Market access

EU ETS update: Will Europe limit market access for speculators?

The European Parliament is set to propose restricting access to the EU Emissions Trading System (EU-ETS) market in a bid to crack down on what some lawmakers call excessive speculation in the block carbon market.

Over the past three to four years, a number of European stakeholders and member states have argued that prices for EU (EUA) emission allowances have risen too much, fueled by an influx of speculative capital and investment and that prices, which have increased ninefold since 2018, are now causing significant economic damage to the region’s industrial complex.

EUA prices have risen from €8 to €25 in 2018, from €25 to €33 in 2020 and from €32 to €90 in 2021. The market is currently trading at around €81 on the European exchange ICE Index.

In 2021, the European Commission asked the European Securities and Markets Agency (ESMA) to investigate the role of speculative traders in the EU ETS, and its report found no signs of abnormal or abusive trading.

“Overall, ESMA considers that the analysis of the data has not revealed any major anomalies or fundamental issues in the functioning of the EU carbon market from a financial supervisory perspective.”

This is confirmed by exchange data, which shows that out of a total derivatives market position of over 2.3 billion EUAs as of December 2021, investment funds – a category that includes ETFs such as KraneShares Global Carbon Strategy ETF (Ticker: KRBN) and KraneShares European Carbon Allowance Strategy ETF (Ticker: KEUA) – held only 62 million EUAs (2.7%).

By way of comparison, financial and credit institutions such as banks held net short positions of more than 1.7 billion European units of account during the same period. Banks are typically involved in servicing compliance buyers and hold large physical portfolios that are hedged by short futures positions.

The ESMA report, however, notes the emergence of financial investors “and instruments” with buy-and-hold strategies, and warns that “these may lead to a reduction in the supply of commercially available physical issue”.

But in its conclusions, the agency concluded that “the observed evolution of carbon prices and volatility appears to have followed market fundamentals”, and only suggested that the Commission could consider imposing management controls on positions for derivatives.

It should be noted that while the European Parliament’s proposed regulation would prevent financial players from opening ledger accounts, this would not affect participation in the derivatives (futures) market, and few stakeholders see a realistic way, beyond setting position limits, that regulators could prevent investors from participating in the EU ETS.

Financial investors generally do not want to physically receive EUAs: the work and time involved in transferring EUAs between ledger accounts reduces the flexibility investors need to quickly enter and exit positions.

Therefore, most market participants do not believe that the proposed regulation would have a significant impact on the functioning of the market, nor on the liquidity and volatility of prices.

On the contrary, it may impact the ability of compliance entities – manufacturers and power producers – to meet their compliance requirements, as some intermediaries may no longer be authorized to hold physical EUAs.

The proposed regulatory change would not affect vehicles that invest in futures or other derivative contracts, including KRBN. The current proposal would be limited to preventing non-compliant participants from holding physical EU quotas.

The proposed regulation is due for a vote by the full Parliament in early June, after which it will move on to negotiations between the Commission, Parliament and the Council of member states. These negotiations also include the comprehensive “Fit for 55” reform package for the EU ETS, including proposals to tighten the overall emissions cap until 2030, introduce maritime emissions to the market for the first time and impose a carbon border adjustment. (CBAM) on imports from third countries.

Some traders are optimistic that the regulation may not pass the co-legislation process, as the Commission may instead be guided by ESMA’s report and member states may not all agree on the measure.

However, it is clear that the subject of market participation non-compliance is unlikely to go away and that the Commission may well begin to consider other means of mitigating the impact of financial speculation.

For KRBN standard performance, top 10 holdings, risk and other fund information, please click here.

For KEUA standard performance, top 10 holdings, risk and other fund information, please click here.