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Carbon trading in

the European Union

An economic assessment of market

functioning in 2021

Prepared for

ICE

15 February 2022

www.oxera.com

Carbon trading in the European Union

Oxera

Contents

Executive summary 1

1 Introduction 4

1.1 Context and objectives of this report 4

1.2 Structure 6

2 The fundamentals of carbon trading 8

2.1 The European Union Emissions Trading Scheme 8

2.2 What are EUAs? 12

2.3 The auction process for EUAs 13

2.4 The role of carbon prices in the transition to net zero 14

3 What is the role of derivatives and derivatives

exchanges in the context of carbon trading? 19

3.1 Derivatives in carbon markets 19

3.2 What is the role of derivatives exchanges? 22

3.3 Regulatory framework governing carbon trading 26

3.4 Trading strategies—who trades and why? 28

4 Evidence of market functioning 33

4.1 Our approach and economic framework 33

4.2 Evidence on resilience 34

4.3 Evidence on price formation 40

4.4 Evidence on liquidity 41

5 How does derivatives trading affect carbon

pricing? 44

5.1 What are the fundamental drivers behind the recent rise in

carbon prices? 44

5.2 What is the link between the carbon price and its derivatives

markets? 48

5.3 What is the impact of speculative trading on carbon pricing? 51

6 Policy implications 58

A Appendices 60

Carbon trading in the European Union

Oxera

Figures and tables

Box 3.1 Characteristics of EUA derivatives traded on ICE 20

Box 3.2 Activities undertaken by derivatives exchanges to

facilitate EU carbon trading 25

Box 3.3 ICE’s market surveillance activities in its carbon

derivatives contracts 27

Box 3.4 An illustrative example of the gains of trading EUAs to

compliance entities 31

Box 3.5 Case study: power utility hedging using EUA futures 31

Box 3.6 Case study: carry trades and cash flow management 32

Figure 1.1 EU carbon price, 2018–21 (€) 4

Figure 1.2 Natural gas costs and carbon costs for EU electricity

generation, July 2020–September 2021 5

Figure 2.1 Phases of the EU ETS 10

Figure 2.2 Illustration of reduction in EU ETS surplus allowances

under the Fit for 55 proposals 12

Figure 2.3 EU ETS compliance timeline 13

Figure 2.4 Merit order effect of the carbon price 15

Figure 2.5 Front-year EUA and implied fuel switching EUA prices 16

Figure 2.6 EU carbon price history and market forecasts for 2030 17

Figure 3.1 Different models of trading 22

Figure 3.2 EUA futures trading volumes by trading mechanism,

2011–21 YTD 23

Figure 4.1 Economic framework for assessing the functioning of

financial markets 33

Figure 4.2 Total number of allowances in circulation and open

interest in EUA futures, 2018–20 35

Figure 4.3 Shares of long and short positions by trader category in

October 2021 36

Figure 4.4 Concentration of trading activity: EUA futures vs other

derivatives 37

Figure 4.5 Number of position holders of EUA derivative contracts

traded on ICE, 2018–21 38

Figure 4.6 Commitment of traders for financial and non-financial

firms, 2018–21 39

Figure 4.7 Commitment of traders by participant type 39

Figure 4.8 Number of contracts traded by contract month and year 41

Figure 4.9 Average daily relative spread for December EUA contract

(%), January 2017–October 2021 42

Figure 5.1 EU carbon price, 2018–21 (€) 46

Figure 5.2 Verified emissions by installation type, 2010–20 47

Figure 5.3 EUA future curve 51

Figure 5.4 Working T-index values on ICE EUA futures (%), January

2018–November 2021 52

Figure 5.5 Relationship between volatility and trading activity of

financial institutions 54

Figure 5.6 Positions on EUA Options as at 1 October 2021, by trader

category 56

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CarbontradingintheEuropeanUnionAneconomicassessmentofmarketfunctioningin2021PreparedforICE15February2022www.oxera.comCarbontradingintheEuropeanUnionOxeraContentsExecutivesummary11Introduction41.1Contextandobjectivesofthisreport41.2Structure62Thefundamentalsofcarbontrading82.1TheEuropeanUnionEmissionsTradingScheme82.2WhatareEUAs?122.3TheauctionprocessforEUAs132.4Theroleofcarbonpricesinthetransitiontonetzero143Whatistheroleofderivativesandderivativesexchangesinthecontextofcarbontrading?193.1Derivativesincarbonmarkets193.2Whatistheroleofderivativesexchanges?223.3Regulatoryframeworkgoverningcarbontrading263.4Tradingstrategies—whotradesandwhy?284Evidenceofmarketfunctioning334.1Ourapproachandeconomicframework334.2Evidenceonresilience344.3Evidenceonpriceformation404.4Evidenceonliquidity415Howdoesderivativestradingaffectcarbonpricing?445.1Whatarethefundamentaldriversbehindtherecentriseincarbonprices?445.2Whatisthelinkbetweenthecarbonpriceanditsderivativesmarkets?485.3Whatistheimpactofspeculativetradingoncarbonpricing?516Policyimplications58AAppendices60CarbontradingintheEuropeanUnionOxeraFiguresandtablesBox3.1CharacteristicsofEUAderivativestradedonICE20Box3.2ActivitiesundertakenbyderivativesexchangestofacilitateEUcarbontrading25Box3.3ICE’smarketsurveillanceactivitiesinitscarbonderivativescontracts27Box3.4AnillustrativeexampleofthegainsoftradingEUAstocomplianceentities31Box3.5Casestudy:powerutilityhedgingusingEUAfutures31Box3.6Casestudy:carrytradesandcashflowmanagement32Figure1.1EUcarbonprice,2018–21(€)4Figure1.2NaturalgascostsandcarboncostsforEUelectricitygeneration,July2020–September20215Figure2.1PhasesoftheEUETS10Figure2.2IllustrationofreductioninEUETSsurplusallowancesundertheFitfor55proposals12Figure2.3EUETScompliancetimeline13Figure2.4Meritordereffectofthecarbonprice15Figure2.5Front-yearEUAandimpliedfuelswitchingEUAprices16Figure2.6EUcarbonpricehistoryandmarketforecastsfor203017Figure3.1Differentmodelsoftrading22Figure3.2EUAfuturestradingvolumesbytradingmechanism,2011–21YTD23Figure4.1Economicframeworkforassessingthefunctioningoffinancialmarkets33Figure4.2TotalnumberofallowancesincirculationandopeninterestinEUAfutures,2018–2035Figure4.3SharesoflongandshortpositionsbytradercategoryinOctober202136Figure4.4Concentrationoftradingactivity:EUAfuturesvsotherderivatives37Figure4.5NumberofpositionholdersofEUAderivativecontractstradedonICE,2018–2138Figure4.6Commitmentoftradersforfinancialandnon-financialfirms,2018–2139Figure4.7Commitmentoftradersbyparticipanttype39Figure4.8Numberofcontractstradedbycontractmonthandyear41Figure4.9AveragedailyrelativespreadforDecemberEUAcontract(%),January2017–October202142Figure5.1EUcarbonprice,2018–21(€)46Figure5.2Verifiedemissionsbyinstallationtype,2010–2047Figure5.3EUAfuturecurve51Figure5.4WorkingT-indexvaluesonICEEUAfutures(%),January2018–November202152Figure5.5Relationshipbetweenvolatilityandtradingactivityoffinancialinstitutions54Figure5.6PositionsonEUAOptionsasat1October2021,bytradercategory56CarbontradingintheEuropeanUnionOxeraFigure5.7EUAcalloptionopeninterestforDecember2021contract57Table3.1Studiesestimatingtheimpactofhedgingonthecostsoffinancing21Table3.2Exchange-tradedcontractsforEUemissions21Table3.3TypicaltradingstrategiesinEUAfutures29Table5.1Literaturereviewonspeculatorsandpricevolatility53Table5.2CorrelationsbetweenEUAvolatilityandthetradingactivityoffinancialinstitutions55CarbontradingintheEuropeanUnionOxera1ExecutivesummaryInthelast18monthstheEUhaswitnessedrapidincreasesinenergyandcarbonprices.Althoughmostcommentatorsconsiderthesepriceincreasestobedrivenprincipallybymarketfundamentals,somepoliticiansandstakeholdershavepointedtotradingbyfinancialinstitutionsashavingdrivenupEUcarbonpricesandcreatedacarbonprice‘bubble’.Notably,somepoliticianshavearguedforstructuralreformstotheEUcarbonmarket,includingmeasuresaimedatcurbing‘financialspeculation’,suchasimposingpositionlimitsoncarbontrading.1Thewell-functioningofamarketthatenablesthetradingofEUemissionallowances(EUAs)aswellasEUAfuturesandotherderivativesisimportantinthecontextoftheEU’sclimateobjectivesgiventheuncertaintiesaroundtheenergytransitionandtheneedtoattractsignificantnewinvestment.Inlightofthis,theEuropeanCommissionhasaskedtheEuropeanSecuritiesandMarketsAuthority(ESMA)toconductanin-depthanalysisoftheEUcarbonmarket.ESMApublisheditspreliminaryreportinNovember2021andisexpectedtodeliveritsfinalreporttotheEuropeanCommissioninearly2022.CommissionedbyICE,thisindependentreportbyOxerahasbeenpreparedtoinformESMA’sassessmentoftheEUcarbonmarket.Itdoessobydrawingonacomprehensivereviewofthemarketmicrostructureandenvironmentaleconomicsliterature,empiricalanalysisbasedonmarketdata,andinsightsfrominterviewswithmarketparticipants.Carbontradingisawell-regulatedmarketintheEU.InadditiontothedetailedrulessetoutinEUdirectivesandregulations,exchangesperformmarketmonitoringandcompliancefunctionstoensurethattrustandconfidenceremainsinthemarket.•Overtime,thetradingofEUAfutureshasdevelopedfromanover-the-countermarkettoapredominatelyexchange-tradedone.Thisshifthashadapositiveimpactonend-users—astheexchangeshavebeensuccessfulinattractingamorediversegroupofmarketparticipants,exchange-tradinghasledtoimprovementsinmarketresilience,liquidityandpriceformation.•Themajorityoftradingtakesplacebetweencommercialentitiesseekingtohedgetheircarbonallowancepriceandvolumerisks,andfinancialinstitutionsandotherliquidityproviders.Financialinstitutionsparticipateinthemarkettotakepositionsortofacilitatetradingbetweencounterparties.Forexample,inNovember2021,investmentfirmsaccountedfor85%ofallshortpositionsandcommercialundertakingsaccountedfor65%ofalllongpositions.WhiletherehasrecentlybeenanincreaseinthenumberofinvestmentfundsparticipatinginEUcarbonmarkets,sofartheoverallsizeoftheirpositionsremainsrelativelysmall,representing4%oftotalpositionsinNovember2021.21RecentcommentshavepointedtothedetrimentalimpactoffinancialspeculationontheEUcarbonmarketduetoincreasedriskofmanipulation.Throughoutthisreportadistinctionismadebetweenspeculationandmarketmanipulation.Marketmanipulationisillegalandimpairsmarketfunctioning.Speculationplaysanimportantroleinensuringthatatradingmarketfunctionswell.2‘InvestmentFunds’accountedfor6.4%oflongpositions,1.7%ofshortpositions,andtherefore4.05%ofallpositionsinNovember2021.SeeICE(2021),‘MiFIDIICommitmentsofTradersReport(COT)’,forthemonthofNovember2021.Forinformationonthedefinitionofthecategoriesoftradersseesection3.4.CarbontradingintheEuropeanUnionOxera2•Financialinstitutionsandothermarketparticipantswillingtotakefinancialpositionsinthemarket(typicallyreferredtointheacademicliteratureas‘speculators’)areintegraltotheprovisionofliquidityandpriceformation.Theybringliquidityandhavefinancialincentivestotakepositionsandassumemarketrisk.Itiswellrecognisedintheliteratureonmarketmicrostructurethatformarketstofunctionwell,speculatorsareneededtotaketheopposingpositionstohedgerstoallowthehedgerstoreducetheirexposure.Inprovidingthisliquidity,speculators,aswellasarbitrageurs,facilitate,priceformationandefficientrisksharing.•Theglobalenergypriceincreaseswitnessedin2021havehighlightedthebenefitsofhedgingandriskmanagement.Firmsthatarewellhedgedhavecontinuedtooperateandservetheircustomers.•ThecarbonpriceiscentraltothedeliveryoftheEU’sclimatepolicy,anditiswidelyrecognisedthattheEUApriceneedstobesubstantiallyhigherthanthepricelevelsseenpriorto2021fortheEUtomeetitsdecarbonisationtargets.Whereitissuggestedthatanomalouspricemovementshaveoccurred,thesecouldbeexplainedbyacombinationofmeasures,suchastheintroductionofmoreambitioustargetstoreducegreenhousegasemissions,andrevisionstotheMarketStabilityReserve(MSR),aswellaschangestoothermarketfundamentals(e.g.abatementcosts,includingtherelativepricesofgasandcoal).Inparticular,theMSR—whichbecameoperationalin2019andwasrevisedin2021—substantiallychangedthefunctioningoftheETSbyaddressingthehistoricaloversupplyofallowances.Insum,theevidenceindicatesthattheEUcarbontradingmarketisfunctioningwell,inthesensethatpricesarerespondingtoinformationonsupplyanddemandconditions,notdeviatingfarfrommarketfundamentals(i.e.policytargets,abatementcosts,andcommodityprices),andthemarketoutcomesareconsistentwiththeoverallobjectivesofEUclimatepolicy.Also,greaterparticipationbyfinancialinstitutionshasimprovedliquidityandmarketresilience.PolicyimplicationsTherehavebeensomecallsforregulatorstoimposepositionlimitsonEUAfutures.Whilepoliciessuchaspositionlimitsmayhelptopreventmarketmanipulationbycurtailingtheabilityofmarketparticipantstobuildupconcentratedpositions,evidencefromothermarketssuggeststhatapplyinginflexiblepositionlimitswithinlegislationmaybecounterproductive,particularlyasthemarketiscurrentlyfunctioningwell.Consequently,itwouldbebettertoleaveexchangestomonitortradingincarbonmarketsandtotakeappropriatemeasuresinresponsetomarketdevelopmentsinrealtime,undertheclosesupervisionoftheNCAs.Ingeneral,wherethereisnoobjectivejustificationforapplyingremediessuchaspositionlimits(i.e.wherethereisnomarketfailureorconcentrationofpositionsinthefirstplace),thispolicymaydistortmarketoutcomeswithoutanybeneficialpurpose.Similarly,itisimportantthatanypolicyactiondoesnotunderminethesuccessoftheEU’sclimatepolicytodateanddevelopmentsinthemarketinfrastructurerelatingtocarbontradingintheEUinrecentyears.TheremaybemeritinESMAimprovingitsabilitytomonitormarketdevelopments.Forexample,itcouldbeusefultoimprovetheconsistencyacrosstheEUofthereportingofpositionsheldbydifferententities,assummarisedintheCommitmentofTradersreports.FurtherguidancefromCarbontradingintheEuropeanUnionOxera3ESMAtoreportingentitiesmayhelp.MarketsurveillanceandmonitoringcouldalsobeimprovedviabettercoordinationanddatasharingarrangementsbetweenthecentralandnationaladministratorsoftheUnionRegistryfortheholdingsofEUAsandtherelevantfinancialregulators.Thereisalsovalueinencouragingthewideruseofriskmanagementandhedginginstrumentsamongfirmsexposedtovolatilityincarbonprices.Failureofenergyfirms,amongothers,tomanagetheserisksappropriatelycouldexposehouseholdsandbusinessestounnecessarypriceshocksduringthetransitiontoalow-carboneconomy.Theimpactonconsumersoffirms’failuretomanagetheserisksalsoincreasesthepressureontheauthoritiestorespondinawaythatcouldunderminetheEU’sclimatepolicy.GiventheplannedexpansionoftheEUETSinthecomingyears,itwillbeimportanttocommunicatepolicychangesclearlyandnotunderminetheworkalreadydone.Indeed,aftermanyyearsofincrementalimprovementstotheEUETSandtheregulatoryregimegoverningthetradingofEUAsandtheassociatedderivatives,theEUcarbonpriceisnowseenasaglobalbenchmarkforcarbontradingandasuccessstorythatotherregionsareseekingtofollow.CarbontradingintheEuropeanUnionOxera41Introduction1.1ContextandobjectivesofthisreportInthelast18months,theEUhaswitnessedrapidincreasesinenergyandcarbonprices.Forexample,naturalgasfuturesforphysicaldeliveryduringQ12022increasedfromaround18€/MWhto125€/MWhbetweenearlyJanuaryandmid-December2021—anincreaseofnearly600%.3Overthesameperiod,priceincreasesofaround50%and100%wereexperiencedforoil4andcoal,5respectively.During2021,thepriceofEuropeanUnionAllowances(EUAs)tradedintheEuropeanUnionEmissionTradingScheme(EUETS)alsoincreasedsignificantly(123%6),asshowninFigure1.1.Figure1.1EUcarbonprice,2018–21(€)Note:They-axisshowstheEEXEUAprimaryauctionpricein€/EUA.Dataprovidedupto8February2022.Source:OxeraanalysisofEEXdata.Citingthesepriceincreases,somepoliticianshave,ontheonehand,raisedconcernsovertheimpactofhigherenergycostsforhouseholdsaswellas3ICETTFQ12022futures.Seehttps://www.theice.com/products/27996665/Dutch-TTF-Gas-Futures/data?marketId=5806944&span=3(accessed30December2021).TTFistheleadingnaturalgashubinEurope,seeOxfordInstituteforEnergyStudies(2021),‘EuropeanTradedGasHubs:Germanhubsabouttomerge’,July,https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/07/European-Traded-Gas-Hubs-NG-170.pdf(accessed30December2021).4ICEBrentFebruaryandMarch2022futures.Seehttps://www.theice.com/products/219/Brent-Crude-Futures/data?marketId=5166945&span=3(accessed30December2021).5ICEAPI2Q12022futures.Seehttps://www.theice.com/products/243/API2-Rotterdam-Coal-Futures/data?marketId=5310599&span=3(accessed30December2021).6ThisgrowthrateisbasedonthechangeinpricefromtheEUAprimaryauctiononEEXon29January2021(thefirstauctiondatein2021)totheprimaryauctionon20December2021(thelastauctiondateof2021).0102030405060708090100Jan-18Jul-18Jan-19Jul-19Jan-20Jul-20Jan-21Jul-21Jan-22Settlementprice(€/EUA)CarbontradingintheEuropeanUnionOxera5industrialandcommercialcustomers.7Ontheotherhand,itisrecognisedthatasubstantiallyhighercarbonprice,inparticular,providesastrongerincentivetoswitchtorenewableenergysourcesandinvestinenergyefficiencymeasures,therebycontributingtolowerenergybillsandemissions.8Thatsaid,asshowninFigure1.2,carboncostsaccountforonlyasmallproportionofrisingenergycosts,withnaturalgascostsbeingthemaindriverforelectricitypriceincreasesinEurope.Figure1.2NaturalgascostsandcarboncostsforEUelectricitygeneration,July2020–September2021Note:They-axisunitiseurosperMWhofelectricityproduced.ThechartshowsthecostsforEUelectricitygenerationfromcombined-cyclegasturbines.EmberClimateassumesemissionsintensityof0.37tCO2e/MWhandaplantefficiencyrateof55%(lowerheatingvalue).Thelightblueareashowstheshareofelectricitygenerationcostthatstemsfromthegascost,whilethedarkblueareashowsthecostthatcomesfrompurchasingEUAallowances.Source:OxeraanalysisofEmberClimatedata.EmberClimate(2021),‘SoaringfossilgascostsresponsibleforEUelectricitypriceincrease’,12October.Althoughmostcommentatorsconsidertheincreaseinenergypricestobedrivenprincipallybymarketfundamentals(i.e.policytargets,abatementcosts,andcommodityprices),somepoliticiansandotherstakeholdershavepointedtotradingbyfinancialinstitutionsashavingdrivenupEUApricesandcreatedacarbonprice‘bubble’.9Notably,somememberstatesandMEPshaveargued7Forananalysisoftheimpactonhouseholdssee,forexample,BancodeEspaña(2021),‘RecentdevelopmentsinSpanishRetailElectricityPrices:TheRolePlayedbytheCostofCO2EmissionAllowancesandHigherGasPrices’,DocumentosOcasionales,No2120.However,itisworthnotingthatSpainisinauniquepositionduetoitshighdependencyongas,limitedinterconnectionlevelsandrelativelyhighshareofconsumerswithelectricitybillsconnectedtothespotpriceintheelectricitymarket.8EuropeanCommission(2021),‘QuestionsandAnswers:CommissionCommunicationonEnergyPrices’,13October,https://ec.europa.eu/commission/presscorner/detail/en/QANDA_21_5202(accessed21December2021).9See,forexample,Reuters(2021),‘GermanutilityStromioasksregulatortolimitEUcarbonmarketspeculators’,8September,https://www.reuters.com/article/eu-carbontrading-idUSL8N2QA4IW(accessed30December2021);Nowacki,M.