The challenges of auctioning pollution (Source: Jan Smith)

Compared to earlier trading periods, Phase III of the EU ETS will see a marked reduction in the free allocation of emissions allowances to industrial installations, with a corresponding increase in auctioning levels. It is hoped that this shift will help redress the imbalance between the importance of the EU ETS in reducing emissions and the current sluggishness of the emissions market. To help achieve the environmental goal of the EU ETS, the auctioning process will have to be carefully designed and regulated so as to incentivize low-carbon development and encourage investment in the emissions market.

The problems of free allocation

Phase I of the EU ETS was characterized by high levels of free allocations of allowances to industrial operators.  The allocations were largely based on historical levels of emissions put forward by the operators themselves to EU Member States, who then distributed the allowances. The consequence was over-allocation of allowances as the cap (constituted of the total allocated allowances) in fact exceeded the actual emissions levels.

Phase II witnessed a tightening of the cap below Phase I levels. However, this did not avert over-allocation, which was significantly due to the decrease in production levels caused by the global economic crisis. Operators have thus found themselves holding substantial levels of freely allocated allowances which are surplus to their production needs.

The over-supply of allowances has significantly affected the emissions market, with prices plummeting since the start of Phase II; allowances are currently trading at around EUR 6/tonne. This does not bode well for the environmental effectiveness of the EU ETS, as it is much cheaper to buy allowances in the market than it is to invest in achieving emissions reductions.

The advent of auctioning 

It is hoped that the use of auctioning gradually from Phase II and much more extensively in Phase III will help stabilize the price of allowances at a sufficiently high level. The use of auctioning is also intended to remove the possibility of windfall profits, where operators can benefit from freely allocated allowances which are not needed to cover production.

Auctioning is intended to take over from free allocation as the principal method of distributing emissions allowances to operators. The expectation is that least 50% of allowances will be auctioned from 2013, compared to approximately 4% to date.

Designing and regulating an effective auctioning process

The auctioning process envisages a common platform operated by the European Commission and the Member States. In addition, individual Member States have the option of establishing national auctioning platforms. The UK, Germany and Poland have already expressed their intention to opt out of the centralized arrangement and conduct auctioning at national level.

Harmonization will therefore not be absolute, which may lead to divergences as between the centralized platform and the respective national approaches. There are concerns that diffusing the auctioning process may make it more difficult to provide the kind of strong price signal that the emissions market so urgently needs. It is also feared that the security issues which have arisen in the past with national emissions registries (previously noted by Climatico) may repeat themselves with national auctioning platforms.

From a market perspective, auctioning raises the question of the involvement of financial regulators. Access to and participation in the auctioning process, which is set to make up the larger part of the emissions market, will have to be adequately supervised so as to ensure transparency and thus aid accurate price formation and avoid market distortion. The UK Financial Services Authority (FSA) has recently published a consultation paper on the proposed extent of its involvement in regulating auctioning.

Towards a viable emissions market

Learning from past errors is vital if the auctioning process is to deliver the price formation and market stabilization results needed to uphold the environmental credentials of the EU ETS. Centralized price and security standards control is crucial in this respect. The European Commission also needs to take the lead in delimiting the scope of financial regulation of auctioning centrally at EU level, to the extent that the emissions market requires protection from information and price distortion.

EUAA trading should not be grounded (Source: David McKelvey)

Trading in the latest type of carbon credit, EU aviation allowances (EUAAs), has begun despite remaining doubts as to the viability of the new market, which have been exacerbated by diplomatic turmoil. The requirement that all airlines, including non-EU operators, comply with the EU ETS has provoked resistance from a number of key countries. It has also raised questions as to the regulatory wisdom of creating a market in emissions allowances where liquidity and price levels remain challenging to maintain.

