The transition to a low carbon economy will require significant long-term financing. Emissions allowances and carbon credits can be valuable assets and, as with other asset classes, their holders may be able to use them as a means of obtaining financing.
Financiers may also want to offer "green loans" and other types of green financing secured by emissions allowances and carbon credits to environmentally-friendly project operators as part of their environmental, social and governance ("ESG") strategies.
However, emissions allowances and carbon credits are a relatively novel asset class and their use as collateral for financing arrangements raises many structural, legal and regulatory considerations that must be considered.
This paper outlines the key issues with a focus on emissions allowances that are recognised for compliance with the European Union (the "EU") and the United Kingdom (the "UK") emissions trading systems ("ETS"). Many of the issues raised in this paper will be applicable to voluntary carbon credits, but the use of carbon credits as a means of raising finance is outside the scope of this paper.
Background to emissions allowances and emissions trading systems
Emissions allowances are tradable instruments that entitle the holder to emit a certain amount of greenhouse gasses (e.g., carbon dioxide, methane, nitrous oxide, sulphur hexafluoride etc.) into the atmosphere. They are typically associated with the so-called "compliance carbon markets".
In a compliance carbon market, the participants are mandatorily required by law to participate in the market by holding, and subsequently surrendering, a number of emissions allowances sufficient to cover their actual, verified greenhouse gas emissions over a particular period. Failure to surrender sufficient allowances attracts significant financial penalties and censure.
Participants in these markets include operators of installations involved in carbon-intensive commercial and industrial activity, including power and heat generation, commercial aviation, chemical production, oil refineries, steel works and other commodity producers.
The EU and UK, amongst other jurisdictions, operate their own respective ETS, which are types of compliance carbon markets.
The EU and UK ETS both operate on a "cap and trade" basis. This means that the number of emissions allowances issued each year is capped at a certain level, with the cap reducing over time based on emissions targets. Participants with excess emissions allowances can trade their emissions allowances with participants that have a shortfall. However, trading in these markets is not limited to entities that are legally required to participate, and a wide range of other entities are actively involved in trading emissions allowances, such as banks, broker-dealers, energy traders and funds.
Emissions allowances under the EU and UK ETS are issued in the primary market by way of regular, periodic auctions. Some emissions allowances are also issued to participants free of charge where there is a risk of "carbon leakage" – which is where industries or companies relocate their operations outside the geographic scope of the ETS to jurisdictions with less stringent emissions regulation to avoid the burden of complying with the ETS. A liquid secondary market has also developed where spot and derivative transactions can be entered into either on exchange or in the over-the-counter markets.
Possible financing structures
There any number of ways in which emissions allowances can be used as a means of raising finance, similar to those which are available for financing equites. The key ones are:
- loans secured by emissions allowances;
- repurchase transactions on emissions allowances;
- spot purchase of emissions allowances coupled with a cash or physically settled forward;
- funded collar transactions on emissions allowances; and
- total return swaps on emissions allowances.
Whatever the structure, and for convenience, we refer to the provider of finance as the "lender" and the receiver of finance as the "borrower".
A loan that is secured by emissions allowances is conceptually very similar to a margin loan. The lender will provide a cash loan to the borrower and the borrower will grant security over its emissions allowances to secure its repayment obligations.
The amount of credit extended by the lender will be determined by reference to the market value of the allowances held as security. A haircut will be applied to the market value to create the required "loan to value" ratio. If the market value falls below a certain level, the borrower may be required to repay part of the loan out of its own resources or by liquidating some of the security or to provide additional allowances as security.
The lender will be able to enforce its security interest against the borrower and sell the emissions allowances if the borrower defaults.
Repurchase transactions ("repo")
Emissions allowances can be considered as a type of uncertificated transferable security and so they could be the subject of a repurchase transaction (or a buy/sell-back transaction). The lender (i.e., the buyer under the repurchase transaction) will purchase the emissions allowances from the borrower (i.e., the seller) at a haircut to their current market value. This is subject to an obligation on the borrower to repurchase "equivalent" emissions allowances from the lender at a future date at a price equal to the original purchase price plus an amount of interest.
