Reforms to the EU Emissions Trading System designed to limit financial entities' access to the carbon market could reduce liquidity and make it more expensive for compliance entities to hedge for the future, market experts say.
The warnings come ahead of a European Parliament vote on the revision of the EU ETS, scheduled to take place in early June. On 17 May, the European Parliament’s environment committee (ENVI) endorsed an amendment to limit financial entities' access to the ETS, which some blame for carbon prices soaring to record highs earlier this year.
The amendment proposes that by January 2025 only compliance entities in the system and their financial intermediaries can operate accounts in the carbon registry used to transfer allowances.
However, the amendment requires the European Commission to publish a report assessing how restricted access to the ETS would impact the integrity and effective functioning of the carbon market. The report is due by July 2023 before any proposal can come into force.
According to Lawson Steele, the former head of carbon and utilities research at Berenberg who speaks widely on the topic, any move to limit trading by financial entities in the carbon market would be "really bad news for the EU".
"The liquidity and price discovery they provide is both important and significant," Steele tells MarketVoice. "Mechanisms such as Article 29a [in the current ETS rules] are in place to stop the price rising too quickly, and this is what [lawmakers] should focus on," he said.
Cornerstone
The reform of the EU ETS was first put forward by the European Commission in July 2021 as part of its ambitious “Fit for 55” package of legislative proposals, which aim to pave Europe’s way to reducing greenhouse gas emissions by 55% by 2030 compared to 1990 levels.
To come into force, the Commission needs backing from the European Parliament and member states in the EU Council. Each institution has the right to propose its own changes to the ETS reforms. Later this year, the two institutions and the Commission will begin talks about the final shape of the reforms.
The ETS, made up of a primary market of allowances (EUA) and a secondary market of derivatives based on allowances, is the cornerstone of the EU's climate policy. It sets a cap on the total amount of CO2 that can be emitted by energy-intensive companies each year, and this cap declines over time. Companies buy these allowances and trade them in the market to fulfill their annual needs.
Companies that reduce their emissions below the target level—for example by switching to cleaner fuels—can sell those excess allowances. The goal is to create economic incentives for companies to reduce their emissions, with market dynamics of supply and demand determining the price of EUAs.
While most EUAs are held and traded by companies that need them to comply with the ETS, banks, brokers and investment firms also participate in the market to take positions and facilitate trading between counterparties.
"For markets to function well, financial institutions or 'speculators' are needed to take the opposing positions to hedgers to allow the hedgers to reduce their risk exposure," said Jostein Kristensen, a partner at consultancy Oxera and author of a recent report that provides an economic assessment of the EU ETS.
"This is even more the case in the carbon market, where there is generally only one supplier of emissions allowances—the government—while there are many natural buyers whose emissions are covered by the EU ETS that often seek to hedge their carbon price risk," he added.
"By opening up trading opportunities to a broader, more diverse group of market participants, the carbon market has become more resilient and better at providing risk-management solutions to companies."
Divided opinion
Nevertheless, the recent ENVI vote brings into sharp focus the perennial debate among policymakers over the impact of speculators in commodity markets.
Energy costs in particular are a hot-button issue, particularly since the 2018 "gilet jaunes" protests in France. Tension has intensified among policymakers in recent months as carbon prices have reached new highs around the same time as energy bills have skyrocketed.
In February, EUAs leapt to a record high of €98.49 per tonne of CO2 after increasing by almost 150% in 2021. Analysts such as Steele say the CO2 price needs to be higher than €100 euros per tonne to make cleaner fuels and technology competitive with polluting alternatives.
But rising CO2 costs have stoked political tensions and prompted several European member states, particularly Poland and Spain, to call for the Commission to intervene in the EU ETS and exclude financial entities. They blame trading activity and "excessive speculation" by financial players for the spiralling CO2 prices.
For Poland, a country that relies on coal for more than 70% of its power, cushioning the impact of higher energy prices on consumers has become a top political priority.
Market regulators, economists and carbon analysts, however, say the price of carbon has risen mainly because of fundamentals, with speculative positions currently too small to be statistically significant.
In particular, they point to natural gas price rises, which have encouraged electricity producers to switch from gas to coal-fired power generation thereby increasing the demand for EUAs, as well as the EU's climate policy reforms.
ESMA report
One such regulator is ESMA, which began investigating trading behaviours in the EU ETS at the behest of the Commission late last year following concerns about excessive speculation. In March, ESMA published its final report which found no major problems in the functioning of the market, although ESMA did recommend the possible implementation of position limits for derivatives.
The report echoes conclusions from its preliminary assessment last November which found that speculative activity makes up only 4% of the EU ETS market.
According to the ESMA report, non-financial entities (CO2-emitting companies) mainly held long positions in carbon derivatives for hedging purposes. Short positions are mainly held by banks and investment firms, providing liquidity and carbon financing. Positions by investment funds remain limited, the report finds, adding that the evolutions of carbon prices and volatility are in line with market fundamentals.
Speaking on a webinar organised by Euractiv on 27 April about possible impacts of excessive speculation, Fabrizio Planta, the head of ESMA's markets and data reporting department, reiterated the findings of the report, saying there were no major abnormal issues with the ETS market.
"Any measure to limit the presence of financial firms in other countries has had a negative effect in the past. Studies have clarified this in places like China and South Korea," Planta said.
"Our conversations with compliance entities—energy companies—show they are generally happy with how the market is functioning," Planta said, adding that limiting the presence of financial firms was "not a solution."
Economists at the European Central Bank have also weighed into the debate with a short report published in April that echoes the view of ESMA. The report says that the sharp rise in CO2 prices since the beginning of 2021 has been driven in large part by a mix of higher gas prices, colder weather causing energy demands to rise, shrinking allowance supply and the adoption of the Fit for 55 climate and energy package.
As such, and citing ESMA’s work, it said "tangible evidence of a strong increase in speculative activity related to potential changes in market structure appears scarce."
Crucial role
As the Parliament vote draws nearer, market participants are keen to point out the benefits of financial institutions participating in the EU ETS.
"The more participants you have, the better the price discovery will be, and this is important," said Steele. "If we're trying to reduce our emissions by 2030 then we need the carbon price to be a signal that it is financially viable for companies to invest in other processes to reduce carbon emissions."
In a co-signed letter to the Commission in February, ten trade associations, including FIA, The International Emissions Trading Association, Eurelectric and the European Federation of Energy Traders, among others, said the ETS market consists of a wide variety of participants – each of which has a critical role in the efficient functioning of the market and reaching Europe’s decarbonisation targets.
"Restricting the participation of financial and non-financial actors would run the risk of weakening the market. It would make it more expensive and complex for compliance entities to hedge for the future and plan for investments into low carbon alternatives. It would reduce the ability of this group to access the market via financials and it would cut liquidity, driving up transaction costs and uncertainty for all participants," the letter says.
"The result of lower liquidity would be increased volatility and would significantly reduce the economic relevance of long-term price signals."
Next steps
The proposals recently agreed by ENVI will be put to a vote between 6 and 9 June by the whole Parliament, which may add further amendments. Member states in the EU Council are also discussing their own changes to the ETS overhaul and will likely announce their opinion at the end of June. Tripartite negotiations among the three EU institutions will begin in September.
[This article was updated on 23 May following the ENVI vote. The original article can be accessed here]