Regulating aviation under the EU ETS

Under the EU ETS, all airlines flying from and to airports situated in the EU will be obliged to surrender allowances corresponding to their levels of flight emissions. Crucially, this obligation extends to non-EU airlines. The move to include aviation in the EU ETS brings the sector in line with the others covered by this environmental regulatory regime, such as energy and metal production industries. The inclusion of aviation in the EU ETS will require airlines to buy and sell emissions allowances in the market in order to ensure that they hold them in sufficient numbers for the purposes of surrender.

Political opposition

The UNFCCC and the International Civil Aviation Organisation (ICAO) have long supported the regulation of aviation emissions through trading, but no global agreement has yet been reached in this respect. The EU’s decision to unilaterally regulate this sector under the EU ETS represents the first practical expression of a focused effort to accelerate the creation of a global mechanism to reduce aviation emissions.

The brave step taken by the EU has not been without controversy. Notable jurisdictions such as the US, China and India have been particularly vociferous in opposing the extension of the EU ETS to their airlines. In particular, the US brought legal action arguing that the extension contravened a number of international agreements, namely the Chicago Convention, the Open Skies Agreement and the Kyoto Protocol. The European Court of Justice (ECJ) held that the EU’s move complied with the relevant agreements and did not infringe the sovereignty of the affected states. However, the judgment did not mark the end of the dispute, since US airlines continue to oppose the trading scheme.

A new market in allowances

The first exchange trade in EUAAs took place on 27 February 2012, and was carried out by Vertis Environmental Finance, a specialised environmental commodities broker, on the ICE exchange. It is early days yet, but other firms’ interest in EUAA trading will be indicative of the levels of liquidity that can be expected in this fledgling market. ICE Futures Europe has expressed its confidence in the EUAA market by launching a form of futures contract with allowances as the underlying product. Interest has also been expressed by other trading platforms, notably the European Energy Exchange (EEX) and BlueNext.

However, uncertainty as to the degree of participation in the scheme by non-EU airlines renders it harder for financial entities to ascertain the value of becoming involved in the EUAA market. China, for instance, has announced that its airlines are banned from complying with the EU ETS. It is unclear what practical steps the EU could take in international law in order to achieve compliance; the problems of monitoring and enforcement have been highlighted in an earlier Climatico post. This situation is markedly different from the beginnings of the EU ETS and its application to EU industrial operators, which was not faced with such serious jurisdictional challenges.

Saving EUAA trading

Active participation in the market is absolutely crucial to the success of the EU ETS to reduce emissions in the aviation sector. Low levels of liquidity would equal low EUAA prices and therefore little incentive for operators to reduce their emissions as opposed to simply continuing to purchase allowances in the market.

International opposition to the application of the scheme to non-EU airlines could potentially be very damaging. Such refusal to participate could drive away financial traders and substantially shrink the market in EUAAs while it is still in its incipient phase. Until the EU can achieve some degree of international cooperation, or at least a diminution in opposition, it is difficult to see how its environmental regulation can be enforced against unwilling parties.

Industrial gas credits – banned from the EU ETS (Source: Isaac Mao)

In the aftermath of the Durban conference analysts have been turning their attention to the continued role of Kyoto Protocol emissions credits in the EU ETS. To date this trading mechanism has provided the biggest market for Kyoto credits, but the position is set to change drastically from 2013 onwards due to significant restrictions on the type and number of permissible credits. It is hoped that this move will address some of the credibility issues that have been plaguing the EU ETS (notably the use of environmentally dubious credits). Moreover, EU emissions allowances (EUAs) will become firmly established as the tradable instrument of choice in the market.

The impact of Kyoto credits on the EU ETS

In addition to EUAs, regulated installations can use credits from two kinds of Kyoto mechanisms, namely Clean Development Mechanism (CDM) and Joint Implementation (JI) projects to fulfil their EU ETS obligations. Each EU Member State currently sets its own limits on the use of CDM and JI credits. Phase III of the EU ETS will see the introduction of a general cap on Kyoto credits of 50% of total, EU-wide emissions reductions.

