On 28 March 2022, the European Securities and Markets Authority (ESMA) published a final report on the EU carbon market.

The final report follows the ESMA’s preliminary report on emission allowances and derivatives which it published last year in response to the issues that the European Commission raised in its October 2021 communication on energy prices, ‘Tackling rising energy prices: a toolbox for action and support’.

In the final report the ESMA makes certain observations regarding the EU carbon market including:

• Overall, the ESMA considers that an analysis of the data has not unearthed any major abnormality or fundamental issue in the functioning of the EU carbon market from a financial supervisory
• The observed evolution of carbon prices and volatility seem to have followed market fundamentals. In this context, the emergence of new participants (and instruments) with buy and-hold strategies warrants future monitoring to the extent that they may lead to a reduction in the supply of physical emission allowances available for trading, even though the available evidence suggests that their impact is only limited so far.
• When looking at trading on emission allowances and counterparties in this market, the various segments of the EU carbon market appear to broadly function as expected.
• Most of the trading in the secondary market takes place through derivative contracts, as many compliance entities seem to take long futures positions with investment firms to acquire emission allowances instead of purchasing them on the spot market.
• Derivative markets are dominated by compliance entities and other non-financials that are holding long positions for hedging purposes and trading with investment firms holding short positions to make a market.
• The ESMA has also observed activity from high-frequency trading firms and market makers engaging in algorithmic trading, often from the UK and US, that are however only holding small net positions.
• There are significant challenges when trying to identify the origins of market participants which makes it complex to obtain a clear picture of who trades and from where. The ESMA considers that these challenges need to be addressed in order to improve future monitoring of EU carbon markets.
• The ESMA is acutely aware that the war in the Ukraine has a major impact apparently also on the carbon market. While emissions allowances prices were declining by 30% in just a few days in late February and early March, natural gas prices reached all-time highs in Europe. There are a number of macro-economic and also technical factors which may explain these developments specifically in the carbon market. There are indications that the decline in the carbon price may be associated with concerns around possible gas supply disruptions or import bans leading to a reduced need for emission allowances, combined with general assumptions concerning an economic downswing and EU countries exiting fossil fuels at an earlier point in time but additional analysis may be required in the future.

In the final report the ESMA puts forward a series of policy recommendations including:

• Extending position management controls to trading venues trading derivatives on emission allowances.
• Adapting position reporting in emission allowances.
• Publishing weekly position reports on open positions in futures on emission allowances only in addition to the current combined reports on open positions in futures on emission allowances and options on futures on emission allowances.
• As part of the MiFIR Regulatory Technical Standard 2 review which is underway, the ESMA will consider the potential need for recalibration of transparency thresholds for emission allowances and emission allowance derivatives.
• Providing further clarity on the distinction between spot emission allowances and derivatives on emission allowances.

The ESMA has also considered the arguments in favour and against the two following measures:

• The application of position limits on the open position a person may hold in emission allowance derivatives and economically equivalent OTC contracts.
• A centralised market monitoring of the carbon market.