EU carbon emission allowances as environmental and financial instruments – is it possible to kill two birds with one stone?

Abstract

In this paper, the consequences of recognition of carbon emission allowances as financial instruments under the EU financial markets law including Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (MiFID II) and the EU environmental law are analysed. We try to answer the question in what way the recognition of carbon emission allowances as financial instruments affected the functioning of the European Union Emission Trading Scheme (EU ETS). In particular, we ask whether it is beneficial or detrimental in terms of the environmental and economic effectiveness of the EU ETS.

Keywords:

• European Union Emissions Trading System (EU ETS)
• European Union Allowances (EUAs)
• environmental law
• Markets in Financial Instruments Directive (MiFID II)
• financial instruments
• secondary market
• economic effectiveness

1. Introductory remarks

The tension between environmental law concerns and freedom of economic activity, which is fundamental for the market economy, has contributed to global contestation of traditional instruments of environmental protection. Increasingly often, the disadvantages of traditional administrative instruments have been noticed and discussed: they include significant application-related costs, the effect of discouraging investment and innovation (owing to the high level of specificity of regulations and short deadlines for adjustment of practice to their content), and a lack of responsiveness to the need for continuous improvement in the quality of the environment.¹ Although public authorities make decisions regarding who should have access to environmental resources and under what conditions within the command-and-control category of measures (administrative instruments), in the case of market-based measures, these decisions are limited to determining conditions for the general exploitation of resources that secure their preservation.² The increasingly frequent invoking of economic concerns has led to an extension of the array of instruments at the disposal of environmental law by means of mechanisms based on economic analysis, ie market-based instruments. In addition to the environmental effectiveness of the devices employed by environmental law, increasingly strong emphasis has been put on their economic effectiveness. Economic effectiveness is sometimes even considered an element of sustainable development.³ Market-based instruments of environmental protection that involve the component of trade in environmental rights are therefore intended to provide for an adequate balance between the environmental and economic effectiveness (a high level of achievement of environmental goals is accompanied by minimisation of related costs).⁴

In the Green Paper on Market Based Instruments for Environment and Related Policy Purposes, issued by the European Commission, the following justification for the application of economic instruments is provided:

The economic rationale for using market-based instruments lies in their ability to correct market failures in a cost-effective way. Market failure refers to a situation in which markets are either entirely lacking (eg environmental assets having the nature of public goods) or do not sufficiently account for the ‘true’ or social cost of economic activity.⁵

Market-based instruments in environmental law are somehow suspended between law and economy; in fact, they are actually hybrid in nature. The marriage between law and economy that is expressed in the mixture of market and non-market elements within such instruments significantly influences the functioning of these mechanisms and their environmental and economic effectiveness. These tools emphasise the role of market components, thus creating markets for certain elements related to environmental protection (for instance, rights to pollute, as is the case within the framework of emissions trading schemes; or for ecological goods, like the proportions of energy from renewable sources, upon which green certificate systems are founded). Market-based mechanisms of environmental law use market signals to achieve environmental objectives. Therefore, they differ significantly from both other economic instruments (such as environmental fees and taxes) and administrative measures.

The possibility of trading environmental rights between participants in a system created by a given market-based instrument constitutes one of the crucial features of market-based instruments in the strict sense. Although such trade is voluntary in the case of all market-based environmental protection instruments, the possibility of concluding transactions is a key feature in terms of recognition of a given mechanism as a market-based instrument. Another key trait (and advantage) of market-based instruments such as emissions trading is their flexibility, construed here as an abundance of options available to addressees of such mechanisms. In the case of traditional administrative instruments, an entrepreneur’s choices are limited to whether they will emit the given volume of substances (and will therefore be required to obtain a suitable permit) or not (and will therefore not be required to obtain a permit). The array of options is much wider in the case of market-based instruments. For example, within the framework of emissions trading, the available options are acquiring a given number of allowances at the stage of the initial allocation or purchasing the missing number of allowances at the stage of the secondary allocation.

Emission trading is currently one of the most popular market-based instruments in the domain of environmental law. Without a doubt, the most prominent example of such a system is the European Union Emissions Trading System (EU ETS),⁶ which is aimed at reducing greenhouse gas emissions. The EU ETS changes dynamically in terms of the roles, relations and proportions between its market elements (such as the principal system of primary allocation of rights by auctioning or secondary trading of European Union Allowances, which shall hereinafter be referred to as ‘EUAs’) and non-market elements (including, in particular, emissions permits; derogations from auctioning; and monitoring, reporting and verification of emissions). In some areas, this development has reinforced market elements, but there are also areas where the effect was the opposite. All such modifications leave their mark on the functioning of the EU ETS and its attempt to reconcile environmental and economic effectiveness. The inclusion of carbon emission allowances in the category of financial instruments by Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (hereafter: MiFID II)⁷ should definitely also be examined in this regard, as it may change the general picture of the environmental and economic effectiveness of the EU ETS. This is the main issue we would like to ponder in our contribution: whether recognition of carbon emission allowances as financial instruments does deliver any added value in terms of environmental and economic effectiveness of the EU ETS.

The research hypothesis of the present contribution is that the qualification of EU carbon emission allowances as financial instruments has contributed to the environmental and economic effectiveness of the EU ETS. To verify the hypothesis, the contribution shall deal with the following issues in turn:

1. Section 2 comprises the identification of the essence of EU carbon emission allowances as environmental commodities and market instruments; in this section, we describe the legal status of carbon emission allowances and their role in the achievement of environmental objectives of the EU ETS from a theoretical perspective. This section lays the foundation for further considerations pertaining to the subject matter of this contribution.

2. Section 3 describes essential features of the EU ETS as a market for carbon emission allowances prior to MiFID II. In this section, we present practical insights about the manner of functioning of the EU ETS before the recognition of EU carbon emission allowances as financial instruments.

3. Section 4 pertains to the rationale for qualification of carbon emission allowances as financial instruments in MiFID II. In this section, we discuss why the European legislator, while performing the reform, did not decide to create a special, tailor-made regime for trade in carbon emission allowances, but instead decided to fully integrate this trade with EU financial markets.

4. In Section 5, we examine whether the qualification of carbon emission allowances as financial instruments has affected their legal character.

5. In Section 6, we focus on exemptions from the scope of application of MiFID II to answer the question of whether MiFID II creates any coherent system of legal norms applicable to various categories of market participants dealing in carbon emission allowances. For the sake of consistency of reasoning, the analysis concentrates on MiFID II and does not encompass other EU legislation on financial markets, which has become applicable to carbon emission allowances after their qualification as financial instruments, specifically Markets in Financial Instruments Regulation (MiFIR)⁸ and Market Abuse Regulation (MAR).⁹

6. Section 7 analyses the degree of achievement of the goals underlying the recognition of carbon emission allowances as financial instruments under MiFID II from the perspective of the secondary market.

7. Section 8 deals with the implications for the environmental and economic effectiveness of the EU ETS of recognising EU carbon emission allowances as financial instruments.

The contribution will focus on the transactions of carbon emission allowances that have been introduced in the EU ETS, ie EUAs. For the sake of the clarity and depth of the examination, the considerations will not pertain to other carbon emission allowances (eg Kyoto units) or derivatives created on the basis of carbon emission allowances.

2. Theory: the essence of EUAs as environmental commodities and market instruments

Within the framework of the EU ETS, there is an annual issuance of a number of EUAs that are thereafter allocated to entities participating in the system. Each EUA is associated with the right to emit one ton of carbon dioxide (or the equivalent of other greenhouse gases). Participants in the system are obliged to account for their emissions by redeeming the respective number of EUAs. These units may be acquired from auctions or obtained from other entities within the framework of secondary trading.

The keystone of the EU ETS is the limit of EUAs (cap), which is determined annually as a linearly decreasing number of EUAs available on the market. Therefore, the EU ETS is a cap-and-trade system, as it is based on the initial allocation of EUAs which are subject to trading. The number of allowances to emit given substances or energies into the environment is determined at a level that is supposed to cause ecological changes, since the decreasing number of EUAs constitutes a strong signal that influences the price of EUAs on the market, subject to rules that regulate supply and demand. Increasing the prices of EUAs induces entities participating in the created market to consider limiting emissions (in particular, by the application of newer and better technological solutions) instead of incurring increased costs of purchasing missing EUAs.¹⁰ The first option solves the problem in a long-term perspective, which is not achieved in the case of acquisition of EUAs.

In contrast to command-and-control-type environmental mechanisms, the emissions trading system, which is a formidable example of a market-based instrument, has a great, but usually forgotten, value related to its influence on the level of adjustment of commercial activity to environmental regulation. That is, it provides an incentive for emitters to adjust their conduct to a greater extent than is necessary in light of applicable norms.¹¹ In the case of traditional instruments, there is no reward for reducing emissions to below the required thresholds, whereas market-based instruments should theoretically encourage emitters to reduce emissions as much as possible.¹² However, it should be emphasised that such an incentive is actually in place only if certain conditions are met both inside and outside the EU ETS, comprising, inter alia, high prices of EUAs, as well as proper shaping and enforcement of rules for monitoring, reporting and verification, so as to avoid emissions not covered by the EUAs.