(2021),‘Thechronicleofacrisisforetold:pricebubblesintheEU’sCO2020406080100120140Jul-20Sep-20Nov-20Jan-21Mar-21May-21Jul-21Sep-21Priceofelecitrcitygenerationin€/MWhEUAcostsGascostsCarbontradingintheEuropeanUnionOxera6forstructuralreformstoemissionandenergymarkets,includingmeasuresaimedatcurbingfinancialspeculation,suchasimposingpositionlimitsonemissionstrading.Inresponse,theEuropeanCommissionrecentlyaskedtheEuropeanSecuritiesandMarketsAuthority(ESMA)toexaminethepatternsofEUAtradingbehaviourandthepotentialneedfortargetedactions.10ESMApublisheditspreliminaryreportinNovember2021,whichfoundthatsince2018,EUApricemovementshavebeenlargelydrivenbyEUETSmarketreformsandtheimpactofeconomicfundamentals,notablyincludingtheimpactsoftheMarketStabilityReserve(MSR)andtheCOVID-19pandemic.11Forexample,asregardstheforwardcurve,ESMAfoundthatthepricedifferentialbetweendailyfuturespricesandDecemberfuturespricesforcontractsexpiringoutto2025remainssmall,andthatthepricedifferentialinrelativeterms(i.e.asapercentageofspotprices)since2020hasremainedstable.12Moreover,ESMAfoundthattheincreaseinthevolatilityofEUApricescoincidedwiththeintroductionofCOVID-19-relatedmeasuresinMarch2020.ItsanalysisindicatesthatEUApricevolatilitycontinuestobesomewhatelevatedbuthasremainedstablewithnodiscernibletrend.13ThenumberandopeninterestofcounterpartiesparticipatinginthetradingofEUAfuturesandotherderivativeshaveincreasedsignificantly.Forexample,ESMA’sanalysishighlightsthatthenumberoffuturespositionholdersincreasedbyaround90%onbothEEXandICEbetween2018and2021.14OnICE,therelativeproportionsofdifferenttypesofpositionholdersremainedstableduringthisperiod,althoughin2021,thelargestgrowthinthenumberofpositionholderswasseeninthecategoriesof‘InvestmentFirms’and‘ComplianceEntitiesandOtherNon-Financials’.15ESMA’sanalysisindicatesthatthesharesofopeninterestheldbydifferentcounterpartycategorieshaveremainedstable.16OxeraunderstandsthatESMAwillcompleteitsassessmentandpublishitsfinalreportbytheendofMarch2022.ThisindependentOxerareport,commissionedbyICE,hasbeenpreparedtoinformESMA’sassessmentofthemarket.1.2StructureThisreportisstructuredasfollows.•Section2describesthefundamentalsofcarbontradingintheEU.•Section3articulatestheroleofderivativesmarketsandexchangesinthecontextofcarbontrading.emissionstradingscheme’,6December,https://www.theparliamentmagazine.eu/news/article/the-chronicle-of-a-crisis-foretold-price-bubbles-in-the-co2-emissions-trading-scheme(accessed30December2021).10EuropeanCommission(2021),‘Tacklingrisingenergyprices:atoolboxforactionandsupport’,COM(2021)660final,p.12.11ESMA(2021),‘Preliminaryreport:EmissionsAllowancesandderivativesthereof’,ESMA70-445-7,15November,p.23,https://www.ESMA.europa.eu/sites/default/files/library/ESMA70-445-7_preliminary_report_on_emission_allowances.pdf(accessed30December2021).12Ibid.,p.26.13Ibid.,pp.28–30.14Ibid.,p.34.15Ibid.16Thatis,‘ComplianceEntitiesandOtherNon-Financials’,‘InvestmentFirms’,and‘FundsandOtherNon-Financials’.SeeESMA(2021),op.cit.,p.36.CarbontradingintheEuropeanUnionOxera7•Section4setsoutaneconomicframeworkandprovidesevidenceforassessingthefunctioningofthemarketforthetradingofEUAs,includinganalysisofmarketresilience,priceformationandliquidity.•Section5explainshowtradinginderivativesmarketsaffectscarbonpricesanddescribesthedriversbehindtherecentriseincarbonprices.•Section6concludesbysummarisingthekeyfindingsandpolicyimplicationsofthisreport.FurtherdetailsontheregulatoryframeworkgoverningthetradingofcarbonderivativesintheEUareincludedinAppendixA1.AsummaryoftheliteratureontheimpactofpositionlimitsonthefunctioningofderivativemarketsisincludedinAppendixA2.CarbontradingintheEuropeanUnionOxera82Thefundamentalsofcarbontrading2.1TheEuropeanUnionEmissionsTradingSchemeTheEUETSisthecornerstoneoftheEU’spolicytocombatclimatechangeandakeytoolformeetingemissions-reductiontargetscost-effectively.WiththeGreenDealandtheFitfor55packages,theEUhassettheambitiontocutgreenhousegas(GHG)emissionsbyatleast55%by2030,andtobecomeclimateneutralby2050.17TheEUETSisthelargestcarbonmarketintheworld.18AccordingtotheWorldBank,itisalsothemostdevelopedandliquidemissionsmarket.19In2020,theEUETSaccountedforalmost90%ofglobalcarbonmarkettrading,20withfourtimesmoretradingvolumethanthenextlargestcarbonmarket.21Today,theEUETScoversaround41%oftheemissionsfrom10,000energy-intensiveinstallations(powerstationsandindustrialfacilities)inEurope,coveringall27EUmemberstates,aswellasIceland,LiechtensteinandNorway.222.1.1Howdoesitwork?TheEUETSisacap-and-tradesystem.23ThismeansthatEuropeanpolicymakerssetalimit(or‘cap’)ontheallowableemissionseachyear,reducingthatcapovertimesothatoverallemissionsfallacrossthesectorscoveredbythescheme.Withinthecap,EUAsareallocateddirectlytoqualifyingfacilitiesorbyauction.ThescarcityofEUAsmeansthattheyhaveavalue,andcompaniesareallowedtotradethoseemissionsallowancesbetweenthemselves.(SeeBox3.4foranexampleofwhytheymightdothis.)Aftereachyear,companieswithcomplianceobligationsundertheEUETS(hereafterreferredtoas‘complianceentities’)mustsurrendersufficientallowancestocovertheiremissions.Underthesystem,complianceentitiesmustholdallowancescorrespondingtotheircarbondioxide-equivalent(CO2e)emissions.Allelseequal,thismakesenergygenerationfromburningcoalandotherfossilfuels,forexample,moreexpensivethanrenewableorotherwise‘low-carbon’generationbasedonwind,solar,ornuclearresources.IfcomplianceentitiesemitmoreCO2ethantheyhavecoveredbytheiremissionallowances,theyfaceafineof€100/tCO2e,aswellasneedingtopurchasetheadditionalEUAs.24Ifacomplianceentityproduceslessemissions17EuropeanCommission(2021),‘2030ClimateTargetPlan’,https://ec.europa.eu/clima/eu-action/european-green-deal/2030-climate-target-plan_en(accessed14December2021).18In2021,ChinalauncheditsnationalETS,becomingtheworld’slargestcarbonmarketintermsofquantityofemissionscovered.TheEUETSremainsthelargestmarketintermsofrevenues.SeeWorldBank(2021),‘StateandTrendsofCarbonPricing2021’,https://openknowledge.worldbank.org/handle/10986/35620(accessed9December2021).19WorldBank(2021),‘CarbonMarketCouldDriveClimateAction’,19July.20Refinitiv(2021),‘CarbonMarketYearinReview2020’,https://www.refinitiv.com/content/dam/marketing/en_us/documents/reports/carbon-market-year-in-review-2020.pdf(accessed2December2021).21Basedon2021outturns,15.2billionEUAsweretradedcomparedto2.4billioncarbonallowancestradedinCalifornia(source:ICE).22EuropeanCommission(2021),‘QuestionsandAnswers-EmissionsTrading–PuttingaPriceoncarbon’,https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3542(accessed2December2021).23Thisisdifferentfromacarbontax,whichdoesnotregulatetheamountofemissions,butratherattemptstodisincentivisecompaniesfromsuchactivitiesbyincreasingthecostbaseofemittingactivities.24EuropeanCommission(2021),‘DevelopmentofEUETS(2005-2020)’,https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/development-eu-ets-2005-2020_en(accessed9December2021).CarbontradingintheEuropeanUnionOxera9thanexpected,itcanbankspareallowancestocoverfutureneedsorsellthemtoanothermarketparticipant.2.1.2Benefitsofacap-and-tradeschemeAkeybenefitofcap-and-tradeschemesisthattheyallowemissionstobereducedinthemostcost-efficientwaypossible.25Aneffectivecarbonpricealsoprovidesapricesignalthatincentivisesinvestmentininnovativelow-carbontechnologies.Atthesametime,firmsareincentivisedtobecomemoreenergy-efficientbecausetheycanthensellany‘excess’emissionallowancesintothemarket.Suchschemeshavetheadditionalbenefitthat—incontrast,forinstance,toacarbontax—thequantityofemissionsissetdirectlybythepolicymaker.Giventhattheultimategoalofclimatepolicyistolimitthequantityofemissionsthatentertheearth’satmosphere,acap-and-tradesystemcanbeconsideredasthemostoutcome-targetedpolicyinstrumentavailable.SubstantialacademicliteraturenowexistsonthecostsandbenefitsofachievingemissionsreductionsviatheuseofmarketsbasedontradablepermitsliketheEUETS,asopposedtoplacinglimitsontheemissionsfromspecificinstallationsdirectly.Forexample,aneconomicanalysisofmarketableemissionpermitsfindsthatimposingfixedlimitsonindividualemitterscancost2–22timestheleast-costalternative,dependingontheextentofcontrolapplied.26Thereasonsforthecostefficienciesfromanexchange-ledapproachtoreducingemissionsincludethat:1.marketsareeffectiveatprocessinginformation;2.marketinstrumentstendtoresultinemissionreductionsbeingundertakenwhereitisleastcostlyinrealterms;3.market-basedapproachesgeneratedynamicgainsthroughresponsesovertimetotheirpatternsofincentives.Importantly,itistradingthatgeneratestheattractivequalitiesofthecap-and-tradescheme.Fordirectregulationofemissionsatthelevelofindividualinstallationstoachievethesamelevelofcostefficiencywouldrequiretheregulatortohaveknowledgeofindividualfirms’marginalabatementcosts.27Thevirtueofmarketmechanismsisthattheyincentivisetheleast-costemissions-reductionpathwaythroughcompetitionbetweenbuyersandsellers.Today,marketparticipantscantradeEUAsbothintheprimaryauctionandonexchangeusingfuturescontractsandotherderivatives(discussedfurtherinsection2.4)basedonEUAs.Thisimprovesthepricediscoveryprocess,asdiscussedbelow.282.1.3TheevolutionoftheEUETSToassessthefunctioningofcarbontradingmarketsintheEU,itisimportanttounderstandthehistoryoftheEUETS.Theschemehasevolvedinphases,assummarisedinFigure2.1below.25Formoredetail,seePerman,R.,Ma,Y.,McGilvray,J.andCommon,M.(2003),NaturalResourceandEnvironmentalEconomics,3rdEdition,Pearson,p.224.26Tietenberg,T.H.(1984),‘MarketableEmissionsPermitsinTheoryandPractice’,paperpresentedattheConference,EconomicsofEnergyandEnvironmentalProblems,Yxtaholm,Sweden,6–10August.27Marginalabatementcostisaneconomicconcept—itisthecosttoanemitterofreducinganadditionalunitofenvironmentalemissions.28Pricediscoveryreferstotheprocessofdeterminingthepriceofanassetinthemarketplace.CarbontradingintheEuropeanUnionOxera10Figure2.1PhasesoftheEUETSSource:Oxeraanalysis.•Phase1(2005–07):duringthisphase,onlyCO2eemissionsfrompowergeneratorsandenergy-intensiveindustrieswerecoveredbytheEUETS,andalmostallallowancesweregiventobusinessesfreeofcharge.Theschemesucceededinsettingapriceforcarbon;however,theissuingoffreeallowancesmeantthattheEUApriceeffectivelyfelltozeroin2007.Thebankingofallowancesbetweenphases1and2wasnotpossible(i.e.emitterswerenotabletouseallowancesissuedinphase1inphase2).29•Phase2(2008–12):thesecondphaseintroducedtheUnionRegistry(replacingthenationalregistries)—whichkeepstrackoftheownershipofallowances—andaddedIceland,LiechtensteinandNorwaytothecap-and-traderegion.Thissecondphasewasmarkedbytheeconomiccrisisin2008andunexpectedlylargeemissionsreductions.Thiscreatedalargesurplusofallowancesthatalsodepressedcarbonpricesthroughoutphase2.•Phase3(2013–20):thethirdphasechangedtheEUETSconsiderably.Bankingwasallowedsuchthatfirmscouldusephase2allowancesinphase3.Moreover,theprevioussystemofnationalcapswasreplacedwithanEU-widecapandtheauctionsystemforallocatingallowanceswasformalised,30withmoresectorsandgasesincludedinthescheme.Crucially,theMSRwasintroducedinJanuary2019todealwiththesurplusofallowancesthatemergedfromthefirsttwophases.Thesystemadaptsauctionvolumesandchangesthetotalnumberofallowancesincirculation(TNAC).•Phase4(2021–30):theEUETSisnowinitsfourthphase,whichwillrununtil2030.Thebankingofallowanceswaspermittedbetweenphases3and4.Keychangesinthisphaseincludeanincreasedannualreductionofthetotalnumberofallowances,areinforcementoftheMSR,andmoretargetedcarbonleakagerulestoacceleratedecarbonisation.InJuly2021,theEuropeanCommissiontightenedandreinforceditsclimateambitions.WhiletheGreenDealsetsouthowtoachieveclimateneutralityintheEUby2050,theFitfor55packageestablishedarevisedintermediatetargetofatleast55%netreductioninGHGemissionsby2030.Tomeetthistarget,theFitfor55proposalmandatesthatthesectorscoveredbytheEUETSneedtoreducetheirGHGemissionsby61%by2030,relativeto200529Seesection2.2foradescriptionof‘banking’.30Auctionswerefirstintroducedaspilotsinvariouscountriesinphase2,butauctioningbecamethedefaultmethodforallocatingallowancesinphase3.SeeEuropeanCommission(2021),‘DevelopmentofEUETS(2005-2020)’,https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/development-eu-ets-2005-2020_en(accessed17December2021).CarbontradingintheEuropeanUnionOxera11levels.Thisrepresentsasignificantincreaseof18percentagepointscomparedtothecurrent43%reductionenvisioned.ToachievethegoalssetoutintheFitfor55package,theannualemissionscapneedstobescaleddownbyalinearreductionfactor(LRF)of4.2%peryear,insteadofthe2.2%currentlyenvisioned.31Inaddition,theCommissionisproposingaone-offreductionoftheoverallemissionscapby117mallowances(‘re-basing')andthegradualremovaloffreeemissionsallowancesfortheaviationsectorby2027.Inothersectorsthenumberoffreeallowanceshasalsobeenreducedovertime.Manufacturing,forexample,atthestartofphase3received80%ofitsallowancesfreeofcharge—thiswasgraduallyreducedto30%by2020.32Sincethestartofphase3,powergeneratorshavenotbeengrantedanyfreeallowancesintheory,althoughsomeallowanceshavebeenissuedtoincentivisethemodernisationofthesectorinsomecountries.SincetheintroductionoftheMSR,ashareofprimaryallowanceshavebeenwithheldfrombeingissuedandinsteadplacedinthereserveeachyear.ThishastheeffectofreducingthenumberofEUAsavailabletoparticipantsintheEUETS.33Figure2.2illustratesthisreductionovertime.Since2019,thereductionrateapplied,foranygivenyearwheretheTNAChasexceeded833million,is24%.Thisratewasduetobereplacedin2023byalowerrateof12%(showninthelightgreybarsinFigure2.2).However,undertheFitfor55package,theCommissionhasproposedtoextendthe24%reductionrateuntil2030(showninthelightbluebarsinFigure2.2).Thiseffectivelydelaysimplementationofthe12%rateuntil2031.Ascanbeseenfromthediagram,iftheFitfor55packageisintroduced,theresultissignificantlyfewersurplusEUAsincirculation.Thereductionofallowancesandtheremovaloffreeallowancesareexpectedtoincreasecarbonpricesinthecomingyearsandcreatestrongpricesignalstodriveemissionsdown.31EuropeanCommission(2021),‘QuestionsandAnswers-EmissionsTrading–PuttingaPriceoncarbon’,https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3542(accessed2December2021).32EuropeanCommission(2021),‘FreeAllowances’,https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/free-allocation_en(accessed17December2021).33TheMSRincludesanautomaticadjustmenttotheTNACifitisoutsideofagivenrange.Specifically,iftheTNACisgreaterthan833m,thenumberofadditionalallowancesplacedintheMSRis24%until2023(and12%thereafter);iftheTNACislessthan400m,aspecifiednumberofallowancesarereleasedfromtheMSR.GiventhattheTNACwasaround1.6billionin2021,theMSRisexpectedtoincrease,makingtheTNACprogressivelysmallerinthecomingyears.From2023onwards,allowancesheldintheMSRthatareinexcessofthepreviousyear’sauctionvolumewillbecancelledandnolongerbevalid.SeeEuropeanCommission(2021),‘Publicationofthetotalnumberofallowancesincirculationin2020forthepurposesoftheMarketStabilityReserveundertheEUEmissionsTradingSystemestablishedbyDirective2003/87/EC’,COM2021/C187/02,pp.1–2,and5.CarbontradingintheEuropeanUnionOxera12Figure2.2IllustrationofreductioninEUETSsurplusallowancesundertheFitfor55proposalsNote:ThediagramillustratestheproposedreductioninthesupplyofsurplusallowancesovertimeundertheinitialMRSscheme(grey)andtheupdatedproposalintheFitfor55proposals(lightblue).Thissurplusisloweredeachyearby24%or12%,thusreducingthenumberofETSallowancesincirculation.Forillustrativepurposes,theTNACisassumedtobeconstanteachyear.FurtherexplanationoftheMSRschemecanbefoundathttps://icapcarbonaction.com/en/?option=com_etsmap&task=export&format=pdf&layout=list&systems%5B%5D=43(accessed13January2022).Source:OxeraanalysisofEuropeanCommissiondata.2.2WhatareEUAs?AnEUAisanentitlementtoemit1tCO2e,andisusedasthemainunitintheEUETS.EUAsaredistinctfromEUemissionsallowancesfortheaviationsector(EUAAs),whichareallocatedonlytotheaviationindustry.34However,sincethestartofphase4oftheEUETS,EUAAsarefungiblewithEUAsfromacomplianceperspective.Thecomplianceyearrunsfrom1Januaryto31December.By30Aprilofthefollowingyear,operatorsofinstallationscoveredbytheEUETSmustsurrenderanEUAforeachtonneofCO2eemittedinthepreviousyear.IfacompanyemittedmoretonnesofCO2eoverthepastyearthancoveredbyitsEUAs,itmustpayafineinadditiontohavingtobuytheadditionalEUAsrequiredtocomplywiththerules.Companiesthatdonotusetheirallowancescan‘bank’themtocoverfutureneedsorsellthemtoothercompanies,asillustratedinFigure2.3.34Moreprecisely,82%arecurrentlygrantedfreeofchargetoaircraftoperators,15%areauctioned,and3%arekeptinaspecialreservefordistributiontofast-growingaircraftoperatorsandnewentrants.201920202021202220232024202520262027202820292030-24%-24%-24%-24%-24%-12%Fitfor55Originalscheme-24%-12%-24%-12%-24%-12%-24%-12%-24%-12%-24%-12%CarbontradingintheEuropeanUnionOxera13Figure2.3EUETScompliancetimelineNote:Permitscouldnotbecarriedforwardfromthefirsttradingperiod(phase1)intothesecondone(phase2),butcouldbecarriedforwardbetweentradingperiodsthereafter(fromphase2onwards).Source:Oxera.2.3TheauctionprocessforEUAsTheprimarymarketforEUAsisrunviaanauction.Marketoperatorscancompetetoruntheauctionforuptofiveyearsaspartofajointprocurementprocess.Currently,theauctionisbeingrunbytheEuropeanEnergyExchange(EEX),aswinnerofthemostrecentprocurementprocess.35Auctionstakeplacedailyaccordingtoapredeterminedcalendar.36Anypartythatmeetstheadmissionrequirements(asperArticles18and19oftheEUAuctioningRegulation1031/20102)canparticipateintheauction.Thisprovidesfairandopenaccessforallparticipants.BiddersincludecompaniesthatareobligedtoparticipateintheEUETS,creditinstitutions,investmentfirms,funds,andcommoditytradingfirmswithoutemissionscompliancerequirements.Revenuesgeneratedfromtheauctionsgotothenationalgovernmentsinvolved.Between2012andOctober2021,therevenuegeneratedbyparticipatinggovernments37fromEUAauctionswas€83.7bn.FromJanuary2021toSeptember2021alone,therevenuegeneratedwas€18.4bn.TheEUETSDirectiverequiresthatmemberstatesuseatleast50%ofauctioningrevenues,ortheequivalentinfinancialvalue,forclimate-andenergy-relatedpurposes.From2013to2019around78%ofrevenueswereusedforclimate-andenergy-relatedpurposes.383528countries(25EUmemberstatesandthreeEEAEFTAstates)auctiontheirallowancesonthecommonauctionplatform.GermanyandPolandhaveoptedoutofthisplatform,asdefinedbytheETSDirective.However,inpractice,GermanyandPolandalsocurrentlyusetheEEXplatformtoauctiontheirallowances.Formoredetail,seeEuropeanCommission(2011),‘CommonplatformforauctioningcarbonallowancesinthethirdphaseoftheEUEmissionsTradingSystem’,newsarticle,21February,https://ec.europa.eu/clima/news-your-voice/news/common-platform-auctioning-carbon-allowances-third-phase-eu-emissions-trading-system-2011-02-21_en(accessed30December2021).36AuctionstakeplaceonMondays,TuesdaysandThursdayseachweekonbehalfofthememberstatesandtheEEAEFTAstatesparticipatinginthecommonauctionplatform,onWednesdaysonbehalfofPoland,andonFridaysonbehalfofGermany.37Theparticipatingstatesincludememberstates,theUK,Iceland,LiechtensteinandNorway.38SeeEuropeanCommission(2021),‘EUEmissionsTradingSystem(EUETS):Auctioning’,https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/auctioning_en(accessed10December2021).Phase32013–20Phase42021–302019202020212022202320242025Bankingpossible:emissionsfrompastyearscanbeusedEachcalendaryearisanaccountingperiod31Mar:reportingdeadlineforlastyear’semissions30Apr:submissiondeadlineforlastyear’semissionsBorrowingpossible:freeallocationsgrantedinFebruarycanbeusedforpreviousyear28Feb:freeallowancesallocatedforcomingyearCarbontradingintheEuropeanUnionOxera142.4TheroleofcarbonpricesinthetransitiontonetzeroCarbonpricesplayacentralroleindrivingtheinvestmentandapplicationoftechnologiesandalternativeenergysourcesrequiredtomitigatetheimpactofclimatechange;andtodeliverthecommitmentsofmanygovernmentsandcompaniesaroundtheworldtoreducecarbonemissionstonetzero.Theeconomicsliteratureisclearthatthemostefficientandtargetedpolicyinstrumenttotacklethecarbonemissions‘externality’isacarbonprice.39Imposingapriceoncarbonemissionspenalisesnegativeexternalitiesaccordingtothe‘polluterpays’principle,ensuringthatenergyproducersandconsumersinternalisethecostsofcarbon-intensivefuelsandactivities,andencouragingtheuseofalternative,lower-carbonenergysourcesandactivities.2.4.4Howdocarbonpricesaffectelectricitygeneration?Electricityisgeneratedfromprimaryenergysourcessuchasoil,coal,naturalgas,nuclearandrenewables(e.g.solarandwind).Inaliberalisedelectricitymarket,pricestypicallyvarybythehour,withthepricedeterminedbytherankingofavailablegenerationtechnologiesandprimaryenergysourcesbasedontheirvariablecosts(includingthecostsoffuelandcarbon,aswellasothercharges).Thisrankingisoftenreferredtoasthe‘meritorder’,wherebythecostofthemostexpensivegenerationtechnologynecessarytomeetdemandinagivenhoursetsthemarketpriceineurospermegawatthour(€/MWh).InEurope,thepriceofthe‘marginal’MWhofelectricityproducedandconsumedoftenresultsfromthecompetitionbetweennaturalgasandcoal-firedpowerplantsthatdifferaccordingtotheircarbonintensity—thatis,thequantityofCO2eproducedperMWhofelectricity.ThetransitiontonetzerorequiresthemeritordertoreflectthebenefitsofelectricitythatcanbegeneratedwithlowerornoCO2eemissions.Thecarbonpricepromoteslessemission-intensivepowergenerationinthemeritorder,asillustratedinFigure2.4.Allelsebeingequal—assumingthattherelativepriceofcoalandgasdoesnotchange—whenthecarbonpriceissufficientlyhigh,anumberofgas-andcoal-firedplantschangepositionsinthemeritorderascoalismorepollutingthangas.Intheshortrun,ahighercarbonpricethereforeincreaseselectricitypricesforagivendemandlevelanddisincentivisesgenerationfrommoreemission-intensiveplants,otherthingsbeingequal.Inthelongrun,asufficientlyhighandstablecarbonpriceprovidesapricesignaltoincentiviseinvestmentinlower-carbonorcarbon-freepowergenerationfacilities.39Theliteraturealsorecognisesthatimposingacarbonemissionspriceisoftenanecessary,butnotalwayssufficient,policyresponsetoaddressingthemarketfailures.Forinstance,thereareotherfactorslinkedtomarketdesignandinformationcoststhatlimittheeffectivenessofthepricesignalsandincentivesprovidedbycarbonpricing.Thereforeitisoftenimportanttosupplementacarbonpricingframeworkwithotherpolicymeasures.SeeGoulder,L.andParry,W.