The linkage between Kyoto mechanisms and the EU ETS has provided these credits with market value. In particular, the price of Certified Emission Reductions (CERs) resulting from CDM projects has to date closely followed that of EUAs, as the former type of credit has been extensively traded by EU ETS regulated entities.

Environmental credentials of Kyoto credits

The usability of Kyoto credits in the EU ETS has been progressively reduced over the years so as to address concerns regarding the effectiveness of the credit-generating projects in combating climate change.

A notable example of credits which will be banned from the EU ETS in Phase III (from 2013) are those generated from the destruction of HFC-23, a by-product of a highly noxious refrigerant which is itself a potent greenhouse gas. HFC-23 crediting has been particularly popular in India and China. It has been strongly criticised by environmental organisations on the basis that the additional HFC-23 may arguably not have been produced at all were it not translatable into Kyoto credits.

Cutting the Kyoto mechanisms short

Phase III of the EU ETS is set to entail considerable quantitative and qualitative restrictions on the applicability of Kyoto credits. These developments reflect the recently amended wording of the EU ETS Directive, which provides that credits must “represent real, verifiable, additional and permanent emission reductions and have clear sustainable development benefits and no significant negative environmental or social impacts”.

From the qualitative perspective, the current ban on the use of credits from nuclear energy or land use, land use change and forestry (LULUCF) activities will continue beyond 2013 alongside the new ban on industrial gas (HFC-23 and N₂O) credits.

On the quantitative front, credits from CDM projects registered after 2012 can only be used in the EU ETS if they originate from a defined list of Least Developed Countries (LDCs), which does not include large emerging economies such as India and China. The exclusion of such countries is intended to motivate them to reduce emissions in ways other than the generation of CERs and thus step up their regulatory approaches to mitigating the effects of climate change.

Where does this leave international emissions credits?

As the demand for CDM and JI credits for use in the EU ETS will inevitably drop from 2013, the continued relevance of these mechanisms will depend on the level of interest that they can generate in other emissions trading schemes, such as the incipient Australian or New Zealand systems. The EU Commission has arguably taken the correct approach in placing clear limits on the usability of Kyoto credits, which has been made dependent on their environmental quality and provenance. In the short term at least it is envisaged that the market in EUAs will emerge as dominant, as it is unlikely that national trading schemes will be able to absorb levels of Kyoto credits on the same scale as the EU ETS.

Disputed land (Source: Achmad Rabin Taim)

Clean Development Mechanism (CDM) credits have been receiving plenty of bad press, with the latest being reports of human rights abuses committed in Honduras over the ownership of credit-producing land. This is particularly serious as the CDM has been set up to feed into the EU ETS, which means that CDM credits find their way into the EU emissions market. Trading in credits whose origin is both legally questionable and ethically suspect does not bode well for the environmental integrity of the EU ETS.

The CDM

EU ETS regulated installations are allowed to use a set proportion of emissions reduction credits generated from CDM projects in developing countries. This is permitted as a way of linking the Kyoto Protocol mechanisms to the EU ETS. In exchange for one CDM credit a Member State has to issue and surrender one emissions allowance and then cancel the credit, which cannot itself be traded within the EU ETS. There are legislative limits on the levels of CDM credits that can be swapped for allowances.

Earning credits in this manner has proved a popular way of fulfilling EU ETS obligations due to the proliferation of CDM projects across the developing world. There are currently over 3,000 CDM projects registered with the UN.

Who owns the land?

CDM projects involve land which is owned by UN approved entities that are in charge of generating the credits. This is the case in Honduras, where the projects under fire have entailed the production of palm oil. Local farmers are protesting against the palm oil plantations and claim that they have been wrongfully evicted from their land so that the CDM projects can go ahead. There are widespread reports of worrying levels of violence against those who are trying to recover their land.