Emissions trading itself does not contribute to the reduction of greenhouse gas emissions: it is the emission limit that does so.¹³ The business decision on whether to reduce emissions or purchase additional EUAs from other participants is made by emitters and based on economic calculations and predictions concerning the functioning of the carbon market. The inherent idea is to allow entities to choose the best option for themselves; while it is ensured (subject to proper monitoring, reporting and verification) that a predetermined level of greenhouse gas emissions reduction would be achieved (by the very existence of the cap), an individual entity is not forced to choose technological changes instead of buying EUAs. It is assumed that emissions would be reduced first and foremost by the entities for which it is more cost-effective than purchasing EUAs. However, economic effectiveness is not guaranteed by market elements; the flexibility of the system is intrinsically interwoven with risk, which may be significantly limited with appropriate knowledge and skills, but which cannot be fully avoided. Thus, it may be seen that, while the market element, ie secondary trading in EUAs, does not itself cause the ecological effect, if this element is accompanied by a given emissions threshold, it may reinforce the environmental effectiveness of the EU ETS. In the context of the environmental effectiveness of the EU ETS as a cap-and-trade system, trade supports the cap; furthermore, trade potentially allows for the economic effectiveness of the system as a whole.

The crucial idea of the EU ETS is the creation of an artificial market for goods that do not have a market character.¹⁴ In the case of emissions trading, these goods are EUAs, which may be defined as settlement units that represent the rights to emit a given volume of greenhouse gases into the atmosphere. The EU law provides some indices on the character of EUAs, but they are rather vague and ambiguous and do not even allow an unequivocal determination of whether EUAs are intangible proprietary rights or transferable public (administrative) rights; it seems that they are both,¹⁵ ie they have elements of public rights and private property rights. The growing literature on this issue tends to examine EUAs as private law instruments (intangible property rights).¹⁶ The private-law approach to EUAs reflects the nature of the EU ETS as a system that fits the growing trend of privatisation of public functions with the aim of achieving environmental objectives through the use of market mechanisms.¹⁷ On the contrary, the partly administrative character of the rights incorporated in EUAs and their close proximity to grants or licences enable one to perceive them as public law instruments.¹⁸

Taking into account the assumptions built into emissions trading, the dual nature of EUAs should be perceived as a natural consequence of a system that mixes market and non-market elements into a unique set of arrangements. Lack of a precise determination of the character of EUAs is usually not considered an obstacle to the functioning of the secondary market. Rather than providing an express declaration of whether EUAs are public or private rights,¹⁹ the vital issue for smooth operation of the market is to ensure the transferability of EUAs and the legal certainty of transfers. Ambiguous as it may be, the nature of EUAs within the EU ETS has not yet hampered the functioning of the mechanism in question. The situation before MiFID II demonstrated the ups and downs of the carbon market; nevertheless, these previous successes and problems did not relate to the nature of EUAs.

3. The functioning of the EU ETS as a market for EUAs before MiFID II

The complexity of the EU ETS results in a broad margin of discretion for its participants, but also requires adequate knowledge and skills to reduce the risk related to wrong decisions within the aforementioned scope, as the flexibility of the EU ETS is inherently connected with the unpredictability of developments in the primary and secondary carbon markets. The unpredictability of the EU ETS itself was recognised by the Court of Justice in the Arcelor²⁰ case as a value and an indispensable feature of this instrument, which should not be subject to modifications; the court emphasised the crucial role that market elements play in emissions trading. Trading of environmental rights and the resulting flexibility allow for the high level of attainment of the environmental goal (greenhouse gas emissions reduction) while preserving values related to economic effectiveness (the underlying concept is that the entities for which emissions reduction is more profitable will pursue that path, while entities that prefer buying EUAs will be able to buy them, so costs of achieving the environmental goal will be diminished). The aim is to reconcile environmental and economic effectiveness (the latter perceived from individual and global perspectives). Within the framework of cap-and-trade systems, cases in which a given entity obtains the appropriate number of allowances within the primary allocation (corresponding to its emissions) are very rare.²¹ Therefore, the stage of secondary allocation (secondary trade), which constitutes proper ‘emission trading’, is particularly important. The provisions of the EU ETS Directive are very brief on this issue, and one may infer from them only that EUAs may be the subject of trading between persons in the European Union, as well as, in the case of conclusion of a proper agreement with third states, with persons in those states (article 12, paragraph 1 of the EU ETS Directive).

Environmental law regulations provide for the option of the secondary trade in EUAs, but they do not impose applicable rules for such trade. Here is where the law of the financial markets enters. Obviously, secondary trade in carbon emission allowances may take place in both regulated markets and over-the-counter (OTC) markets. From the perspective of this trade, the use of regulated markets is not necessarily a legal requirement. In the case of the EU ETS, secondary trade was also carried out before the recognition of EUAs as financial instruments by virtue of MiFID II. The MiFID I Directive²² encompassed trade in EUAs, but only when EUAs represented the underlying of derivative contracts.²³ The secondary trade in EUAs themselves took the form of bilateral transactions that were concluded OTC, outside regulated markets and, consequently, without any enhanced supervision performed by market regulators. This system allowed persons engaged in trade in EUAs to have great leeway in deciding on the exact shape of particular transactions. Regrettably, it suffered from several drawbacks.

4. The inclusion of EUAs in the list of financial instruments in MiFID II

Compared to the MiFID I Directive, MiFID II extends the scope of the notion of ‘financial instrument’ to EUAs. From a technical perspective, this turning point is achieved in a very simple manner. MiFID II basically incorporates any units that meet the requirements of the EU ETS Directive in its section C of the Annex 1 point C11; this is tantamount to extension of the category of financial instruments to EUAs.

According to the European Commission, this extension achieves two goals. First, the inclusion of EUAs in the list of financial instruments should introduce greater security for traders in EUAs. Second, at the same time, the qualification of EUAs as financial instruments should not interfere with the purpose of the market, which remains the reduction of emissions.²⁴ Consequently, MiFID II tries to fulfil (or at least not impair) both environmental and financial market purposes.

Before adopting MiFID II, the European legislator was aware of the compelling need to provide greater security for traders in EUAs, as the lion’s share of carbon emission allowance transactions were concluded in the form of segment transactions for immediate delivery of EUAs (‘spot’ transactions), which were not subject to market supervision.²⁵ In addition to the need for increased supervision over the secondary market in EUAs, the need for increased transparency, liquidity²⁶ and integrity of this market was urgent.²⁷ The desired result was improved efficiency of EUAs trading.²⁸

Obviously, all of these needs are interrelated and should be perceived in the wider systemic context of strengthening the stability of the EU financial system and minimising the systemic risks that arise for financial market actors, such as hedge funds or credit institutions.²⁹ Putting EUAs under the umbrella of MiFID II was only part of the broader plan of the European legislator who aimed at stricter regulation of the EU financial markets after the financial crisis of 2008. One of the main purposes for the adoption of MiFID II was the general transformation of OTC markets into markets recognised by MiFID II.³⁰ In this regard, it has been stressed that the reason for including EUAs in the category of financial instruments is not the financial characteristics of these instruments but the characteristics of EUAs trading markets, which have become more organised and have started to perform liquidity and price discovery functions similar to those of trading venues typical of the financial sector.³¹ In fact, the qualification of EUAs as financial instruments was motivated predominantly by financial market purposes. The EU response to market deficiencies of the secondary trade in EUAs was full incorporation of this trade into the legal architecture of the EU financial markets, which was performed by recognising EUAs as financial instruments in MiFID II. However, it would not be the whole truth to suggest that it was the only plausible response to fraudulent practices that had occurred on the spot secondary market in EUAs. The other option that the European legislator considered was to develop a tailor-made regime for the secondary spot trading in EUAs.

The question to be raised in this context is why the decision finally adopted by the European legislator was to fully integrate the secondary trade in EUAs with the EU financial markets through the qualification of EUAs as financial instruments and not to create a special tailor-made regime for trade in EUAs. As evidenced in the Impact Assessment accompanying the adoption of MiFID II, both options were considered comparable with regard to their potential positive and negative impacts on stakeholders of the secondary spot trading in EUAs.³² The negative impacts were predicted to include additional costs for intermediaries that would require a MiFID II licence or authorisation to operate within a tailor-made regime.³³ Also, considerable benefits were expected for both options. It was assumed that both options would contribute to increased investor protection and the establishment of a comprehensive regulatory framework for the carbon market.³⁴ Considerable differences between the two options were envisaged only within one area. It was assumed that the extension of the application of MiFID to the secondary spot trading in EUAs would provide full consistency with the rules of the financial markets, while the development of a tailor-made regime would bring more flexibility to adapt to the specificities of the carbon market without providing full consistency with financial market rules. This difference is crucial to understand why the option ultimately chosen was the full integration of the secondary spot trading in EUAs with EU financial markets. Full integration should primarily serve market efficiency and allow one to avoid market fragmentation that would develop if a tailor-made regime were adopted. Therefore, qualification of EUAs as financial instruments should be perceived in the wider context of MiFID II, which was designed for overcoming market fragmentation.³⁵

However, at the same time, many fears related to the recognition of EUAs as financial instruments have been expressed in surveys by persons engaged in the secondary trade in these instruments. As indicated in the already quoted report on the legal nature of EUAs, the majority of the companies surveyed expect to reduce or cease CO₂ spot trading or CO₂ trading in general once MiFID II enters into force.³⁶ In addition, The precise impact of these changes on the EU allowance market liquidity or on a reduction in the number of market participants due to fear of additional burdens that MiFID II may impose on market participants (administrative burden, reporting obligations) and on smaller companies, in particular, remains to be seen.³⁷ It derives from this survey that participants in the secondary trade in EUAs not only did not expect any positive effects of the reform but expressed serious concerns about its anticipated negative effects. In the following parts of this contribution, the tension between the grounds for the reform advanced by the European legislator and concerns expressed by market participants will be examined in order to assess the impact of the reform on trade in EUAs and, thereafter, on the environmental and economic effectiveness of the EU ETS.