(2008),InstrumentChoiceinEnvironmentalPolicy,ResourcesfortheFuture,April;Perman,R.,Ma,Y.,McGilvray,J.andCommon,M.(2003),Naturalresourceandenvironmentaleconomics,PearsonEducation,thirded.CarbontradingintheEuropeanUnionOxera15Figure2.4MeritordereffectofthecarbonpriceNote:Thechartassumesthattherelativepricesofcoalandgasremainconstantbetweenthelowandhighcarbonpricescenario.Asdescribedinthetextabove,electricitypricesaredeterminedbythemarginalcostofenergysourcesinthemeritorder.Thebarsrepresentthemarginalcostofeachenergysourcewith,forexample,themarginalcostofcoalincreasingfromthelowtothehighcarbonpricescenario.Inbothscenariosdemandforelectricityissetatafixedlevel.Themarketpriceisdeterminedbythepointwherethemarginalcostoftheenergysourcesinthemeritordermeetsthisfixeddemandlevel.Source:Oxeraanalysis.WhereasFigure2.4isanillustrationofthepotentialforacarbonpricetochangethemeritorderandtherebyresultinloweremissions,powersectoremissionsarealsoinfluencedbytherelativepricesofgasandcoal.Asdiscussedinsections1.1and5.1.1,thegaspricehasincreasedbyseveraltimesmorethanthepricesforcarbonandcoalin2021.Asaresult,theincreaseinthecostofgas-firedgenerationhasmorethanoffsettheimpactofincreasedcarbonpricesoncoal-firedgenerationcosts.ThegreatercostQuantity(MW)GasPrice(€/MWh)P1DemandRenewablesCoalLowcarbonpricescenarioWithalowcarbonprice,coalhaslowermarginalcostthangasPrice(€/MWh)Quantity(MW)DemandP2HighcarbonpricescenarioThisorderisreversedwithasufficientlyhighcarbonprice.RenewablesCoalGasCarbontradingintheEuropeanUnionOxera16competitivenessofcoal-firedpowergenerationhasinturnledtohigherEUpowersectoremissionsdespitethehigherpriceofEUAs.40Figure2.5showstheEUApricethatmustbeexceededtoincentiviseaswitchawayfromcoal-firedpowerproductiontogas-firedgenerationgiventhecostofcoalandgasduring2020and2021.Thisimpliesthatinlate2021EUApriceswouldhavehadtoreacharound€200/tCO2etoreducecoal-firedgenerationfurther.Figure2.5Front-yearEUAandimpliedfuelswitchingEUApricesNote:TheimpliedEUApricethatwouldleadtofuelswitchingfromcoaltogasiscalculatedbasedonthefollowingassumptions:efficiencyofgasplant=40%,efficiencyofcoalplant=56%;emissionsintensityofcoalplant=0.337tCO2/MWhthermal;emissionsintensityofgasplant=0.221tCO2/MWhthermal.Source:OxeraanalysisbasedondatafromBloomberg.ItisimportanttonotethattheEUApriceisnottheonlymeasurethatcanreduceemissionsfromcoal-firedgeneration.Indeed,severalEUmemberstateshaveplannedtheearlyclosureofcoalplantstoensurephase-outsinthe2020sand2030s.Meanwhile,thepaceofreductioninemissionsandabatementcostsintheelectricitysectorwillcontinuetoinfluencetheEUETSpricealongsidethedevelopmentsinotherindustriescoveredbytheEUETS.2.4.5AreEUcarbonpricesontracktodelivernetzero?InthecontextoftherecentspikeinEUcarbonprices,arelevantpublicpolicyquestioniswhetherthecurrentcarbonpriceisconsistentwiththeEU’sdecarbonisationtargets.4140InQ32021,thecarbonfootprintoftheEUpowersectorroseby1%comparedtoQ32020.TheEuropeanCommissionexpectedcarbonemissionstorisein2021duetohighcommodityprices,especiallygas,whichtriggeredgreateruseofcoal-firedgenerationtothedetrimentofgas-firedgeneration,inspiteofhighcarbonprices.SeeEuropeanCommission(2022),‘QuarterlyreportonEuropeanelectricitymarkets’,Vol14,p.3.41TheFitfor55packagesuggeststhatthesectorscoveredbytheEUETSwouldneedtoreduceGHGemissionsby61%on2005levelsby2030.050100150200250300Jan-20Feb-20Mar-20Apr-20May-20Jun-20Jul-20Aug-20Sep-20Oct-20Nov-20Dec-20Jan-21Feb-21Mar-21Apr-21May-21Jun-21Jul-21Aug-21Sep-21Oct-21Nov-21Dec-21Pricein€CarbonpriceImpliedfuelswitchingcarbonpriceCarbontradingintheEuropeanUnionOxera17TheIMFhasstatedthatthecarbonpriceneedstobeUS$75globallytokeepglobalwarmingbelow2°C.42Inasimilarvein,thenewGermancoalitiongovernmenthasstateditsintentiontointroduceacarbonpricefloorof€60/CO2e.TheOECDhasestimatedthatthecarbonpricewouldneedtobe€120/tCO2eby2030tomeettheobjectivesetoutintheParisAgreementofdecarbonisingby2050.43RecentforecastsindicatethatthecurrentpriceleveliswellwithinthetrajectorythatisexpectedandrequiredtomeettheEU’sclimateobjectives.Forexample,ICIS,amarketintelligencefirm,andresearchinstitute,PIK,areforecastingpricestorisetobetween€90/tCO2eand€129/tCO2eby2030.PlattsAnalyticsisforecastingEUAstoreach€100/tCO2eby2030,largelydrivenbythetightnessfromimplementingtheFitfor55EUETSproposals.44Figure2.6EUcarbonpricehistoryandmarketforecastsfor2030Note:They-axisunitiseurospertonneofCO2e.RecentforecastsfromICISandPIKexpectEUETSpricestorangebetween€90/tCO2eand€129/tCO2ein2030.Source:OxeraanalysisbasedonEUETSauctionpricesfromBloomberg,andpriceforecastsfromICISandPIK.Euractive(2021),‘Analyst:EUcarbonpriceontracktoreach€90by2030’,19July;Pietzcker,R.(2021),‘TighteningEUETStargetsinlinewiththeEuropeanGreenDeal:ImpactsonthedecarbonizationoftheEUpowersector’,AppliedEnergy,293:1July.AspartoftheFitfor55proposals,theCommissionisproposingtoexpandtheEUETStocovernewsectors.45Underitsproposal,emissionsfrommaritimetransportwillbeincludedintheexistingEUETS,whileemissionsfromfuelsusedinroadtransportandbuildingswillbecoveredbyanew,separate,EU-wideemissionstradingsystem.Theexpansionofthecap-and-tradesystems42Perry,I.(2021),‘Fivethingstoknowaboutcarbonpricing’,InternationalMonetaryFund.43OECD(2021),‘EffectiveCarbonRates2021’,p.4,https://www.oecd.org/tax/tax-policy/effective-carbon-rates-2021-highlights-brochure.pdf(accessed17December2021).44S&P(2021),‘Spotlight:EUcarbonpricestrengthenstorecordhighsinNovember’,8December,https://www.spglobal.com/platts/en/market-insights/latest-news/energy-transition/120821-spotlight-eu-carbon-price-strengthens-to-record-highs-in-november(accessed15December2021).45‘ProposalforaRegulationoftheEuropeanParliamentandoftheCouncilamendingRegulation(EU)2018/842onbindingannualgreenhousegasemissionreductionsbyMemberStatesfrom2021to2030contributingtoclimateactiontomeetcommitmentsundertheParisAgreement,COM(2021)555,final,14July2021.020406080100120140201320142015201620172018201920202021202220232024202520262027202820292030EUAspotpriceRecentforecastsofcarbonpricein2030takingintoaccounttheEU'sclimateobjectivesassetoutintheGreenDealandtheFitfor55PackageCarbontradingintheEuropeanUnionOxera18highlightsthatthecarbonpricingsignalswillbecomeevenmoreimportantinthefuture.TheimpactonthepriceofEUAsofthisexpansionwilldependlargelyonwhethernewsectorscanuseEUAsforcomplianceandthenetsupply–demandbalanceofthesesectors.Thecarbonpricesofthedifferentsectorswillalignifunitsfromdifferentsectorsarefullyfungible.Assumingthattheabatementcostsinnewsectorsarehigher,theinclusionofthesefurthersectorscanbeexpectedtoleadtohigherEUAprices.Insum,thediscussionaboveindicatesthatwhiletherecentpricechangeshavebeensignificant,thelevelsstillfallwellwithintherangesthatmightbeexpectedintheperiodupto2030.CarbontradingintheEuropeanUnionOxera193Whatistheroleofderivativesandderivativesexchangesinthecontextofcarbontrading?3.1DerivativesincarbonmarketsAderivativeisafinancialcontractwhosepricedependson,orisderivedfrom,theperformanceofanunderlyingasset,benchmark,commodity,orotherinstrument,andthroughwhichtheassociatedfinancialriskscanbetradedbetweenparties.Forthepurposesofthisreport,weareinterestedincontractsderivedonthepriceofEUAsastheunderlyingvariable,andparticularlythefollowing.•EUAfutures.TheseareagreementsbetweentwopartiestobuyorsellanEUAatacertaintimeinthefutureforacertainprice.Theseareelectronicallydeliveredcontracts—acontractthatishelduptoitsexpiryresultsinthephysicaldeliveryofEUAswithintheUnionRegistry.Futuresareexchange-tradedderivatives.•EUAoptions.Thesearetradedbothonexchangesandover-the-counter(OTC).ThedifferencesbetweenexchangetradingandOTCtradingisexplainedmoreinsection3.2.Acall(put)optiongivestheholdertherighttobuy(sell)theunderlyingEUAcontractatacertaindateforacertainprice(knownasthe‘exercise’or‘strikeprice’).•EUAswaps,EUAforwardsandotherbespokederivativecontractsbasedonthepriceofanEUA.46ThesecontractsaretypicallyprivatelynegotiatedwithfinancialinstitutionsandtradedOTC.Box3.1describesthemainproductcharacteristicsofEUAderivativestradedonICE.46Aswapisanagreementtoexchangecashflowsinthefutureaccordingtoaprearrangedformula.Aforwardisacontractthatobligatestheholdertobuyorsellanassetforapredetermineddeliverypriceatapredeterminedfuturetime.CarbontradingintheEuropeanUnionOxera20Box3.1CharacteristicsofEUAderivativestradedonICEEUAfutures•Contractsize:onelotof1,000EUAs(i.e.1,000tCO2e).Minimumtradingsize:onelot.•EUAfuturesaredeliverablecontractswhereeachclearingmemberwithapositionopenatcessationoftradingforacontractmonthisobligedtomakeortakedeliveryofEUAstoorfromatradingaccountwithintheEUAdeliveryperiod.TheexpirydateisthelastMondayofthecontractmonth.•TheEUAdeliveryperiodistheperiodstartingat09.00LondonLocalTime(LLT)onthebusinessdayfollowingthelastdayoftradingofacontractandendingat15.00(LLT)onthethirdbusinessdayfollowingthatlastdayoftrading.EUAoptions•TheEUAOptionsContractisanoptionontheEUAFuturesContract.Uponexercisingtheoptionatexpiry,onelotofEUAOptionsbecomesonelotofEUAFuturesContracts.•EUAOptionsareEuropeanstyle,suchthatIn-The-Moneyoptionsareautomaticallyexerciseduponexpiry.In-The-Moneyoptionsuponexpirycannotbeabandonedandbothcounterpartiesmusthonourtheirlegofthetrade.Uponexpiry,At-The-MoneyandOut-of-The-Moneyoptionswillexpireworthless.•TheunderlyingcontractistheDecemberFutureoftherelevantyear.Forexample,theunderlyingfortheMar2021optionistheDec2021Future.Source:ICEwebsite.Derivativesplayanessentialroleincarbonmarkets.Theycantransferawiderangeofrisksintheeconomyfromoneentitytoanother,andindoingsohelpimprovetheefficiencyofmarkets.Derivativesmarketsalsoplayamajorroleinenhancingtransparencybycontributingtomarketparticipants’assessmentoffuturecarbonpricing.Indoingso,theycontributetolong-termsustainabilityobjectivesandprovidehelpfulsignalstopolicymakersthatarerelevanttotheregulationofcarbonemissions.Carbonderivativesalsoprovideparticipantswiththeabilitytohedgerisksassociatedwithfluctuatingenergyprices(seesection3.4forsomeexamples).Theycanbeusedbycompaniesthataredirectlyorindirectlyexposedtocarbonprices.•Forinstance,complianceentitiescanuseemissionsderivativestomeettheirobligationsandmanagetheirrisksinacost-efficientmanner.•Othercompanies(withoutcomplianceobligationsundertheEUETS)thatproduceorareinvestinginemissions-reductionstechnologiesmayalsoseektousecarbonderivativestomitigateoravoidexposuretocarbonpricerisk.Theycandothisbyplacingpositionsinfuturesandoptionsmarkets.Theabilitytohedgelowersthefundingcostsforthesecompaniesbyreducingtheuncertaintyoftheircashflows.47AssummarisedinTable3.1,severalacademicpapersshowthat,byreducingthevolatilityofthesecashflows,hedgingcanhaveatangibleimpactonthecostofcapital.Thisresearchindicatesthattheabilitytohedgecanreducethecostofdebtbyaround19–54basispoints(bp)andthecostofequitybyaround24–78bp.47Inafrictionlessmarket,individualinvestorscanhedgethemselves.Iftheassumptionsofaperfectcapitalmarketareviolated(e.g.ifinvestorsdonothaveperfectinformationoraccesstothesamehedginginstruments),firm-levelhedgingcanincreaseshareholdervalue.CarbontradingintheEuropeanUnionOxera21Table3.1StudiesestimatingtheimpactofhedgingonthecostsoffinancingStudyFindingBartrametal.(2011)1Theuseofhedgingcanreducebetasby15–31%,whichcantranslatetoacostofequityreductionof75bpCampelloetal.(2010)2Achangeinhedgingintensitybyonestandarddeviationreducesloanspreads,loweringthecostofdebtby54bpCarteretal.(2006)3Jet-fuelhedgingincreasesairlinefirmvaluebyaround12–16%ChenandKing(2014)4Thecostofdebtofhedgersislowerthanthatofnon-hedgersby19.2bpforinvestment-graderatingand45.2bpforspeculative-graderatingGayetal.(2011)5Derivativesusershaveacostofequityfinancingthatisbetween24bpand78bplowerthanthatofnon-derivativesusersNote:Thecostofequityreductionestimateisbasedonamarketriskpremiumof5%.Source:1Bartram,S.M.,Brown,G.W.andConrad,J.(2011),‘Theeffectsofderivativesonfirmriskandvalue’,TheJournalofFinancialandQuantitativeAnalysis,46:4,pp.967–99.2Campello,M.,Lin,C.,Ma,Y.andZou,H.(2010),‘Therealandfinancialimplicationsofcorporatehedging’,NBERWorkingPaperNo.16622.3Carter,D.A.,Rogers,D.A.andSimkins,B.J.(2006),‘Doeshedgingaffectfirmvalue?EvidencefromtheUSairlineindustry’,FinancialManagement,35:1,pp.53–86.4Chen,J.andKing,T.D.(2014),‘Corporatehedgingandthecostofdebt’,JournalofCorporateFinance,29,pp.221–45.5Gay,G.D.,Lin,C.M.andSmith,S.D.(2011),‘Corporatederivativesuseandthecostofequity’,JournalofBanking&Finance,35:6,pp.1491–506.Sometimesthetimeperiodoftheriskexposurethatisrequiredislaterthanthedeliverydatesofallthefuturescontractsthatcanbeused.Thehedgermustthenrollthehedgeforwardbyclosingoutonefuturescontractandtakingthesamepositioninafuturescontractwithalaterdeliverydate.Hedgescanberolledforwardmanytimes—aprocedureknownas‘stackandroll’.EUAderivativescontractsalsoprovideusefulpricingsignalsforinvestorsseekingtoallocatecapitaltoprojectsthatwouldbenefitfromtheenergytransitionand/ortoassessandmanagetheclimatetransitionrisksintheirportfolios.SeveralderivativesexchangesofferstandardisedfuturesandoptionsderivativescontractsonEUemissionsallowances,asshowninTable3.2.Table3.2Exchange-tradedcontractsforEUemissionsTradingvenuePrimarymarketSecondarymarketsNewYorkMercantileExchangen/aInDeliveryMonthEUAfuturesInDeliveryMonthOptionsonEUAfuturesEEXAuctionsofEUAandEUAADailyfuturesonEUAandEUAAMonthly,quarterly,andyearlyfuturesonEUAYearlyoptionsonEUAfuturesYearlyfuturesonEUAAICEn/aDailyfuturesonEUAMonthlyfuturesonEUAMonthlyfuturesonEUAAQuarterlyoptionsonEUAfuturesNasdaqOslon/aDailyfuturesonEUAQuarterlyandyearlyfuturesonEUANote:monthlycontractscanbetradedaspartofastrategywhichallowsamarketparticipanttoeffectivelytradeaquarterorfullyear.CarbontradingintheEuropeanUnionOxera22Sources:ESMA(2021),op.cit.,https://www.cmegroup.com/trading/energy/emissions/?redirect=/trading/energy/emissions/index.html(accessed13December2021)andinterviewswithICE.3.2Whatistheroleofderivativesexchanges?TradinginEUAderivativestakesplaceonorganisedderivativesexchangesandover-the-counter(OTC).OTCisabroadterm,referringtotradingamongstdecentralisednetworksofbuyersandsellers,usuallyintermediatedbyasmallnumberofhighlyinterconnectedfinancialinstitutions(brokers).OTCtradingcanalsotakeplaceonabilateralbasis,wherebythecounterpartieshavedirectrelationshipswitheachother.Incontrast,exchangetradingtakesplaceonasinglecentralisedorderbookandonamultilateralbasis(i.e.allbuyersandsellersinteractwitheachotheratthesametime).ThesedifferentmodelsareillustratedinFigure3.1below.Figure3.1DifferentmodelsoftradingSource:Oxera.Aswithmanynewercommoditymarkets,earlytradingactivityinEUAspredominantlytookplacethroughdirectbilateralcontractingorviavoice-andelectronic-brokerageplatforms.However,theshareofexchangetradingincreasedrelativelyquickly,suchthatbytheendofphase1oftheEUETSin2007,aroundone-thirdoftradingvolumeswasexecutedonexchanges.48Currently,c.70%oftradingactivitytakesplaceontheorderbookofexchanges,asshowninFigure3.2below.48SeeEllerman,A.D.andJoskow,P.L.(2008),‘TheEuropeanUnion’sEmissionsTradingSysteminPerspective’,May.CarbontradingintheEuropeanUnionOxera23Figure3.2EUAfuturestradingvolumesbytradingmechanism,2011–21YTDNote:They-axisunitisbillionsofEUAstraded,where1EUA=anentitlementtoemit1metrictonneofCO2e.DataincludestradingvolumeofEUAfuturesandexcludesEUAoptions.ExchangeorderbooktradingconsistsoftradingthattakesplaceontheorderbooksofICE,EEXandNasdaq.Offorderbooktradesconsistsofpre-negotiated/brokeredtradesreportedtotheexchangeasblocktrades.2021datacoversJanuary–October.Source:OxeraanalysisoftradingdatafromTrayportLimited.©TrayportLimited2021.Allrightsreserved.ThistransitionofEUAtradingtowardsacentralised,liquidandtransparentexchangeorderbookhasrelied,inpart,ontheinvestmentsundertakenbyderivativeexchangestofacilitatepriceformationandtrading.Thisincludesprovidingthephysicalplatforminfrastructureandsettingtherulesbywhichordersinteract,aswellasongoingactivitiessuchasmonitoringandsurveillance(seeBox3.2below).ThetransitionofEUAstoexchange-basedtradinghashadimportantimplicationsfortheoveralldevelopmentoftheEUcarbontradingmarket.