This dire situation highlights one of the key problems with the CDM. How can the ownership of the CDM credits be secure when the ownership of the credit-generating land itself has been thrown into doubt? Many of the developing countries which host these types of projects lack an adequate land registration system whereby ownership can be adequately recorded and subsequently protected. This leads to situations like the present one in Honduras, where land disputes between parties with competing claims can degenerate into something much more sinister.

Banning the “bad” CDM credits?

The CDM has brought the inadequacy of land ownership protection present in these developing legal systems into the EU’s own back yard. Not only does this render the ownership of the credits themselves disputed, but it also brings with it the allegation that the system is being built on unethical practices. While the EU is in no way responsible for these unfortunate events, the controversy is stretching to the EU ETS due to the reliance of regulated installations on CDM credits to earn emissions allowances.

There are demands from within the EU to ban those CDM credits which have been tainted by human rights abuse allegations. It is rightly perceived that the EU ETS cannot be associated with grave breaches of this nature. This kind of ban on suspect credits has happened before with Chinese CDM projects which were said to lack any environmental integrity. The projects in question involved producing a noxious gas (HCFC-22) simply to burn its equally noxious output (HFC-23) and thereby earn credits.

Increased vigilance is needed

The controversy that surrounds the CDM is not fading away very easily. This is because the UN’s monitoring powers in respect of projects which are spread worldwide are not sufficiently strong to prevent the system from being abused. The EU ETS is suffering the consequences, which may well add to the volatility of the emissions market. The EU needs to be especially vigilant. Having to ban a new type of offending credit on a regular basis is cumbersome, but the more sweeping alternative of seriously questioning the CDM has not been seriously put on the table so far.

Easier to lose than land (Source: Salisbury Area Plaques)

In anticipation of the centralised European registry for the EU ETS the Commission has turned its attention to the legal issues surrounding the traceability of stolen emissions allowances. The approach taken is deferential to the national laws of individual Member States rather than providing a harmonised EU-wide rule. However, the Commission’s proposals have done little to address the risks faced by market participants if found to be unwittingly holding stolen allowances. This is not particularly helpful for the overall health of the emissions market.

Identification and recording of emissions allowances

Much like a land registration system, each emissions allowance within the EU ETS is currently identified by a unique serial number (called a unique unit identification code in the EU ETS registry regulation) and is recorded in one of the national Member State registers, depending on which Member State it has been allocated to. The Community Independent Transaction Log (CITL) supervises and verifies all transfers of allowances between national registries to ensure that they comply with the EU ETS rules.

Phase III of the EU ETS (commencing in 2013) will see a centralisation of the registry system, with all emissions transactions being carried out through a single EU registry, the European Union Transaction Log (EUTL). The central registry will be operated by the European Commission and will replace the individual Member State registries.

Theft of emissions allowances

Since the start of 2011 the emissions market has witnessed several incidents of allowances being stolen from national registries. Eastern European Member States in particular were affected, with millions of euros’ worth of allowances being lost when fraudsters broke into the electronic registry systems. This brought the emissions spot market to a halt in January 2011.

A substantial number of these allowances have not been recovered to this day. This is in spite of each allowance having a serial number, which in theory at least should make its movement through the accounts in the registries easily traceable. However, the approach of the Commission has been to leave the recovery of stolen allowances to the legal systems of individual Member States, without attempting to draft any generally applicable rules in this respect.

Where have all the serial numbers gone?

That derogating to individual Member States represents official policy in this area has been confirmed recently by the Commission’s intention to amend the EU ETS registry regulation to make serial numbers confidential. This means that any stolen allowances will no longer be capable of identification; the responsibility for holding them rests with their owner at any particular time.