5. The legal nature of EUAs under MiFID II

Incorporation of EUAs into the notion of ‘financial instrument’ in MiFID II has not brought about any changes in the legal status of EUAs.³⁸ The reasons for such incorporation that materialise in the combination of environmental and financial market purposes have not necessitated any clarification of the legal status of EUAs. First, financial markets serve to trade in private law instruments. Therefore, the express incorporation of EUAs into the list of financial instruments in MiFID II constitutes an additional confirmation of their legal status as instruments incorporating intangible property rights. Secondly, the public elements present in the legal nature of EUAs do not preclude these instruments from being traded in financial markets. The specificity of the EU ETS materialises in the special public method of creation of EUAs, with the Union Registry playing the central role. This role has remained stable, since the EU ETS registry system has not been affected by the MiFID II regime.³⁹ However, the public elements present in the special regime for the creation and registry of EUAs may constitute an obstacle to the tradability of EUAs, principally in the economic sense. Even since the inclusion of EUAs in MiFID II, the price of EUAs has not been fully determined by market mechanisms.⁴⁰ For many years, the demand on the EUA market remained lower than the total quantity of EUAs supplied on the market (oversupply). In recent years, this trend has appeared to reverse due to the actions of the European Commission, which tightened the cap on EUAs by actions such as backloading or the introduction of the Market Stability Reserve (MSR).⁴¹ The exercise of the competences conferred on the European Commission under the EU ETS regime means that the supply, demand and price of EUAs are, to a significant extent, artificially shaped outside of market mechanisms.⁴² However, this does not necessarily result in a compromise of the principles of the financial markets. While exercising its competence to determine the cap on EUAs, the European Commission does not differ from issuers of financial instruments that decide the amount of supply of these instruments in a financial market. What actually matters is the concrete content of financial market regulations now applicable to the EU ETS and their impact on the environmental and economic effectiveness of that mechanism.

6. The scope of application of the MiFID II regime with regard to persons dealing in EUAs

6.1. Definition of an investment firm in MiFID II

The qualification of EUAs as financial instruments under MiFID II poses a question concerning whether all persons dealing in EUAs in financial markets are subject to MiFID II requirements. MiFID II does not require a formal transformation of persons dealing in financial instruments into investment firms because the status of an investment firm is acquired by the sole fact of providing investment services and undertaking investment activities (Article 4(1)(1) of MiFID II). In light of Article 4(1)(2) of MiFID II, the definition of ‘investment services and activities’ is based on the notion of ‘financial instruments’.⁴³ Since EUAs fit into the definition of financial instruments, persons providing services and undertaking activities related to EUAs should be considered investment firms.

The list of activities that constitute investment services and activities that is specified in Section A of Annex I to MiFID II has a broad character. It encompasses not only services and activities associated with the normal scope of activities of investment firms, such as execution of orders on behalf of clients (pt. 2) or investment advice (pt. 5), but also dealing in financial instruments on own account (pt. 3). As such, the list could cover activities performed by all persons that deal in EUAs, including emitters of greenhouse gases who deal in EUAs on their own account. If these categories of emitters were subject to the MiFID II compliance requirements applicable to investment firms, this could have an aggravating effect on the economic effectiveness of the EU ETS. In this context, it is vital to examine whether MiFID II provides for any exemptions from its personal scope of application that could be available for persons dealing in EUAs.

6.2. Exemptions from the personal scope of application of MiFID II

MiFID II introduces a few exemptions from its scope of application for persons dealing in EUAs.⁴⁴ The first exemption, which is prescribed in Article 2(1)(e) of MiFID II, refers to operators with compliance obligations under the EU ETS regime who deal in EUAs on their own account.⁴⁵ This remains a particularly plausible solution for emitters engaging in bilateral trade in EUAs outside of trading venues.

The second exemption includes persons whose dealing in EUAs constitutes only an ancillary activity to their own business (Article 2(1)(j) of MiFID II). The criteria to determine that an activity has an ancillary character in relation to the main business were established in Articles 2–3 of the Commission Delegated Regulation (EU) 2017/592;⁴⁶ these were quite sophisticated and developed the so-called ‘ancillary activity test’, which consisted of three subtests: Overall Market Threshold Test, Trading Test, and Capital Employment Test. Simplification of the ancillary activity test was one of the prerequisites of the Capital Markets Recovery Package, advanced by the Commission as part of the Commission's overall coronavirus recovery strategy. The MiFID ‘Quick Fix’ Directive, which was adopted in February 2021 as Directive 2021/338,⁴⁷ and the Commission Delegated Regulation 2021/1833 of 14 July 2021⁴⁸ introduce modifications to the scope of the ancillary activity test.

The third exemption provided for by Articles 3(1)(d) and (e) of MiFID II is left to the discretion of the EU member states. This optional exemption, when introduced by EU member states, can be applied only to persons who are fully owned or controlled by emitters of greenhouse gases and are used by them as business vehicles for the sole purpose of hedging the commercial risks of dealing in EUAs. In light of Article 3(2) of MiFID II, the member states’ regimes shall submit the exempted persons to requirements that are at least analogous to the requirements under MiFID II.

6.3. Drawbacks of the personal scope of application of MiFID II with regard to persons dealing in EUAs

The foremost impression left by the analysis of the personal scope of application of MiFID II to persons dealing in EUAs is the multiplicity and diversity of provisions concerning this issue. MiFID II creates a fragmented tripartite regime under which some persons dealing in EUAs are fully exempted from MiFID II requirements, some are partially exempted, and others are not exempted. The regime is multi-layered as it can consist of MiFID II, supplemented by Commission Delegated Regulation 2021/1833 and fragmented rules established at national level. A full and unconditional exemption from the MiFID II obligations is available only for emitters dealing in EUAs on their own account.

Although the newly introduced changes to the ancillary activity test have been greeted with apprehension,⁴⁹ the status of persons attempting to benefit from this exemption is still far from clear. While the already abandoned Overall Market Threshold Test was considered overly complex and constituting a red-tape requirement,⁵⁰ there are no grounds to expect that its successor will not be assessed similarly. Under the newly introduced De Minimis threshold test (Article 2(1)(a) and Article 3 of Commission Delegated Regulation 2021/1833), persons seeking to benefit from the ancillary activity exemption are no longer required to examine the relationship between their dealing in EUAs and the size of their overall market trading activity. However, the newly imposed threshold of EUR 3 billion constitutes an inflexible criterion, under which the peculiarities of diverse market activities are not sufficiently considered. It raises serious doubts why persons whose dealing in EUAs does not exceed EUR 3 billion but nevertheless constitutes a great percentage of their overall market trading activity (eg financial intermediaries that specialise in dealing in EUAs) remain exempted from the MiFID II obligations while persons whose dealing in EUAs exceeds EUR 3 billion but constitutes only a minor percentage of their overall market trading activity (eg financial intermediaries engaged in various forms of market activities, for which dealing in EUAs constitutes only a minor part of the overall activity) remain not exempted.

With regard to the third exemption, the general conferral of powers upon the EU member states, introduced in Article 3 of MiFID II, provides them with a wide margin of appreciation in establishing relevant rules at a national level. This could result in the creation of national regimes parallel to the one established by MiFID II⁵¹ that differ from each other between the EU member states. Theoretically, the application of the ‘at least analogous’ criterion by national legislators should ensure that persons benefiting from exceptions regulated at the national level will not be favoured by national legislation in the areas identified by Article 3 of MiFID II⁵² and thus produce harmonious effects between national legislation and MiFID II. However, in practice, considerable differences between the domestic legal orders of EU member states and MiFID II are unavoidable.⁵³ Consequently, the status of persons attempting to benefit from the partial exemption provided for in Article 3 of MiFID II remains the least clear. These persons bear high compliance costs in terms of identifying the set of rules that apply to their services and activities related to dealing in EUAs.

The high level of fragmentation of the MiFID II regime cannot be justified solely by the character of the secondary trade in EUAs that engages different market participants and requires diversified approaches. Within its personal scope of application, MiFID II tries to introduce a two-tier approach, in which access to the market and obligations of financial intermediaries differ from those of emitters dealing in EUAs for the purposes of compliance with the EU ETS.⁵⁴ This attempt eventually proves futile, because the multiplicity of forms of dealing in EUAs, including bilateral trade and several forms of multilateral trade, has been accompanied by the multiplicity of exemptions from the personal scope of application of MiFID II. Regrettably, exemptions are neither product-specific⁵⁵ nor market- or person-specific, but depend primarily on the character of dealing in EUAs.