•First,comparedtoOTCtradingmodels,exchangetradingcanreducebarrierstoentryfornewparticipantsandmaketradingmoreaccessible.Newtradingparticipantsdonothavetoestablishbilateraltrading,credit,andsettlementrelationshipswithincumbentparticipants.Instead,traderscanaccessanexchange’splatformthroughasinglepointofentry:theexchange.Thisaccessalsomeansthatatradercanexecuteagainstallcounterpartiespostingpricesonanexchange,incomparisontobrokervenues,inwhichthetradercantradeonlywithcounterpartieswithwhichithasestablishedatradingandcreditagreement.InthecaseofEUAs,exchange-tradedfuturesmaybeeasiertoaccessforcertaininvestors(e.g.UCITSfunds)thantheprimaryorOTCmarkets.•Second,exchangetradingrulesfacilitatenon-discretionary,anonymousandmultilateraltrading.Thenon-discretionarynatureofanexchangeorderbookmeansthatordersarematchedautomaticallyonaprice–timebasis.Therefore,inordertotrade,participantsmustprovidecompetitivequotes(i.e.loweraskpricesorhigherbidprices).Anonymityoftradingcanalso02468101220112012201320142015201620172018201920202021NumberofEUAstradedExchangeorderbookOfforderbookCarbontradingintheEuropeanUnionOxera24bringbenefitstoparticipantsbyreducingtheriskofinformationrevelationandadverseselection.49•Third,byopeningupopportunitiestoabroader,morediversegroupofmarketparticipants,exchangesfacilitatetheprovisionofliquidity,tothebenefitofcarbonemitterswithcomplianceobligations.Thesecompanieswilloftenneedtopurchasefuturestomeettheirregulatoryobligationsandmanageriskinacost-effectiveway.•Fourth,exchangetradingtakesplaceinahighlytransparentenvironment,wherequotes(pre-tradeinformation)andprices(post-tradeinformation)arevisibletoalltraders.Marketswithacentralisedprice-formationmechanism(combinedwithmarketsurveillanceandenforcement)tendtobelesssusceptibletopricemanipulationthanmarketsthatarecharacterisedbyopaquenessandpricedispersion(i.e.identicalassetstradingatdifferentpricesatthesametime).49Knowingtheidentityoftheparticipantmayprovideinformationwithrespecttothedirection(buyingorselling)ofthetrade,andthepricingavailablemaythereforebeframeddifferently.CarbontradingintheEuropeanUnionOxera25Box3.2ActivitiesundertakenbyderivativesexchangestofacilitateEUcarbontradingTofacilitateareliableandefficientprice-formationprocessinthetradingofEUAfuturesandoptions,aderivativesexchangeundertakesseveralactivities,someofwhichprovidedirectbenefits,whileothersaremoreindirectlybeneficial,butstillimportant.Therangeofactivitiescanbedividedintothefollowinggroups.1.ProvidinghighlyresilientplatforminfrastructureTofacilitatetrades,thefirstrequirementisthatmarketparticipantshaveaccesstoaforumwheretheycanmeetandindicatetheirintentions.Derivativeexchanges,suchasICE,providethisthroughonlineelectronicplatformsthatallowuserstospecifytheirpriceandvolumeconditionsanonymouslyandbematchedwithotherswhoarewillingtotradeonthoseterms.ICE,forexample,grantsfree,non-discriminatoryaccesstoitsWebICEplatformtomarketparticipantswhomeetauthorisationrequirements.Byvettingpotentialmembers,andrequiringmemberstohavesystemsinplacetovettheirclientsinturn,derivativesexchangesensurethattheirmembersholdthelicences,permits,necessaryexpertiseandotherrequirementstoconductbusinessontherelevantexchange.2.AttractingagoodmixofparticipantsDerivativeexchangesaimtoachievetradingflowsfrombuyersandsellers,andthereforeseektoattracttherightsortsofuserstotheplatformandfacilitateahealthymixofparticipants.Asnotedabove,onewayofmaintainingqualitycontrolisbymakingsurethatpotentialmembersmeetauthorisationrequirements.Intheexchangemodel,allparticipantsenterthemarketviaasinglepointofaccessandtradingtakesplacesonamultilateralbasis(i.e.allbuyersandsellersinteractwitheachotheratthesametime).Aswellasreducingsearchfrictionsassociatedwithtradingonabilateralbasis,centralisedtradingplatformscanalsoreducethecostoftradingthroughincreasedcompetitionandliquidityprovision.3.SettingtherulesofthegameAnotheractivityundertakenbyderivativesexchangesisthesettingofrulesthatdictatetheprice-formationprocess.Exchangeshavearesponsibilitytopublishandproviderulesonmanyaspectsofthetradingprocess,including,forexample,establishingorderquantitylimits,pricereasonabilitylimits,intervalpricelimitsandsettlementperiods.FurtherinformationonpricereasonabilityandintervalpricelimitsisprovidedinBox3.3.Bycreatingarulebooktoestablishacceptabletradepractices,exchangescanminimisefraudulentactivityandprotectpropertyrights,aswellasreducingthetransactioncostsassociatedwithtrading.4.MonitoringandenforcementInadditiontosettingtherulesthattradersmustfollowontheirplatform,derivatesexchangesmustmonitorandenforcetheirrules,includingreportingpotentialbreachesoftheEU’sMarketAbuseRegulation(MAR).Theprocessofmonitoringandenforcementisself-regulated,butisalsooftenconductedincollaborationwiththerelevantregulatoryauthorities.Surveillanceanddetectiontoolsalertexchangesofunusualbehaviour.Exchangesestablishconditionswhich,whenmet,triggeralerts.Uponnotificationofasurveillancealert,theexchangecanconductaninvestigation,andthiscouldresultinaSuspiciousTransactionReport(STOR)senttotherelevantNationalCompetentAuthority.Alertconditionscanbesettodetectpriceorvolumespikesoralerttheexchangetomorespecificsuspicioususerbehaviour.Anotherexampleofmonitoringandenforcementactivitiesconductedbyexchangesistheuseofintervalpricinglimits.Thesepricelimitsactastemporarycircuitbreakersthatreducethelikelihoodofshort-termpricespikesoroutsizedmarketmovements.Intervalpricinglimitparameterscanvaryovertimebasedonmarketconditions,butareintendedtobetriggeredonlyinthecaseofextremepricemovesovershortperiodsoftime.SeeBox3.3formoreinformationaboutintervalpricinglimits.Source:Oxera,basedoninterviewswithICEandcarbontraders.CarbontradingintheEuropeanUnionOxera263.3RegulatoryframeworkgoverningcarbontradingThetradingofEUAcontractsandEUAderivativesisawell-regulatedactivityintheEU.Inparticular,theEUregulatoryframeworkaroundEUAsandEUAderivativesismadeupofthefollowing:50•theMarketsinFinancialInstrumentsDirectiveandRegulation(MiFIDIIandMiFIR);•theMARandtheEuropeanMarketInfrastructureRegulation(EMIR);•thetoolsavailabletoESMAandthenationalcompetentauthorities(NCAs)tomonitorandsupervisethismarket.Assuch,thetradingofEUAsandEUAderivativesissubjecttocertainrulesaimedatpromotingmarkettransparencyandintegrity,aswellaspreventingmarketabuseandmarketmanipulation.Forexample,theEUlegislativeframeworksetsoutwhocanbuyandsellEUAsandEUAderivativesandunderwhatconditions.Inparticular,theEUMarketAbuseRegulation(MAR)prohibitsinsiderdealing,unlawfuldisclosuresofinsiderinformationandmarketmanipulation.51CompanieswithlargeinstallationsregulatedbytheEUETSaresubjecttostricterrulesoninsideinformationtopreventunfairadvantageamongmarketparticipants.Therearealsoseparaterulesgoverningtheactivitiesofparticipantsintheprimaryauctionsandthesecondarymarkets.Derivativesonthemostliquidemissionsallowancescontractsaresubjecttoweeklyanddailypositionreporting.Thesereportingrequirementsapplytocontractswithatleast20marketparticipantsandanabsoluteamountofthegrosslongorshortvolumeoftotalopeninterestofatleast10,000lotsforcommodityderivatives.IncludedinthisreportingframeworkareEUAfuturestradedonICEandEEX.PositionreportsarenotmadeavailableonderivativestradedinOTCmarkets,onEUAAs,dailyfuturesonEUAs,optionsonEUAfutures,orEUAfuturestradedonNasdaqOslo.EmissionsallowancesarenotsubjecttopositionlimitsandpositionmanagementcontrolsbasedonrulesunderMiFIDII.However,derivativesexchanges,suchasICE,conductpositionmanagementandmarketsurveillanceactivitiesontheseassets.Box3.3belowsummarisessomeofthemainmarketsurveillanceactivitiesthatICEconductstoensureanorderlyfunctioningofitscarbonderivativemarkets.TheseactivitiesaresupervisedbytherelevantNCA,suchastheDutchAuthorityfortheFinancialMarkets(AFM)forICEEndex.50SeeAppendixA1foramoredetailedoverview.51‘Insiderdealing’referstotheuseofinsideinformationtoexecutedealstoone’sadvantage.Thisincludestheexecutionofordersbasedoninsiderinformation,aswellasthecancellationandamendmentofordersbasedoninsiderinformation.‘Marketmanipulation’referstotheactofmisleadingthemarketthroughcertainactivityortoactivitiesthatmanipulatetheprice.Formoredetail,seeRegulation(EU)No596/2014oftheEuropeanParliamentandoftheCouncilonmarketabuse(marketabuseregulation),https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0596&from=EN(accessed31January2022).CarbontradingintheEuropeanUnionOxera27Box3.3ICE’smarketsurveillanceactivitiesinitscarbonderivativescontractsSystemsandcontrolsareimportantinreducingthelikelihoodofordersenteredinerror,preventingtheexecutionoftradesatunrepresentativeprices,andreducingthemarketimpactofsuchtrades.ICEhasimplementedproactiveandreactivemeasurestoensurethatitscarbonderivativestradingmarketsarewellfunctioningandlimitthelikelihoodoferroneoustrades.Examplesofproactiveactivities(i.e.exanteinterventions)includethefollowing.•NoCancellationRanges(NCRs):exceptinexceptionalcircumstances,onceexecutedatradewillstandandwillnotbesubjecttoadjustmentorcancellation.NCRsthereforesetsparametersaboveorbelowanexchangesetanchorpriceforeachcontractwithinwhichadisputedtradewillstand,evenifexecutedinerror.•PriceReasonabilityLimits:theseareprice‘reasonability’limitstoprevent‘fatfinger’errors.Thelimitistheamount,setbytheexchange,thatthepricemaychangeinonetradingsequencefromtheanchorprice.•IntervalPriceLimits(IPL):theseprovidefunctionalitytolimitlargepricemovementsfromoccurringwithinagiventimeframe.Foreachenabledcontract,theexchangesetstheIPLthatlimitstheextentthatpricescanmovewithinasettimeframeknownasthe‘re-calculationtime’.IfabidorofferattemptstobreachtheIPL,themarketwillenteraholdperiodpreventinganyfurthertradingbeyondthelimituntiltheendoftheholdperiod.•Positionmanagementcontrols:exchangesmonitoropeninterestdevelopmentsonanongoingbasisandsetsaccountabilitylevelsinthespotmonthandothermonthswhenitdeemsitisnecessarytopreventandaddressdisorderlytrading,supportorderlypricingandsettlementconditions,andensuretheefficiencyofmarkets.Positionmanagementconsiderspositionsheldbypositionholders,andanyrisksthesemaypresenttomarketorder,inthecontextmainlyof:pricingandpricetrendsintherelevantmarkets;thenatureofthepositionholder;thepositionsinrelatedmarkets;concentration;positiondevelopmentovertime;seasonality;openinterest;activityinrelatedunderlyingfinancialinstruments;incentiveschemeparticipation;andtheextentandqualityofengagementwiththeexchangeandresponsetoinquiries.•Othermeasures:exchangescansetvolumereasonabilitylimitsthatpreventvolumesgoingaboveacertainleveltobeeitherdesignatedfortradingortraded.Forexample,ICEoffersoptionalpre-confirmationmessageswhichappeartomarketparticipantsbeforetheexecutionofalltrades.Theplatformalsoprovidestheoptiontolimitthequantitythatausercantraderatherthantradingthetotalquantitythatisavailabletobetradedataspecificprice.Examplesofreactiveactivities(i.e.measuresappliedexpost)includethefollowing.•TradeAdjustmentPolicy:anytradeexecutedatapricewithinthepricereasonabilitylimitbutoutsideoftheNCRforthatcontract,ifnotifiedtoanexchangewithinthedesignatedtimeperiodofeightminutesfromthetimeoftheoriginaltrade,willbeinvestigatedbymarketsupervision.•Tradingalerts:ICEmonitorsEUAfuturesandoptionscontractstodetectmarketanomaliesandmarketabuse.Adedicatedmarketsurveillanceteamsupervisesthealertstriggered,repliestousers’queries,reportspotentialregulatorybreaches,andconductsinvestigationsincollaborationwiththerelevantcompetentauthoritywhereneeded.Exchangesundertakestheseactivitiesinclosecollaborationwiththerelevantcompetentauthorities.Therearealsoregularmeetingsbetweenexchangesandtherelevantauthoritiestofollowuponmarketmonitoringactivities.Source:OxeraanalysisbasedonICEinternalandpublicinformation.SeeICEEndex‘Policy–PriceAdjustmentandTradeCancellation’,https://www.theice.com/publicdocs/endex/ICE_Endex_Trade_Cancellations_Price_Adjustment.pdf,accessed25January2021;ICEEndex‘NoCancellationRanges,ReasonabilityLimitsandIntervalPriceLimits’,https://www.theice.com/publicdocs/endex/ICE_Endex_NCR_Reasonability_Limits.xlsx(accessed25January2021).ICEEndex‘PositionManagementControlsPolicy’.CarbontradingintheEuropeanUnionOxera28TherehavebeensomecallsfortheEUtoimposepositionlimitsonemissionsallowances.Theeconomicsliteratureisgenerallyscepticalabouttheefficiencybenefitsofregulatorsimposingsuchpositionlimitsonmarketparticipantsinfuturesmarkets,despitethegoodintentionsofensuringefficiencyandpriceformation.AppendixA2summarisestheliteratureonpositionlimits.3.4Tradingstrategies—whotradesandwhy?ThemarketmicrostructureliteraturereferstothreebroadcategoriesoftradersinderivativesmarketsandthisisnodifferentinthecaseofthetradingofEUAfuturesandoptions.52Atahighlevel,thereare:•hedgers—whichusederivativestoreducetherisktheyfacefrompotentialfuturemovementsinamarketvariable.ThevariableinthiscaseislikelytobethepriceofanEUA,butitcouldalsobethepriceofarelatedvariable,suchasanothercarbonprice,arelatedenergyprice,oranothervariablehighlycorrelatedwithEUAs;•speculators—whichusetheinstrumentstotakeapositiononthefuturedirectionofamarketvariable;•arbitrageurs—whichtakeoffsettingpositionsintwoormorefinancialinstrumentstolockinaprofit.Inpractice,someinstitutionsmayundertakeamixtureoftheseactivities.Forexample,atradingentitymayengageinacombinationofarbitrage,speculativeand/orhedgingstrategies,dependingontheirspecificstrategyandriskappetite.Itisimportanttodrawadistinctionbetweenspeculationandmarketmanipulation.Marketmanipulationisillegalandimpairsmarketfunctioning.Speculationisanimportantpartofensuringthewell-functioningofatradingmarket.Inamarketsuchasthetradingofemissionsallowances,manyparticipantsarenaturallyseekingtohedgebytakingnetlongfuturepositions.Insuchamarket,meetinghedgingdemandrequirescounterpartiesthatarewillingtotakecomplementaryshortfuturespositions.Suchahedgingcounterpartyroleistypicallyassumedbyfinancialintermediaries,andthisiswhatweseeinpracticeinthecaseofthetradingofEUAfutures.Table3.3belowdescribesthetypicaltradingstrategiesappliedinEUAfuturescategorisedbytypeofinstitution.52Hull,J.C.(2022),Options,FuturesandOtherDerivatives,11thEd.,Pearson,chapter1,pp.23–45.CarbontradingintheEuropeanUnionOxera29Table3.3TypicaltradingstrategiesinEUAfuturesCategoryofinstitutionExamplesMotivation(s)totradeTypicaltradingstrategyEmittersCommercialentitiesinpowerandheatgeneration,energy-intensiveindustrysectorsincludingoilrefineries,steelworks,productionofiron,aluminium,metals,cement,lime,glass,ceramics,pulp,paper,cardboard,acidsandbulkorganicchemicalsMeetingcomplianceobligationsHedgingagainstEUApriceandvolumesrisksBuyEUAfuturestomeetcomplianceobligationsand/orhedgeSellEUAfuturesifhave‘excess’EUAsTakingpositionsMixoflongandshortpositionsFreeingupshort-termcapitalSellEUAsandbuyEUAfuturesLow-carboninnovators/entrepreneursFirmsinvestinginemissions-reductiontechnologiesHedgingagainstEUApriceandvolumerisksBuyEUAsandsellEUAfuturesInvestmentfirmsorcreditinstitutionsBanksMarket-making(toprofitfromthedifferenceinthebid–askspread)MarketaccessforcomplianceentitiesMixoflongandshortpositionsCarrytradeBuyEUAsandsellEUAfuturesInvestmentfundsETFs,pensionsfunds,insurancecompanies,collectiveinvestmentschemesExposuretocarbonasanassetclassHedgingagainstinflationrisksSeekingpotentialdiversificationduetohistoricallylowcorrelationtotraditionalassetclassesPredominantlybuyEUAfuturesOthertradinghousesAlgorithmictradingfirms,commoditytradersMarket-making(toprofitfromthedifferenceinthebid–askspread)SeekingarbitrageopportunitiesTakingpositionsMixoflongandshortpositionsNote:“Emitters”referstofirmswithobligationsundertheEUETSplusassociatedcommercialundertakings,asdefinedinESMA(2021),‘QuestionsandAnswersonMiFIDIIandMiFIRcommodityderivativestopics’,pp.39–40,https://www.esma.europa.eu/sites/default/files/library/esma70-872942901-36_qas_commodity_derivatives.pdf(accessed30December2021).Carrytradereferstoatradingstrategyofbeinglongonthephysicalcertificateandshortonthefuture,providingclearinghousedisintermediatedfinancingforcommercialundertakings.CCSreferstotechnologiesthatcaptureandstoreemittedCO2topreventitfromenteringtheatmosphere.Source:Oxera.EnergyproducersandindustrialgroupsoftenseektobuyEUAsviathefuturesmarkettohedgetheirexposuretothecarbonpriceandtoensurethattheyhaveenoughcreditstocoveranticipatedemissions.TheymayalsoshortEUAfuturesiftheyhaveemittedlessthanplannedinthepreviousyear.Box3.4andCarbontradingintheEuropeanUnionOxera30Box3.5belowsetoutcasestudiestodemonstratethebenefitstocomplianceentitiesoftradingEUAandEUAderivatives.Box3.6detailshowemittersandinvestorsmightprofitfromcarrytradesandcashflowmanagementusingcarbonderivatives.Emittersinothersectors(e.g.shipping,buildingsandtransport),whicharenotcurrentlywithinscopeoftheEUETS,mayalsoseektooffsetorhedgetheircarbonfootprintviathetradingofEUAfutures,forethicalreasonsand/orinanticipationofthescopeoftheEUETSexpandinginthefutureundertheFitfor55package.FinancialintermediariestypicallyseektotradeEUAsandEUAfuturesandoptionswithaviewtoprovidingliquidityfortheirclients(andthenprofitingfromthedifferenceinthebid–askspread)and/ormarketaccess(someentitiesmayaskafinancialinstitutiontotradeonitsbehalfonanagencybasisiftheyfindittoocomplexorexpensivetobuyEUAsorEUAfuturesdirectlyviatheauctionortheorderbookofanexchange).InvestmentfundsmaybuyEUAfuturestogaintargetedexposuretotheEUAcap-and-tradeallowanceprogramme.InrecentyearstherehasbeengrowthinthenumberoffundsholdingpositionsinEUAfutures;however,thesizeofthesepositionsremainslimitedtodate(representingonly4.1%oftotalpositionsinEUAfuturesintheweekcommencing8November2021and4.6%onaveragethroughout2021upuntilNovember2021).53InvestorsalsocombineportfoliosinvestinginEUAswithothercarbonfundstoattunetheirallocationtotheglobalcarboncreditmarket.Theremayalsobeothermotivations.Forexample,fundsmayinvestinEUAsowingtothepotentialforportfoliodiversificationduetothehistoricallylowcorrelationwithtraditionalassetclassesortohedgeagainstinflationrisks,amongotherreasons.54ExamplesoffundsbuyingEUAsincludeKraneSharesEuropeanCarbonAllowanceETF,iPathEUCarbonexchange-tradednoteandWisdomTree’sEuropeanfund.OtherprominentinvestmentfundstakingpositionsonEUAsincludeSparkChange’sexchange-listedETC(whichseekstoinvestinEUAsintheprimarymarket)andCarbonCapManagement’sWorldCarbonhedgefund.Asisevidentfromanalysisofthecommitmentoftraders(COT)reportsofICEandEEXforEUAfutures,thelargesttradingpositionsarebetweenfinancialinstitutionssellingEUAfuturesagainstcommercialsentitiesthatbuythemwithaviewtohedgingEUApriceandvolumerisktomeettheircomplianceobligationsundertheEUETS,asdiscussedinsection3.3.53Source:OxeraanalysisofICE’scommitmentoftrader(COT)reports.54See,forexample,thecorrelationmatrixinICE(2021),‘ICECarbonFuturesIndexFamily’,p.3.https://www.theice.com/publicdocs/ICE_Carbon_Futures_Index_Family_Primer.pdf(accessed30December2021).CarbontradingintheEuropeanUnionOxera31Box3.4AnillustrativeexampleofthegainsoftradingEUAstocomplianceentitiesAsimplenumericalexampleillustrateshowtheabilitytotradeemissionspermitscanreducethecoststocomplianceentities.Taketwofacilitiesthatearnthesamemarginalprofitperunitbeforeaccountingforthecostofcarbonemissions.Thesemaybetwofacilitiesownedbydifferentcompaniesinthesamesectororplantsincompletelydifferentsectors.