ieta position on transparency and oversight in the eu’s carbon market

8/8/2019 IETA Position on Transparency and Oversight in the EUs Carbon Market

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P a g e |1 IETAMAKINGMARKETSWORKFORTHEENVIRONMENT

RuedelaLoi235,Boite27

1040Brussels,Belgium

+32(0)22301160;[email protected]

Market integrity and transparency regime for the EUs carbon marketIETA Position Paper

June 2010

Key messages

IETA strongly condemns any forms of market abuse;

IETA supports appropriate measures for enhancing oversight, transparency and integrity of

the carbon market based on an impact assessment with a thorough cost-benefit analysis;

Carbon derivatives are mainly traded on central platforms which provide a high level of

transparency and are subject to high levels of financial regulation;

The Commissions proposals for regulation of OTC derivatives must not drive out liquidity in

this young and growing market, and must allow for efficient price formation to achieve CO 2

emission reductions at the lowest cost;

IETA supports well-defined, targeted transparency measures for highly bespoke physical

contracts that are traded bilaterally or over-the-counter to support efficient price discovery

and market integrity;

Transparency rules for the physical carbon market could be embedded into the work on

market integrity and transparency of physical power and gas markets;

IETA looks forward to discussing with the Commission the appropriate scope of the MiFID

review which should ensure that the same market participants benefit from an appropriate

level of regulatory protection in order to safeguard their interests and the integrity of the

market in general;

An EU-wide carbon market monitoring function should be introduced within existing EU

regulatory structures to allow data exchange and coordination among national regulators

while the power of investigation would remain at national level;

It should be clarified that all oversight rules applying to EUA should apply also to secondary

market transactions on CER/ERU or other instruments that would become tradable in the

EU ETS under future arrangements.


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IETApositionontransparencyandoversightinthe

EUscarbonmarketJanuary19,2011

P a g e |2 IETAMAKINGMARKETSWORKFORTHEENVIRONMENT January19,2011

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Introduction

This paper outlines the International Emissions Trading Association (IETA)s view on various

initiatives concerning regulation and oversight of the EUs carbon emissions market (EU ETS)1.

IETA is the leading voice of the international business community on the subject of

emissions trading. IETA supports efforts to address the pressing environmentalchallenge of climate change, and is dedicated to the establishment of environmentallyeffective market-based emissions trading systems that generate reductions at least cost

to the community.

There is only one regulatory initiative2 which will directly address carbon market oversight in the

EU, but regulatory developments in financial and commodity derivatives markets will also haveimplications for carbon market participants.

IETA welcomes the initiation on 17 December 2009 of a series of stakeholder consultations bythe Commission on commodity derivatives and asks for further clarity concerning how carbonproducts will be included in the following regulatory initiatives:

- Review of the Market Abuse Directive (MAD);

- Enhancement of regulatory framework for over-the-counter (OTC) derivatives;- Enhancement of trade and price transparency in the Market in Financial Instruments

Directive (MiFID);

- Review of exemptions from MiFID for commodity firms;

- Possibility to empower regulators to set position limits;- Proposal for EU level oversight of electricity and gas forward physical and spot markets,

which might include carbon emissions, with regard to market integrity and transparency.3

IETA urges the Commission to ensure that the carbon market and its products are not subject tounnecessary regulatory overlaps. Stakeholder consultation by all Directorate Generals isessential to ensure coherence and reduce costly and confusing duplication. The design and

implementation of any regulatory framework must follow the better-regulation principle andmust be founded on sound market failure and cost benefit analysis to ensure the

competitiveness of EU industry.

IETA welcome the Commissions recognition in its 2009 Communication on derivatives4 that

different solutions might be needed for different asset classes. It is critical that the Commission

takes account of the diverse range of assets and participants (compliers, traders, investors) itintends to cover. To prevent unintended consequences, regulatory solutions must not be

applied uniformly to all asset classes without prior analysis of the market characteristics of each

asset.