The Commission’s proposal is that unknowing purchasers of stolen allowances should be allowed to keep them, while the interpretation of “purchaser in good faith” should be left to the national laws of each Member State. However, Member States have different rules regarding the tracing of stolen property. Emissions market participants would be left uncertain as to what they are holding in their registry accounts. They would no longer be able to identify which allowances are stolen, and would also be potentially liable to losing them if the law of a particular Member State stipulated that the allowances should be returned to their original owner.

Effects on the market

This level of uncertainty does not bode well for the emissions market and could seriously undermine the viability of the EU ETS. There have already been objections to the Commission’s proposal not to publish serial numbers. Coupled with this are the recent closures by some financial institutions of their emissions trading desks, amid fears that the market is too unstable to merit involvement. While the Commission’s attempts to address the security issues in the EU ETS are in themselves commendable, the approach has not so far elicited the desired response from the market.

Who will regulate? (Source: Sébastien Bertrand)

The EU ETS remains high on the UK Parliament agenda following a recent submission by Barclays Capital calling for an independent and separate regulator for the regime. The submission provides a much needed focus on some of the key peculiarities of the EU ETS which have been known to cause tension in the emissions market. In particular, the wide ambit of the EU ETS, open as it is to anyone who wishes to trade in emissions allowances (EUAs), is a potential cause for concern due to the inherent risks of market manipulation.

Who regulates?

The body currently in charge of managing the EU ETS is the European Commission, specifically the Directorate-General for Climate Action (DG CLIMA). Besides being responsible for developing and implementing climate change policy at the EU and international levels, DG CLIMA has the added task of supervising the workings of the EU emissions market.

What is somewhat surprising is the lack of express involvement of another Commission department that would logically have the requisite expertise in this area, namely DG Internal Market. After all, the bulk of the emissions market is made up not of spot trading, but rather of derivatives (specifically forwards) trading based on the EUAs as underlying assets, as this helps participants hedge against possible price volatility. The flexibility and openness of the emissions market has attracted large swathes of financial entities that trade in EUAs and EUA-based instruments for speculatory reasons rather than for compliance with the EU ETS.

The EU ETS – beyond environmental protection

The creation of such extensive emissions trading has taken the EU ETS from the purely environmental and regulatory sphere which it was initially intended to inhabit and placed it firmly in the realm of the financial markets. However, unlike other financial markets, the emissions market is not fully regulated as it is open to entities which are neither under EU ETS compliance obligations nor regulated as financial firms, notably under the Markets in Financial Instruments Directive (MiFID).

The risk of the Commission losing its grip over emissions trading has materialised on a number of occasions, with instances of VAT fraud and theft of EUAs from Member States’ national registries crippling the market. This is particularly damaging to investor confidence as it seriously undermines the credibility of emissions trading.

A sui generis regime?

This level of trouble has not been seen on any other commodities markets, and may suggest that emissions trading is in a class of its own and may require special treatment. The Barclays Capital submission suggests that participation in the market should be restricted to EU ETS and MiFID regulated firms, and that a separate regulator should be appointed that is independent of policymaking bodies. The latter measure would ensure that no public policy-based intervention would occur in respect of emissions prices. This point is particularly interesting given recent UK proposals to introduce a carbon price floor (see earlier Climatico post).

A special regulator in charge of the EU ETS would dilute DG CLIMA’s control over emissions trading as a tool of environmental protection as this goal would presumably have to be balanced against the merits of developing and maintaining a viable market in emissions in its own right. This may be a healthy outcome as it could enable the new regulator to harness the expertise of the EU financial regulation regime while bearing in mind that the EU ETS is a creature of public policy, and as such should pursue the environmental goal of emissions reductions. Whether the EU Commission has the resources or willingness to fashion this hybrid regulatory regime is of course another question.

What about the market? (Source: Financial Times)

As part of the latest budget the UK government announced its intention to introduce a price floor for the emissions market. It is hoped that this move will encourage low carbon investment by disincentivising regulated entities from emitting at current levels.

