Background on Carbon credits trading
The EU Emissions Trading Scheme ("ETS") is a cap and trade scheme that seeks to reduce greenhouse gas emissions across the EU. It operates by setting a cap on carbon dioxide emissions from factories, power stations and other energy-intensive installations. Each installation is allocated a number of emission allowances also known as carbon credits. Each carbon credit represents the right to emit one metric tonne of CO2 into the atmosphere. Installations incur heavy fines for emitting greater CO2 emissions than they have the carbon credits to cover.
The ETS provides for carbon credits to be traded. This allows installations who expect to exceed their carbon credits to purchase more from installations with surplus credits. Other potential buyers include businesses who wish to partake in the ETS on a voluntary basis. This has allowed for a carbon credits trading market to develop.
According to the European Commission ("the Commission") between 2005 and 2010 the annual turnover of the European carbon market grew from around €6 billion to €90 billion. The majority of carbon credits trading takes place in the form of derivatives trading (futures, options etc).
However, direct trading of the carbon credits themselves also occurs and is known as "spot trading". The ETS regulates the trade of carbon credits between installations, but does not regulate trade by other parties such as financial institutions.
Current Financial Services Regulatory Framework
The Markets in Financial Instruments Directive ("MiFID") came into force on 1 November 2007. It is a key component of EU financial services regulation. MiFID applies to businesses that regularly provide specified services and activities in relation to certain types of investments on a professional basis.
Currently, MiFID applies to the trading of certain types of derivatives of carbon credits, but not to the trading of carbon credits themselves, which are not classified as financial instruments.
Regulatory review: MiFID II
In May 2011 the Commission published a discussion paper on carbon trading regulation and invited stakeholder discussion on the subject. This occurred as part of a wider review of the operation of the MiFID regulatory framework. On 20 October 2011 the Commission published legislative proposals to amend MiFID, commonly referred to as "MiFID II".
Significantly, MiFID II classifies carbon credits, not just derivatives of carbon credits, as financial instruments. This will bring carbon credit trading within the updated MiFID regulatory framework. The impact of this classification will be threefold:
- Professional traders and intermediaries in carbon credits (both spot and derivatives) will need to obtain MiFID authorisation; in the UK this will entail authorisation by the Financial Services Authority ("FSA");
- Trading venues offering spot trading in carbon credits will also need to obtain MiFID authorisation; and
- All participants in the carbon trading market will be subject to the Commission's prohibitions on insider dealing and market abuse. These are currently in the form of the Market Abuse Directive ("MAD").
Although MAD is currently under review, any equivalent or further prohibitions implemented by the Commission will continue to apply to all participants in the carbon trading market.
It should be noted that installations themselves are not required to be licensed by MiFID, as long as any carbon trading activity is ancillary to their main business. However, installations will be required to comply with market abuse and insider dealing regulation.
The real impact of this proposal will be felt by professional traders and intermediaries specialising in spot trading, who have previously not had to comply with the bulk of EU financial regulation.
By bringing the carbon spot trading market within the scope of MiFID regulation, the European Commission hopes to improve transparency of the market, and reduce the risk of market abuse. This in turn will afford greater protection to participants in the market as a whole, particularly to purchasers of carbon credits from financial institutions that previously operated from within a black hole of regulation.
The MIFID II proposals are currently with the European Parliament and the Council of the European Union for discussion. According to the FSA a final agreement on the proposals is expected by the end of 2012, but implementation of the new measures is not expected until at least 2015.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.