1

A glossary is annexed to the paper, for clarification of different concepts used.2

According to article 12(1a) of Directive 2003/87/EC, the European Commission is to examine by end-2010 whetherthe EUs emission trading scheme is sufficiently protected from insider dealing and market manipulation and bringforward regulation to ensure it.3 IETA will submit a separate reply to the consultation published by DG Energy on 31 May on Initiative for the

integrity of traded energy markets.4

COM(2009) 563/4 Ensuring efficient, safe and sound derivatives markets: Future policy actions


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As a first step, one must distinguish between physically settled spot/forward and derivatives

markets. Derivatives of carbon allowances traded on exchanges and OTC5 are largely

regulated.

IETA supports the introduction of targeted regulatory measures for trading of physical

spot/forward carbon emission allowances6 that complement the efficient operation of deep,

liquid and competitive markets. A consistent and proportionate regulatory framework will attractparticipation, reward innovation, and enhance environmental efficiency.

IETA also emphasizes the need for EU regulators to co-ordinate with each other, to establishharmonized transparency standards, definitions and reporting for the pan-European carbon

market and for cross-border cooperation in detecting fraudulent activity.

In this context, IETA welcomes the adoption of amendments to the registry regulation in theclimate change committee of February 2010. The fast-track implementation of security features

and the introduction of a single EU registry for phase III will make it far more difficult to fraud thesystem and abuses will be more easily detected and can be faster dismantled.

What are carbon emission allowances?

A carbon emission allowance is a unit which grants the holder the right to emit one tonne of

carbon dioxide equivalent during a specified period, which shall be valid only for the purposes of

meeting the requirements of the EU Emissions Trading Directive. Carbon emission allowancesare traded pre-dominantly for compliance usage.

IETA notes that there are substantial interdependencies between European emission

allowances markets and some other energy markets (mainly electricity and gas) since there are

linkages in the price formation processes of these markets.

(1) Spot deals

Emission allowances7 can be sold in spot markets where delivery is scheduled to be made

within two trading days or another generally accepted standard delivery period. Spot trading ofemission allowances is currently not subject to any specific EU legislation8. Spot contracts areexplicitly excluded from the scope of MiFID.9

5

OTC options, futures, swaps and other derivative contracts relating to emissions allowances are regulated underMiFID if they can be settled in cash.6

Here we only address the trading of spot allowances in the secondary market but the forthcoming regulation on

auctioning of EU allowances for phase III should address the risk of market manipulation in the primary market.7

For the avoidance of doubt, the reference to allowances is a reference to EU Allowances (EUAs), Certified EmissionReductions (CERs), Emission Reduction Units (ERUs) and any other compliance unit.8

Romania has recently reclassified spot EUAs as financial instruments (23/02/2010). IETA does not believe that ablunt unilateral reclassification is the right way to regulate the carbon market. IETA supports the call by the French

governments Prada report for a harmonization of the legal status of emission allowances and uniform application oftax/accounting rules across the EU.9

Art 38 of MiFID Implementing Regulation. Moreover, MiFID earmarks energy as a "commodity" while carbon creditsare not mentioned. It is, however, not very plausible that carbon credits would fall within the definition of "commodity"as this excludes intangible rights and goods, while explicitly including energy.


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(2) Physically settled OTC forward deals

Contracts are written based on the price and character of emission allowances. These can

mirror the underlying behaviour of the allowances and depending on the detailed terms of thecontract, they have to be satisfied by the delivery of emission allowances or through a cash

settlement process. A physical carbon contract is traded via bilateral bespoke contracts (over-

the-counter). Physical OTC forwards are non-financial instruments and not covered by MiFID.