•Facility1incursacostof€50/tCO2eemissionsreduction.•Facility2incursacostof€300/tCO2eemissionsreduction.ClearlytheemissionsreductioncanbeachievedatlowercompliancecostsatFacility1thanatFacility2.SupposethepriceofanEUAis€200/tCO2eandthatthetwofacilitieswereinitiallyallocatedEUAsconsistentwiththeindividualemissionslevelsrequiredundertheemissionsstandard.Facility1(thelow-costseller)gainsbyreducingitsemissionsfurtherthanthestandardrequiresandsellingtheallowanceitnolongerneedstoFacility2.•Facility1receives€200fortheemissionsallowancebutpaysonly€50toachievetheemissionsreduction,foranetgainof€150.•Facility2isabletobuytheemissionsallowancefor€200andreduceitscompliancecostsby€300,foranetgainof€100.Thusthetotalgainfromtradingissplitbetweenthebuyerandtheseller,withbothgainingfromtradingtheEUA.Source:Oxera,basedonEllerman,A.andHarrison,D.(2003),‘EmissionstradingintheU.S.’,PewCenteronGlobalClimateChange,https://web.mit.edu/globalchange/www/PewCtr_MIT_Rpt_Ellerman.pdf(accessed30December2021).Box3.5Casestudy:powerutilityhedgingusingEUAfuturesConsideralargepowerutility,whichendeavourstomeettheenergyneedsofitscustomers.Thisutilityhasmanyplants,withdifferentenergytypes,andwillusewhicheverplantsitexpectswillbemostefficienttomeetdemand.Theutilityanticipatesneedingtogenerate10GWhofelectricityinthenearfuturetomeetexpecteddemand.Itintendstogenerate5GWhofthisfromgasplants,knowingthatEUAsarerequiredtocovertheresultingemissions.TheutilitythenworksouthowmanyEUAsarerequiredtomeetthat5GWhgasvolume.OncetheutilityhasestimatedhowmanyEUAsitwillneedinthefollowingyeartocoveritsproduction,ithasachoice:towaituntilthepermitsareneededandbuytheEUAsintheprimaryauctionatthattime,ortosecuretherequirednumberofpermitsnowonthefuturesmarketforitsproductioninthefollowingyear.EveniftheutilityhasnoknowledgeaboutwhetherfutureEUApricesaregoingtoincreaseordecrease,itmightstillchoosetopurchasetheEUAsattheknownfuturescostinorderto‘lockin’aprice,therebyminimisingriskexposureandhelpingittogetgreatercertaintyoveritsfuturemargins.Source:Oxera,basedoninterviewswithcarbontraders.CarbontradingintheEuropeanUnionOxera32Box3.6Casestudy:carrytradesandcashflowmanagementInvestorsandemitterscanengageinstrategiesthatmakethemostofdifferencesbetweenthepriceofEUAsandEUAfutures.A‘longcarry’involvesthepurchaseofanEUAandsellinganEUAfuturescontract.Itisalsopossibletodotheopposite.A‘shortcarry’involvessellinganEUAandbuyinganEUAfuturescontract.Whilealongcarrymightbethepreferredstrategyforinvestorslookingtoachievetradingprofits,theshortcarrymaybenefitutilitiesorotheremittersasitfreesupcashintheshorttermwhilealsoleavingthemholdingEUAsthatarerequiredtocovertheiremissionsatsomefuturedate.LongcarryConsideratraderwhoundertakesalongcarry.Asnotedabove,thismeansthatitbuysanEUAandsellsalater-datedfuturescontract.ThisstrategywillgeneraterevenueforthetraderincaseswherethepriceoftheEUAfutureishigherthanthecurrentEUAprice,whilealsohedgingagainstinterimpricemovements.Todemonstratethis,imaginethatthepriceofanEUAis€20,whiletheone-yearfuturespriceis€21toreceiveanEUAinayear’stime.Tocompletethetrade,thetraderpurchases100EUAsattoday’spricefor€2,000(€20x100)whilealsotakingashortposition(i.e.selling)100EUAsatthefuturespricefor€2,100(€21x100).Inaddition,thetraderisrequiredtopostacertainamountofcollateraltomeetmarginrequirementsonitsshortfuturesposition.Ayearlater,thefuturesexpireandthetraderispaid€2,100forsellingthe100EUAsthatitboughtatthespotpriceayearpreviously,andanycollateralpostedisreturned.Fromthetrader’sperspective,thegrossprofitfromthelongcarrywouldbe€100(€2,100–€2,000)lesstheexchange,clearingandregistryfees,andafterpayingtheinterestonanyfundsborrowedtofinancethepurchaseofEUAsattheoutset.ShortcarryEmitterscantaketheoppositepositionbysellinganEUAatthespotpriceandbuyinganEUAfuture.AshortcarrywouldallowanemitterwithEUETScomplianceobligationstofreeupcashintheshorttermwhilestillensuringthatitsecuresaccesstoEUAsintimetosubmitthesetotherelevantauthorities.Todemonstratethis,consideranemitterthatiscurrentlyholding100EUAsthatitknowsitwillneedtosubmitinoneyear’stimetocoveritsemissionsarisingfromgas-firedelectricityproduction.AssumethattheEUAandfuturespricesarethesameasinthelongcarryexample.Tocompletethetrade,theemittersellsits100EUAsfor€2,000(€20x100)whilealsopurchasing100EUAfuturesexpiringinoneyear’stimeatacostof€2,100(€21x100).Intheyearbetweenundertakingthetradeandthefuturesexpiring,theemitterbenefitsfromaccessto€2,000incashanditreceives100EUAswhenitsfuturesexpire.Inthisinstance,thecostoffreeingup€2,000was€100plusanyexchangeandclearingfeesandmarginrequirements.Thismaybeanimportantcashflowmanagementstrategyforemittersthatwanttoborrowbutmightotherwisehavetopayhighinterestratesusingtraditionalroutes—forexample,forentitieswithalowcreditrating.Source:Oxerabasedoninterviewswithcarbontraders.AshighlightedinTable3.3andinBox3.6,carrytradesprovidebenefitstoemittersandcommercialundertakingsaswellasremuneratingfinancialfirmsforcostsandrisksoftakingtheothersideofthesetrades.Itthereforefollowsthatifpositionlimitswereimposedinawaythatwasbindingonfinancialfirms,thenthiscouldresultincommercialfirms(includingemitterswithcomplianceobligations)notbeingabletopurchasefutures.Alternatively,positionlimitscouldresultinhighertradingcostsandcounterpartyrisksifcommercialfirmsinsteadsoughttomeettheirhedgingrequirementthroughOTCtransactions.Inturn,thehighercostsofexchangetradingbecominglessliquidwouldalsoimpactallmarketparticipants.CarbontradingintheEuropeanUnionOxera334Evidenceofmarketfunctioning4.1OurapproachandeconomicframeworkAwell-functioningfinancialmarketisonethatdeliversahigh-quality,trustedprice-formationprocess,andprovidesliquidityduringnormalmarketfunctioningandintimesofstress,whileremainingresilienttomanipulationandabusivepractices.Marketsthatsatisfythesecorefunctionsbringimportantbenefitstoend-users—forexample,byprovidingtrusted,reliablepricingsignals,aswellasallowingcompaniesandinvestorsto(re)allocatetheirholdingsofEUAsatlowcost,enablingthemtomanagetheirfinancialrisksaccordingtotheirpreferences.Whenassessingwhetheramarketisperformingthesefunctionswell,thereareanumberofmetricsthatareusefultoconsider,asshowninFigure4.1.Thesemetricsareanalysedinthissection,toassesstheeconomicperformanceofthemarketfortradingEUAfutures.Figure4.1EconomicframeworkforassessingthefunctioningoffinancialmarketsSource:Oxera.OurapproachwastoconductempiricalanalysisbasedondatafromICE,EEX,andpubliclyavailablesources.Wealsoreviewedtheacademicandpolicyliterature,whichsupportedourfindings.Ourkeyfindingsareasfollows.•Overtime,thetradingofEUAfutureshasdevelopedfromanOTCmarkettoapredominantlyexchange-tradedone.Thisshifthashadapositiveimpactonend-users—astheexchangeshavebeensuccessfulinattractingamorediversegroupofmarketparticipants,exchange-tradinghasledtoimprovementsinmarketresilience,priceformationandliquidity.•Thereisawiderandmorediversesetoftradersactiveinthemarket,includingawiderangeoffinancialandnon-financialparticipants.DatafromtheCOTreportssuggeststhatfinancialfirmsplayadifferentroleinthemarkettonon-financialfirms.•Therelativecostoftradinghasreducedsince2017astheamountoftradingon-exchangeandthenumberofmarketparticipantshavecontinuedtoCarbontradingintheEuropeanUnionOxera34increase.ThiscomparestopreviouslyobservedtrendsoffallingabsoluteandrelativecostsduringearlierphasesoftheEU-ETS.•Priceformationhasimprovedovertimeasmorecontractsbecameavailablefortrading,despitechallengesassociatedwithpolicyuncertainties.Tradingqualityandmarketefficiencyhasimprovedmarkedly,particularlysincetheearlyphasesoftheEUETS.•Overall,theevidenceavailabletodateindicatesthatthemarketforthetradingofEUAfuturesisfunctioningwellandisnowseenasasuccessfulcasestudyforotherregionsseekingtodevelop(orintegrate)theirowncarbontradingmarkets.Thesepointsareexaminedinturnbelow.4.2Evidenceonresilience‘Resilience’inthiscontextreferstotheabilityofthemarkettoabsorb,ratherthanamplify,shocksandremainfreefrommanipulationandabusivepractices.AsnotedbyIOSCO,thisisparticularlyimportantincommoditiesderivativesmarkets,wherethesupplyoftheunderlyingassetislimited.55Limitsonthesupplyofacommoditytobedeliveredcanresultinmarketcongestion,squeezes,corneringorotherdisruptions,56allofwhichcanleadtoapoorlyfunctioningderivativesmarket.InthemarketforEUAs,thereareseveralreasonswhyitisrelativelydifficultforanindividualparticipanttoexercisemarketpowerorotherwisedistorttheEUAprice.First,EUAsarebankablefrompreviousEUETSphases(seesection2.1.3)andcomplianceperiods(calendaryears),whichmeansthatthequantityofEUAsincirculationthatcanbeusedtofulfilderivativescontractsortomeetcomplianceobligationsiscurrentlymuchlargerthanthetotalvolumeofEUAderivativescontracts.Figure4.2belowshowstheTNACandopeninterestinEUAfuturestradedonICEbetween2018and2020.Ascanbeseen,thetotalquantityofallowancesincirculationwasamultipleoftheamountofopeninterestinEUAfutures.ThisratioisexpectedtodecreaseasaresultoftheMSR(seesection2.1.3),but,duetothelowerthresholdintheMSRforreleaseofallowances,TNACisexpectedtocontinuetoexceedtheamountofopeninterestinEUAfuturesfortheforeseeablefuture.57Second,theactualsurrenderofEUAsforcompliancepurposesoccursonlyonceperyear(30April)andaftertheendofthecomplianceyear(31December).Thisisincontrast,forinstance,tothepowermarket,wheretheunderlyingcommodityneedstobemadeavailableeveryhouratasubstantialcostfornon-delivery.Tosqueezethepowermarket,amarketparticipantpotentiallyneedstobepivotalinagivenhouronly,whiletocornertheEUAmarketaparticipanttoholdasubstantialproportionoftheTNAC.55IOSCO(2021)‘PrinciplesfortheRegulationandSupervisionofCommodityDerivativesMarkets’,November2021.56Amarket‘corner’or‘squeeze’describesasituationwheretheunderlyingassetorcommoditynecessaryfordeliveryonexpirationofafuturescontractisheldbyoneormoremarketparticipantsactinginconcertconstitutesasubstantialproportionofthequantityofunderlyingcommoditieseligiblefordeliveryagainstthecontract.IOSCO(2021),op.cit.57ThecalibrationoftheMSRincludeswithinDirective2018/410/EUathresholdforthereleaseofincrementalallowancesintothemarketwheretheTNACisbelow400mEUAs.CarbontradingintheEuropeanUnionOxera35Furthermore,asubstantialshareofEUAswasfreelyallocatedtocomplianceentities,whichcouldselltheirEUAstothemarketifapricesqueezeoccurred.Third,thetradingofEUAsispurelyelectronicandinvolvesonlynegligiblestorage,transportandcarrycosts.Incontrasttophysicalcommoditiessuchasgasandoil,corneringthemarketforEUAsismoredifficultbecauseanymarketparticipantcansupplyallowancestoanyotherparticipant—irrespectiveoftheirlocation—immediatelyandwithoutanytransportcosts.Figure4.2TotalnumberofallowancesincirculationandopeninterestinEUAfutures,2018–20Note:They-axisunitisthenumberofEUAsinbillions.OpeninterestinEUAfuturesiscalculatedastheyearlymaximumopeninterestforcontractswithexpirydateinagivenyear.Forexample,theopeninterestin2020correspondstothelargestopeninterestthroughout2020forcontractswithdeliveryin2020.Source:OxeraanalysisofICEdataandEuropeanCommissiondataonTNAC.Oneindicatorofmarketfunctioningisthenumberofcomplaints.Complaintscouldsignallackofresiliencetomarketmanipulationorabusivepractices.OxeraunderstandsthatICEEndexhasreceivednocomplaintsfrommarketparticipantstradingEUAderivativesonitsplatform.AnotherwaytoassessthecurrentresilienceoftheEUAfuturesmarketistoexaminethemarketsharesheldbythelargestmarketparticipants.Thelargerthemarketsharesthemorelikelyitisthatoneoftheparticipantscouldexertadegreeofcontroloverquantitiesandprices.Figure4.3showsasnapshotofEUAderivativescontractpositionsheldbyindividualtradersinOctober2021onICE.Ascanbeseen,thelargestindividualmarketparticipant(aninvestmentfirm)heldonlyaround15–20%oftheopeninterest.Thiscorrespondstoroughly5%ofallEUAsincirculation,whichisunlikelytobesufficienttoexertasignificantdegreeofcontrol.Inthecaseofinvestmentfirms,thisshareislikelytobeheldonbehalfofmultiplebeneficialowners.0.00.20.40.60.81.01.21.41.61.8201820192020NumberofEUAsinbillionTNACOpeninterestinEUAfuturesCarbontradingintheEuropeanUnionOxera36Figure4.3SharesoflongandshortpositionsbytradercategoryinOctober2021Note:ThetradercategorisationfollowsthedefinitionsusedintheCOTreports.Forthelargesttradercategoryofbothlong(i.e.commercialundertakings)andshortpositions(i.e.investmentfirms)thechartpresentsthepositionsbrokendownatthetraderlevel.Source:OxeraanalysisbasedonICEdata.ThenormalisedHerfindahl–HirschmanIndex(HHI)ofnetpositionsinEUAfutureswas0.0421inOctober2018and0.0303inOctober2021.58AsnotedbyESMA,anHHIvalueofbelow0.1indicateslowconcentrationandanHHIbetween0.1and0.2indicatesmediumconcentration.59Alessconcentratedmarketstructuredecreasestheprobabilityofmarketmanipulationandmeansthatifonetraderexits,theimpactonthemarketwillbesmall.ItisusefultocomparethelevelofconcentrationinEUAfutureswithothertypesofderivatives.ESMAcalculatedtheHHIofderivativeexposuresin2020andfoundlowconcentrationsacrossallassetclasses,rangingfrom0.04forinterestratederivativesto0.08forcreditderivatives.AsshowninFigure4.4,themarketconcentrationofEUAfuturesisevenlowerthanallofthesecategories.ThelevelandreducingtrendofHHIinEUAfutures,aswellasthelimitedmarketshareofthelargestEUAfutureslongandshortpositionholders,indicateahighlevelofcompetitionandmarketresilienceinthetradingofEUAfutures.58OxeraanalysisofICE’spositionsdata.TheHerfindahl–HirschmanIndex(HHI)isacommonmeasureofmarketconcentrationandisusedtodeterminemarketcompetitiveness,oftenpre-/post-mergerandacquisition(M&A)transactions.HHIiscalculatedasthesumofmarketsharessquaredofallparticipantsinthemarket,andrangesbetween0(perfectcompetition)and10,000(monopoly).TheEuropeanCommission’smergerguidelinesstatethattheCommissionisunlikelytoidentifycompetitionconcernsinamarketwithapost-mergerHHIbelow1000(equaltoanormalisedHHIof0.1).59SeeESMA(2021)‘EUDerivativesMarkets:ESMAAnnualStatisticalReport2021’,17December2021,ESMA-50-165-2001,https://www.esma.europa.eu/sites/default/files/library/esma50-165-2001_emir_asr_derivatives_2021.pdf(accessed31January2021),footnote22.CarbontradingintheEuropeanUnionOxera37Figure4.4Concentrationoftradingactivity:EUAfuturesvsotherderivativesNote:HHInormalisedbetween0and1.HHIvalueforEUAfuturestakenfromanalysingICEpositiondataattraderlevelforOctober2021.HHIvalueforothercategoriesofderivativestakenfromESMAanalysisofderivativesexposuresforQ42020inits2021AnnualStatisticalReportontheEUderivativesmarket.ESMAnotedthattheHHImetricsinQ42020weresimilartothoseofayearearlieracrossallassets.AccordingtoESMAandtheEuropeanCommission’sguidelines(inthecontextofcompetitionlaw)anHHIvalueofbelow0.1indicateslowconcentrationandanHHIvalueofbetween0.1and0.2indicatesmediumconcentration.Sources:OxeraanalysisofpositionsdatareceivedfromICEandESMA(2021)‘EUDerivativesMarkets:ESMAAnnualStatisticalReport2021’,17December2021,ESMA-50-165-2001,https://www.esma.europa.eu/sites/default/files/library/esma50-165-2001_emir_asr_derivatives_2021.pdf(accessed31January2021).EuropeanCommission,‘GuidelinesontheassessmentofhorizontalmergersundertheCouncilRegulationonthecontrolofconcentrationsbetweenundertakings’,2004/C31/03,https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A52004XC0205%2802%29(accessed26January2021).Whenassessingtheresilienceofamarket,wecanalsoconsiderthedepthandbreadthofparticipantsactiveinthemarket.Examiningtherelativebalancebetweennon-financialparticipants,whichareprimarilyusingthemarkettohedgeunderlyingexposures,andotherfinancialparticipants,canalsobehelpful.Thedepthanddiversityoftradingparticipants,aswellasbeingakeydriverofliquidity(seesection5.4),arealsoinformativeastowhetherthemarketisatriskofpricemanipulation.Atradingparticipantmayhaveanincentivetomanipulatepricesinanumberofways—forexample,apolluterseekingtoreducepricesinordertoreducetheirfinancialburden,oratraderaccumulatingasufficientlylargelongpositiontodrivethepriceupwards.However,theseCarbontradingintheEuropeanUnionOxera38concernswilltendtodiminishinlargemarkets,whereexercisingmarketpowerismuchharder.60Figure4.5belowshowshowthenumberofpositionholdersinEUAfutureshasincreasedformostcategoriesofparticipant.Overall,thenumberoffinancialparticipantsholdingpositions(i.e.investmentfirms,investmentfundsandotherfinancialfirms)hasincreasedfromaround200inearly2018toover500inNovember2021.Similarly,thenumberofnon-financialparticipants(commercialundertakingsandoperatorswithobligations)increasedfromaround150toalmost300overthesameperiod.Therealsoappearstohavebeenare-categorisationwherebysomefirmspreviouslyclassedasoperatorswithobligationsarenowclassedascommercialundertakings.ThisdataisbroadlyconsistentwithrecentanalysisconductedbyESMA(acrossbothICEandEEX).61Figure4.5NumberofpositionholdersofEUAderivativecontractstradedonICE,2018–21Note:They-axisunitisthenumberoflegalentitieswithpositionsinEUAfutures.Changesinpositionallocationsbetweengroupsmightbeduetomisreporting,andmightnotreflectactualchangesinthecompositionofpositionholders.Source:OxeraanalysisbasedonCOTdatafromICE.Figure4.6providesabreakdownoftheoverallmagnitudeofthelongandshortpositionsheldbyparticipanttype.Thisdatashowsthatnon-financialfirmstendtoholdlongpositions(darkgrey),whilefinancialfirmstendtoholdshortpositions(lightblue).Thisisbroadlyinlinewiththeexpectedfunctioningofthemarket,wherebynon-financialentitiesbuyEUAfuturestohedgetheircarbonpriceexposure,whilefinancialcounterpartiesactasintermediariestofacilitatetradingandprovideliquiditytothemarket.Althoughthemagnitudeofpositionsheldbyallfirmtypesfollowsanannualcycle,theoverallmagnitudeofpositionshasremainedbroadlystableovertheperiod.60Tietenberg,T.