On 31 March 2008, the United Kingdom’s Financial Services Authority (FSA) published “The Emissions Trading Market: Risks and Challenges Report” (Report), which sets out its views on the risks present in the new and expanding emissions market, and the possibility of them affecting the FSA-regulated derivatives market.
Throughout the Report, the FSA makes it clear that presently it does not regulate the emissions market. However, in light of the rapid growth of the emissions market, the Report is important because the FSA states it still has responsibilities to review the market, as it may affect activity which the FSA does regulate, specifically the emissions derivative markets. In the Report, the FSA delineates its regulatory remit with regards to commodity and exotic derivatives by reference to the EU Markets in Financial Instruments Directive (Directive 2004/39/EC), the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, the Financial Services and Markets Act 2000, and other related legislation, as well as summarising its collaborative role with other entities and regulatory bodies.
The FSA identifies a number of risks associated with the emissions market and offers suggestions to mitigate such risks, including, inter alia, the following:
- Foundation of the emissions market: market confidence is at risk where a balance between supply and demand cannot be achieved. Common standards must be set, and interconnections between relevant markets must be maintained to allow a more flexible and liquid emissions market.
- Integrity of the emissions market: market integrity is at risk where participants exploit the link between the products they offer and any climate change advantages, where the advantages that could be derived are actually minimal.
- Integrity of emissions market participants: the FSA is aware of certain firms holding out FSA authorisation which has not been granted with specific regard to emissions trading. This gives the incorrect impression the FSA is potentially endorsing activities which are (presently) out of its remit.
- Lack of experience and risk management: as the emissions market is in its infancy, many firms’ risk management policies might not address the risks of emissions trading, thereby leaving a risk management gap. The FSA regards this as potentially harmful to investors, and appropriate methods should be developed to target this.
- Availability of information: the timely and orderly release of information, much of which is done by market officials, is crucial to confidence in what the FSA sees as a “politically-generated and managed market”. The quality of information available should also be scrutinised closely.
- Market abuse: the FSA seems to believe the emissions market is not any more susceptible to abuse than any other commodities market per se (further detail on the FSA’s stance on market abuse in commodity markets generally can be found in the FSA’s paper, “Growth in commodity investment: risks and challenges for commodity market participants,” published March 2007). The principal difference between the emissions trading market and other commodities markets is that the underlying is a dematerialised allowance certificate as opposed to a physical commodity.
- Market liquidity: whilst there is generally good liquidity in the emissions markets, the increasing expansion of these markets potentially may create a risk to the confidence and functioning of the emissions market should liquidity become fragmented.
Whilst no US regulator has published any similar study or report concerning US or global emissions trading, the US Commodity Futures Trading Commission (CFTC) is watching the emerging markets. CFTC Commissioner, Bart Chilton, while addressing the recent commencement of carbon product trading on the NYMEX Green Exchange, stated that he “can certainly see carbon becoming the biggest of any derivatives product in the next four to five years. And that would of course mean overtaking T-bills [Treasury] and any contract that is out there right now”. CFTC economists confirmed that US greenhouse gas emissions contracts grew 131 per cent in 2006, compared with a 31 per cent rise in worldwide futures contracts.
Quite apart from its content, the FSA’s Report is significant in being the first policy pronouncement from a major financial services regulator, and will be reviewed closely by the FSA’s counterparts in other jurisdictions, not to mention emissions trading market participants. The FSA’s Report concludes that the emissions market is currently functioning well, and that the FSA will continue to scrutinise it in light of the possible impact the market’s development could have on the FSA’s evolving statutory obligations.