In our opinion, the adoption of the ‘character of dealing’ approach, in which precedence has been given to the legal character of dealing in EUAs as the relevant criterion for the application of exemptions from the personal scope of application of MiFID II, has led to massive fragmentation of the EU regime for trade in EUAs. Fragmentation manifests itself in several exemptions being available for the same person at the same time, depending on the character of activities undertaken while dealing in EUAs. For example, an emitter dealing in EUAs can simultaneously:

• remain fully exempted from MiFID II requirements in relation to dealing in EUAs on their own account.

• remain fully exempted from MiFID II requirements in relation to providing investment services to the customers or suppliers of their main business, provided that these services constitute an ancillary activity to their main business.

• remain partially exempted from MiFID II requirements in relation to transactions undertaken for the sole purpose of hedging the commercial risks of their parent companies that fully control them and belong to the emitters’ sector.

• remain not exempted from MiFID II requirements in relation to providing investment services to their customers or suppliers of their main business when these services exceed the threshold of activities that are ancillary to their main business.

The adverse effects produced by the approach taken by the EU legislator encompass the worsening of conditions for market participants engaged at the same time in various forms of dealing in EUAs. Although recital 22 to MiFID II seems to confirm that exemptions introduced by MiFID II apply cumulatively and there are no reasons why combining exemptions should not be allowed,⁵⁶ the possibility of simultaneous combination by the same person of exemptions specified in Articles 2 and 3 of MiFID II remain unclear.⁵⁷

Fragmentation of the MiFID II regime could constitute an acute problem also for groups of companies organised around a company belonging to the emitters sector. Within the complex set of exemptions, only the ancillary activity exemption is examined on a group level. However, this exemption is specific and not unconditional. Under MiFID II, no universal exemption is provided for groups of companies that engage emitters. Group members not belonging to the emitters’ sector, even if established and operating for the purposes of complying with the EU ETS of their parent companies belonging to the emitters’ sector, cannot benefit from the unconditional exemption from the MiFID II regime, which is designed only for emitters dealing on their own account. Instead, they are left with the possibilities of benefiting from the ancillary activity exemption, which is full, but not unconditional, or from the optional exemptions allowed by the EU member states, which are not full and not unconditional. Consequently, an expanded level of legal advice is needed to identify a relevant set of legal obligations for group members.

7. The impact of the recognition of EUAs as financial instruments on the functioning of the secondary market in EUAs

7.1. Preliminary remarks

The impact of the recognition of EUAs as financial instruments on the secondary market in EUAs should be assessed from the perspective of the purposes underlying this legislative change, described in Section 4, namely increased supervision over EU financial markets as well as increased transparency, liquidity and integrity of these markets. Although the analysis of the framework of the MiFID II regime allows for the conclusion that the secondary market in EUAs has become subject to far-reaching supervision and transparency obligations,⁵⁸ achievement of the other purposes can be questioned.

7.2. Integrity of the secondary market in EUAs

The purpose of increasing the integrity of the secondary market in EUAs has supposedly not been achieved. The reason for this lies in the fragmentation of this market and the fragmentation and proliferation of the legal provisions that govern the trade in EUAs. Obviously, the question of fragmentation of legal sources is relevant not only to the market in EUAs, but generally to EU financial markets⁵⁹ and should be perceived in a wider global context.⁶⁰ However, in the realm of EU trade in EUAs, the dilemma of fragmentation of legal sources proves particularly troublesome. This would not be the case if the mosaic of legal sources were applicable only to professionals, ie trading venues and investment firms (brokers) that deal professionally in EUAs.⁶¹ Regrettably, this conundrum of legal sources also applies to emitters of greenhouse gases that deal in EUAs for the purposes of compliance with the EU ETS, who become actual or potential addressees of additional legal obligations.

Exemptions from the personal scope of application of MiFID II constitute a significant departure from the purpose of MiFID II, referred to in Section 4, namely full integration of the secondary market in EUAs with the EU financial markets. By introducing these exemptions, the EU legislator not only did not fulfil its ambitious goal of providing full consistency of the secondary trade in EUAs with the EU financial markets,⁶² but also abandoned the idea of developing a comprehensive tailor-made EU regime for this trade. It derives from the above considerations that, paradoxically, a higher level of integration with the EU financial markets would have been achieved by the development of a tailor-made regime for trade in EUAs, which, additionally, would have been more flexible in adapting to the specificities of the carbon market.

7.3. Liquidity of the secondary market in EUAs

The high level of fragmentation of the MiFID II regime for trade in EUAs exerts antagonistic effects on the liquidity of markets in these instruments. On the one hand, fragmentation of the MiFID II regime, which results in proliferation of markets in EUAs, contributes to increased liquidity, because not only hermetic OTC markets have been opened to trade in EUAs, but also numerous categories of trading venues, including regulated markets, multilateral trading facilities (MTFs) and organised trading facilities (OTFs).⁶³ It seems that the opening of regulated markets, including EEX in Germany, ICE Endex in the Netherlands, and Nasdaq Oslo in Norway, has played a decisive role in stimulating the liquidity of markets in EUAs.⁶⁴

However, fragmentation of the MiFID II regime undermines market confidence, which presumably exerts negative impacts on market liquidity. The level of illiquidity of the secondary market in EUAs is also increased by the existing fragmentation of trade.⁶⁵ Empirical data from the Chinese market for carbon emission allowances evidence that greater market fragmentation can result in lower liquidity and can weaken the effectiveness of emissions allowances’ pricing and market efficiency.⁶⁶

The general impact of the recognition of EUAs as financial instruments on the liquidity of the secondary market in these instruments is hardly measurable because the level of liquidity depends on many factors, including tighter emission caps, resulting in rising scarcity of EUAs.⁶⁷ In the short term, fear of insecurity after introducing new regulations generally leads to a decrease in liquidity.⁶⁸ However, in the long term, liquidity is usually restored.⁶⁹ In the case of MiFID II, the negative effects of fragmentation may be compensated for by increased confidence in this regime, which undoubtedly occurs due to the increased level of legal security brought about by the MiFID II supervision and transparency obligations.

7.4. Transaction costs for participants in the secondary market in EUAs

The increase in transaction costs borne by intermediaries and trading venues was anticipated at the time of MiFID II adoption.⁷⁰ In fact, these persons bear higher transaction costs and remain under stricter market supervision, making their access to the carbon market more restricted.⁷¹ But the increase in costs borne by market participants also affects emitters. As a result, they bear higher costs of compliance with the EU ETS. For emitters who trade in EUAs, the costs of identifying the relevant legal regime, together with the costs of fulfilling the obligations imposed on them by MiFID II, are not the only economic burdens to be assumed. The above-mentioned costs should be added to the increased agency costs imposed on emitters by trading venues, systematic internalisers⁷² and counterparts in OTC trade as a result of the increased own costs of these persons. Regardless of the form of trade in EUAs, agency costs imposed on emitters remain higher than those incurred by emitters trading OTC under MiFID I.

7.5. Final remarks

The assessment of the scope of the MiFID II regime for trade in EUAs leads to ambiguous conclusions. On the one hand, the benefits brought about by the increased legal security for traders in EUAs are unquestionable. On the other hand, the purposes of strengthening the integrity of the secondary market in EUAs and supposedly increasing the liquidity of this market have not been achieved. Moreover, the costs borne by market participants have grown considerably.

8. The implications for the environmental and economic effectiveness of the EU ETS of recognising EUAs as financial instruments

8.1. Preliminary remarks

In respect of the subject matter of the present contribution, the main question that should be posed is whether the recognition of EUAs as financial instruments, attained by close integration of the secondary market in EUAs with the EU financial markets in MiFID II and motivated primarily by financial market purposes, has proved beneficial for the environmental and economic effectiveness of the EU ETS.

To grapple with this task, the notions of environmental and economic effectiveness should be defined for the purpose of this contribution. We decided to abandon the differentiation between ‘efficiency’ and ‘effectiveness’, present in the economic literature, where efficiency is deemed the directive to lead actions appropriately, while effectiveness is construed as the disposition to take correct actions.⁷³ In this contribution, environmental effectiveness should be recognised as the level of achievement of predetermined environmental objectives, whereas economic effectiveness will be construed as a means of measuring the efficacy and purposefulness of the implementation of given market-based instruments in environmental law by comparison (ratio) of the value of the actual effects (output) to the factors invested in order to achieve them (input).

8.2. Results with respect to the environmental effectiveness of the EU ETS

When discussing the environmental effectiveness of the EU ETS, it should be borne in mind that the basic goal of that system is to reduce greenhouse gas emissions from installations covered by its scope of application. The overall EU target related to the functioning of the EU ETS is to reduce greenhouse gas emissions by a certain percentage. The most current goal in this respect, introduced in the European Green Deal, is the reduction of such emissions by 55 per cent⁷⁴ (from 1990 levels) by 2030, whereas the previous aim was a 20 per cent reduction by 2020.⁷⁵

Generally, as already mentioned, emissions trading itself does not contribute to the reduction of greenhouse gas emissions: trade plays an important role in achievement of the environmental goal solely with regard to a predetermined reduction level. Thus, as far as the environmental effectiveness of the EU ETS with regard to that predetermined reduction level is concerned, the secondary trade element is redundant; its existence and intensity are not a problem for the attainment of the aforementioned level.

