Carbon markets could have position limits regime
Although an ESMA report has helped dispel fears of excessive speculation in the trading of emissions allowances, some form of position limits regime is likely in the near future
Regulators are considering imposing position limits on carbon markets to prevent any adverse impact that could result from excessive speculation.
A report from the European Securities and Markets Authority (ESMA) recently concluded that the European market is so far functioning correctly, but the same report also proposed introducing position limits on carbon derivatives, and even a centralised market monitoring of the carbon market at the EU level, in line with the ACER-style monitoring for gas and power.
Given the important role that carbons markets are set to play in the transition to net zero – it is widely believed that total emissions reduction simply won’t be possible for a significant number of firms – the level of focus on carbon markets is unsurprising.
“There is a concern that excessive speculation in the trading of emissions allowances and carbon credits could undermine the scheme,” said Caroline Dawson, partner at Clifford Chance. “One solution under discussion is position limits, and another is restricting access of financial institutions in the trading of emissions allowances.”
Dawson argued that regulators need to tackle the issue with caution, especially if they go for the latter option, since financial institutions provide liquidity for carbon markets, as they do for other markets.
“To what extent speculation can be deemed excessive is a long-standing debate that still doesn’t have a clear answer,” said Eric Litvack, chairman at the International Swaps and Derivatives Association (ISDA). “What is certain is that speculation does add liquidity to the market. However, it would not surprise me if we saw some form of position limits in the future. If so, policymakers should tread very carefully.”
A source close to the Commodity Futures Trading Commission (CFTC) said that the US was also considering position limits. On June 2, the regulator will hold its first-ever voluntary carbon convening. The trading of carbon offsets and carbon derivatives will be covered during the meeting, among other topics.
“I don’t think we should be surprised by fluctuations and volatility in the carbon market,” said a derivatives-focused banker. “But policymakers should be careful. Reducing access of financial institutions could reduce the liquidity provided by those financial institutions that are greasing the market wheels.”
Using a variety of data sources, the ESMA report identified that long positions in carbon derivatives are mainly held by non-financial entities for hedging purposes, while short positions are mainly held by banks and investment firms providing liquidity and carbon financing. Positions by investment funds remain limited, with positions principally held by third-country funds. The share of high-frequency and algorithmic trading is significant in the carbon market, even if the relevant firms are only holding very small or no actual positions.
“Some think the carbon markets are the equivalent of the sub-prime mortgage market,” said Bill Winters, CEO at Standard Chartered, speaking at the ISDA conference in Madrid. “But that clearly is not the case.”
Tilman Lueder, head of securities markets at the European Commission, said skyrocketing prices led some markets participants to blame speculation. However, on the whole, the markets are “working as they are supposed to be working”.
“Now we are moving on to investigate speculation in energy markets,” said Lueder, noting a slowdown in the transition from coal to clean energy. “What’s driving the downward trend? Are derivatives part of the problem? Is there panic? Is there speculation?”
Expansion versus regulation?
While some market participants advocate for a tighter regulatory structure, not just for speculative activities but across the board, others argue that the carbon markets should first be allowed to grow.
“The process of transitioning is sometimes tarred with a greenwashing brush,” said Belinda Ellington, MD, general counsel, global commodities, ESG for global markets at Citigroup Global Markets. “However, project-based carbon credits divert capital to real-world investment. Financial institutions create liquidity in both the voluntary and allowances markets. It is a growing area.”
Winters expects carbon markets to grow to “100 times” its present size in order to meet net-zero ambitions by 2030. As chair of the Taskforce for Scaling Voluntary Carbon Markets, he advocates for more standardisation in pricing mechanisms together with a more robust governance and legal structure. He argues that this would help scale the markets to the size they need to be and mitigate greenwashing risk. Currently, the market infrastructure is insufficient.
“While carbon markets need more integrity and clearer pricing, regulation risks disrupting the growth trend,” said the derivatives-focused banker. “I think we need to let the market reach a critical mass before we start to interfere with the governance structure.”
Although issuance of voluntary carbon credits topped $1 billion last year, they remain controversial, with critics doubting the credentials of some of the projects that underpin the credits and arguing that they give companies license to continue polluting when the focus should be on emissions reductions. Even so, allowing firms to buy credits is set to play a crucial role in the transition to a low-carbon economy, especially for hard-to-abate sectors where transition efforts are more complicated.