivatives of emission allowances are financial contracts with emission allowances as their underlying assets. They provide flexibility with respect to managing carbon price risk.
As the EU ETS is a market-based system to reduce the greenhouse gas emissions, the main categories of traders in the European carbon market are energy companies and industrial companies that have obligations under the EU ETS. In order to ensure market liquidity, financial intermediaries such as banks and investment firms also trade, usually on behalf of smaller companies and emitters.
The auction platforms, secondary market trading venues, as well as the clearing houses and settlement systems provide the necessary services and infrastructure to ensure that transactions in emission allowances are properly executed.
The rules on markets in financial instruments (MiFID2/MiFIR) and on market abuse (MAR/CSMAD) fully apply to emission allowances and derivatives thereof. They also cover other units recognised for compliance under the EU ETS, e.g. allowances issued under the Swiss ETS.
The carbon market has experienced significant growth in size and sophistication with an overall annual turnover of tens of billions of euros. The carbon market therefore needs a robust level of oversight in order to ensure that it remains credible and free from any market abuse.
Moreover, 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 climate neutral economy. As the Commission's analysis for the 2030 climate and energy framework and the European Green Deal Communication (COM(2019) 640 final) have shown, this transition requires significant investments in the coming decades. To ensure these investments, a robust carbon price is needed, and the carbon price comes directly from the carbon market.
The rules of the Markets in Financial Instruments Directive (MiFID2) and Regulation (MiFIR) enhanced the overall transparency of the carbon market both in terms of data publicly available to all participants and the information submitted to supervisors.
The application of these rules also ensures 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 is to the benefit of other market participants and clients of professional traders and intermediaries (often ETS-compliance buyers relying on professional help to buy and sell emission allowances).
Furthermore, the rules on market abuse – more specifically the Market Abuse Regulation (MAR) and a Criminal Sanctions for Market Abuse Directive (CSMAD) – apply both to the auctioning and secondary market trading of emission allowances and derivatives.
The Market Abuse Regulation contains rules to prevent, detect and sanction abusive practices – comprising both insider dealing and market manipulation – irrespective of whether they take place on a trading venue or in a purely bilateral, off-venue context and irrespective of whether they take place in the Union or in a third country.
Last but not least, professional intermediaries in the carbon market are required to apply customer due diligence measures as provided by the Anti-Money Laundering Directive. Such verification complements the measures foreseen at the level of the EU ETS registry.
Under the existing market abuse rules, each EU Member State appoints a national competent authority to ensure the proper functioning of their financial markets.
These national authorities, competent for the surveillance of financial markets, are also responsible for the monitoring of the carbon market, both with respect to the auctions and the secondary market. At European level, their actions are coordinated by the European Securities and Markets Authority (ESMA), as is the case for other financial instruments.
The national competent authorities have the power to impose remedial action or sanctions when they decide that certain behaviours give rise to market abuse. In order for them to carry out their market monitoring tasks, the financial markets legislation establishes a number of reporting and transparency requirements applicable to trading venues and investment firms trading in emission allowances.
As part of the reporting requirements, trading venues and investment firms have to communicate to the competent authorities detailed data on transactions in emission allowances or derivatives thereof, carried out on the trading venues and over-the-counter (OTC). The reporting requirements also include an obligation for trading venues and investment firms to provide the competent authorities with position data as regards emission allowances.
As part of the transparency requirements, trade data and weekly aggregated position data are made public by trading venues and investment firms.
In addition, the auction platform, the secondary market trading venues and investment firms (including specialised trading desks of ETS operators) have an active duty to prevent, detect and report cases of suspicious transactions to the national competent authority.
Individual ETS compliance buyers buying and/or selling emission allowances on own account and the entities like trade associations which provide investment services in emission allowances are exempted from authorisation and compliance duties under MiFID2, 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 is also 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. However, the rules on reporting of positions apply. The competent authorities therefore have at their disposal information on positions held. Trading venues are also required to publish aggregated weekly breakdowns of the positions held by market participants.