(2011),‘Carbonpricing:lessonsderivedfromexperience’,November,http://personal.colby.edu/personal/t/thtieten/TT_IMFdraft11-11%20full.pdf(accessed30December2021).61ESMA’sanalysisisbasedonweeklypositionreportingdataitreceivesdirectlyfromtradingvenues.AnalysisbyESMAfoundthatthenumberofmarketparticipantshasincreasedacrossallcategoriesofparticipants,onbothvenues,andinrelativelyhomogeneousproportions.SeeESMA(2021),‘Preliminaryreport:EmissionAllowancesandderivativesthereof’,November.0100200300400500600700800900FebMarAprMayJunJulAugSepOctNovDecJanFebMarAprMayJunJulAugSepOctNovDecJanFebMarAprMayJunJulAugSepOctNovDecJanFebMarAprMayJunJulAugSepOctNovCommercialundertakingsOperatorswithobligationsInvestmentfirmsInvestmentfundsOtherfinancials2018201920202021CarbontradingintheEuropeanUnionOxera39Figure4.6Commitmentoftradersforfinancialandnon-financialfirms,2018–21Note:They-axisunitisbillionsofEUAs.Financialfirmsconsistofinvestmentfirms,investmentfundsandotherfinancialfirms.Non-financialfirmsconsistofcommercialundertakingsandoperatorswithobligations.Source:OxeraanalysisbasedonCOTdatafromICE.Figure4.7highlightsthat,withinthebroadercategoryoffinancialfirms,investmentfirmsandinvestmentfundsaccountforthemajorityofpositionsandlargelyholdnegativepositions.Intermsofmagnitude,investmentfundsandotherfinancialsplayalessprominentrole.Figure4.7CommitmentoftradersbyparticipanttypeNote:They-axisunitisbillionsofEUAs.Sizeoflong(abovetheaxis)andshort(belowtheaxis)positionsinEUAfutures.ThisisthesamedataasshowninFigure4.6.Changesinposition-1.5-1.0-0.50.00.51.01.5NumberofEUAs(bn)Financial(long)Non-financial(long)Financial(short)Non-financial(short)-1.5-0.50.51.5-1.5-0.50.51.5-1.5-0.50.51.5-1.5-0.50.51.5-1.5-0.50.51.5NumberofEUAs(bn)InvestmentfirmsInvestmentfundsOtherfinancialsCommercialundertakingsOperatorswithobligationsCarbontradingintheEuropeanUnionOxera40allocationsbetweencommercialundertakingsandoperatorswithobligationsmightbeduetochangesinthereportingmethodologyand/ormisreporting,andmightnotreflectactualchangesinthecompositionofpositionholders.UntilNovember2020,ICEsetthiscategorisationcentrallybasedonresearchingifthepositionholderhadanactivitythatwouldrequirethemtoregisteraninstallation.AspartofICE’sapproach,tradingaffiliatesoflargeemitterswereconsideredasoperatorswithobligations.SinceNovember2021,positionholdershaveself-reportedtheircategorisation.Weunderstandthatmanytradingaffiliatesoflargeemitterswerereportedascommercialundertakings.Source:OxeraanalysisofCOTdatafromICE.4.3EvidenceonpriceformationAnotherimportantindicatoroftenassociatedwithwell-functioningmarketsisthebreadthofcontractsavailablealongthefuturespricingcurve.Asdiscussedabove,carbonpricesprovideanimportantpricingsignalforinvestmentdecisionsandeffectiveriskmanagement.Thefurtherouttransparentandliquidcontractsareavailable,themoreinformedthepricediscoveryprocessis.Themorepricingpointsavailable,thelongerthematurityonthelongest-datedcontract,andthemoreliquiditythesecontractsattract,themoreriskmanagementopportunitiesandinformationareavailabletomarketparticipants.Thelongest-datedcontractavailabletoparticipantsseekingtotradeEUAfutureshasincreasedslightlyovertime.In2010,ICEofferedtradinginDecembercontractsouttofiveyearsahead.62Incomparison,ICEcurrentlyoffertradinginDecembercontractsuptosevenyearsahead63andEEXoffertradinginDecembercontractsuptonineyearsahead.64Figure4.8showshowthevolumestradedatdifferentlevelsoftheEUApricingcurvehavechangedovertime.TherehasbeenasignificantincreaseinthevolumeoftradingforthefrontDecembercontract(fromaround3.4mcontractsin2015toaround6.8mcontractsin2020).Volumesintheone-andtwo-year-aheadDecembercontractsalsoincreasedin2020comparedto2015.Thissupportspreviousacademicanalysis,whichalsoconcludedthatmarketefficiencyhadimprovedmarkedlyovertheperiod2008–11.6562ICE(2010),‘CEECXContracts:EUAsandCERsUserGuide’May,https://www.theice.com/publicdocs/ICE_ECX_user_guide.pdf(accessed30December2021).63ICE(2021),‘ICEEndexEUAFutures’,https://www.theice.com/products/197/EUA-Futures(accessed30December2021).64EEX(2021),‘EEXFuturesSpotProduct’,https://www.eex.com/fileadmin/EEX/Markets/Environmental_markets/Emissions_Spot__Futures___Options/20200619-EUA_specifications_v2.pdf(accessed30December2021).65Ibikunle,G.,Gregoriou,A.,Hoepner,A.G.F.andRhodes,M.(2012),‘Liquidityandmarketefficiency:Europeanevidencefromtheworld’slargestcarbonmarket’,Workingpaper.CarbontradingintheEuropeanUnionOxera41Figure4.8NumberofcontractstradedbycontractmonthandyearNote:Barsrefertomillionsofcontractstradedintherelevantcalendaryearinlots:1lot=1,000EUAs.Agivennumberonthex-axisspecifiesthenumberofyearsonfromthetradingyear.Forexample,‘0’appliestotheDecemberorMarchcontractfortheyear,‘1’appliestoaDecemberorMarchcontractexpiringinthefollowingyear,andsoon.Notethedifferentscalesofthey-axesforDecemberandMarchcontracts.Source:OxeraanalysisofICEdata.Thefigureabovealsoshowsverylimitedtradingactivityincontractsexpiringbeyondthreeyearsintothefuture(despitethembeingofferedbyICE).Thelackoftradingvolumesinlonger-maturitycontractsmaybelinkedtotheunderlyingmarketdesignofEUAs(e.g.thefactthatsurplusallowancescanbekepttocoverfutureneedsandthelowstoragecostsassociatedwithholdingEUAs)anduncertaintyregardingfuturerules.Ultimately,thissuggeststhatuserscanmeettheirhedgingneedsthroughthecontractsalreadyofferedbyexchanges.4.4EvidenceonliquidityAnotherusefulindicatorofwhetheramarketisfunctioningwellistheoverallliquidity,whichisasignificantcomponentoftheoverallcostoftrading.Ingeneral,onewouldexpectawell-functioningmarkettoexhibitloworfallingcostsoftrading.Indeed,previousacademicanalysisofEUAfuturesfoundthattradingcostsfellsubstantiallyovertheperiod2008–11.66Acommonmetricusedtoassessliquidityassociatedwithagivenfinancialinstrumentisthebid–askspread.Thismeasuresthedifferencebetweenprevailingbestbuyandbestsellprices.66Ibikunle,G.,Gregoriou,A.,Hoepner,A.G.F.andRhodes,M.(2012),‘Liquidityandmarketefficiency:Europeanevidencefromtheworld’slargestcarbonmarket’,Workingpaper.CarbontradingintheEuropeanUnionOxera42Thereisalargebodyofacademicliteratureshowinghowbid–askspreadsinacompetitivemarketaredeterminedbyvarioustradingfrictions,suchasorderprocessingcosts(e.g.thefeesandoverheadsassociatedwithexecutingandsettlingtrades),inventoryholdingcosts(whenrisk-aversetradersholdingapositionareexposedtounfavourablefluctuationsinprices),andadverseselectioncosts(theriskoftradingwithamoreinformedparticipant).67Thesecostsarebornebymarket-makersandotherliquidityproviders,whichwillreacttoincreasesinthesecostsbydemandinggreatercompensationthroughawiderbid–askspreadand/orreducingtheirpropensitytotrade(resultinginlessmarket‘depth’).Inmarketswithbarrierstoentryfortradingparticipants,bid–askspreadscanalsobewiderduetolimitedcompetitionbetweenliquidityproviders.Figure4.9belowshowsthat,asthenumberoftradingparticipantsinEUAfutureshaveincreasedsinceJanuary2017,relativespreads(calculatedastheaveragequotedspreaddividedbytheclosingprice)inthebenchmarkDecembercontracthavecomedownsignificantly(fromjustunder0.4%toaround0.06%).68Figure4.9AveragedailyrelativespreadforDecemberEUAcontract(%),January2017–October2021Note:Thequotedbid–askspreadiscalculatedasthedifferencebetweenthequotedaskpriceandthequotedbidprice.Theaveragedailyquotedspreadiscalculatedbasedonasimpleaverageofallnewbid–askspreadsthroughoutthetradingday.Duetodataavailability,relativespreadisestimatedbydividingthedailyaveragequotedspreadbytheclosingprice.Allbid–askspreadsrelatetothenearestDecembermonthlyfuturescontract—forinstance,forJanuary–December2018,theDecember2018contractisused.ThenumberoftradingfirmsisbasedonthenumberoffirmsthattradedEUAfuturesinagivenmonth(notnecessarilythefrontDecembercontract).Source:OxeraanalysisofICEdata.67Thefirstpapertorelatebid–askspreadstoinventoryriskwasStoll(1978).GlostenandMilgrom(1985)isakeypaperrelatingtotheadverseselectioncomponentofbid–askspreads.SeeStoll,H.(1978),‘Thesupplyofdealerservicesinsecuritiesmarkets’,JournalofFinance,33:4,pp.1133–1151;andGlosten,L.R.andMilgrom,P.R.(1985),‘Bid,askandtransactionpricesinaspecialistmarketwithheterogeneouslyinformedtraders’,JournalofFinancialEconomics,14:1,pp.71–100.Foradiscussionofthetheoryandliterature,seeFoucault,T.,Pagano,M.andRoell,A.(2013),MarketLiquidity:Theory,Evidence,andPolicy,OxfordUniversityPress.68Thesamedatashowsthatspreadshaveincreasedinabsoluteterms.ThisincreaseinabsolutespreadsislikelyduetothetwelvefoldincreaseinpricesofEUAsoversameperiod.AspricesofEUAshaverisen,theabsoluteimpactofpricefluctuations(andthereforetheinventoryholdingrisk)willalsoincrease.0501001502002503003504000.00%0.05%0.10%0.15%0.20%0.25%0.30%0.35%0.40%Jan-17Mar-17May-17Jul-17Sep-17Nov-17Jan-18Mar-18May-18Jul-18Sep-18Nov-18Jan-19Mar-19May-19Jul-19Sep-19Nov-19Jan-20Mar-20May-20Jul-20Sep-20Nov-20Jan-21Mar-21May-21Jul-21Sep-21NumberoftradingfirmsAveragequotedspreads/closingprice(%)Numberoftradingfirms(right)Relativespread(left)CarbontradingintheEuropeanUnionOxera43ThesignificantfallinrelativespreadssuggeststhattransactioncostsfortradingEUAs,asaproportionoftheprice,havecomedownovertime.Thischangeislikelytobelinkedtothesignificantgrowthinthenumberoftradingfirms,asshowninFigure4.9,particularlyastherewasnosignificantsustainedchangeinvolatilitysince2018,akeydriverofinventoryholdingcoststhatisalsoreflectedinthebid–askspread(seeFigure4.9).Asnotedabove,ingeneralthemoreparticipantsthatenterthemarketwishingtobuyorsellatornearthecurrentprice,thegreaterthecompetitionforliquidityprovisionandthenarrowerthebid–askspread.CarbontradingintheEuropeanUnionOxera445Howdoesderivativestradingaffectcarbonpricing?Thissectionexplainshowactivityinderivativesmarketsaffectscarbonpricesanddescribesthedriversbehindtherecentriseincarbonprices5.1Whatarethefundamentaldriversbehindtherecentriseincarbonprices?Asdiscussedinsection2,thecarbonpriceisultimatelybasedonthesupplyanddemandofemissionsallowances.Theacademicandpolicyliteratureidentifiesseveralfactorsthatinfluencecarbonprices.Specifically,therecentpriceincreasecanbeattributedtohighgaspricestriggeringaswitchfromgas-firedtocoal-firedgenerationleadingtogreateremissionsfromthepowersector,growthindemandforenergydrivenbyCOVID-19economicrecovery,andETSpolicyreformaimedatachievingaprogressivelytightercaponGHGemissions.Thissectionexpandsoneachofthesedriversinturn.5.1.1RisinggaspricesEconomicliteraturehasalsoconsideredtheimpactoffuel-switchingbehaviourandtheassociatedmarginalabatementcostsofpowergeneratorsswitchingfromcoaltogas.69Asnotedinsection2.4,coal-firedgenerationproducesmoreemissionsthangas-firedgeneration,which,inturn,ismorepollutingthanrenewableelectricity.Inthelastseveralyearstherehasbeenasteadydeclineintheshareofcoal-firedpowergenerationinEurope,butthereversalofthistrendin2021goessomewaytoexplainingtherecentincreaseindemandforemissionsallowances.70Overthepastdecade,manycountrieshavereducedtheirrelianceoncoalinordertomeetemissions-reductiontargets,andhavetherebyincreasedtheirrelianceongasandothergenerationtechnologies.Until2020,EuropeancarbonpriceswouldtosomeextenthavebeenlimitedbytheflatorfallingdemandforEUAbycountriesthatwereincreasinglyswitchingfromusingcoalasafuelforpowergenerationtogasandrenewableenergysources.However,sincetheendof2020,anumberoffactorshavereversedthis,increasingtherelativeattractivenessofcoalovergasasafuelforpowergeneration.First,Europeangasproductionandpipelineimportshavefallenconsistentlysince2017.CapacitylimitsongasimportsfromNorway,togetherwithoperationalsupplydisruptionsanddelaystotheopeningofnewpipelinecapacity(NordStream2)fromRussia,havealsoadverselyaffectedEUgassuppliessincelate2020.71Inaddition,acolderwinterin2020/21inEuropeandelsewhereresultedinsignificantreductionsingasvolumesremaininginstoragebysummer2020,andtheseweresubsequentlynotreplenishedintimeforthestartofwinter2021/22.7269See,forexample,Keppler,J.H.andMansanet-Bataller,M.(2010),‘CausalitiesbetweenCO2,electricity,andotherenergyvariablesduringphaseIandphaseIIoftheEUETS’,EnergyPolicy38:7,pp.3329–3341.70IEA(2021),‘Coal2021:Analysisandforecastto2024’,pp.6,13.Availableat:https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/12/Insight-108-Supply-Side-Factors-in-European-Gas-Prices.pdf.71Sharples,J.(2021),‘Aseriesofunfortunateevents:Supply-sidefactorsintheEuropeangaspricerallyin2021andoutlookfortherestofwinter’,December,pp.9,10,12,13–16.Availableat:https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/12/Insight-108-Supply-Side-Factors-in-European-Gas-Prices.pdf.Chazan,G.,Wilson,T.andSeddon,M.(2021),‘EuropeangaspricesriseafterGermanconcernsoverNordStream2’,FinancialTimes,13December.72Sharples,J.(2021),‘Aseriesofunfortunateevents:Supply-sidefactorsintheEuropeangaspricerallyin2021andoutlookfortherestofwinter’,December,pp.18–20.Availableat:https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/12/Insight-108-Supply-Side-Factors-in-CarbontradingintheEuropeanUnionOxera45Second,worldwidedemandforgashasalsoincreasedrapidlyinrecentyears,whichhasresultedinupwardpressureonthepriceofLiquefiednaturalgas(LNG).CountriessuchasChinaandIndiahaveseengasasawaytoreduceunacceptablelevelsofairpollutionincitiesthatisprimarilycausedbycoaluse.Infact,Asianowaccountsfor70%ofglobalLNGimports.Thislonger-termtrendcombinedwithsignificantgrowthindemandforLNGinAsiaandlower-than-expectedgrowthinLNGsupplyin2021resultedinlowerLNGvolumessuppliedtoEuropein2021.73HigherAsianLNGpriceshavethereforeresultedinhighergaspricesinEuropeduetoLNGincreasinglybeingEurope’smarginalsourceofgas.74Giventhatgasandcoalaresubstitutesfortheproductionofelectricity,andduetothemorelimitedavailabilityofgasandrisingdemandinEurope,therelativeattractivenessofcoal-firedpowergenerationincreasedsignificantlyin2021duetomuchhighergaspricesandtherelativelysmallincreaseincoalpricesin2021(seesection1.1andFigure1.2).Thisthereforegoessomewaytoexplainingrecentincreasesincarbonprices.Indeed,untilrecently,thebenchmarkDecemberEUAcontracthadconsistentlytradedbelowthepriceatwhichtheleast-efficientgas-firedpowerplantsdisplacethemost-efficientcoalplants.755.1.2COVID-19recoverySince2020therehasbeenageneralriseindemandforallenergysourcesaselectricitydemandhasincreasedfollowingasharprecoveryfromtheCOVID-19pandemic.Figure5.1belowillustrateshowthesteepincreaseincarbonpricessinceJanuary2021coincidedwithatimeofrapideconomicrecoveryenabledbytherolloutofvaccinationprogrammes.Incontrast,thereversehappenedfollowingthe2007financialcrisis,whereloweconomicactivityresultedinlowdemandforenergyandadropinthecarbonprice.Economicgrowthiswidelyunderstoodtobeoneofthedriversofcarbonprices.European-Gas-Prices.pdf(accessed1February2022).Reuters(2021),‘OnthecuspofEurope'swinterseason,gasstoragehits10-yrlow’,23September.73Sharples,J.(2021),‘Aseriesofunfortunateevents:Supply-sidefactorsintheEuropeangaspricerallyin2021andoutlookfortherestofwinter’,December,pp.24–26.Availableat:https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/12/Insight-108-Supply-Side-Factors-in-European-Gas-Prices.pdf(accessed1February2022).74Sharples,J.(2021),‘Aseriesofunfortunateevents:Supply-sidefactorsintheEuropeangaspricerallyin2021andoutlookfortherestofwinter’,December,pp.23–24.Availableat:https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/12/Insight-108-Supply-Side-Factors-in-European-Gas-Prices.pdf(accessed1February2022).75Lewis,M.(2020),‘Deepdecarbonisation:greenhydrogen,netzeroandthefutureoftheEU-ETS’,BNPParibas,https://www.icef.go.jp/pdf/2020/program/plenary_session/MarkChristopherLewis_P.pdf(accessed30December2021).CarbontradingintheEuropeanUnionOxera46Figure5.1EUcarbonprice,2018–21(€)0102030405060708090100Jan-18Jul-18Jan-19Jul-19Jan-20Jul-20Jan-21Jul-21Jan-22EUApriceMarketcrashduetoCOVID-19pandemicEuropeanCommissionproposesnewtargettoreducenetemissionsbyatleast55%by2030,andtoaddittoEUlawGaspricehavebeensurgingsincethestartoftheyearandexceed$10/MMBtuinJulyCoalandgasswapinthemeritordercurveinmostEuropeancountries,drivingupdemandforEUAsVaccinationprogrammestakeoff,economicrecoverybeginsEMArecommendsBioNTech/PfizervaccineforconditionalmarketingauthorisationRecoveryasfirstwaveofpandemicfadesPresentationoftheEuropeanGreenDealApprovalofETStradingreformNote:They-axisunitiseurospertonneofCO2e.ThischartshowstheEEXEUAprimaryauctionsettlementprice.Dataprovidedupto10December2021.Source:OxeraanalysisofICEdata.5.1.3ETSpolicyreformWhilethedemandforcarbonallowanceshasbeenincreasedbythefactorsnotedabove,thesupplyofcarbonallowanceshassimultaneouslybeendecreasingovertime.UndertheFitfor55package,thesupplyofEUAshasbeenreducedfurthertoachieveahigherrateofreductioninemissionsby2030.Moreover,theproposedexpansionoftheEUETStocoveradditionalsectorssuchasmaritimetransportwillfurtherinfluencetheexpecteddemandandsupplyforEUAsinfuture,includingpotential‘pre-compliance’demandfromemittersinsectorsthatwillbecoveredbytheEUETSinfuture.GiventhatallowancespurchasedtodaycanbeusedtomeetEUETScompliancerequirementsinanyyearuntil2030,thesepolicychangescouldhaveasignificantimpactonthecarbonpricetoday(seesections2.1.3and2.2).Asexplainedinsection2.1,theMSRisexpectedtosteadilyreducethenumberofemissionspermitsavailabletomarketparticipantsovertimeandthesemaynotbereintroducedtothemarketinfutureyears.Historicallytherehasbeenanoversupplyofpermitsinthemarket,withmanygivenoutfreeofcharge,andtheintentionoftheMSRistocorrectforthisoversupply.TheEUAauctionsaredesignedtoensurethattheoverallsupplycontinuestobeinlinewithlong-termdecarbonisationtargets,andthismaynotbesufficienttomeetdemand,dependingontheprogressonemissionreductionsforthesectorscoveredbytheEUETS.CarbontradingintheEuropeanUnionOxera47Figure5.2Verifiedemissionsbyinstallationtype,2010–20Note:They-axisunitismilliontonnesofCO2e,where1EUA=anentitlementtoemit1tonneofCO2e.VerifiedemissionsrefertoemissionsofinstallationsthatarecoveredbytheEUETS.Dataexcludestheaviationsector.Forfurtherinformation,see:https://www.eea.europa.eu/data-and-maps/dashboards/emissions-trading-viewer-1(accessed30December2021).Source:OxeraanalysisofEUETSdata.Furthermore,sincethesupplyofEUAsiscurrentlybeingre-assessedbytheEuropeanCommission,76thepriceisalsopartlyareflectionofmarketparticipants’expectationsoftheimpactsofpastandfutureregulatorydecisions.Inthispricingparadigm,carbonpricesshouldreflectmarketparticipants’perceptionsoftheeffectivenessandcredibilityofthedesignoftheEUETS,aswellastheirassessmentofpolicymakers’commitmenttoensuringthatthesupplyofEUAsisengineeredtodeliverthisoutcome.77Indeed,thiscanbeseeninFigure5.1,withthepricesrisingaftertheEUETSreforminFebruary2018andaftertheEuropeanCommissionfirstproposedrevisingthe2030targetinSeptember2020.PolicyuncertaintyisthereforepotentiallyastrongdriverofthelevelandvolatilityofEUcarbonprices.TotheextentthatrecentEUETSpricedevelopments(intermsofbothpricelevelsandvolatility)haveraisedconcernsover‘excessivespeculation’(seesection5.3),itisimportanttoconsidertheextenttowhichthiscouldbetheresultofchangestofundamentalpricedrivers(i.e.policytargets,abatementcosts,andcommodityprices),thegreaterparticipationoffinancialinstitutionsinEuropeancarbonmarkets,and/orpolicyuncertainty.TheimpactofpolicyuncertaintyonEUcarbonpriceswasrecentlyinvestigatedbyFriedrichetal.(2020),78whoanalysedEUETSpolicychanges.Specifically,76EuropeanCommission(2021),‘ProposalforaDirectiveoftheEuropeanParliamentandtheCouncilamendingDirective2003/87/ECestablishingasystemforgreenhousegasemissionallowancetradingwithintheUnion,Decision(EU)2015/1814concerningtheestablishmentandoperationofamarketstabilityreservefortheUniongreenhousegasemissiontradingschemeandRegulation(EU)2015/757’,COM(2021)551final,14July.Availableat:https://ec.europa.eu/info/sites/default/files/revision-eu-ets_with-annex_en_0.pdf.EuropeanCommission(2021),‘ProposalforaDecisionoftheEuropeanParliamentandtheCouncilamendingDecision(EU)2015/1814asregardstheamountofallowancestobeplacedinthemarketstabilityreservefortheUniongreenhousegasemissiontradingschemeuntil2030’,COM(2021)571,14July.Availableat:https://ec.europa.eu/info/sites/default/files/revision-market-stability-reserve_with-annex_en.pdf.ThecurrentlegislationinplaceisDirective2018/410/EU.Availableat:https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018L0410&from=EN.77Lewis,M.