(3) Cash-settled carbon derivatives

Several types of derivative contracts (e.g. forwards, futures, options and swaps that are traded

on a regulated exchange or an MTF) relating to emission allowances fall within the scope of

MiFID if they are settled in cash or may be settled in cash at the option of one of the parties(MiFID, Section C(10) of Annex I). Carbon derivatives listed on exchanges (also if physicallysettled) are under the full scope of MiFID and harmonised throughout the EU. Consequently, no

further rules are necessary for these markets.

Clarification is required to whether the criteria for classification of carbon derivatives as financialinstrument within MiFID cover all type of credits (EUAs, CERs, ERUs, etc.). MiFID only

mentions derivative contracts relating to "emission allowances", but it is unclear whether thisonly relates to EUAs, or to other carbon credits as well (CERs, ERUs, or even VERs). There

seems no reason why EUA derivative contracts would be treated differently from derivatives

relating to other tradable carbon credits, but regulatory clarification on this issue would beappreciated.

The first section of this paper addresses market transparency and supervision for both

spot/physical forward and derivative carbon markets. The second section looks at the regulatory

coverage for OTC/derivatives carbon markets. The third section brings forwardrecommendations to adequately regulate the spot/physical forward carbon market.

Section I Transparency and market supervision

1. IETA believes it is important to distinguish between data that may be collected and publicly

disclosed and data that may be collected and reported to regulators by data owners/marketparticipants, e.g. traders, electricity generators.

I.1 Fundamental data transparency

2. IETA recognizes a need to increase the availability of fundamental emissions data

collected by Member States to allow market participants to make informed trading decisions:

- Providing more frequent and, at least, quarterly estimation of aggregate emissions (by

sector and by country) in the system will enhance the efficiency of the ETS and

confidence in the system. These estimates should rely on reporting of emissions data

produced using simplified methodologies by installations/operators. While these


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estimates would not be audited (as opposed to annual verified emissions) operators

should be accountable for the information they report (subject to best possible efforts).

- These figures should be published alongside energy usage and sectoral GDP.

-They should be published within a timescale that is agreed between the Member Statesto be reasonable and which is policed by the Commission.

- We further believe that all Governments should publish their latest projections for

national emissions by sector for 5 future years and for the last year of the EU-ETSPhase where that is later. Release of this data, upon request, is already a requirementfor Member States under Directive 2003/4/EC.

- The Commission should assemble data from all Member States and publish a

compendium at least annually.

3. DG Energy and CESR/ERGEG might usefully consider whether to include emissions in their

work on fundamental data transparency in relation to power and gas markets, while takinginto account differences.

4. It is important that information is released in a consistent, orderly and timely manner. Data

releases should be made more frequently; this would build confidence in the market. Thequality of the market and its development is at risk if information is not accurate. Also,information has to be accessible and data presented in a consistent and homogeneous

manner.

I.2 Pre-/Post-trade transparency

5. A balance has to be stuck to avoid disproportionate or ill-conceived transparencyrequirements that negatively impact liquidity in what is still a young and growing market.

6. IETA supports appropriate disclosure of trades and positions to regulators to ensure theypossess the relevant information necessary for them to discharge their regulatory functions.

IETA believes that public disclosure of trade data by individual market participants (e.g.installations) should be avoided as it could expose individual trading patterns if anonymity is

not preserved.

7. Consideration might be given to the role trade repositories10 can play in the collection andprovision/publication of aggregate post-trade data while guaranteeing anonymity to marketparticipants; ideally this data should then be provided by the trading platforms.

8. Pre-trade data refers to market-relevant information, e.g. liquidity, price level, bid-offerspread, etc. The level of pre-trade data is generally good in the carbon market due to the

high level of transactions executed on exchanges/via platforms. Whether or not atransaction should be subject to pre-trade transparency requirements should depend on the

level of standardization, liquidity level, and possibility to trade on platforms (Exchange, MTF,Broker) and/or clearing.

10

A trade repository is a centralized database. It allows compliance with transparency requirements through a singlereporting flow. The trade repository would be accessible for regulators subject to confidentiality requirements.Reporting could also take place at a consolidated level through exchanges, brokers or MTFs.