This is the inherent and inevitable concession within the framework of the EU cap-and-trade system that environmental effectiveness makes in favour of economic effectiveness. The underlying idea of the EU ETS as a market-based instrument is that reduction efforts are undertaken by entities for which such efforts pay off, while the remaining ones should have the possibility to buy the missing EUAs.

However, when possibilities for surpassing that level are considered, the picture is different; high intensity of the secondary trading in EUAs may be an obstacle for surpassing the predetermined reduction level, since this is achieved through massive reduction of emissions rather than purchasing rights thereto. In other words, to exceed the level in question, the more EU ETS participants who decide to reduce their emissions to the lowest technologically possible levels instead of buying the missing EUAs within the secondary market, the better. If it is assumed that the actual goal of emissions trading is not so much a percentage reduction of greenhouse gas emissions but a strong stimulation of investments allowing for transformation to a carbon-neutral economy, then it must be remembered that its implementation depends mainly on the development of EUA prices, and not on the cap itself.

Bearing in mind the decision to extend the financial market regime over all transactions concerning EUAs, it seems that the trade element is considered a necessary evil rather than an equal component within the cap-and-trade mechanism. Although the main objective of the EU ETS is theoretically expressed as emissions reduction that reaches (but does not necessarily exceed) the given ratio, the environmental goal of emissions trading, from the point of view of the European legislator, in fact seems to consist rather in the rapid, comprehensive transformation of the European economy, with investments that help achieve the greatest possible reduction in greenhouse gas emissions – even if such an objective is not explicitly mentioned in the EU ETS Directive. In this context, it is crucial to create a strong price signal that results from a significant shortage of EUAs available on the market with regard to the needs of market participants,⁷⁶ so that they would be encouraged (forced?) to choose and pay for emissions reduction rather than for rights to emit. Of course, adoption of such a perspective makes flexibility of the system nothing more than a theory.

In practice, regarding investments aimed at achieving reductions that exceed the predetermined general cap, it is indicated that in its second settlement period (2008–2012) the EU ETS affected investment decisions only to a limited extent⁷⁷ and could have contributed only a 3­–12 per cent reduction in greenhouse gases emissions.⁷⁸ Until now, the impact of the EU ETS on investments has been rather modest; the most common form of reducing emissions was to switch installations to generating energy from gas instead of coal; however, this effect has been limited by high prices of natural gas.⁷⁹ At the same time, in recent years, emissions reduction has gained significant momentum. In 2020, verified emissions from stationary installations decreased by 11.4 per cent compared to 2019,⁸⁰ while in in 2019, there was also a significant decrease in emissions from stationary installations, of 9.1 per cent compared to 2018.⁸¹ Should this considerable progress in emissions reduction be attributed to MiFID II or rather to other factors, including MSR adoption, which took place parallelly?

Arguments invoking greater security for traders due to recognition of EUAs as financial instruments are irrelevant in terms of environmental effectiveness because such effectiveness to the extent determined by the cap does not depend on the intensity of trading but is shaped by the number of EUAs available on the market. The entry into force of MiFID II could improve the environmental effectiveness of the EU ETS only with regard to emissions reductions that exceed the predetermined cap. This could happen if prices of EUAs rose and trading possibilities decreased as an effect of the recognition of EUAs as financial instruments. Despite previous declarations by the EU legislator, recognition of EUAs as financial instruments actually should discourage entities that do not trade in EUAs on a professional basis, including emitters of greenhouse gases, from concluding such transactions. This should be a consequence of the onerous administrative, informational and financial burdens that entities engaged in trading in EUAs have to bear. However, in our opinion, discouraging the EU ETS addressees (emitters) from participating in the secondary trade in EUAs could force them to take investment decisions to reduce emissions only to a very limited extent. It would be simpler to escape the system by increasing the so-called ‘carbon leakage’ (moving activity to other countries that do not have such a strict climate policy) or continuing emissions illegally without the adequate number of EUAs (this possibility depends on the level of efficiency of the applied monitoring systems). As we point out in Section 8.3, emitters have not been discouraged from participating in the secondary trade in EUAs, neither by fragmentation of the MiFID II regime nor by rising prices of EUAs. Therefore, the fast pace of emissions reduction, noticeable in recent years, should not be explained by the recognition of EUAs as financial instruments, but rather by the diminishment of the number of EUAs available on the market resulting from the adoption of MSR. The reform introduced by MiFID II constitutes a strike against the flexibility of emissions trading (next to other reforms undertaken with regard to the EU ETS, such as the creation of MSR). Consequently, the EU ETS may be distorted in its nature as it is deprived of the values usually featured by market-based environmental protection instruments (such as flexibility), and only the disadvantages of such mechanisms remain (such as a relatively high level of risk). Nevertheless, these changes neither enhance nor impair the environmental effectiveness of the EU ETS. In conclusion, we would not expect any added value to be brought about by the MiFID II regulations concerning EUAs in terms of the environmental effectiveness of the EU ETS.

8.3. Results with respect to the economic effectiveness of the EU ETS

Since the EU ETS as an example of a market-based instrument of environmental protection is expected to balance environmental and economic effectiveness, any change affecting the functioning of this system should be assessed from the perspective of its impact not only on the environmental effectiveness, but also on the economic effectiveness. Scientific research shows that the achievement of the goals of the 2020 European Union climate and energy package⁸² leads to only moderate global effects, which are estimated in the literature as lower than 4 per cent.⁸³ Meanwhile, costs related to the sole implementation of the EU ETS amount to billions of euros, including both costs incurred by enterprises and public expenses in connection with maintenance of infrastructure associated with the system. These costs are encumbering not only emitters. Currently, a sharp increase in gas and electricity prices, noticeable in particular on wholesale markets⁸⁴ but touching upon also retail markets, has negative consequences for economies recovering from lockdowns and restrictions introduced due to the COVID-19 pandemic. High (and rapidly growing) prices for gas and electricity not only aggravate the problem of energy poverty but also have detrimental consequences for the industry, particularly plants that operate within energy-intensive sectors (such as metal or fertiliser production). The latter occurrence forces enterprises to close businesses or to increase the prices of offered goods and services, creating additional incentives for inflation. At the same time, prices of EUAs have tripled over the period of one calendar year: from around 30 euros in January 2021 to the level of 90 euros in December 2021 and a record high of 96 euros in February 2022 (now decreased to the level of under 90 euros).⁸⁵

Bearing in mind the aforementioned circumstances, it is necessary to examine whether recognition of EUAs as financial instruments has actually boosted the prices of EUAs, thereby contributing to high energy prices. There is quite a complicated chain of circumstances that leads to the current situation with respect to energy prices,⁸⁶ but prices of EUAs definitely do affect the prices of energy (and, by virtue of the logic inherent in the EU ETS as a market-based instrument of environmental law, they are intended and bound to exert such an impact). The related problem – well visible before the present armed conflict caused by Russian invasion of the territory of Ukraine, but far more acute in times of the limitation of supplies of natural gas and coal from the eastern direction – is that in a tangled web of factual circumstances, where prices of EUAs are high, a vicious circle that influences energy supply and energy prices may easily be created. Normally, higher gas prices would naturally cause switching to other energy sources, including coal, to decrease energy prices, but in the current situation higher reliance on coal as a source of energy directly results in higher prices of EUAs. This double-edged sword is hardly avoidable due to the insufficient availability of renewable energy. The fact that the prices of EUAs are a significant element in the puzzle of factors creating drastic rise of energy prices is per se a particularly good reason to conduct research on the impacts of recognition of EUAs as financial instruments on the economic effectiveness of the EU ETS.

Ensuring greater security on the carbon market, which was aimed to be achieved by the recognition of EUAs as financial instruments and extension of the financial markets regime over all transactions concerning EUAs, should not necessarily act in favour of the economic effectiveness of the EU ETS. On the one hand, increased security on the carbon market constitutes a strong incentive for financial market participants to engage in trade in EUAs. As a result, secondary trade in EUAs becomes more effective. However, increased trade security contributes to higher participation costs. To increase the level of general security on the market, contributions consisting of numerous administrative, information and financial burdens are required from carbon market participants.

And, which should be underlined, within the framework of emissions trading systems in general and the EU ETS in particular, there have already been significant transaction costs. As indicated in the literature, these costs may amount to up to half of the emissions reduction costs, and such a burden is heavier for small entities⁸⁷ because these transaction costs are subject to a linear decrease as the volumes of acquired EUAs increase.⁸⁸ Increases in transaction costs, caused by MiFID II, are reflected in the prices of EUAs: the higher the costs of participation in trading, the higher the prices of EUAs, which should additionally decrease the general economic effectiveness of the EU ETS.

