Emissions Allowances - Extended Scope of Financial Instruments under MiFID II
The MiFID II Directive has been a significant catalyst for the much-needed overhaul in the European financial regulatory market. MiFID II has extended its regulatory confines over financial instruments. The serious concerns attaching to the unregulated spot trading market and resulting fraudulent practices have been the much needed propellant bringing emission allowances under the purview of MiFID II. Emissions have in fact been accorded the full status of financial instruments, as a new category under MiFID II[1].
Transactions in emissions trading are generally two-fold with the vast majority of transactions involving derivative instruments and the remainder classified as spot contracts.[2] In contrast to MiFID, which solely regulated emissions derivatives, MiFID II seeks to classify all emission allowances as financial instruments. Such classification has effectively sought to ensure that regulation is extended to cover both derivatives and spot market trading, hence attributing to both the same levels of obligations in terms of transparency, investor protection and integrity.
How will Operators of Spot Market Transactions be affected?
The effect of MiFID II will be such that operators of spot transactions will require authorisation from the relevant financial regulator for the continued provision of investment services or related activities.
More specifically, the following services and activities will now be caught by the Regulation:
- dealing on own account;
- dealing on behalf of clients;
- reception and transmission of orders;
- investment advice;
- safe-guarding and administration of clients’ assets (custody)
Naturally, other standard requirements, which a regulated entity is typically exposed to, will also be in force. For instance, the operator will be expected to engage in know-your- customer checks, transaction reporting and record keeping, and also to comply with financial promotion rules, investor protection rules and capital requirements. Conduct of business requirements (terms and conditions of business for clients) and organizational requirements (systems and controls, management structures) will also be applicable. [3]
Exemptions
MiFID II provides a certain degree of leeway to those companies whose emissions activities are ‘ancillary’ to their main business. Moreover, the latter concerns both spot and derivatives trading, but not operators making use of high frequency algorithmic trading techniques.[4] Companies whose emissions activities are indeed ancillary, would be exempt from regulating their trading in spot markets and consequently discharged from obtaining authorisation from the Regulator.
The ancillary activities exemption captures two different types of firms:
- Firms dealing on own account, including market makers, in commodity derivatives or emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders;
- Firms providing investment services, other than dealing on own account, in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business. [5]
The European Commission has commented with respect to the technical criteria which will be used to establish the exact meaning of ‘ancillary’ in determining when an activity falls to be considered as such in relation to the company’s main business at a group level.
An activity is deemed to be ancillary and thus allowing a company to avail of the ancillary activities exemption, if it satisfies the respective thresholds set out in the following tests:
Market Share Test: The first test compares the level of a person’s trading activity against the overall trading activity in the Union on an asset class basis to determine the person’s market share.[6] Hence such a test determines whether the persons in the group are large participants relative to the size of the financial market in that asset class and as a consequence be required to obtain authorisation as an investment firm.
The threshold for the emission allowances asset class is set at 20%, meaning that a firm falls below the threshold if its trading activity is less than 20% of the overall EU carbon market activity. Hedging transactions are not taken into account for this test, when calculating a firm’s trading activity.[7]
Main Business Test: The second test assesses the size of the trading activity, excluding privileged transactions and transactions executed by authorised entities of the group, undertaken by the group in all asset classes against the size of the overall trading activity, including privileged transactions and transactions executed by authorised entities of the group, undertaken by the group in total for all asset classes. [8]
The activity is considered to be ancillary to the main business of the group, and the firm is thus exempt, where the size of the trading activities does not account for more than 10% of the total size of the trading activity of the group. This applies provided that the Market Share Test threshold is also met.
By way of derogation, if the size of a firm's trading is:
- 10-50% of its total trading, it constitutes a minority of activities at group level only where the size of the trading activity for each of the asset classes accounts for less than 50% of each threshold in the market share test (i.e. less than 10% for EUA trading); or
- equal or above 50% of its total trading, ancillary activities shall be considered to constitute a minority of activities at group level only where the size of the trading activity for each of the asset classes accounts for less than 20% of each threshold in the market share test (i.e. less than 4% for EUA trading). [9]
[1] ‘emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme)’ MiFID II Annex 1, Section C [11]
[2] A spot contract is understood as a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made within the longer of the following periods:
- two trading days;
- the period generally accepted in the market for that commodity, asset or right as the standard delivery period
[3]Shearman and Sterling LLP, ‘Proposed Regulation of EU Emissions Allowances as Financial Instruments’ (2011)
[4] IETA – Climate Challenges, Market Solutions, ‘MiFID II: how will it impact participants in the EU ETS?’ < http://www.ieta.org/resources/MarketOversightWG/MiFID%20II%20Briefing_final_29_10.pdf>
[5] MiFID II Directive [20]
[6] ESMA, ‘RTS 20: Draft regulatory technical standards on criteria for establishing when an activity is to be considered to be ancillary to the main business’, [3]
[7] Commission Delegated Regulation (EU) of 1.12.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business’, Article 2(1)(h)
[8] ESMA [6].
[9] Commission Delegated Legislation (EU), Article 3