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9. Exchanges/MTFs publish pre-trade information (i.e. bids/offers) for instruments traded on

their platform. It should be ensured that pre-trade transparency requirements could not

negate the anonymity that exchange trading provides exposing participants tradingarbitrages.

10. IETA understands that the Commission is investigating these issues on a broader level withits initiatives aimed at enhancing the resilience of OTC derivatives market following thefinancial market crisis. IETA encourages the Commission to launch thorough impact

assessments to weigh potential advantages (i.e. price discovery) and disadvantages (i.e.market development and effectiveness of risk management actions).

11. In terms of current market transparency on trades, information is readily available via theplatforms themselves or via data vendors/publishers.

12. Anonymised, delayed data (published reasonably close to real time) about the occurrenceand volume of all transactions executed in an electronic trading system (e.g. onexchanges/MTF) would provide reliable price information on liquid standardized (andtherefore relevant) contracts while preserving liquidity. It would also help all parties gain a

better understanding of market evolution and key trends.

13. The publication of pure bilateral transactions post-trade raises challenging questions as to

the value of such information. Bilateral bespoke transactions are normally highlybespoke/tailored in their nature. The relevance therefore to the price discovery process ofany information contained in such disclosures is likely to be of limited relevance. There are

also significant practical difficulties associated with making such information public whilst

maintaining confidentiality.

I.3 Supervisory regime

14. An EU-wide carbon market monitoring function, allowing for an effective coordination andexchange of data among national supervisors who would retain power of investigations,

should be introduced within existing EU regulatory structures, e.g. European Securities andMarket Authority (ESMA) or Agency for Cooperation of Energy Regulators (ACER).

15. To prevent conflicts between regulators, it is of outmost importance to avoid overlaps and to

ensure that regulators have appropriate powers to supervise the entire carbon market, e.g.covering both spot/physical forward and financial derivatives. However, access to relevant

data should be granted on request to all relevant authorities.

16. The rule making process should remain in the hands of the competent sectoral authoritiesas the carbon market is defined by an environmental objective.

17. This authority would also have to keep strong ties with the supervision and competitionauthorities of the various market sections and of nearby markets, such as power and gas.


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Section II Oversight of carbon derivatives

II.1 General Comments

1. IETA believes that the general level of oversight of the EU ETS derivatives market issufficient but there is scope for targeted measures to prevent market abuse.

2. Emissions derivatives markets were not imminently concerned by the financial crisis.Markets remained liquid and, apart from a demand-induced price decrease, no adverseimpacts were felt.

3. Fundamental re-casting, amendment or deletion of the exemptions in MiFID couldpotentially bring into its scope numbers of industrial companies (including airlines) who use

carbon markets to manage their compliance obligations and other risks inherent to their corebusiness. It is also important that the same market participants benefit from an appropriate

level of regulatory protection in order to safeguard their interests and the integrity of themarket in general.

4. IETA is aware of uncertainties created by differing national transposition and interpretationof the definition of financial instrument in relation to derivatives on emissions allowances.

IETA is ready to support the Commission in addressing these issues in the context of the

MiFID review.

II.2 Record keeping and reporting to regulators

5. IETA finds it important that regulators should have access to all relevant information

necessary to fulfill their regulatory obligations.

6. The record keeping obligations in MiFID enable regulators to access all relevant data relatedto financial derivatives transactions. IETA believes such an approach provides regulatorswith the appropriate supervisory tools whilst limiting additional burden on market players.

This would also be a sensible approach to the regulation of carbon derivatives.

7. The type of information to be reported beyond instruments admitted to trading on aregulated market needs to carefully considered and determined ex-ante. A balance has to

be struck between providing the regulators with the information needed to undertake itsregulatory task and the cost burden for providing the information. The costs can be reduced

through recourse to a trade repository (cf footnote 10).