(2020),‘Deepdecarbonisation:greenhydrogen,netzeroandthefutureoftheEU-ETS’,BNPParibas,https://www.icef.go.jp/pdf/2020/program/plenary_session/MarkChristopherLewis_P.pdf(accessed30December2021).78Friedrich,M.,Fries,S.,Pahle,M.andEdenhofer,O.(2020),‘Rulesvs.DiscretioninCapand-TradePrograms:EvidencefromtheEUEmissionTradingSystem’,WorkingPaper.05001,0001,5002,0002,50020102011201220132014201520162017201820192020Verifiedemissions(MtCO2e)CombustionoffuelsAllotherinstallationsSupplyoffreeandauctionedEUAsCarbontradingintheEuropeanUnionOxera48theylookedatthedevelopmentoftheMSRin2018totestitsimpactonthestabilityofcarbonpriceswhilealsoaccountingforchangesinotherfundamentalpricedrivers.AkeyfindingofthisresearchwasthatfollowingtherevisionstotheEUETSinMarch2018,priceformationfortheDecember2018futurescontractbecameuntetheredfrommarketfundamentalsuntilOctober2018.Inthisperiod,thedriversoftheEUAprice,suchascoal,gasandoilpricesandequityindices,didnotincreaseinimportanceaspricedeterminants,nordidthesedriversshowthesamegrowthbehaviourseenintheEUAprice.Basedoneconometrictestsfortheidentificationofpricebubbles,Friedrichetal.(2020)statedthattherecouldhavebeenanEUApricebubblebetweenMarchandOctober2018.ItisnotablethatthisperiodwasalsoassociatedwithsignificantincreasesinthevolatilityoftheDecember2018future(i.e.the‘frontyear’contractatthetime),asseeninFigure5.5(bottompanel).Referringtothenatureandtimingofpolicyannouncementsatthetime,Friedrichetal.(2020)concludedthattheevidencesuggestedthatitwas‘sentimentaboutthefuturescarcityofallowances[that]mayhavebeenthedecisivefactor’.79Theyalsopointoutthatthatspeculationthatisinducedbychangestothemarketdesigncanserveabeneficialpurposeofestablishinganewequilibriumprice.80Inlightofthis,itisnotablethatin2021theescalationinEUAprices(i.e.thefront-yearcontract)wasnotaccompaniedbyincreasesinvolatilitysimilartothosein2018,asseeninFigure5.5(bottompanel).Indeed,withtheexceptionofthespikeinvolatilityassociatedwiththestartoftheCOVID-19pandemicinearly2020,volatilityin2021forthefront-yearcontracthasremainedatthesamerelativelylowlevelsincemid-2019.Onbalance,eachoffactorsdiscussedinsections5.1.1to5.1.3hascontributedtowardstherecentrisesincarbonprices.Althoughpolicyreformrestrictingthesupplyofpermitswasexpectedtohaveanupwardseffectoncarbonprices,thishasbeenexacerbatedbytheimpactofincreasinggasprices,whichhascontributedtoaswitchbacktocoal-firedpowergeneration,andwithitanincreaseddemandforEUAs.ThesechangesalsocomeduringaperiodofstrongmacroeconomicrecoveryasEuropeemergesfromtheinitialimpactoftheCOVID-19pandemicthathasfurtherincreaseddemandforelectricitygeneration.5.2Whatisthelinkbetweenthecarbonpriceanditsderivativesmarkets?WhenpeoplerefertotheEUcarbonprice,theyareoftenreferringtothepriceastradedontheprimarymarketauctiontakingplaceonEEX.Theymayalso,however,bereferringtothepriceofEUAfuturestradingonderivativesexchanges,suchasICE.Anaturalquestiontoaskisthen:whatisthelinkbetweentheseprices?WhiletheprimaryauctionpriceisfortheimmediatepurchaseofanEUA,thepriceofanEUAfuturewilllargelyreflecttheexpectedpriceofanEUAatsomefuturedate.Asexplainedinsection3.1,futuresrepresentanagreementtobuyorselltheunderlyingassetatacertainpointinthefuture.Aspotmarkettransactioneitherintheprimaryauctionorthroughtheuseofdailyfutures,representsthesaleandpurchaseofanEUAtoday.79Ibid.,p.36.80Ibid.CarbontradingintheEuropeanUnionOxera49Forstorablecommodities,therelationshipbetweenspotandfuturespricesisduetothepossibilityofarbitrageopportunities.Financialtheorydictatesthatasthefuturescontractapproachesmaturity,thedifferencebetweenthespotpriceandthefuturespriceshouldconverge,asthetwocontractsbecomeeconomicallyidentical.Beforematurity,thepricedifferentialisdrivenbytheopportunitycostofthemoneypaidforthespotallowanceandthepossibilityofarbitrageopportunities.Inthecaseofmostcommodities,thisarbitrageopportunityisdrivenbytheeconomicsofstorage(alsocalledthe‘costofcarry’).81Theownerofacommoditymaybenefitfromowningthephysicalcommodityandthereforehavingeasilyaccessibleinventory(e.g.theabilitytomaintainproductiondespiteshortagesorfluctuationsinsupply).Thisisknownasthe‘convenienceyield’.Whenthefuturescontractpriceisabovethespotprice,themarketisin‘contango’.Whenthefuturespriceisbelowthespotprice,themarketisin‘backwardation’.AnumberoffeaturesuniquetoEUAsarerelevanttotherelationshipbetweenspotandfuturesprices,includingthefollowing.•Thereiseffectivelyonlyone‘physical’supplierintheprimarymarketforEUAs:thegovernment.82Asthereisonlyonesupplierandmanynaturalbuyers(complianceentities),thismakestheroleoffinancialintermediariesevenmoreimportantforliquidityprovision.•ThecostofstorageislowsinceanEUAisjustanaccountingentryintheEUregistrysystem.ThemaincostsofholdinganEUAcomprisethefeespayabletocoverthecostsofthenationaladministrator,aswellasthecostsinvolvedinmanagingtheuser’selectronicaccount(overheadsplusthecostofcapital).Asindicativeexamples,in2020theannualfeesleviedbytheFrenchadministratorrangedfrom€250to€950peraccountwhiletheGermanadministratorcharged€170toopenanaccountand€600asanaccountadministrationfeefortheentiretradingperiod.83•TransportcostsforEUAsarelowasanEUAcanbetransferredtoanotherpartyelectronicallybytheauthorisedaccountholder.Therearesomerestrictionsontransfers,andcertaintransfersmaytakelongertoprocess.8481Thearbitrageopportunityisasfollows:thetraderinitiallyborrowsmoneyandusesittobuyanassetinthespotmarketandsellsthecommodityforward.Traderthenstoresasset(forafee)untilthepointwhenfuturescontractexpires.Atexpirationtradermustpaybacktheborrowedmoneyplusinterestandstoragecosts.Iftheforwardpriceexceedsthenetamountowed,thenthetraderwouldbeabletomakeariskfreeprofit.Ifthiswerethecase,traderswouldbuyspotandsellfuturessuchthatthebasisdisappears.Assumingyoucanshortthespotmarket,samepropertyholdsinreverse.82EUAsissuedbyEUmemberstatesandEEAcountriesarecurrentlyauctionedthroughasingleplatform.See:https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/auctioning_en#ecl-inpage-441.83FrenchMinistryfortheEcologicalTransition(2020),‘DecreeofDecember21st,2020establishingfortheyear2020theamountoftheaccountmanagementfeesforaccountholderspursuanttoArticleR229-36oftheFrenchenvironmentCode’,21December,availableathttps://www.seringas.caissedesdepots.fr/sites/www.seringas.caissedesdepots.fr/IMG/pdf/5.en_fees2020.pdf(accessed1February2022).SeealsoDeutscheEmissionshandelsstelle(2022),‘Europeanemissionstrading’,availableathttps://www.dehst.de/EN/european-emissions-trading/union-registry/account/account_node.html(accessed1February2022).84Accountsheldbyoperators(i.e.operatorsofemittinginstallations/aircraft)mayonlytransferEUAstoaccountsthattheyhaveidentifiedas‘trusted’.AccountsheldbytradersmaytransferEUAstoanyaccount.Transferstoanaccountwhichhasbeenidentifiedas‘trusted’bytheholderoftheEUAareexecutedimmediately.Transferstootheraccountsaresubjecttoadelayofapproximatelyoneday.SeeArticle35and55ofCDR2019/1122.CarbontradingintheEuropeanUnionOxera50Somenationaladministratorslevyfeestocoverthecostsofprocessingtransactions.•AnEUAisfungibleacrosstimeperiodswithinphasesoftheEUETS,andiscurrentlyexpectedalsotobefungibleacrossfuturephases.TheEUAdoesnotdepreciateinqualityovertime.•ThereisnoadditionalbenefitfromholdinganEUAbeyondcompliance.Incontrasttofinancialassetsandothercommodities,therearenoadditionalexpectedpayoffs(e.g.dividends).85•AnEUAisreallyneededonlyatcertaintimesintheyearthatcorrespondtothecompliancetimetable.Keydatesare31December,thelastdayofthecomplianceyear,and30April,whenthecomplianceentitiesneedtoreportandthensubmittheiremissionallowancesforthepreviouscalendaryear.WithEUAsbankableacrossEUETSphasesandcomplianceperiods,theEUAfuturescurveshouldintheoryreflectthemarket’sassessmentofthepriceatwhichsufficientemissionswouldbeabatedsuchthattheemissionscapestablishedbytheEUETSismet.Putdifferently,ifthemarketisfunctioningefficiently,today’sEUApriceshouldinprinciplereflectexpectationsofthefuturecost(in€/tCO2e)requiredtodeliverthelastunitsofemissionsreductions,adjustedforthecostofcapital.Inpractice,thetotalquantityofemissionsreductionsneededtomeetthelong-termpolicygoalandthecostofthemarginalemissionsreductionsthatwouldberequiredremainshighlyuncertain.However,recentforecastsindicatethatEUApricesareexpectedtorangebetween€90/tCO2eand€129/tCO2ein2030(seesection2.4.5).Asdiscussedinsection5.1.3,intheshorttomediumterm,EUApriceswillalsobeinfluencedbymarketparticipants’perceptionsofpolicymakers’commitmenttoensuringthatthesupplyofEUAscontinuestobeconstrainedsuchthattheEUremainsontracktomeetitsdecarbonisationobjective.Sofar,asnotedbyESMAandtheEuropeanCentralBank(ECB)intherecentassessments,EUAfuturespriceshavebeenrelativelyflat,albeitslightlyupward-sloping,asshowninFigure5.3.TheECBstatedthattheslopeofthecurvemayshiftinthefuture,particularlyifmarketparticipantsbecomeconcernedthatregulatorsmayrestricttherighttocarryoverallowancesfromoneyeartothenext.8685Inthecaseofmanycommodities,thereisoftenabenefitassociatedwithholdingthephysicalcommodity.Forexample,havingimmediate,physicalaccesstoacommoditylikecorn,wheatoroilheldinstorageattimesofconstrainedsupply(relativetodemand)avoidstheopportunitycostsofnotbeingabletomeetdemand.86ECB(2021)‘EconomicBulletin’,Issue6/2021,Box5.SeealsoBredin,D.andParsons,J.(2016),‘WhyisSpotCarbonsoCheapandFutureCarbonsoDear?TheTermStructureofCarbonPrices’,TheEnergyJournal,37:3.CarbontradingintheEuropeanUnionOxera51Figure5.3EUAfuturecurveNote:They-axisunitiseurospertonneofCO2e.Pricesasatlasttradingdayofgivenmonth.Source:OxeraanalysisofICEdata.Insum,thespotandfuturesmarketpricesarecloselylinked.Botharepredominatelydrivenbymarketfundamentals,meaningfactorsaffectingthedemandandsupplyoftheunderlyingEUAs.5.3Whatistheimpactofspeculativetradingoncarbonpricing?Asdiscussedinsection3.4,speculatorsplayanimportantroleincarbonmarketsbyprovidingliquidityandtakingtheothersideofthetradetonaturalhedgers,asshowninFigure4.6andFigure4.7.Whilecarbonmarketscannotfunctionwithoutthepresenceofspeculativetrading,someconcernshavebeenraisedregardingthepotentialriskthat‘excessive’speculationinEUAfuturesbyfinancialinstitutionsmayleadtoacarbonbubble(i.e.EUApricesandvolatilitybeinghigherthantheunderlyingfundamentalscanjustify).Forexample,QueminandPahle(2021)87analysepubliclyavailablepositionreportsandcomputeametricof‘excess’speculationcalledthe‘WorkingT-Index’.88TheauthorsshowthatT-indexvaluesincreasedfromaround50%to90%oftotalhedgingvolumesfrom2018to2020,andhavefluctuatedbetween70%and90%sincethen(seeFigure5.4below).ThesameauthorsalsoidentifyanincreaseinthevolumeofopeninterestinfrontDecembercontractslistedonEEX,whichtheyinterpretasanotherindicatorofspeculativeactivity.8987Quemin,S.andPahle,M.(2021),‘Financialsthreatentounderminethefunctioningofemissionsmarkets’,WorkingPaper.88InamarketwherenethedgingislongTheWorkingT-indexreflectsthetotalvolumelongpositionsthatarenotmadeforhedgingpurposes,expressedasapercentageoftotal(longandshort)hedgingvolume.SeeWorking,H.(1960),‘Speculationonhedgingmarkets’,FoodResearchInstituteStudies,1:2,pp.1–36.89Here,theauthorsarguethathedgingactivitywillbeconcentratedinlongermaturitycontracts.Thismeansthatfrontyearopeninterestremainsroughlyflatovertime,asfrontyearhedgeswillmostlybeprovisionedinearlieryears.Theauthorssuggestthatsignificantincreasesinfrontyearopeninterestpointtoexcessivespeculation,asspeculativetradingwillconcentrateonthemostliquidcontractssinceitiseasiertoadjustpositions.010203040506070SpotDec21Dec22Dec23Dec24Dec25Dec26Price(€permetrictonneCO2)ContractMar-20Jan-21Oct-21CarbontradingintheEuropeanUnionOxera52Figure5.4WorkingT-indexvaluesonICEEUAfutures(%),January2018–November2021Note:WorkingT-indexvaluesarecalculatedas‘other’shortpositionsinexcessofnethedging(risk-reducinglongpositionsminusrisk-reducingshortpositions).Marketbalanceimpliesthatthisisequivalentto‘other’longpositions.Valuesareexpressedasaproportionoftotalhedging(risk-reducinglongpositionsplusrisk-reducingshortpositions).Separatevaluesarepresentedforspeculationbyfinancialinstitutions(investmentfirms,investmentfundsandotherfinancialfirms)aswellasbyallmarketparticipants.Source:OxeraanalysisofICECOTdata.AhighT-indexvaluedoesnotbyitselfprovideevidencethatamarketischaracterisedby‘toomuch’speculation.Asexplainedinsection3.4,thedistinctionbetweenspeculationandhedgingisnotalwaysclear-cut.Forexample,emittersthatarenotcurrentlywithinthescopeoftheEUETSseektohedgetheircarbonfootprintbytradingEUAsinanticipationofthescopeoftheEUETSexpandinginthefutureorforethicalreasons.Ineithercase,itmaynotbeobviouswhethersuchtradingis‘risk-reducing’or‘speculative’.Moreover,thecorrelationbetweentheT-indexandpricechangesofEUAfuturesisnearzero:around-0.01forthefront-yearcontractbetweenJanuary2018andNovember2021.90Fromapublicpolicyperspective,thekeyquestionishowspeculationaffectsmarketquality(e.g.throughexcessivepricesorvolatility).Tobetterunderstandthepotentialeffectofspeculativetrading,thefollowingsubsectionprovidesarecapofthemaininsightsfromtheacademicliterature.GiventheuniquefeaturesassociatedwithEUAmarkets,asdiscussedinsection5.2,itisalsohelpfultoconsiderhowEUAandEUAfuturespricevolatilityhasevolvedovertime.90OxeraanalysisofICEdata.Thisfindingisconsistentwithresearchonothercommoditiesthatfindsasimilarresult.See,forexample,Buyuksahin,B.andHarris,J.H.(2011),‘Speculators,pricesandmarketvolatility’,Workingpaper;andAlquist,R.andGervais,O.(2013),‘Theroleoffinancialspeculationindrivingthepriceofcrudeoil’,TheEnergyJournal,34:3,pp.35–54.0%10%20%30%40%50%60%70%80%90%100%110%Jan2018Jul2018Feb2019Aug2019Mar2020Sep2020Apr2021Nov2021WorkingT-index(%)FinancialinstitutionsAllparticipantsCarbontradingintheEuropeanUnionOxera535.3.4Howdoesspeculativetradingaffectcarbonpricevolatility?Speculativetrading(i.e.traderstakingapositiononthefuturedirectionofamarketvariable)mayaffectpricevolatilityinoneoftwoways.•Speculatorsmaytradeprimarilyonthebasisofproprietaryinformation.Thismeansthat,duetotheirtradingactivity,pricesadjustmorequicklytoreflectfundamentalvaluedrivers(i.e.theactivityleadstolowervolatility).91Anaïvespeculatorwouldgobankruptveryquickly.•Speculatorsenteringthemarketincreasecompetitionforliquidityprovision.Improvedliquidityforagivenassetmay,inturn,leadtoreducedvolatility(forexample,asincomingordersarelesslikelytoabsorballtherestingquotesontheothersideoftheorderbook).Severalacademicpapershaveempiricallytestedtherelationshipbetweenspeculativetradingandpricevolatilityincommoditymarkets(seeTable5.1).Overall,muchofthisempiricalliteraturesuggeststhatspeculatorstendtodampen(notincrease)pricevolatility(aswellascontributingtoliquidity,asdiscussedinsection4.4).Table5.1LiteraturereviewonspeculatorsandpricevolatilityPaperKeyfindingsGilbert(2010)GilbertusesdataonindexfundpositionsintheUSagriculturalfuturesmarketsasaproxyfortotalindex-relatedfuturespositionsinallmarkets.Grangercausalitytestsusingthisproxymeasuresuggestthatindexinvestorsmayamplifyfundamentallydrivenpricemovements.IrwinandSanders(2011)IrwinandSanderstestwhetherthegrowthinindexfundshasincreasedpricevolatilityinagriculturalandenergymarkets.Todoso,theyconductaGrangercausalitytestbetweenmeasuresoftraders’positionsandspeculationagainstvolatilityofreturns.Theyfindnoevidencetosuggestthatindexfundscausedapricebubbleinagriculturalcommoditymarkets.BuyuksahinandHarris(2011)BuyuksahinandHarristestthecorrelationbetweentheWorkingT-indexanddailypricechangesinthecrudeoilmarket.Theyreportanearzerocorrelationbetweenthetwoseries.Brunetti,BuyuksahinandHarris(2011)Brunettietal.considerspecificcategoriesoftradersandtestwhetherpositionstakenbyeachcausechangesinvolatilityinoilprices.Theyconcludethattheresultsareconsistentwithspeculatorsprovidingliquidityandrespondingtomarketconditions,ratherthantheopposite.AlquistandGervais(2013)AlquistandGervaisfindthatfinancialfirms’positionsdidnotcauseoilpricefluctuationsduring2007/08.TheyusetheWorkingT-indextoexaminetheimportanceoffinancialfirmsindrivingoilpricevolatilityandfindnoempiricalevidencetosuggestastrongrelationshipbetweenthepositionofspeculatorsandpricechanges.Bohl,PutzandSulewski(2021)Bohletal.conductafixed-effectspanelregressionacross20commoditymarkets.Thismodelfindsnoevidenceofasignificantrelationshipbetweenspeculativeactivityandthedegreeofinformationalefficiency,aftercontrollingforvolatilityandliquidity.Source:Gilbert,C.(2010),‘Speculativeinfluencesoncommodityfuturesprices,2006-2008’,UNCTADWorkingPaper;Irwin,S.H.andSanders,D.R.(2011),‘Theimpactofindexfundsincommodityfuturesmarkets:asystemsapproach’,JournalofAlternativeInvestments,14,pp.40–49;Buyuksahin,B.andHarris,J.H.(2011),‘Dospeculatorsdrivecrudeoifutures?’,EnergyJournal,32,pp.167–202;Brunetti,C.,Buyuksahin,B.andHarris,J.H.(2011),91Foramarketmicrostructuremodelthatshowshowpricesadjusttoreflectthetradingbehaviourofinformedtraders,see,forexample,Glosten,L.R.andMilgrom,P.R.(1985),‘Bid,askandtransactionpricesinaspecialistmarketwithheterogeneouslyinformedtraders,JournalofFinancialEconomics,14:1,pp.71–100.CarbontradingintheEuropeanUnionOxera54‘Speculators,pricesandmarketvolatility’,Workingpaper;Alquist,R.andGervais,O.(2013),‘Theroleoffinancialspeculationindrivingthepriceofcrudeoil’,TheEnergyJournal,34:3,pp.35–54;Bohl,M.T.,Putz,A.andSulewski,C.