What is market oversight and why is it important?
The European carbon market has grown significantly both in size and sophistication during its first six years of operation, but it remains a relatively young market. The purpose of the EU Emissions Trading Scheme (EU ETS) is to ensure that the greenhouse gas emission reductions that are necessary in the participating sectors are made at least cost. It is therefore important to ensure that the market can continue to expand and be relied upon to give an undistorted carbon price signal. It follows that there needs to be an appropriate market oversight framework, the main purpose of which is to secure fair and efficient trading conditions for all market participants. This is achieved by way of transparency requirements as well as by preventing and sanctioning market misconduct, in particular insider dealing and market manipulation. However, the framework should be broader than that and also provide safeguards to minimise the risk that the carbon market is used as a vehicle for other illegal activities, such as VAT fraud (see also the reply to the last two questions).
Why has the Commission issued a Communication on carbon market oversight?
Article 12(1a) of Directive 2003/87/EC1 provides that the Commission, by 31 December 2010, shall examine whether the market for emission allowances is sufficiently protected from insider dealing and market manipulation.
In this Communication the Commission gives a first assessment of the situation.
What is the Commission’s conclusion at this stage?
The carbon market in Europe has developed well since the launch of the EU Emissions Trading Scheme in January 2005. From a market oversight perspective, it can be concluded that a major part of the carbon market is subject to appropriate market regulation already, namely the trading in derivatives of allowances and other units that can be used for compliance in the EU ETS (currently CERs and ERUs), which largely falls under financial markets regulation. However, the spot trading in emission allowances is currently not regulated at EU level, while a handful of Member States have decided individually to extend rules applicable to trading in financial instruments to such allowances when traded on spot markets established within their jurisdictions. The spot market is relatively limited and represented no more than 20-25% of the total trading volume in the European carbon market in 2009. More details on the structure of the carbon market are given in the Communication itself.
What are the next steps?
During 2011, the Commission will examine in greater detail the current level of market oversight and in particular the options available to enhance it (incl. the classification of allowances as a financial instrument).
How will stakeholders be involved?
An internet-based stakeholder consultation will be conducted in the first half of 2011. Stakeholders who are familiar with the carbon market and its interactions with energy and financial markets are encouraged to respond to the stakeholder consultation and advise the Commission on the best way to protect this market from any form of market misconduct.
In addition, an ongoing public stakeholder consultation2 relating to the review of the Market in Financial Instruments Directive3 (MiFID) also addresses the carbon market, notably the option to classify emission allowances as a financial instrument. The consultation is open until 2 February 2011.
Will the Commission issue a legislative proposal and if so, when can it be expected?
If the results of further work and consultations indicate that the level of market oversight should be enhanced, the Commission would present such a proposal in 2011.
Any legislative proposal to introduce an enhanced oversight framework for the carbon market must be based on careful analysis and impact assessment. The benefit of any safeguards ensuring market integrity will be weighed carefully against any negative impacts on liquidity and on access to the carbon market for different participants (notably small emitters, SMEs). The Commission will strive to ensure maximum consistency between financial markets legislation, energy markets legislation and any rules to be developed for the carbon market.
How does the work done on carbon market oversight relate to the work on energy market oversight and financial market oversight?
In view of the structure of the carbon market as regards products traded (derivatives), trading venues (often multilateral trading facilities or regulated markets under financial markets regulation) and participants (large share of financial intermediaries), the ongoing work on enhancing the oversight of financial markets will directly enhance the level of oversight in the carbon market as well. While the Commission’s proposal for an integrity and transparency framework for the energy markets does not apply directly to any part of the carbon market, it is relevant in the sense that it concerns a market with significant linkages to carbon trading. Its introduction may have a disciplining effect on the overall market conduct of certain actors with presence in both the energy and carbon markets.
What are the options for enhancing the carbon market oversight framework at this stage?
A priori, the Commission has identified a number of options, the costs and benefits of which will be assessed in a study. One option is the inclusion of the European carbon market under financial markets legislation, e.g. by replacing the currently existing spot trade by trade in “spot futures”4 admitted to trading in regulated markets. The option to define EU ETS compliance units as financial instruments will also be explored, with particular focus on the suitability and proportionality of such an approach. Bringing spot transactions in EU ETS compliance units – as instruments in their own right – under the ambit of rules set out in the Market Abuse Directive and/or the Markets in Financial Instruments Directive as well as any other financial markets legislation necessary for the efficiency and integrity of the carbon market is an alternative that will also be studied.
Would any market oversight rules adopted for the EU ETS apply only to emission allowances or also to CERs and ERUs that can also be used for compliance in the EU ETS?
This question will be studied in more detail in 2011, but it is likely that any new market oversight provisions would apply to all units that can be used for compliance in the EU ETS.
Will the introduction of large-scale auctions of allowances in phase 3 not create new risks for the integrity of the market?
No, despite the fact that auctions of phase 3 allowances will be spot, the Auctioning Regulation contains specific provisions that apply to auctions which protect the integrity of the market. In addition only “regulated markets” are allowed to function as an auction platform. A “regulated market” is the type of multilateral trading platform which is subject to the most comprehensive regulation under financial markets legislation.
What fraudulent behaviour has occurred in the carbon market and what did the Commission do to address it?
During 2009 and 2010, three types of incidents occurred in the carbon market, which illustrates the wider range of risks that need to be dealt with: (i) Value Added Tax (VAT) fraud, (ii) so-called “phishing attacks” on holders of accounts in the electronic registry, and (iii) resale by a Member State of Certified Emission Reductions (CERs) that operators had already used for compliance under the EU ETS. If used credits re-enter the European carbon market, market actors do not know whether any one credit can still be used for compliance, or whether it has already been used once. Such uncertainty must be avoided.
The Commission reacted swiftly to all of these incidents, and will not hesitate to do so again, should new risks emerge in the market.
Firstly, a Directive enabling Member States to apply reverse charging of VAT to allowances and other units that can be used for compliance under the EU Emissions Trading Scheme was adopted in March 2010 and entered into force in April 2010.
Secondly, a number of amendments have been made to the Registries Regulation5. These measures formally entered into force in October 2010 although some could be applied earlier. The measures include reinforcing the requirements for opening an account in the electronic registry and giving National Administrators the power to refuse to open a new account in the registry. National Administrators are also able to suspend or close accounts, subject to an appeals procedure. Finally, the Regulation now clearly states that CERs or ERUs that have been surrendered for compliance can only be transferred into a retirement account and may not be surrendered again nor transferred to an operator account or personal holding account in the EU ETS.