The making of Emissions Trading laws – understanding the EU legislative process

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Introduction -

Unlike most traded commodity markets, the market for trading carbon credits or emissions allowances in the EU is not one based on its utility, usage or consumption. A carbon credit is not used in manufacturing processes or consumed like power or grain. Its market is entirely an invention of policy as implemented through legislation and regulation with a view to reducing the carbon emissions in the EU. Any demand for a carbon credit or emission allowance (“allowances”), is also therefore a creation of those legislative and regulatory processes. That process has left the EU Emissions Trading Scheme (“EU ETS”), today in its third phase, moribund with an over-supply of allowances. Although the EU ETS is a relatively new market, it has certainly had its share of teething problems. Some of these problems (e.g. VAT fraud and addressing security aspects from carbon registry hacking incidents) have been through a lack of foresight on the part of the European Commission (the “Commission”) and the member states. Others, such as the over-supply problem, have been as a result of a combination of fewer allowances required through financial crisis induced lower industrial output, and the lack of ambition on the part of the developed world (including the member states) to take on more stringent caps for its emissions output. In the case of each of these problems, the Commission’s response has been to propose more legislation to tweak, amend or revise its original legislation. We have seen three versions of a ‘new’ Registry Regulation between 2009 and 2011, and have just had a fourth new version in May 2013. As the Commission proposes various ‘fixes’ or applies band-aids to the various problems it has to address, it sometimes builds on bad policy with more bad policy. The inclusion of the aviation sector within the EU ETS and the subsequent ‘temporary’ exclusion for one year only, springs to mind as a good example of the Commission’s “bandaid” approach to legislative intervention. “Two wrongs don’t make a right” seems an apt description of much of the legislation recently introduced, including some that has been designed to have retrospective effect.

Therefore, how does a participant in the carbon market manage risk and uncertainty arising from a volatile and unpredictable legislative process? Unlike any other market, in the EU ETS it becomes essential to understand the legislative process as part of the toolkit of risk management, used by risk managers looking after traders. The importance of understanding the legislative process and the price volatility that can be triggered from a knee-jerk reaction to minor steps in the legislative process, was most visibly seen in the Commission’s recent proposal known as the ‘Backloading’ proposal. We will use the ‘Backloading’ proposal as an example to illustrate the legislative process followed in the EU ETS. This client alert seeks to demystify the labyrinth that is the EU rule making process in the EU ETS.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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