How this proposed unilateral measure will interact with the EU ETS remains to be seen. The purpose of emissions trading is to give polluters the discretion to decide whether to buy more EU emissions allowances (EUAs) in the market or invest in greener technologies, depending on which avenue is more cost-efficient. Having to pay a pre-set price for EUAs effectively removes this choice and distorts the emissions market as the cost-benefit calculation has already been performed by the regulator.

A tax by any other name…

The effect of the carbon price floor would be akin to that of a tax on emissions, since it would guarantee a minimum price level which UK polluters would have to pay to the government irrespective of the real market price of EUAs. It has not yet been clarified how this would operate in conjunction with trading under the EU ETS; one option would be to require polluters to make up the difference between the market price and the minimum set price. This would provide the UK with a hybrid tax-trade approach to emissions reductions, whilst the other EU Member States remain wedded to the EU ETS only.

A key advantage of a carbon tax over a trading system is the guarantee that the revenues from the former accrue to the national government rather than to polluters. This makes it more likely (at least in theory) that the money will be spent on low carbon initiatives rather than simply being reinvested in the polluters’ business or helping to boost their profits. The flipside is that regulated entities do not enjoy the cost-balancing flexibility associated with emissions trading. A proposed EU-level carbon tax was in fact rejected by industry in the 1990s.

Design issues

A cap-and-tax system could work well to reduce emissions if appropriately designed. Specifically, the price would have to be set at a level which is neither excessively high (so as not to seriously stall productivity) nor woefully low (which would be of little help in motivating polluters to reduce their emissions).

Of course, the price level would also have to take into account the fluctuations in the emissions market and would thus have to be crafted in a way which allows for any requisite adjustments.

What hope is there left for the market?

The proposed hybrid system makes the regulator’s job easier as it removes the uncertainty associated with fluctuations in the market price of CO2, which has recently fallen to around €12/tonne. This has been caused by overallocation of EUAs to polluters and decreased levels of productivity due to the difficult economic climate.

On the other hand, the whole point of having a market in emissions is that the price level is left to be freely valued by supply and demand, as with conventional markets. A cap-and-tax system would enable the UK government to artificially manipulate the price of EUAs and thus unilaterally interfere in the EU-wide emissions market as national environmental policy dictates. This is concerning as it undermines the very notion of market freedom on which the EU ETS is premised.

Either one or the other

Paradoxical as it may seem, if the EU emissions market is to function effectively, some level of price volatility is in fact desirable in order to incentivise entities engaged in emissions trading for investment rather than compliance purposes to take part. Tying the EU-wide price of carbon to Member State national environmental policy sends out the wrong signals as it strongly suggests that the market may not be genuinely free.

The UK government may be rightly concerned about the adequacy of the market price for carbon as a tool of environmental policy aimed at achieving emissions reductions. However, it cannot have it both ways without significantly diverging from the uniformity of the EU ETS.

Are these emissions real? (Source: Pavel Ahmed)

Emissions trading continues to court controversy following recent events which have seen Romania, an EU ETS country, suspended from trading its Kyoto Protocol emissions units by the UN. The knock-on effect has been to exclude Romania from the spot market in EU ETS allowances (EUAs) for a predicted period of six months.

This incident highlights the ease with which EUAs can be fashioned out of unverified emissions. In Romania’s case, a substantial surplus of Kyoto units (which can translate into EUAs) was created on the basis of inadequately reported emissions. It is therefore understandable that the UN has stepped in to prevent flooding the market with these “tainted” instruments. However, the actual existence of the units in the first place raises questions as to the verifiability of what feeds into the EU ETS.

Emissions reporting failures

The UN’s Kyoto Protocol enforcement branch found that Romania’s standards for monitoring and verifying projects which generated emissions units fell short of the UN-mandated requirements. Estimating emissions from forest management was identified as a particularly serious issue as they formed the bulk of the country’s greenhouse gas emissions.

