Emission allowances trading: some financial services regulatory considerations

May 2024  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2024 Issue

The European Union (EU) Emissions Trading Scheme (ETS) is a cornerstone of the EU’s policy to combat climate change and its key tool for reducing greenhouse gas emissions. Europe is the world’s first major carbon market and remains the largest one. The EU ETS (on which the UK ETS is closely modelled) is a complex part of the regulatory architecture aimed at reducing greenhouse gas emissions.

There are myriad environmental regulatory considerations to be dealt with, but financial services (FS) regulation also impacts the area. In particular, there are challenges for firms conducting cross-border activities in relation to emission allowances with EU residents from outside the EU.

The UK

There are two types of specified investment under the Regulated Activities Order (RAO) for the purpose of the UK ETS: (i) emission allowances themselves and certain derivatives where an allowance is the underlying asset; and (ii) emission allowances that are auctioned as financial instruments or two-day emissions spots (together, ‘emissions auction products’).

Importantly, emission allowances are only specified investments if a firm (such as a Markets in Financial Instruments Directive (MiFID) firm, a credit institution, a third-country firm or an operator of a multilateral trading facility) is performing investment services or ancillary services in relation to them.

The emissions auction product specified investment relates only to the regulated activity of bidding in emissions auctions (whereby a bid is received, transmitted and submitted on an auction platform). Two forms of allowance product may be auctioned: two-day spot and five-day futures.

Bidding in emissions auctions does not form part of any other regulated activity and so a person seeking to carry on bidding activity will only require permission for bidding in emissions auctions to do so and will not require permission for any other regulated activities (article 24A(2) of the RAO).

An emission allowance is a security. This means that any person wishing to carry out any activity in relation to it will need to consider whether any of the regulated activities relating to securities apply. This envisages the broader range of regulated activities (e.g., dealing as principal, dealing as agent, arranging deals in investments and making arrangements with a view to transactions in investments) applying to emission allowances in contrast to the single regulated activity that applies in relation to emissions auction products.

Auction participants will need to register with the Intercontinental Exchange (ICE) as the appointed auction platform. Auction participants will also require an account in the UK Emissions Trading Registry. Entities can open a UK ETS account to take part in auctions.

Once allowances have been released through auctions and free allocation, they can be traded on the UK ETS secondary market. The secondary market provides a means for market participants to source allowances outside auctions and free allocation, and it enables participants to plan ahead through hedging future carbon costs.

ICE Futures Europe hosts a secondary market for UK allowance derivatives. In approaching the UK market, firms from third countries will generally benefit from exemptions under the financial promotion regime to do business with professional clients and eligible counterparties, such that UK authorisation might not be required.

The EU

Emission allowances are ‘financial instruments’ for the purpose of MiFID II. Accordingly, investment and ancillary services in relation to them are regulated in the EU and a person providing such services in the EU would generally need to obtain a licence from the relevant financial regulator in the member state where they are being provided.

This includes a person from a non-European Economic Area (EEA) state that carries on regulated activities in the EEA – a ‘third-country firm’. If a third-country firm wishes to carry on regulated activities on terra firma in an EU member state in relation to financial instruments it must do so through a licensed branch or subsidiary unless it is otherwise exempt – e.g., where the service provider is ‘an operator with compliance obligations’ dealing on its own account and not executing client orders or acting for third parties (an exemption which applies equally in the UK).

An ETS trading account will be required in the EU for the purpose of trading in the secondary market but it may be established in any member state and an authorised representative in the relevant member state appointed to operate the account for the participant.

Under the EU regulatory system, it is possible in certain circumstances for third-country firms to engage with EU resident clients without the need to be licensed in the EU. Broadly, an exemption from licensing may be available where: (i) the business is conducted on a ‘reverse solicitation’ basis; (ii) in the case of certain categories of clients, a member state has adopted a third-country regime which would permit certain third-country firms to engage with such clients and provide regulated services without having to obtain a licence; or (iii) the European Commission (EC) has adopted an equivalence decision in accordance with the EU legislation in relation to the third country which would allow the third-country firm to provide services to certain types of clients in the EU subject to compliance with certain conditions.

The availability of any exemption from a licensing requirement will depend on the nature of the client, the service provided or the activity being conducted, the specific requirements of the member state of residence of the client and the categorisation of the client.

MiFID II does not restrict the performance of investment services and activities with EU clients by third-country firms on a cross-border basis where this is at the client’s “own exclusive initiative”. This is the reverse solicitation exception. In its Q&A paper on MiFID and MiFIR investor protection and topics, the European Securities and Markets Authority (ESMA) provides guidance on the operation of the reverse solicitation exception.