The 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).
The duty to disclose inside information is placed not on the issuer (as is the case of traditional financial instruments such as shares and bonds), but on the participants in the European carbon market.
The information to be disclosed – satisfying all essential criteria of inside information set out in MAR – concerns the physical activity of the disclosing party (e.g. capacity and utilisation of installations).
At the same time, MAR includes an exemption for those participants in the European carbon market whose activity (expressed in terms of annual emissions or thermal input or a combination thereof) falls below a minimum threshold. That threshold is determined by the Commission Delegated Regulation (EU) 2016/522.
As a result, the disclosure duty applies only to 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 (term used in MAR) are typically 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 Auctioning Regulation contains specific rules regarding market oversight in the primary market. However, the regulatory framework for the auctioning of emission allowances is closely aligned with the rules applicable to the secondary market in financial instruments. In addition, some financial market rules such as on market abuse apply directly to auctions.
Financial market legislation strictly regulates the activities of the auction platform and of secondary market trading venues that offer emission allowances or derivatives thereof.
The auction platform and trading venues all need to have an authorisation issued by their national supervisory authority. In order to obtain and maintain such authorisation, they must comply with a number of organisational and operational requirements.
These requirements include for example a duty to monitor the transactions that take place on the platform/venue for market abuse and money laundering, a duty to notify the authorities in case of suspect transactions, as well as certain transparency and reporting duties.
The national supervisory authority shall monitor the compliance of the auction platforms and trading venues with these requirements on an ongoing basis. It may impose sanctions and suspend/withdraw their authorisation in case they no longer comply with the conditions of the authorisation.
In addition to ETS operators, investment firms are also active on the primary and secondary carbon market. Financial market legislation strictly regulates the activities of investment firms that participate in the European carbon market on behalf of clients (financial intermediaries).
Most of these firms will need an authorisation from their national supervisory authority. In order to obtain and maintain this authorisation, they must comply with a number of organisational and operational requirements. These requirements include for example a duty to properly check their clients, to abstain from and to report cases of suspected money laundering, terrorist financing or market abuse, various reporting and transparency obligations, etc.
The national supervisory authority shall monitor investment firms on an ongoing basis for compliance with the financial market rules governing their organisation and activities and can impose sanctions or suspend/withdraw their authorisation in case of issues.
Clearing houses and settlement systems provide services to the market participants with regards to the trades of spot emission allowances on market venues and any trades in derivatives of emission allowances.
The Union registry records any physical delivery of allowances, but it does not record the financial information of market transactions. Furthermore, it also records the creation of allowances, surrendering for compliance with the EU ETS and their deletion, as well as free allocation.
Fluctuations in the price of carbon under the EU ETS reflect the balance of supply and demand, driven by market fundamentals. 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 consists of futures and other derivatives trading. 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.
Furthermore, the extension of financial rules to the spot market segment provides for an even safer and more reliable trading environment.
In the early years of the EU ETS, fraudsters and cyber hackers tried to gain illegal profits from the European carbon market. This led to the adoption of a number of preventive measures in the field of Value Added Tax (VAT) and the Union registry. The classification as from January 2018 of emission allowances as financial instruments complemented the efforts to provide a safe and efficient trading environment and to enhance confidence in the carbon market.
No, the classification of allowances as financial instruments does not have any direct impact on the accounting treatment of emission allowances under the Union law. Member States are obliged to report annually on their national regimes on the accounting and fiscal treatment of allowances. Despite the absence of harmonisation in this respect, the current regulatory framework provides the necessary legal underpinnings for a mature, transparent, and liquid carbon market, whilst ensuring the market's stability and integrity.
The list of national competent authorities responsible under the Market Abuse Regulation can be found on ESMA’s webpages.
The list of European Financial Intelligence Units, which deal with issues related to money laundering and terrorist financing, can be found on the webpages of Europol.