EU regulator advises stepped-up EU ETS financial trades scrutiny

Following concerns raised by Spain, a regulator's review of the EU's main carbon trading mechanism has cleared financial market players of blame for meteoric carbon price rises but still wants to rein them in.

The EU's financial regulator, the European Securities and Markets Authority (ESMA) found that new laws had not led to manipulative trading of emission allowances (EUA) in the EU Emissions Trading System (ETS) in a 28 March report. The EU ETS is seen as the EU's key lever for reaching net-zero under a proposed Fit for 55 package of policies.

In its report, ESMA noted that "The various segments of the EU carbon market appear to broadly function as expected" and there were currently no "major deficiencies" in how it operates.

Non-compliance buyers, such as banks and investment firms, have been legally allowed to use EUAs as investments since 2018. Related investing rose in the second half of 2021, according to Budapest-headquartered broker Vertis Environmental Finance.

Spain argued that this activity was increasing appetite for EUAs required by power generators and hiking electricity costs paid by consumers in a 30 September paper sent to the European Commission (EC).

But ESMA found "relevant firms are only holding very small or no actual positions." As such, it advised considering new rules governing the firms to ensure "fair and orderly" markets, but it warned a shorter leash for firms could not keep EUA price swings in check.

Carbon market scrutiny recommended

ESMA suggested better monitoring, transparency and, potentially, new regulations for financial market players.

For example, it suggested amending the EU Auction Regulation to ensure that ESMA is updated on transactions in the primary EUA market.

Other measures could potentially come in the form of position management controls and position reporting for EUA derivatives. Transparency measures might include reporting on futures, on top of current combined reports that include futures. This could take the form of, for example weekly reports on open positions in futures and counterparty classifications, among other things.

It said a closer watch on financial markets was needed to keep enough EUAs in circulation. "[T]he emergence of new participants (and instruments) with buy-and-hold strategies warrants future monitoring to the extent that they may lead to a reduction in the supply of physical emission allowances available for trading, even though the available evidence suggests that their impact is only limited so far," said ESMA in the report.

EUA account holders could also be better identified in the EU Registry that keeps track of the ownership of allowances.

ESMA regretted that a lack of data on "who trades what from where" had proved a challenge when trying to investigate the carbon trading claims.

It advised that the EU's co-legislative bodies take the report and consider whether more carbon market rules are necessary.

ESMA offers to monitor EU ETS

ESMA weighed up the pros and cons of EU-level monitoring of carbon markets, now undertaken by the authorities in individual EU member states, to prevent future "abuse."

It presented six arguments in favor and four against a central watchdog, but said more research was required.

A centralized watchdog could detect market manipulation, apply limits on holdings of derivative open positions, and could also facilitate cross-market monitoring, for example of not only EUAs but also wholesale gas or power markets, it said.

These markets are currently the subject of EC legislative proposals to tame gas price volatility and ease price pressure on consumers.

ESMA's preferred structure was joint EUA market surveillance by three countries — the Netherlands, Norway and Germany — in order to "swiftly" enhance the market monitoring of the bloc-wide carbon market.

The alternative to this could be a modeled on how the EU's Agency for the Cooperation of Energy Regulators (ACER) regulates EU wholesale energy markets, where ESMA acts in the place of ACER.

Ukraine war lowers carbon price

At the start of March, war in Ukraine and worries of Russian gas shortfalls caused compliance buyers to sell-off of EUAs, seeking to raise liquidity amid energy price concerns. A parallel drop in demand for EUAs caused prices to fall 35%, according to the research arm of Dutch digital banking group ING.

The war in Ukraine has had a "major impact on the carbon market," found ESMA, although it observed the carbon price has since recovered.

The regulator noted that EU ETS market participants' belief that fossil fuel would be needed less in the EU — whether due to gas supply disruptions, Russian gas import bans or assumptions of economic downturn — may have caused the temporary collapse in the carbon price.

Despite this volatility in early March, financial market players see the report as further confirmation of the resilience of the current EU ETS regulations. "Remember, since the selloff that stoked fears of policy reversal we have had: [EU ETS price control policy] Market Stability Reserve reaffirmed, Fit-for-55 reaffirmed and the 'no major deficiency' report from ESMA communications," tweeted Managing Director, Head of Climate Investments and Strategy at ETF provider KraneShares on 29 March.

Posted 31 March 2022 by Cristina Brooks, Senior Journalist, Climate and Sustainability

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.