As previously discussed on Climatico, the EU ETS has already experienced a host of problems generated by Member States’ shortcomings in adequately administering the trading of EUAs. However, the problem goes even deeper: the very emissions on which the EUAs are based are not always properly monitored. This means that EUAs do not necessarily guarantee the existence of corresponding efforts to cut down the release of greenhouse gases in the atmosphere. On the basis of figures not backed by properly verified and transparent reporting, Romania would have been able to use some of its allocated Kyoto units for compliance with the EU ETS. This could have had serious negative consequences for the scheme’s emissions reduction credentials.

Damage to the EU emissions market

The failures in verification have a potentially wider impact on the EU emissions market. The UN’s suspension of Kyoto units trading translates into Romania’s exclusion from spot trading of EUAs under the EU ETS. This may turn out to have grave effects on the EU emissions market as it causes uncertainty (since the date for lifting the suspension has not yet been firmly set) and could undermine general investor confidence in the market, according to the Joint Implementation Action Group. Since the viability of the EU ETS is premised on a liquid and functioning emissions market, this could deal another serious blow to its environmental goals.

More specifically, the suspension also hurts Romanian firms which are regulated by the EU ETS. This regime aims to incentivise polluters to reduce their emissions by allowing them to do so at the lowest cost. In theory at least, regulated firms can choose to cut emissions either by installing greener technologies or by trading EUAs in the market in order to cover their greenhouse gas output. Since a substantial part of the Kyoto units would have been allocated to Romanian firms for use within the EU ETS, the suspension has the effect of temporarily excluding these firms from the emissions market and thus damaging their reputation as market participants. This is another way to damage the EU emissions market as a whole by depriving it of valuable and much needed volumes of trade.

What is the alternative?

The UN’s apparently drastic response can be justified in view of the blow that would have been dealt to the Kyoto Protocol if unverified (and potentially ungrounded) emissions units would have been allowed into the market. On the other hand, credible arguments have been made that the damaging effects of this decision on the international market in emissions and the EU ETS far outweigh the risk of affecting the Protocol’s environmental integrity. Each path comes with its own caveats. It must not be underestimated how difficult it is to achieve a generally acceptable trade-off between successful environmental protection and a viable emissions market.

Support without supervision? (Source: Ian Chou)

Emissions trading sceptics will feel that they have been proven right in the wake of the latest news on the emissions market; the UK Financial Services Authority (FSA) has recently issued an official warning on carbon scams. The warning follows an increasing number of complaints from people who have been approached with potentially fraudulent emissions trading schemes.

In reality, there is little that the FSA can do, unless the investments offered fall within the (relatively restricted) list of instruments covered by the UK and EU financial regulation regimes. Letting most of EU emissions trading fall through the regulatory net could seriously distort this market at a time when environmental regulators are working hard to incentivise firms to invest in the EU ETS. Without investor confidence, the EU ETS cannot function to pursue its environmental goals.

The emissions market

Emissions allowances can be bought and sold by anyone, not just EU ETS regulated polluters; this is called the emissions spot market. Spot trading does not fall within the EU financial regulation regime as emissions allowances themselves are not considered financial instruments. It is only if the allowances traded take the form of instruments such as futures that EU financial supervision is triggered, as the activity may be a regulated investment service and would also be covered by market abuse legislation.

It follows that large swathes of the emissions market remain untouched by financial regulation, despite the potential for fraud against investors that the FSA warning has highlighted. The risk of unsavoury behaviour such as insider trading and market manipulation is therefore rife.

Does it matter?

This loophole has not gone unnoticed. In France, legislation was passed in late 2010 which would cover the emissions spot market in the same way as the market in emissions-based financial instruments, following recommendations in a government-commissioned report. Unfortunately, to date this has not been extended to other Member States or the EU in general.

