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.
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.