However, recognition of EUAs as financial instruments may not be perceived as the only factor contributing to the increase in EUAs prices. An increase in EUA prices has been observed since 2018 in anticipation of the start of MSR.⁸⁹ It was the reform of the EU ETS, introduced in 2018 and encompassing the establishment of MSR⁹⁰ and strengthening the linear reduction factor (which specifies the amount that the cap will be reduced annually⁹¹), rather than the entry into force of MiFID II, that contributed to a significant decrease in the number of EUAs available on the market and to the increase in the prices of these instruments.⁹² In theory, together with the growing scarcity of carbon emission allowances, the demand for them should gradually decrease. Paradoxically, in recent years, the number of participants in the secondary market in EUAs has tended to grow.⁹³ Why has secondary trade in EUAs become increasingly attractive to market participants, despite the growing scarcity of EUAs and their growing prices? Is it driven by the recognition of EUAs as financial instruments and the opening of financial markets for trade in these instruments?

The growth in the number of participants in the secondary market in EUAs has become noticeable since 2018.⁹⁴ In our opinion, this phenomenon cannot be explained in any other way than as determined by the recognition of EUAs as financial instruments, which took place upon the entry into force of MiFID II in the same year. It appears that the increased security for traders brought about by MiFID II remains significant not only for emitters who purchase EUAs for the purpose of compliance with the EU ETS, but also for persons not encompassed by the scope of application of the EU ETS, as it constitutes an incentive to invest in EUAs. Consequently, after the entry into force of MiIFD II, increased security for traders in EUAs has led to growth in demand, which has been reflected in higher prices of EUAs.⁹⁵

Entities outside the EU ETS are naturally not interested in keeping the prices of EUAs low (contrary to addressees of the EU ETS); instead, they consider price increases advantageous in terms of possible returns on investment. Therefore, their activity should result in higher prices of EUAs. The growing demand should generate higher prices due to the speculative bubble model.⁹⁶ Some indices of a speculative price bubble, together with a significant increase in volatility of EUA derivatives, were observed on the secondary market in EUAs between March and October 2018.⁹⁷ However, they should be attributed rather to the fear over the future scarcity of EUAs⁹⁸ after the aforementioned EU ETS reform and not to the entry into force of MiFID II.

The increase in EUA prices appears to be generated primarily by the growing activity of emitters and investment firms trading on behalf of emitters and not by speculative traders. Non-financial entities, including greenhouse gas emitters with the EU ETS compliance obligations, still account for the majority (63 per cent) of the notional amounts of trade in EUAs.⁹⁹ This figure remains stable, although the total number of trades of non-financial entities decreased to 36 per cent in December 2021, due to the increase in activities of investment firms and credit institutions.¹⁰⁰ The activities of persons that may potentially engage in speculative trading, including investment funds, remain relatively low (8 per cent on the secondary futures market for EUAs in the third quarter of 2021¹⁰¹). Consequently, the current shape of the secondary market in EUAs does not reveal any significant increase in speculative trading that could contribute to the rising prices of EUAs and could be attributed to MiFID II.

Thus, the reform of the secondary trade in EUAs advanced by MiFID II exerts antagonistic effects on the economic effectiveness of the EU ETS. On the one hand, the costs of participation in the secondary trade in EUAs have increased for all categories of market participants, including emitters. Additional participation costs are to a great extent generated by fragmentation of the legal regime for the secondary trade in EUAs brought about by MiFID II, which constitutes an impediment for market participants, forcing them to bear additional costs of legal advice. From this perspective, the economic effectiveness of the EU ETS has been negatively affected. On the other hand, it appears that neither massive fragmentation of the legal regime for the secondary trade in EUAs, nor increased costs of that trade, outweigh benefits brought to traders by increased legal security provided for by MiFID II. In fact, increase in prices of EUAs, and, consequently, in energy prices, seems to be generated predominantly by factors other than the reform of the secondary trade in EUAs advanced by MiFID II. The secondary market in EUAs constantly grows, and this growth can be explained as the MiFID II effect. In light of the available data, recognition of EUAs as financial instruments generated a strong incentive for greenhouse gas emitters and financial intermediaries to participate in trade in EUAs. That contributes to a rise in prices of EUAs, although the risk of an increase in speculative trading has not yet materialised.

Therefore, MiFID II adequately serves the economic effectiveness of the EU ETS; even despite its possible impact on the growing prices of EUAs. Still, the identified drawbacks of the MiFID II regime for trade in EUAs can negatively affect the economic effectiveness of the EU ETS in the longer term. There exist several barriers to the growth of the secondary market in EUAs resulting from its fragmentation and increased costs of participation. Although these barriers can be easily crossed by financial intermediaries, they can constitute a serious impediment for the emitters of greenhouse gases who deal on their own account in EUAs.

9. Conclusions

The entry into force of MiFID II constitutes a turning point in the development of the EU ETS as a cap-and-trade system for allocation and trade in EUAs. At first glance, the legislative change brought about by MiFID II has only a technical character and does not interfere with the legal nature of EUAs, which remains ambiguous. However, the essence of this change has profound impacts on the functioning of the EU ETS as it opens the secondary trade in EUAs on the EU financial markets.

The MiFID II reform brings numerous negative consequences with respect to the integrity of the secondary market in EUAs, as well as increased transaction costs for market participants. What might be surprising in this context is the growing popularity of the secondary trade in EUAs after the entry into force of MiFID II. It appears that from the macroeconomic perspective, the identified deficiencies have been more than compensated for by the increased level of legal security for traders resulting from the MiFID II umbrella. To date, the economic and environmental effectiveness of the EU ETS have not been impaired by MiFID II, although there are serious impediments to the future growth of the secondary market in EUAs.

Based on the EU experience, recognising emission allowances as financial instruments could be recommended for countries that consider an emissions trading system as an economic policy instrument to reduce greenhouse gas emissions. However, it should be borne in mind that full integration of the secondary trade in emission allowances with national financial markets could possibly lead to increased costs of participation in the emission trading system, not to mention possible threats to the integrity and liquidity of secondary markets in emission allowances. In our opinion, therefore, creating a special, tailor-made regime for trade in emission allowances would be a cheaper and more straightforward option, within which the above-mentioned risks would be mitigated.

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

The publication was funded by the Priority Research Area Anthropocene under the programme ‘Excellence Initiative – Research University’ at the Jagiellonian University in Krakow, Poland.

Notes

1 RB, Stewart, The Importance of Law and Economics for European Environmental Law, Yearbook of European Environmental Law, vol 2 (OUP 2002), 2; R Stavins, Market-Based Environmental Policies: What Can We Learn from US Experience (and Related Research)?, KSG Working Paper No. RWP03-031, 2 July 2003, 2 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=421720>, accessed 16 December 2022

2 J Munro, Emissions Trading Schemes under International Economic Law (OUP 2018), 28

3 K Bosselmann, ‘Losing the Forest for the Trees: Environmental Reductionism in the Law’ (2010) 2(8) Sustainability 2441

4 Vide I Parry and others, Getting Energy Prices Right: From Principle to Practice (International Monetary Fund 2014), 165, stating that with proper design, reflecting environmental costs, emissions trading can reconcile and balance environmental and economic considerations.

5 European Commission, The Green Paper on Market-Based Instruments for Environment and Related Policy Purposes of 28.03.2007, COM(2007)140 final, point 2.1

6 The first and biggest supranational system for greenhouse gas emission allowances trading, created within the European Union and afterwards extended to the European Economic Area (EEA) states, which encompasses several thousands of installations from various economic sectors, including aviation. The EU ETS was introduced and has been regulated by directive 2003/87/EC of the European Parliament and of the Council of 13.10.2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC (OJ L 275 of 25 October 2003, 32, as amended), hereinafter referred to as ‘the EU ETS Directive’. According to the European Securities and Markets Authority (ESMA), in 2020 the EU ETS accounted for almost 90 per cent of the global carbon market value. See ESMA, Final Report: Emission Allowances and Associated Derivatives, ESMA70-445-38 (28 March 2022) 16 <www.esma.europa.eu/sites/default/files/library/esma70-445-38_final_report_on_emission_allowances_and_associated_derivatives.pdf>, accessed 16 December 2022

7 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, OJ L 173 of 12 June 2014, 349–496

8 Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012, OJ L 173 of 12 June 2014, 84–148

9 Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC, OJ L 173 of 12 June 2014, 1–61

10 Vide European Commission, Green Paper (n 5), point 2.1. See also A Hedges, ‘The Secondary Market for Emissions Trading: Balancing Market Design and Market Based Transaction Norms’ in D Freestone, Ch Streck (eds), Legal Aspects of Carbon Trading: Kyoto, Copenhagen, and Beyond (OUP 2009), 313

11 NO Keohane, SM Olmstead, Markets and the Environment (Island Press 2016), 195

12 Vide European Commission, Green Paper (n 5), point 2.1

13 Judgement of the Court of Justice of 16.12.2008, C-127/07 Société Arcelor Atlantique et Lorraine and Others versus Premier ministre, Ministre de l’Écologie et du Développement durable and Ministre de l'Économie, des Finances et de l'Industrie, ECLI:EU:C:2008:728, pt. 31

14 P Hacker, G Dimitropoulos, ‘Behavioural Law & Economics and Sustainable Regulation: From Markets to Learning Nudges’ in K Mathis, BR Huber (eds), Environmental Law and Economics (Springer International 2017), 160