Problems have already been experienced in the emissions spot market where fraudsters have managed to avail themselves of the lack of financial regulation. 2009 saw a number of widespread and very serious instances of VAT fraud which temporarily brought the Parisian carbon exchange BlueNext to a halt. The exchange experienced an inexplicable increase in trades which led to the exchange being closed and the French authorities declaring emissions allowances exempt from VAT. This measure caused trades to drop significantly, which may indicate the extent to which VAT fraud was driving a substantial number of them.

The effects of this uncertainty on the EU ETS could be considerable. Without investor confidence in the quality of the emissions market, the EU ETS, premised as it is on the continued ability to trade valuable allowances which are genuine and verifiable, would not work.

EU-level action

These occurrences may justify the classification of emissions allowances as financial instruments under EU financial regulation, which would mean that traders in the spot markets would be subject to considerably more stringent regulatory requirements. This means more compliance costs for firms and more supervisory costs for regulators. However, this would arguably be a small price to pay to safeguard the integrity of the emissions market and thereby ensure the continued success of the EU ETS.

It is encouraging that the EU Commission has recognised the gravity of the incidents and has been running a consultation process to identify ways to improve market oversight. It remains to be seen what improvements will materialise.

Grounded? (Source: David Jones)

The EU’s commitment to taking serious action on aviation emissions has been courting controversy of late due to its proposed inclusion of the international transport sector in the EU ETS. From 2012 all arriving and departing flights in the EU will have to be covered by corresponding emissions allowances (EUAs).

Regulating flight operators will be entrusted to individual Member States. This raises the issue of effective enforcement by countries who have a less than satisfactory track record in preventing fraud in the emissions market. Added to this is the problem of increased administration costs as levels of EUA allocations will have to be decided for a substantial number of airlines. International operators have been left feeling alienated and sceptical of the EU’s ability to direct resulting funds towards pursuing environmental goals.

Monitoring and enforcement

Each of the 27 Member States will be responsible for administering the application of the EU ETS to a number of designated operators. Once the EU Commission has decided how many EUAs will be allocated to each country, the Member States will be charged with calculating and allocating the appropriate levels of allowances to the airlines.

The number of operators within each Member State’s jurisdiction is significantly higher now that international operators are also included. While some countries have a good history of administering the allocation and trading of EUAs, in the past others have been hit by incidents of theft of EUAs from national registries and large-scale VAT fraud. The emissions market was brought to a standstill following attacks in early 2011. Competent registration and monitoring of EUAs is therefore paramount if the EU ETS is to work in its extended format.

Only time will tell if we can trust the Member States to live up to their task. The introduction of a new, centralised emissions registry at EU level from 2012 will hopefully address this concern, as managing the emissions market will no longer be within the ambit of individual Member States. However, this in turn may create its own problems of increased bureaucracy. The EU Commission could be in danger of spreading itself too thin in an attempt to regulate an overly challenging number of aviation operators.

Increased administration costs

Since Member States will have to decide on the levels of allocation to each operator, they will need to expend significant resources on analysing large amounts of unfamiliar emissions data from operators. This information is likely to be in a non-standardised format which may well differ between airlines and thus increase the administrative burden. To what extent the Member States will have the capacity to verify the accuracy of the data is also something that remains unclear.

How to achieve real results?

International operators have been complaining about the lack of transparency prevalent in the EU regarding the destination of the income raised from auctioning allowances. They are particularly worried that the revenues raised will simply be absorbed by individual Member States rather than spent on green technology R&D or emissions reductions. This is in addition to general opposition to the application of the EU ETS in a way which is perceived as illegal in its disregard for non-EU states’ sovereignty.

The combination of mistrust on the part of operators and the questionable capacity of the EU mechanisms to adequately police the extension of the EU ETS outside its territorial remit is a potentially toxic one. In reality, is it really likely that the EU will apply the ultimate sanction of excluding non-compliant operators from its airspace? Without the possibility of effective enforcement, the expansion of the EU ETS may only serve to antagonise instead of achieving environmental results.