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.

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