15 European Commission, Legal Nature of EU ETS Allowances: Final Report (Luxembourg 2019), 46–47 <https://op.europa.eu/en/publication-detail/-/publication/9d985256-a6a9-11e9-9d01-01aa75ed71a1>, accessed 16 December 2022

16 B Holligan, ‘Commodity or Propriety? Unauthorised Transfer of Intangible Entitlements in the EU Emissions Trading System’ (2020) 83(5) Modern Law Review 980, 982–989 and 1007; R Wilhelmi, ‘Commodification and Financialization in the Energy Sector: Emission Allowances and Electricity’ in Ch Godt (ed) Regulatory Property Rights: The Transforming Notion of Property in Transnational Business Regulation (Brill/Nijhoff 2016), 203. See also M Colangelo, Creating Property Rights: Law and Regulation of Secondary Trading in the European Union (Martinus Nijhoff 2012), 177–181; E Yliheljo, ‘The Variable Nature of Ownership of Emission Units in the Intersection of Climate Law, Property Law, and the Regulation of Financial Markets’ (2021) 11(1) Climate Law 45; KFK Low, J Lin, ‘Carbon Credits as EU Like It: Property, Immunity, TragiCO₂medy?’ (2015) 27(3) Journal of Environmental Law 377; K Gorzelak, ‘The Legal Nature of Emission Allowances Following the Creation of a Union Registry and Adoption of MiFID II – Are They Transferable Securities Now?’ (2014) 9(4) Capital Markets Law Journal 373; L Bennet, ‘Are Tradable Carbon Emissions Credits Investments? Characterization and Ramifications under International Investment Law’ (2010) 85(5) New York University Law Review 1597–1598; K Anttonen, M Mehling, K Upston-Hooper, ‘Breathing Life Into the Carbon Market: Legal Frameworks of Emissions Trading in Europe’ (2007) 16(4) European Energy and Environmental Law Review 96

17 Holligan (n 16), 980. More on this issue: CT Reid, ‘The Privatisation of Biodiversity? Possible New Approaches to Nature Conservation Law in the UK’ (2011) 23(2) Journal of Environmental Law 203; CT Reid, W Nsoh, The Privatisation of Biodiversity: New Approaches to Conservation Law (Edward Elgar 2016), 17–23

18 Colangelo (n 16), 162

19 European Commission, Legal Nature of EU ETS Allowances (n 15), 101

20 Judgement of the General Court of 2 March 2010, T-16/04 Arcelor SA versus European Parliament and Council of the European Union, ECLI:EU:T:2010:54

21 AD Ellerman and others, Pricing Carbon: The European Union Emissions Trading Scheme (CUP 2010), 89

22 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ L 145, 30 April 2004, 1–44

23 F Annunziata, ‘Emission Allowances as Financial Instruments’ in D Busch, G Ferrarini, S Grünewald (eds) Sustainable Finance in Europe: Corporate Governance, Financial Stability and Financial Markets (Palgrave Macmillan 2021), 481

24 European Commission, Markets in Financial Instruments Directive (MiFID II): Frequently Asked Questions, Memo/14/305, Brussels 15 April 2014, 10 <https://ec.europa.eu/commission/presscorner/api/files/document/print/en/memo_14_305/MEMO_14_305_EN.pdf>, accessed 16 December 2022

25 European Commission, Review of the Markets in Financial Instruments Directive (MiFID) and Proposals for a Regulation on Market Abuse and for a Directive on Criminal Sanctions for Market Abuse: Frequently Asked Questions on Emission Allowances, Memo/11/719, Brussels, 20 October 2011 <https://ec.europa.eu/commission/presscorner/api/files/document/print/en/memo_11_719/MEMO_11_719_EN.pdf>, 1, accessed 16 December 2022; European Commission, Report on the Functioning of the European Carbon Market, Brussels, 18 November 2015 COM(2015) 576 final <https://www3.eurelectric.org/Download/Download.aspx?DocumentFileID=90179>, 24, accessed 16 December 2022

26 European Commission, Legal Nature of EU ETS Allowances (n 15), 7

27 Ibid, 8. See also N Moloney, EU Securities and Financial Markets Regulation (3rd edn, OUP 2014), 346; Bennet (n 16), 1587

28 European Commission, Legal Nature of EU ETS Allowances (n 15), 8

29 F Della Negra, MiFID II and Private Law: Enforcing EU Conduct of Business Rules (Hart 2019), 12

30 Moloney (n 27), 461

31 F Annunziata, ‘Investment Services and Investment Funds’ in F Fabbrini, M Ventoruzzo (eds) Research Handbook on EU Economic Law (Edward Elgar 2019), 486

32 European Commission, Impact Assessment Accompanying the Document Proposal for a Directive of the European Parliament and of the Council on Markets in Financial Instruments and the Proposal for a Regulation of the European Parliament and of the Council on Markets in Financial Instruments. Commission Staff Working Paper, SEC (2011) 1226 final, Brussels, 20 October 2011 <https://ec.europa.eu/transparency/documents-register/detail?ref=SEC(2011)1226&lang=en>, accessed 16 December 2022

33 European Commission, Impact Assessment Accompanying the Document Proposal (n 32), 48–49

34 Ibid

35 NJ Clausen, KE Sørensen, ‘Reforming the Regulation of Trading Venues in the EU under the Proposed MiFID II – Levelling the Playing Field and Overcoming Market Fragmentation?’ (2012) 9(3) European Company and Financial Law Review 278 and 296–297. Fragmentation of markets results in several adverse effects for markets, including the lack of sufficient transparency for monitoring authorities and market participants. See European Commission, Impact Assessment Accompanying the Document Proposal (n 32), 5–6, 10 and 12. On the micro- and macroeconomic implications of fragmentation of markets in the context of MiFID, see R Gillet, S Ligot, HO Firouzi, ‘The Challenges and Implications of the Markets in Financial Instruments Directive (MiFID) and of Its Revision (MiFID II, MiFIR) on the Efficiency of Financial Markets’ in R Douady, C Goulet, PCh Pradier (eds) Financial Regulation in the EU: From Resilience to Growth (Palgrave Macmillan 2017), 151–198

36 European Commission, Legal Nature of EU ETS Allowances (n 15), 104

37 Ibid, 107

38 Gorzelak (n 16), 377; Yliheljo (n 16), 71

39 Gorzelak (n 16), 386

40 Wilhelmi (n 16), 201

41 Decision (EU) 2015/1814 of the European Parliament and of the Council of 6 October 2015 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC, OJ L 264 of 09 October 2015, 1–5

42 Wilhelmi (n 16), 202

43 M. Lehmann, ‘Article 4 of MiFID II’ in M Lehmann, Ch Kumpan (eds) European Financial Services Law: Article-by-Article Commentary (Nomos/Hart 2019), 30; Della Negra (n 29), 28. See also D Busch, G Ferrarini, JP Franx, Prospectus Regulation and Prospectus Liability (OUP 2020), 131: The financial instrument concept concurs with the definition of two other core concepts of MiFID II: investment service and investment firm

44 F Annunziata, Can Finance Help Save The Planet? The Case of Emission Allowances and MiFID II, Bocconi Legal Studies Research Paper No. 353956, January 2020, 11–13; Yliheljo (n 16), 71

45 See Recital 20 to MiFID II Directive

46 See specifically art 1–3 of Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business, OJ L 87 of 31 March 2017, 492–499

47 Directive (EU) 2021/338 of the European Parliament and of the Council of 16 February 2021 amending Directive 2014/65/EU as regards information requirements, product governance and position limits, and Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms, to help the recovery from the COVID-19 crisis, OJ L 68 of 26 February 2021, 14–28

48 Commission Delegated Regulation (EU) 2021/1833 of 14 July 2021 supplementing Directive 2014/65/EU of the European Parliament and of the Council by specifying the criteria for establishing when an activity is to be considered to be ancillary to the main business at group level, OJ L 372 of 20 October 2021, 1–10

49 Opinion of EUROPEX – Association of European Energy Exchanges, 24 June 2021 <https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13040-Investment-market-transparency-amended-ancillary-activity-exemption-specifications-/F2660125_en>, accessed 16 December 2022; see also Futures Industry Association, FIA Feedback on the European Commission’s Consultation on the Draft Delegated Act for the Amended Ancillary Activities Exemption in MiFID II, 24 June 2021 <www.fia.org/sites/default/files/2021-06/FIA%20Response%20to%20EC%20Delegated%20Act%20on%20AAE%20MiFID_June%202021.pdf>, accessed 16 December 2022

50 Eurelectric, Joint Energy Associations Group (JEAG) Supports EU Commission’s Draft Delegated Regulation for the Implementation of the Ancillary Activity Exemption Based on Established Regulatory Technical Standards, Opinion of 24 June 2021, 2 <https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13040-Investment-market-transparency-amended-ancillary-activity-exemption-specifications-/F2660124_en>, accessed 16 December 2022

51 Lehmann (n 43), 22

52 E. Radmore, What to do about MiFID 2?, Womble Bond Dickinson Articles and Briefings, 31 July 2017 <www.womblebonddickinson.com/uk/insights/articles-and-briefings/what-do-about-mifid-2>, accessed 16 December 2022

