Regulating bidding in emissions allowances auctions: FSA proposals on authorisation, standards and market abuse

Auctions of EU Emissions Allowances may begin as early as July 2012 on the central common European auction platform.  The regulatory framework for the auctioning of aviation and phase III emissions allowances is set out in the Commission Regulation (EU) No 1031/2010 as amended by Commission Regulation (EU) No 1210/2011 (CAR).  However, specific elements of CAR need to be implemented by EU Member States to allow certain persons to participate in the auctions.

The Treasury is consulting on legislative amendments to make bidding in the auctions a regulated activity.  In parallel, the FSA is consulting on prudential and conduct rules (including amendments to the market abuse regime) which will apply to certain UK firms who must be authorised in order to bid in such auctions.  The timeframe for responding to these proposals is short, but the organisational implications for firms wishing to participate in regulated auction bidding are not insignificant. 

Although, for the most part, auctions are not anticipated until autumn 2012, the European Commission may begin auctions on the central platform as soon as July 2012. The FSA's consultation therefore closes on 19 April, to enable final rules to be made in late May 2012.  The FSA hopes to be able to process authorisation applications received by mid-June in time for any auctions scheduled to take place in July 2012.

The FSA's working assumption is that around 50 firms (10 of which will be new to the market) are likely to be looking to participate in auctions of emissions allowances.  All firms seeking to bid, even those that do not require FSA authorisation to do so, will need to apply to the auction platform on which the auctions will be conducted for admission to bid.  

When authorisation is required

Three categories of firms will need to be authorised to bid:

• MiFID authorised investment firms bidding on behalf of clients;
• credit institutions authorised under the Banking Consolidation Directive bidding on behalf of clients; and
• exempt firms under article 2(1)(i) of MiFID either bidding on behalf of clients of their main businesses or on their own account.

The FSA sees the new regulated activity of bidding in EU emissions allowances auctions as comparable to ‘dealing in investments as principal’, ‘dealing in investments as agent’ and ‘arranging deals in investments’.  It envisages that applications for variation of permissions by authorised firms that already have permissions covering these activities should be relatively straightforward, unless the FSA takes the view that a firm's bidding activities would materially alter the risks posed to its business.  

'Auction regulation business': in two situations, UK firms will need to be authorised to bid for emissions allowances, and in so doing will not be conducting MiFID business:

• Firms qualifying for an exemption under article 2(1)(i) of MiFID when bidding in relation to either type of auction product (a 2-day spot or a 5-day future) on its own account or on behalf of clients of its main business; and
• MiFID investment firms (other than a UCITS investment firm) or credit institutions authorised under the Banking Consolidation Directive when bidding in relation to a 2-day spot auctioned product on behalf of its clients.

FSA proposals

A limited prudential requirement (a holding of £50,000 in capital) will apply to MiFID exempt firms that wish to undertake auction regulation business.

The authorisation and conduct of business requirements for bidders which are not undertaking MiFID business are set out in Article 59 of CAR and have direct effect (Annex 4 of the FSA's consultation paper).  However, the FSA intends:

• to apply the same anti money laundering measures to bidders as are applicable to other firms, and
• to approve individuals carrying out key roles within a bidder to ensure the firm’s overall suitability and to enable the application of enforcement powers - these include governance,  moneylaundering and customer functions, and a CASS oversight function for firms that opt-in to CASS.

In relation to MiFID business bidding, the FSA's handbook will apply to incoming EEA firms, and to UK firms seeking to provide services in another Member State, in the same way as other MiFID business.  Although authorisation is a home state responsibility, the proposed anti money laundering and financial crime requirements are host state matters; incoming EEA firms with branches in the UK will also need to have a money laundering reporting function. 

A UK firm seeking to carry on bidding services in another Member State will be subject to CAR and to the FSA's requirements other than those in SYSC 6.3 (financial crime).

Firms will be required to notify the FSA of breaches of directly applicable provisions in CAR, and will also need to comply with the general provisions on reporting, to produce annual controllers reports and close links reports, to verify standing data and make a declaration of compliance on an annual basis within 30 business days of the firm’s accounting reference date. They will also be supervised as a matter of routine and their conduct in the auctions will be monitored by the platform concerned.

The FSA proposes an ‘opt-in’ regime under CASS to enable firms to overcome the administrative issues involved in seeking to apply the same standard of protection to auction regulation business and to other MiFID business (to enable them to mix their client money with money received in relation to auction regulation business) and to harmonise their treatment of client assets.  There will be an exception to the requirements on the registration and recording of legal title where it is not practicable for a firm to register the legal title to emissions auction products that are financial instruments (including 2-day emission spots for firms undertaking auction regulation bidding), and will allow the firm to hold them in its own name.  

Firms that do opt in to CASS need to appreciate that this will have an effect on COBS and SUP - as set out in proposed CASS 1.4.11 G.    Those firms will also need to keep a written record of the effective date of the opt-in; if they wish to cease to opt-in, they will need to discharge outstanding CASS obligations and ensure written records are kept.

Auction regulation business will not be covered by the Financial Services Compensation Scheme, nor by the DISP 1 complaints handling requirements.  Firms conducting non-MiFID auction regulation bidding will not covered by the Financial Ombudsman Scheme (FOS) - the voluntary jurisdiction of the FOS will not include auction regulation bidding, although it will include MiFID bidding business.  However, the FSA will, as required by CAR 59(7), entertain complaints about bidders’ non-compliance with the conduct rules and conditions of authorisation within CAR.

The FSA intends to monitor the operation of the emissions allowances auction bidding market and to keep the need for the application of these (and potentially other) provisions under review.

Market Abuse

The FSA is also consulting on consequential amendments to the Code of Market Conduct (MAR 1) to reflect the provisions of the Recognised Auction Platforms Regulations 2011  (the RAP Regulations) that establish a market abuse regime applicable to emissions allowances auctioned on a Recognised Auction Platform coming into effect in June 2012. 

The extended market abuse regime under MAR 1 will apply in relation to 5-day futures as these are included within the definition of financial instruments under Article 1(3) MiFID.  The current regime already applies to these instruments when traded on the secondary market of a prescribed market.  MAR 1 will refer to articles 37-43 of CAR, which apply directly to 2-day spot auctioned products, but will provide no additional guidance.

The FSA proposes quite extensive amendments to MAR 1:

• to include a new MAR 1.9A in respect of an eighth type of behaviour - involving breach of articles 38-41 of CAR - which will apply in relation to two-day spot auctioned products  under section 118(8A) of FSMA;
• to ensure current guidance is appropriate for auctioned products (specifically, amendments to MAR 1.3 to MAR 1.9 to clarify its application to auctioned 5-day futures auctioned on an auctions platform and to align the provisions with those applicable to 2-day spot auctioned products); and
• to ensure the inside information provision in the Glossary of the FSA Handbook reflects section 118C as modified by the RAP Regulations.

If emissions allowances are classified as financial instruments under a recast MiFID, they will qualify as financial instruments for the purposes of MAR.  Once the Market Abuse Regulation is adopted at EU level and takes effect, it will be directly applicable to Member States, and further provisions on market abuse in relation to auctioned products may be set out in delegated acts.  At that point MAR will need further amendment.