8. IETA believes that reporting should be done through the systems of exchanges, MTFs,brokers and central clearing platforms and, if applicable, by trade repositories; this would be

an efficient and practicable response to the need for regulators to access relevant datawithout imposing a significant burden on individual firms.

9. Position reporting can provide a useful tool for regulators in identifying concentrations of riskin a particular instrument or market. It should be limited to large positions. Once again,exchanges, MTFs, brokers, CCPs and, if applicable, trade repositories should provide


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details of position to the regulator and it should be an integrated and harmonized process

delivered to a central data repository.

10. Given the commercially sensitive nature of such information, such data should only be madeavailable to regulators.

11. IETA is ready to explore further with regulators how such information might be used toenhance public transparency.

II.3 Market integrity

12. In order to remove uncertainties in the scope of application, IETA strongly supports

alignment of the definition of financial instrument in MAD with that of MiFID. However, thisalignment should not result in the inadvertent expansion of MAD to cover OTC and spotmarkets in commodity derivatives and similar products.

13. IETA would like to highlight that all markets need participants who are willing to take theother side of a trade whether a physical producer/hedger, bank or index fund. Speculativeinterests add depth and liquidity to the market and should not be viewed as detrimental to

market integrity per se.

14. Position limits are a blunt regulatory tool that should not be imported into the EU regulatory

framework. Position limits can hinder the ability of producers/manufacturers to hedgeeffectively or expose these firms to a detrimental regulatory risk (risk that regulators will setposition limits) and commercial risk (carbon price risk). Moreover, in the absence of forward

allowance sales by Governments ahead of 2013, position limits could unnaturally limit the

ability of market participants to close the speculative gap (which is driven by real hedging

needs and not by speculative aims) built between advanced hedging demand for allowancesfrom 2010 onwards and the subsequent spot sales of allowances several years hence from2012 at the earliest.

15. Power producers and other industrial firms are naturally short with CO2 and have to

participate in the CO2 market for compliance reasons. They are hedgers of commodity riskand have by definition important CO2 positions. Position limits would seriously limit theirability to hedge the CO2 risk.

16. For emerging markets with limited initial liquidity, it is normal that market-makers, acting intheir role, build positions that can accrue to a significant extent of overall open interests

(e.g., in the carbon market, for quarterly contracts like March, June, September). Imposing a

prioria position limit on all contracts could thus be detrimental to liquidity and thus marketdevelopment. The position reporting should allow the regulator to fully investigate thereasons for an important position, and require it to be scaled down if needed.


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Section III Oversight of physical spot/OTC forward markets

III.1 General Comments

1. The large majority of trade in the EU ETS physically settled spot and OTC forward markettakes place for compliance purposes.

2. There could be some improvement in the physical spot/OTC forward markets, which iscurrently not covered by MiFID regulation. As discussed in section 1 above there is room forimprovements in regards to post-trade transparency. Moreover, transactions are not

covered by a market abuse regime as for financial markets and it is possible for unregulated

entities to operate on behalf of third parties. However, simply extending MiFID or MAD tocover non-regulated physical markets is not the right approach.

3. Yet, customers should be protected whether they are served by financial institutions or other

intermediaries, hence some form of regulation should be there to cover the entities that arecurrently not regulated.

4. IETA believes that market integrity rules could be integrated in the tailor made regime beingdiscussed for wholesale electricity and gas trading, as one of the option suggested also by

ERGEG-CESR in their advice to the Commission11. It is of outmost important that this does

not fragment the supervisory regime for the carbon market.

5. Targeted exemptions from regulatory requirements might be justified for operators which areintervening on the market only for achieving their EU-ETS compliance obligation. This isjustified by the fact that they present no significant risks to clients' protection and that they

could have no operational set up to manage certain regulatory requirements at a reasonable

cost.

III.2 Record keeping and reporting to regulators

6. IETA strongly believes regulators should have access to all relevant information necessaryto fulfill their regulatory/supervisory obligations.