53 See the discussion held in Ireland, aiming at identifying ‘gaps’ in national legislation that needed to be filled to properly exercise the discretion granted by art 3 of MiFID II and to provide ‘at least analogous’ rules to those of MiFID II. Department of Finance, Public Consultation on National Discretions in the Markets in Financial Instruments Directive (‘MiFID 2') Incorporating Elements of the Insurance Distribution Directive (‘IDD'), June 2016, 9–10 <https://assets.gov.ie/7117/f3c15b585d9144f191f37c148e46449d.pdf>, accessed 16 December 2022

54 Yliheljo (n 16), 71–72. Difference in treatment of these categories of market participants is justified by no risk of market manipulation by emitters. See European Commission, Legal Nature of EU ETS Allowances (n 15), 139

55 Yliheljo (n 16), 72

56 Financial Conduct Authority (FCA), FCA Handbook: The Perimeter Guidance Manual. Guidance on the Scope of the UK Provisions which Implemented MiFID. Q46A, 49 <https://www.handbook.fca.org.uk/handbook/PERG/13.pdf>, accessed 16 December 2022

57 According to the UK national authority (the FCA), it is not generally possible to combine these exemptions. See ibid, Q46

58 Lehmann (n 43), 4; K Lanoo, MiFID II and the New Market Conduct Rules for Financial Intermediaries: Will Complexity Bring Transparency?, European Capital Markets Institute (ECMI) Policy Brief 2017, 4–10; P Yeoh, ‘MiFID II Key Concerns’ (2019) 27(1) Journal of Financial Regulation and Compliance 112–113; I Sheridan, ‘MiFID II in the Context of Financial Technology and Regulatory Technology’ (2017) 12(4) Capital Markets Law Journal 427

59 D Valiante, ‘CMU and the Deepening of Financial Integration’ in D Busch, E Avgouleas, G Ferrarini (eds) Capital Markets Union in Europe (OUP 2018), 23

60 S Claessens, Fragmentation in Global Financial Markets: Good or Bad for Financial Stability?, Bank for International Settlements Working Papers No 815, October 2019 <https://www.bis.org/publ/work815.pdf>, 1–29, accessed 16 December 2022

61 Gillet, Ligot, Firouzi (n 35), 168

62 European Commission, Impact Assessment Accompanying the Document Proposal (n 32), 48

63 See definitions of a regulated market, MTF and OTF in art 4(1)(21–23) of MiFID II

64 Secondary trading in EUAs concentrates upon ICE Endex. ESMA, Final Report (n 6) , 14

65 IA Kalaitzoglou, BM Ibrahim, ‘OTC Trades and Liquidity in the European Carbon Market: More than Meets the Eye’ (2020) 52(16) Applied Economics 1745

66 K Chang, R Chen, J Chevallier, ‘Market Fragmentation, Liquidity Measures and Improvement Perspectives from China's Emissions Trading Scheme Pilots’ (2018) 75(C) Energy Economics 259

67 G Ibikunle, A Gregoriou, Carbon Markets: Microstructure, Pricing and Policy (Palgrave Macmillan 2018), 159

68 Ibid, 160

69 Ibid

70 European Commission, Impact Assessment Accompanying the Document Proposal (n 32), 48; see also Yliheljo (n 16), 72

71 Yliheljo (n 16), 72

72 See definition of a systematic internaliser in art 4(1)(20) of MiFID II

73 MM Helms, Encyclopedia of Management (Thomson Gale 2006), 211; B Clark, ‘Managerial Perceptions of Marketing Performance: Efficiency, Adaptability, Effectiveness and Satisfaction’ (2000) 8 Journal of Strategic Marketing 5

74 European Commission, Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions – The European Green Deal, Brussels 11 December 2019, COM/2019/640 final, point 2.1.1

75 Recital (3) of the directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community, OJ L 140 of 05 June 2009, 63–87

76 Hedges (n 10), 313

77 AM Leiter and others, ‘Environmental Regulation and Investment: Evidence from European Industry Data’ (2011) 70 Ecological Economics, after J Meckling, ‘The Future of Emissions Trading’ (2014) 5 Wiley Interdisciplinary Reviews: Climate Change 570

78 RG Newell and others, ‘Carbon Markets 15 Years after Kyoto: Lessons Learned, New Challenges’ (2013) 27 Journal of Economic Perspectives, after Meckling (n 77), 570

79 Ellerman and others (n 21), 192

80 European Commission, Report from the Commission to the European Parliament and the Council on the Functioning of the European Carbon Market in 2020 Pursuant to Articles 10(5) and 21(2) of Directive 2003/87/EC (as amended by Directive 2009/29/EC and Directive (EU) 2018/410), Brussels, 26 October 2021, COM(2021) 962 final, 23

81 European Commission, Report from the Commission to the European Parliament and the Council. Report on the Functioning of the European Carbon Market, Brussels, 18 November 2020, COM(2020) 740 final, 5

82 European Commission, 2020 climate & energy package, <https://ec.europa.eu/clima/eu-action/climate-strategies-targets/2020-climate-energy-package_en>, accessed 16 December 2022

83 V Termini, ‘Energy and European Institutions’ in S Micossi, GL Tosato (eds) The European Union in the 21st Century: Perspectives from the Lisbon Treaty (Centre for European Policy Studies 2009), 116

84 According to the Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, ‘Tackling Rising Energy Prices: A Toolbox for Action and Support’ of 13 October 2021 (COM(2021) 660 final), in the period 2019–2021 on average, in the European Union, wholesale electricity prices doubled, while wholesale gas prices quadrupled. And that was well before the start of the armed conflict between Russia and Ukraine that has made the problem even more acute.

85 European Energy Exchange AG (EEX), EU ETS Auctions, <www.eex.com/en/market-data/environmentals/eu-ets-auctions>, accessed 16 December 2022

86 Among the main root causes that have jointly contributed to high prices of gas and electricity experienced in the European Union, the European Commission identifies not only global demand for energy at large and gas in particular, linked to the post-pandemic recovery and lower production of renewable energy in Europe due to seasonal weather conditions, but also prices of EUAs – see Communication from the Commission to the European Parliament (n 84). However, it seems that the communication does not deliver a full picture: we should have in mind also the low level of storage of natural gas in the European Union, huge import reliance of the EU with regard to natural gas (lack of gas supplies by Gazprom) and decline of domestic gas production in Europe. After the date of that communication, the problem of rapidly rising energy and gas prices has aggravated seriously due to armed invasion of Russia in the territory of Ukraine and related restriction of supplies of natural gas, as well as the embargo on imports of coal from the eastern direction.

87 Ellerman and others (n 21), 259

88 RH Weber, ‘Emission Trading Schemes: A Coasean Answer to Climate Change?’ in Mathis, Huber (n 14), 369

89 ESMA, Preliminary Report. Emission Allowances and derivatives thereof, ESMA70-445-7, 15 November 2021 <www.esma.europa.eu/sites/default/files/library/esma70-445-7_preliminary_report_on_emission_allowances.pdf>, 23, accessed 16 December 2022

90 According to G Perino, M Willner, ‘EU-ETS Phase IV: Allowance Prices, Design Choices and the Market Stability Reserve’ (2017) 17(7) Climate Policy 937, MSR is expected to increase prices of EUAs in the short term, while in the very long run, the price path remains unaffected.

91 Ch Flachsland and others, ‘How to Avoid History Repeating Itself: The Case for an EU Emissions Trading System (EU ETS) Price Floor Revisited’ (2020) 20(1) Climate Policy 134–135

92 Ibid, 135. The increase in prices of EUAs is generated also by rising gas prices and growth in demand for energy triggered by COVID-19 economic recovery. See Oxera Consulting LLP, Carbon Trading in the European Union: An Economic Assessment of Market Functioning in 2021, 15 February 2022, 44–46 <www.oxera.com/wp-content/uploads/2022/02/Oxera-EU-carbon-trading-report-2.pdf>, accessed 16 December 2022

93 ESMA, Preliminary Report (n 89), 34

94 Ibid

95 This trend has been most visible from the second half of 2020, when rapid increase in the number of market participants has been accompanied by the surge in prices of EUAs. See ESMA, Final Report (n 6), 86–87

96 According to the European Union Agency for the Cooperation of Energy Regulators (ACER), increased hedging activity of financial players constitutes one of the most significant incentives for the growth of prices of EUAs, together with the reduction of the number of auctioned EUAs. See ACER, ACER’s Preliminary Assessment of Europe's High Energy Prices and the Current Wholesale Electricity Market Design: Main Energy Price Drivers, Outlook and Key Market Characteristics, November 2021 <https://extranet.acer.europa.eu/Official_documents/Acts_of_the_Agency/Publication/ACER's%20Preliminary%20Assessment%20of%20Europe's%20high%20energy%20prices%20and%20the%20current%20wholesale%20electricity%20market%20design.pdf>, 6, accessed 16 December 2022

97 Oxera Consulting LLP (n 92), 48

98 M Friedrich and others, Rules vs. Discretion in Cap-and-Trade Programs: Evidence from the EU Emission Trading System, Munich Society for the Promotion of Economic Research – CESifo GmbH Working Paper No. 8637, 36 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3718517>, accessed 16 December 2022

99 ESMA, Final Report (n 6), 61

100 Ibid, 61–62

101 ESMA, Preliminary Report (n 89), 35