Recital 111 of MiFID II states that where a third‐country firm solicits clients or potential clients in the EU or promotes or advertises investment services or activities together with ancillary services, it shall not be deemed to be a service provided at the own exclusive initiative of the client.

ESMA is of the view that such solicitation, promotion or advertising should be considered regardless of the person through whom it is issued: to have been issued by the third-country firm itself, an entity acting on its behalf or having close links with such third-country firm or any other person acting on behalf of such entity.

ESMA’s position is that every communication means used, such as press releases, advertising on the internet, brochures, phone calls or face to face meetings, should be considered to determine if the client or potential client has been subject to any solicitation, promotion or advertising in the EU on the firm’s investment services or activities or on financial instruments.

Further a reverse solicitation in the first instance does not entitle the third‐country firm to market new categories of investment products or investment services to that client other than through the branch, where one is required in accordance with national law. Indeed, in ESMA’s opinion, the reverse solicitation exemption is based on the premise that the product or service is marketed at the client’s own exclusive initiative and can only be applied to the specific product or service requested.

Therefore, when providing a one-off investment service to a client, the third-country firm may not sell to that client a product or service from the same category unless requested to do so by the client at its own exclusive initiative and only at the time the client asks for an investment product or service.

It is readily apparent from the foregoing, that the reverse solicitation exception is narrowly construed in the EU and should not be relied upon as a basis for a business model.

Article 46(1) of the Markets in Financial Instruments Regulation (MiFIR) creates an exception which allows third-country firms the right to provide investment services or perform investment activities (with or without any ancillary services) to EU-eligible counterparties and per se professional clients without establishing a branch and without being subject to supervision by an EU competent authority. However, to qualify for this exception the firm must be registered in a register of third-country firms maintained by ESMA.

ESMA will maintain the register and will register a third-country firm that has applied for the provision of investment services or performance of activities throughout the EU in accordance with article 46(1) only where the following conditions are met: (i) the EC has adopted an equivalence decision in relation to the third country in accordance with article 47(1) of MiFIR; (ii) the firm is authorised in the jurisdiction where its head office is established to provide the investment services or activities to be provided in the EU and it is subject to effective supervision and enforcement ensuring full compliance with the requirements applicable in that third country; and (iii) cooperation arrangements have been established between the third country and the EU.

A third-country firm that provides services in the EU on a cross-border basis under article 46 of MiFIR must tell its EU clients, before the provision of any investment services, that it is not allowed to provide services to clients other than eligible counterparties and per se professional clients and that it is not subject to supervision in the EU. The firm must also give the name and the address of the competent authority responsible for supervision in the third country. This information must be provided in writing and in a prominent way (article 46(5) of the MiFIR).

To date, an equivalence decision has not been adopted by the EC, so that the register has not been activated. This does not mean, however, that cross-border business from a third-country is impossible – article 46(4) MiFIR provides that member states may allow third country firms to provide investment services or perform investment activities together with ancillary services to eligible counterparties and per se professional clients in their territories in accordance with national regimes in the absence of the EC adopting an equivalence decision in accordance with article 47(1).

Furthermore, article 54(1) of MiFIR provides transitional relief, allowing a third-country firm to continue to provide services and activities in an EU member state under the state’s national regime for three years after the EC does eventually adopt an equivalence decision relating to the relevant third country.

The attractive benefit of the article 46 MiFIR regime is that registration under article 46(1) of the MiFIR will entitle a third-country firm to conduct business with eligible counterparties and per se professional clients throughout the EU on a cross-border basis without any further formalities in relation to any member state.

The national third-country regimes, to the extent that member states have them, obviously only apply on a state by state basis and the position in each relevant jurisdiction ought to be analysed before a firm conducts business there. Indeed, the position varies enormously among member states: from those with no third country permissive regime at all (such as France), to those which require a notification to the regulator (such as Belgium), to those which require some form of third country licence or registration (such as Denmark).

In conclusion, the regulated emission allowances market under the UK and European trading schemes is very involved and its complexity is enhanced by the overlay of financial services regulatory requirements where they apply. Currently, rules approaching the EU market are not harmonised and an analysis of the position in each relevant member state needs to be undertaken to understand the relevant FS regulatory requirements.

 

John Ahern is a partner at Watson Farley & Williams LLP. He can be contacted on +44 (0)20 7814 8000 or by email: jahern@wfw.com.

© Financier Worldwide

BY

John Ahern

Watson Farley & Williams LLP

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