(2021),‘Speculationandtheinformationalefficiencyofcommodityfuturesmarkets’,Workingpaper.Asnoneofthesepapersconsideredcarbonmarketsspecifically,itisusefultotesttherelationshipdirectlyusingactualdataonEUAprices.Figure5.5showshowvolatilityinEUApricesonICEchanges,asthenumberofpositionholdersincreasesovertime.Overall,thisdatasuggeststhatdespiteanincreaseinthenumberofpositionholdersandaslightincreaseintheshareofpositionsheldbyfinancialfirms,pricevolatilityhasnotincreased.Figure5.5RelationshipbetweenvolatilityandtradingactivityoffinancialinstitutionsNote:They-axisunitforthesecondandthirdchartispercentage.Thepercentageoftotalpositionsreferstothesizeofthepositionsheldbyinvestmentfirmsandinvestmentfunds,respectively,inEUAfuturesasaproportionoftotalpositionsonEUAfuturesintheweeklyCOTCarbontradingintheEuropeanUnionOxera55reportingperiod.Volatilityisthestandarddeviationofdailyreturnsbasedona21-dayrollingwindow.Thefront-yearcontractreferstothecontractsettledinDecemberoftherespectivecalendaryear.Similarly,thefront-monthcontractreferstothecontractsettledattheendoftherespectivecalendarmonth.Similarly,here‘Spot'referstothelastavailableEUAauctionprice.Source:Oxera.Anindicationoftheunderlyingrelationshipcanbeseenmoreclearlybylookingatthecorrelationsbetweeneachofthetimeseriespresentedabove.AsTable5.2shows,thecorrelationbetweenEUAauctionpricevolatilityandthenumberofpositionholdersandtheshareofpositionsheldbyfinancialfirmsrespectivelyisnegative(andstatisticallysignificant)inallcases.Thisresultisinlinewithwhatwouldbeexpectedbasedonourliteraturereviewinthecaseofothercommodities.However,itisworthnotingthatthemagnitudeofthecorrelationsislow,indicatingthatthenegativerelationshipisnotparticularlystrong.Table5.2CorrelationsbetweenEUAvolatilityandthetradingactivityoffinancialinstitutionsVolatilityofEUA…AuctionpriceFront-monthfutureFront-yearfutureNumberofinvestmentfirmsholdingpositions-0.23-0.20-0.22Numberofinvestmentfundsholdingpositions-0.25-0.16-0.16Δofnumberofinvestmentfirmsholdingpositions-0.07-0.08-0.05Δofnumberofinvestmentfundsholdingpositions-0.05-0.04-0.03Numberofpositionsheldbyinvestmentfirms-0.020.050.08Numberofpositionsheldbyinvestmentfunds-0.26-0.19-0.19%ofpositionsheldbyinvestmentfirms-0.24-0.10-0.13%ofpositionsheldbyinvestmentfunds-0.24-0.20-0.21WorkingT-index-0.08-0.03-0.01Note:Thedataonpositionsisavailableonaweeklybasis.Volatilitiesonthereportingdays(everyfiveworkingdays)areusedtocomputecorrelations.Thesuperscriptindicatesap-valueoflessthan0.05.Source:Oxera.5.3.5Howdoesoptionstradingaffectcarbonprices?WhilefundamentalsoverrecentmonthshavepushedupthepricesofEUAs,therehasalsobeenincreasedactivityinoptionstrading.Optionsarewidelyusedfinancialinstrumentsbyalltradercategories,asshowninFigure5.6(below),aspartofprudentriskmanagementand/orasacost-efficientwaytoestablishpositions.OptionscanbeacheaperwayforamarketparticipanttoestablishapositiononEUAsthanthefuturesmarket.CarbontradingintheEuropeanUnionOxera56Figure5.6PositionsonEUAOptionsasat1October2021,bytradercategoryNote:They-axisunitisnumberoflots:1lot=1,000EUAs.EUAoptionsareEuropean-styleoptionsontheEUAfuturescontract,suchthatuponexpiryautomaticexercisewilloccurofoptionsthatareinthemoney(out-of-moneyoptionswillexpire).TheunderlyingcontractistheDecemberfutureoftherelevantyear.Forexample,theunderlyingvariablefortheMarch2021optionistheDecember2021Future.Thechoiceofreportingthepositionsonthedateof1October2021wasarbitraryandtimelyatthepointofthedatarequesttoICE.Source:OxeraanalysisofICEdata.InrecentmonthstherehavebeenreportsofincreasedactivityinEUAoptionstrading.Forexample,openinterestincalloptioncontractswithexpiryinDecemberofthesameyearrosefromaround188mEUAsinmid-November2020toaround351mEUAsinmid-November2021.Atthesametime,theshareofin-the-moneycalloptionshasdoubledfrom25%to50%.InspiteoftheevidencelinkingfundamentalstotheriseinthepriceofEUAs,asdiscussedinsection5.1,somecommentatorshavequestionedwhetheroptionstradingmayhavealsocontributedtotheincreaseinEUAprices.92Theimpactofoptionstradingonthecarbonpricedependsonhowthesellerof,say,acalloptionishedgedandwhattheparticipantexercisinganoptionwantstodowiththeEUAsafterwards.Tradingactivityincalloptionscouldhaveimplicationsforunderlyingfuturespricesifincreasesincalloptionopeninterest(seeFigure5.7)leadtoadditionalbuyingofEUAfuturesasahedge.TheremightbeupwardpricingpressureiftheoptionexercisedwerenothedgedandthehedgingproviderneededtobuyEUAsintheprimarymarkettoensuredeliveryofthecontract.Incontrast,therecouldbedownwardpricingpressureiftheoptionbeingexercisedwaspreviouslyhedgedand/orifthetraderexercisingtheoptionchosetoselltheirEUAbackintheopenmarket.92SeeforinstanceEvans,M.(2021),‘Spotlight:EUcarbonpricestrengthenstorecordhighsinNovember’,SPGlobalPlatts,8December;CarbonPulse(2022),‘KeyEUlawmakerplanstoproposestepstocurbcarbonmarket“manipulation”,14January.010000200003000040000500006000070000LongShortLongShortLongShortLongShortCommercialundertakingInvestmentfirmorcreditinstitutionInvestmentfundOtherfinancialinstitutionCalloptionsPutoptionsCarbontradingintheEuropeanUnionOxera57FeedbackfrominterviewswithEUcarbontradersindicatesthatmanyoftheDecember2021calloptionsthatwereinthemoneyweretheresultofpositionstakenatthestartoftheyearinanticipationoftheEUtighteningitsclimateobjectivesaheadofCOP26andthepublicationoftheFitfor55package.Whiletheevidenceinsection5.1showsclearlythatfundamentaldemandandsupplyfactorshaveputupwardpressureonthepriceofEUAs,wehavenotseenanyevidencethatsuggeststhatoptionsonEUAshaveamplifiedthiseffect.Indeed,ifmanyoftheoptionsthatarenowinthemoneywerewellhedged,theeffectcouldhavebeenthereverse.Figure5.7EUAcalloptionopeninterestforDecember2021contractNote:They-axisunitismillionsofEUAscalloptionopeninterestfortheDecember2021contract,thex-axisiseurospertonneofCO2e.Dataextractedfromwebplotdigitzer.com.Source:OxeraanalysisofS&PGlobalanalysisusingdataprovidedbyICEandPlattsAnalytics.ThediscussionabovesupportstheviewthatspeculatorsplayanimportantandpositiveroleinthefunctioningofthemarketfortradingEUAfuturesandoptions.01020304050EUAs(m)Strikeprice(€)CarbontradingintheEuropeanUnionOxera586PolicyimplicationsTheEuropeanCommissionhasaskedESMAtoconsiderwhetherthereisaneedfortargetedactionintheEUcarbonmarket.Thissectionsummarisesthekeyfindingsandpolicyimplicationsoftheanalysispresentedintheprevioussections.Awell-functioningcarbontradingmarketplaysanimportantroleinthedeliveryoftheEU’sdecarbonisationgoals.Inparticular,itprovidestransparentpricesignalsthatallowsparticipantstoallocatecapitalandmanageriskefficientlyinthefaceoftheuncertaintiesthatsurroundtheenergytransition.Thisfunctionwillcontinuetobecriticalinhelpingachieveanefficienttransitiontothenetzeroobjective.Theevidencepresentedinthisreportindicatesthatthemarketisfunctioningwellandasexpected.Overtime,thetradingofEUAfutureshasdevelopedfromanOTCmarkettoapredominatelyexchange-tradedone.Thisshifthashadapositiveimpactonend-users.Inparticular,asexchangeshavebeensuccessfulinattractingamorediversegroupofmarketparticipants,exchange-tradinghasledtoimprovementsinmarketresilience,priceformationandliquidity.MosttradingtakesplacebetweenentitiesseekingtohedgetheirEUApriceandvolumeriskswithfinancialinstitutionsandotherliquidityprovidersontheothersideofthetrade,whoarewillingtoprovidequotesbyearningthespreadandbytakingaposition.Whiletherehasbeenanincreaseinthenumberoffundsinvestinginthecarbonmarket,thesizeoftheirpositionsremainsrelativelysmall.Allofthesemarketparticipantsareprovidingimportantcontributionstothewell-functioningofthemarket.ThesuccessoftheEUcarbontradingmarketupuntilthispointislargelyduetotheEU’spolicyambitiontodate,aswellastheactivitiesoffinancialmarketparticipantsandinfrastructureproviders.Emissionstradingisnowawell-regulatedmarketintheEU.InadditiontothedetailedrulessetoutintheEUregulatoryframework,theexchangesoperatewithinacomprehensivemarketmonitoringandcomplianceframework,toensurethattrustandconfidenceremainsinthemarketTherehavebeensomecallsforregulatorstoimposepositionlimitsonEUAfutures.Evidencefromothermarketssuggeststhatapplyinginflexiblepositionlimitswithinlegislationmaybecounterproductive,particularlyasthemarketiscurrentlyfunctioningwell.Itwouldbebettertoleaveexchangestomonitortradingincarbonmarketsandtotakeappropriatemeasuresinresponsetomarketdevelopmentsinrealtime,undertheclosesupervisionoftheNCAs.Thatsaid,itwouldbehelpfultoimprovetheconsistencyacrosstheEUofthereportingofpositionsbyentitiesaspartoftheCOTreports.FurtherguidancefromESMAtoreportingentitiesmayhelp.MarketsurveillanceandmonitoringcouldalsobefurtherimprovedviabettercoordinationanddatasharingarrangementsbetweenthecentralandnationaladministratorsoftheUnionRegistryfortheholdingsofEUAsandtherelevantfinancialregulators.9393Article67(1)ofCommissionDelegatedRegulation(EU)2019/1122of12March2019supplementingDirective2003/87/ECoftheEuropeanParliamentandoftheCouncilasregardsthefunctioningoftheUnionRegistryprovidesthat‘thecentraladministratorandthenationaladministratorsshallcooperatewithpublicCarbontradingintheEuropeanUnionOxera59Despitesomeconcernsraisedabouttherecentincreaseinprices,thereislittleevidencetosuggestthatthepricelevelisabovethatimpliedbythefundamentals.ItisworthrecallingthattheEUApriceisestablishedinamarketdrivenentirelybypolicymakersandlegislation.Accordingtomanyforecasters,theEUApricetodayis,infact,lower(nothigher)thanwhereitneedstobetoreachtheEU’sdecarbonisationtargets.ItisimportantthatanypolicyactiondoesnotunderminethesuccessoftheEU’sclimatepolicyactiontodateanddevelopmentsinthemarketinfrastructurearoundcarbontradingintheEUinrecentyears.Whereitissuggestedthatanomalouspricemovementshaveoccurred,thesearebestexplainedbyacombinationofchanges,suchastheintroductionofmoreambitiousemissionreductiontargets,revisionstotheMSR,andchangestoothermarketfundamentals(e.g.changestoexpectedabatementcosts,includingtherelativepricesofgasandcoal).GiventhelikelyexpansionoftheEUETStoothersectorsinthecomingyears,itwillbeimportanttocommunicatepolicychangesclearlyandnotunderminetheworkalreadydone.Indeed,aftermanyyearsofinvestment,theEUETSisnowseenasaglobalbenchmarkforcarbontrading,andasuccessstorythatotherregionsareseekingtofollow.Thereisalsomeritinencouragingwideruseofriskmanagementandhedgingamongfirmsexposedtovolatilityincarbonprices.FailuretomanagetheserisksappropriatelycouldexposeEuropeanhouseholdsandcompaniestounnecessarypriceshocksduringthetransitiontoalow-carboneconomyandrisktheEUmissingitslegallybindingdecarbonisationtargets.Hedgingincentivescanbeputinplaceby,forexample,removingfreeallowancesassoonaspossible.bodieschargedwiththesupervisionofcomplianceunderDirective2003/87/ECandpublicbodiescompetentfortheoversightofprimaryandsecondarymarketsinallowancesinordertoensurethattheycanacquireaconsolidatedoverviewofallowancesmarkets’.WeunderstandthatthisisinsufficienttoaffordESMAandtherelevantfinancialregulatorsdirectaccesstodataoninvestors’holdingsinEUAsonanongoingbasis.CarbontradingintheEuropeanUnionOxera60A1EUregulatoryframeworkoncarbontradingThisappendixsummariesthekeypiecesofEUregulationcoveringthetradingofEUAfuturesandEUAoptions.A1.1CarbonmarketsundertheEU’ssecondMarketsinFinancialInstrumentsDirective(MiFIDII)andMarketsinFinancialInstrumentsRegulation(MiFIR)•WithMiFIDII,emissionallowanceshavebecomefinancialinstrumentsunderAnnexI,SectionC(11).Incontrasttoenergymarkets,spotmarketsofemissionallowancesdonotfallundertherealmofREMIT.•Despitebeingsubjecttoweeklyanddailypositionreporting,derivativesonemissionallowancesdonotfallunderthedefinitionofcommodityderivativesunderMiFIDIIandarethereforenotsubjecttopositionlimitsandpositionmanagementcontrols.•EUAsandthederivativesonEUAsneedtobereportedtothenationalcompetentauthorities(NCAs)asofJanuary2018,accordingtoMiFiR.ThetransactiondataprovidedunderMiFIDisoneofthetoolsthatenablesNCAstosystematicallymonitorforabusesundertheMAR.94Inaddition,theorderdatacollectedinaccordancewithMiFIRisimportanttodetectmarketmanipulations;however,thisorderdatainformationisnotincludedinthetransactionreporting,andNCAswillhavetogathersuchdatathroughrequeststothetradingvenues.•ThereareparticularrulesgoverningwhichtransactionsinfinancialinstrumentsrelatedtoEUAsarecoveredbyMiFiR—seeparagraph17ofESMAreportformoreinformation.95•SinceJanuary2018,forEUAsandderivativestradedonEEXandNasdaqOslo,theNCAsareBaFinandFIN-NOrespectively.ForderivativesonemissionallowancestradedonICE,therelevantcompetentauthoritysinceJanuary2018hasbeentheUKFinancialConductAuthority,whiletheAFMtookovertheresponsibilityafterthemigrationoftradingfromtheUKICEFuturesEuropetotheDutchentityICEEndexinJune2021.A1.2CarbonmarketsundertheEU’sMarketAbuseRegulation(MAR)•TheMARisaimedatpromotingintegrityofthemarketsthroughtheprohibitionofinsiderdealing,unlawfuldisclosureofinsideinformationandmarketmanipulation.Inadditiontotheseprohibitions,MARprovidesforancillaryrulestobefollowedbyissuersandintermediariesinanattempttopreventmarketabuse,andforsignificantpowersforNCAsinthedetectionandprosecutionofbreaches.•TheMARapplieshorizontallytoallfinancialinstrumentsadmittedtotradingonanEU-regulatedmarketortradedonanMTForOTF,includingEUAs.•TheMARprovidesthatemissionsallowancemarketparticipantsshoulddisclose,timelyandinthepublicdomain,theinsideinformationwhichtheyholdabouttheiractivities.TheMARexpresslyprohibitsplacingorders,94SeeRecital32ofMIFIRstatesthat“Thedetailsoftransactionsinfinancialinstrumentsshouldbereportedtocompetentauthoritiestoenablethemtodetectandinvestigatepotentialcasesofmarketabuse,tomonitorthefairandorderlyfunctioningofmarkets,aswellastheactivitiesofinvestmentfirms.95ESMA(2021),‘Preliminaryreport:EmissionsAllowancesandderivativesthereof’,ESMA70-445-7,15November,https://www.ESMA.europa.eu/sites/default/files/library/ESMA70-445-7_preliminary_report_on_emission_allowances.pdf(accessed30December2021).CarbontradingintheEuropeanUnionOxera61enteringintotransactionsordisseminatinginformationthroughthemediathatgivefalseormisleadingsignalsasthesupply,demandorpriceofafinancialinstrument,orthatarelikelytosecureitspriceatanabnormalorartificiallevel.Individualorconcertedactionsaimedatsecuringadominantpositionoverthesupplyof,ordemandfor,afinancialinstrumentarealsoprohibited.•ThebuyingorsellingofEUAsorrelatedderivativesonthesecondarymarketsisalsoconsideredmarketmanipulationwheneverithastheeffectofcreatingormaintaininganartificialpricefortheauctionedproducts,orwhereitmisleadsbiddersintheauctions.Theauctionpricesandsecondarymarketpricesareinterrelated,astheauctionshouldbecancelledaccordingtoArt.7(6)ofRegulation1031/2010iftheauctionclearingpriceissignificantlybelowthepriceonthesecondarymarket.Thisaimstopreventmarketparticipantsfrombenefittingfromarbitragebetweentheprimaryandsecondarymarkets.•Toensurepreventionanddetectionofmarketabuse,theMARprovidesthatmarketoperators,investmentfirmsoperatingatradingvenue,andanypersonprofessionallyarrangingandexecutingtransactions,aretoestablisharrangements,systemsandprocedurestodetectandreporttoNCAssuspiciousordersandtransactions(STORs)—includingEUAsandderivatives.Inadditiontotheexpostmechanism,marketoperatorsandinvestmentfirmsareobligedtoestablishandmaintaineffectivesystemsandproceduresinordertopreventmarketabuse.•Tradingvenuesarerequiredtohaveeffectiveproceduresinplacetomaintainafairandorderlymarket.ICE,forexample,appliesreal-timeandT+1monitoring,andisexpectedtosubmitSTORswheneveritnoticessuspicioustradingbehaviouronitsplatform.TheAFMorganisesperiodicmarketconductmeetingswithICEEndex,wherealertsgeneratedbytheautomatedsurveillancesystemarediscussedindetail.Uponrequest,ICEEndexsharesEUAderivativesorderdatawiththeAFMtosupportthematicmarketsurveillanceinvestigations.A1.3CarbonmarketsundertheEU’sEuropeanMarketInfrastructureRegulation(EMIR)•TheEMIRwasestablishedintheaftermathofthe2009financialcrisistomaketheOTCderivativesmarketmoretransparent,reducesystemicrisks,andpreventmarketabuse.TheEMIRcontainsanobligationtoreportdetailedinformationupontheconclusion,modificationorterminationofanyderivativecontract(bothOTCandexchange-tradedderivatives)—includingEUAderivatives—totraderepositories(TRs).•TheEMIRsetsreportingobligationsforallfinancialcounterparties,whichincludeinvestmentfirms,creditinstitutions,insuranceundertakings,andnon-financialcounterpartiesthattradeinEUAderivatives.ThistherebyimprovesthetransparencyofEUAderivativestrading.CarbontradingintheEuropeanUnionOxera62A2LiteraturereviewontheimpactofpositionlimitsonmarketfunctioningIncasesofextremevolatilityand/ortopre-emptmarketmanipulation,exchangesmayapplypositionlimitsorcircuitbreakers.96Theyonlydothiswhereitisappropriate,dependingonthespecificcircumstancesofthetradingenvironmentandthecharacteristicsoftheunderlyingcommodity.Violatingtheselimitstypicallyresultsindisciplinaryactionbytheexchange.Therationalebehindimposingpositionslimitsistopreventspeculatorsfromgainingpowertoexertundueinfluenceonthemarket,therebyensuringefficiencyandauthenticityinpricemovements.Positionlimitsaregenerallyconstruedasaproactivemechanismtocurbmarketmanipulation.Thiscontraststocircuitbreakers,whicharereactive.Theeconomicsliteratureisquitescepticalaboutthebenefitsofregulators(ratherthanexchanges)imposingpositionlimitsonmarketparticipantsinfuturesmarkets,despitethegoodintentionsoftheregulatorstoensureefficiencyandpriceformation.Manystudiesarguethatgovernmentregulationofmanipulativepracticesinfinancialmarketsissuperfluous,astradingvenuesthemselvesareincentivisedtotakeprecautionsagainsttheexerciseofmarketpower.97Inparticular,thecorebusinessmodelofatradingvenueistomaximiseorderflow,byattractingmarketparticipantstosubmitbids.Themoreauthenticthepricemovements,andgreaterthemarketintegrity,themorelikelytheexchangeistoattractorderflow.Thisiswhyexchangesinvestinactivitiestomanageandmonitortradingbehaviourandpositionsinamannerthatensuresmarketintegrity,whileminimisingpotentialimpactsonmarketefficiency,liquidityandpricediscovery(asdiscussedfurtherinsection3.2inthemainreport).AsnotedbyESMAtheuseofinstruments,suchascircuitbreakers,bytradingvenuestointerruptexcessivepricesareeffectiveiftheyaddresstransitoryvolatility(definedasthetendencyforpricestofluctuatearoundtheirfundamentalvalue).However,ESMAalsonotedthatcircuitbreakersarenoteffectiveiftheyaddressfundamentalvolatility.Inthiscaseatradinghaltpreventspricesfromreflectingthenewinformationonfundamentalvalues.98Akeyriskofregulatorsembeddinghard-codedpositionlimitsintolegislationisinflexibilitytoadapttothemarketcontextandenvironment.Otherstudiesfindthatpositionlimitsreduceliquidity,increaseexecutioncosts,affectpricevolatility,andleadtoatransferofbusinessfromexchangestoOTCmarkets.99Theimpactonliquidity,executioncostsandvolatilitystemsfromthefactthatbindingpositionlimitsreducethevolumeoftrading,frombothspeculatorsandhedgers(totheextentthatlimitsonspeculativetradingactivity96Brennan,M.(1986),‘Atheoryofpricelimitsinfuturesmarkets’,JournalofFinancialEconomics,16,pp.213–33.Circuitbreakerstemporarilyhalttradingwhentheprice(oritsvariation)ofanindividualsecurityoranindexfallsmovesinexcessofapre-determinedlevel.97See,forexample,Easterbrook,F.(1986),‘Monopoly,manipulationandtheregulationoffuturesmarkets’,JournalofBusiness,69,pp.103–127;andFiscel,D.andRoss,D.(1991),‘Shouldthelawprohibit‘manipulation’infinancialmarkets?’,HarvardLawReview,105,pp.503–553.98ESMA(2020),‘Marketimpactsofcircuitbreakers–evidencefromEUtradingvenues’,ESMAWorkingPaperNo.1,2020.99Edwards,F.(1984),‘Theclearingassociationinfuturesmarkets:guarantorandregulator’,inR.Anderson(ed.),Theindustrialorganisationoffuturesmarkets,Lexington;Pliska,S.andShalen,C.(1991),‘Theeffectsofregulationsontradingactivityandreturnvolatilityinfuturesmarkets’,JournalofFuturesMarkets,11,pp.135–151.CarbontradingintheEuropeanUnionOxera63accommodatehedgingdemand,whichislikelyinthecaseofEUAsasspeculatorsasagrouptakepositionsoppositetonethedgingpositions).Someacademicpapersgofurtherandfindthatpositionlimitsarecounterproductiveanddetrimentalforsocialwelfare.Forexample,researchbyGwilymnandEbrahim(2013)presentsageneralequilibriummodelwithinasettingofrationalexpectations,completemarkets,andcompetitionbetweeneconomicsagents.Undertheseconditions,theauthorsfindthatexcessivespeculation,withorwithouttheintentiontomanipulatethefuturesmarket,isnotworthwhileforthespeculator,asitservestoenrichotheragentsintheeconomyattheexpenseofthespeculator.100Therestraintsplacedonspeculators,intheformofpositionlimits,aretransmittedtohedgersthroughthedemandandsupplyoffutures,therebyinhibitingtheirfreedomandultimatelyimpairingthesocialwelfareofallagentsintheeconomy.100Gwilymn,R.andEbrahim,M.(2013),‘Canpositionlimitsrestrain‘rogue’trading?’,JournalofBanking&Finance,37:3,pp.824–836.www.oxera.com

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