7. All transfers of allowances are tracked by the registries system, which can also be

monitored for suspicious behaviour. Data should be available for competent authorities onrequest. However, registries do not capture price information/information on open interest on

forward contracts. This information could be collected through a trade repository.

8. It is important that regulators have the necessary powers to request relevant informationfrom individual market participants. However, appropriate safeguards must be included so

as to prevent or guard against so-called Phishing expeditions.

11

CESR and ERGEG advice to the European Commission in the context of the Third Energy Package Responseto Question F.20 Market Abuse (Ref: CESR/08-739 and E08-FIS-07-04)


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9. Transactional and hedging information is at the core of many companies risk management

strategies. Physical OTC carbon hedges are often large, strategic and by nature tailor-

made. Publication of detailed non-aggregated information on trades concluded may pose

serious confidentiality questions and thus should be carefully evaluated.

10. IETA also notes that the Commission should be mindful of the varied capacity different

carbon market actors have for tracking and storing data. In this sense a fine balancebetween costs and benefits should be assessed. Investment firms, currently required byMiFID to keep record of all transactions, already have this competency. Much of the energy

sector also has capacity to record transactional data. However, many other compliers,including many of the energy-intensive industries and small compliers, have different needs

and limited capacity to track and collect data.

III.3 Market integrity

11. IETA acknowledges recent concerns surrounding the integrity of the emissions marketarising as a result of the VAT carousel fraud. While, this is indeed a tax-related issue thathas occurred in other sectors of high-value goods (e.g. mobile phones, computer chips,etc.), it has also demonstrated weaknesses in the regulatory regime for the carbon market.

12. Given the nature of the market, we highlight the need to avoid overlaps to safeguard against

abusive or manipulative behaviour. In particular, IETA believes that prevention of market

manipulation should be addressed within an appropriately defined Market Abuse framework.Afterwards, if an abuse of market dominance is being detected, anti-trust laws andcompetition authorities should be responsible.


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Glossary

-Oversight: regulatory and supervisory framework aiming at protecting market integrity, i.e.

prevent opacity or disruption through illicit behaviour.

- Supervision: checking of compliance of market participants with regulatory framework.

Punitive measures are taken if rules are not respected.

- Monitoring: similar to supervision but without possibility for punitive actions in case of non-

compliance.

- Regulation: set of legally binding rules that set the framework conditions for certain

activities. Example: Market in Financial Instruments Directive (MiFID) regulates financial

instruments and activities related thereto.

-Supervisory body: legal entity with remit to investigate market abuses on behalf of thegovernment.

- Market abuse: The EUs Market Abuse Directive aims to ensure that behaviour such as

insider dealing and market manipulation is properly deterred and sanctioned. In this paper,

market abuse also covers fraudulent behaviour more broadly, e.g. VAT fraud.

- Market manipulation: describes a deliberate attempt to interfere with the free and fair

operation of the market and create artificial, false or misleading appearances with respect to

the price of, or market for, a security, commodity or currency.

- Insider trading: trading of a companys securities (e.g. bonds or stock options) by individuals

with potential access to non-public information about the company.- Commodity: any goods of a fungible nature that are capable of being delivered, including

metals and their ores and alloys, agricultural products, and energy such as electricity.

- Transparency and its different components:

- Fundamental: publication of data which defines a market in terms of demand/supply,

e.g. CO2 emissions in the case of the carbon market, commodity production in the

case of commodity markets, etc.

- Pre-trade: publication of data which precedes a trade, e.g. bids and offers.

- Post-trade: publication of data which is the result of a trade, e.g. price, volume and

time of trades.

- Trade repository: centralized database which allows to comply with transparency

requirements through a single reporting flow.

- Multilateral trading facility (MTF): a multilateral system which brings together multiple third-

party buying and selling interests in a way that results in a contract.

ieta position on transparency and oversight in the eu’s carbon market

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