Title to the emissions allowances will pass from the borrower to the lender, and the lender will have recourse to the emissions allowances via contractual netting arrangements should the borrower default.
The same economics can be achieved by the lending of emissions allowances against cash collateral. Emissions allowances can also be lent against other collateral but in that case it is not a financing transaction.
Spot and forward transactions
A repo transaction is economically equivalent to a combination of a spot transaction and a forward transaction. Derivatives can therefore be used to replicate the effect of a repurchase transaction.
In this structure, the lender will outright purchase the emissions allowances from the borrower on a spot basis at their prevailing market value. Title to the emissions allowances will therefore pass from the borrower to the lender. The borrower will then simultaneously agree to purchase the same amount of equivalent emissions allowances from the lender at a future date. The forward price will be equal to the spot purchase price plus an amount of interest.
Repurchase transactions typically over-collateralise the lender through the application of a haircut to the purchase price for the emissions allowances. This feature can be replicated by margining the forward transaction and imposing an independent amount in favour of the lender equal to the amount of over-collateralisation.
The forward may either be settled physically (i.e., the lender will actually deliver the emissions allowances to the borrower) or in cash (i.e., the lender will pay the then prevailing market value of the emissions allowances to the borrower in lieu of delivery). However, the borrower will likely want the emissions allowances returned to it if it is subject to the ETS and must surrender allowances, making physical settlement the more attractive option from the borrower's perspective.
Funded collars are used in the equity markets as a technique for financing the acquisition of an equity stake or using an existing equity stake as a means to raise finance, in each case whilst simultaneously protecting the acquirer from large movements in the price of the equity. The same technique can be applied to emissions allowances.
Where the borrower has an existing holding of emissions allowances, a funded collar involves the borrower purchasing a put option and selling a call option on the emissions allowances. The counterparty to both options is the lender. The put option protects the borrower from a decline in the price of the emissions allowances once the price has fallen below the strike price of the put. The sale of the call option finances (in whole or in part) the purchase of the put option, but this caps the gain that the borrower can make if the price of the emissions allowances exceeds the strike price of the call.
Once the collar is in place, the lender lends cash to the borrower and takes the emissions allowances and the collar as collateral. The combined value of the emissions allowances and the collar will always be less than the principal amount of the loan, so the lender has effectively substituted credit risk on the borrower for market risk on the emissions allowances. This has the added benefit that the borrower will not have to post additional collateral if the value of the emissions allowances declines, as would be the case for a margin loan.
If the borrower defaults on the loan, the lender will appropriate the emissions allowances and close out the collar. The value of the collar will be set off against the repayment of the loan, and the liquidation of the emissions allowances will account for the remaining balance of the loan.
The structure will be broadly similar where the borrower wants to use the financing to acquire a new holding of emissions allowances.
The collar may be subject to mandatory margining rules depending on the nature of the parties as the collar is comprised of options, which are a type of derivative. Single-stock equity options are currently excluded from the EU and UK mandatory margining rules, but no such exclusion exists for options on emissions allowances.
Total return swaps
Total return swaps can be used to synthetically replicate the economic effects of a repurchase transaction. The lender (total return payer) will purchase outright the emissions allowances from the borrower (the total return receiver) or in the market. The economic benefits and burdens of the emissions allowances will be passed back to the borrower by the total return swap whereby the lender will pay the total return associated with the emissions allowances to the borrower, and the borrower will pay a floating amount of interest on the notional amount of the swap (which may be fully or partially funded). The lender will then either sell equivalent emissions allowances back to the borrower at the end of the transaction or account for the change in market value over the term of the transaction where cash settlement applies.
Again, title to the emissions allowances will pass from the borrower to the lender, and the lender will have recourse to the emissions allowances should the seller default.
The swap may also be subject to mandatory margining rules depending on the nature of the parties as the total return swap is a type of derivative.
Structuring and documentary considerations
This section considers some of the key structuring and documentation issues that will need to be addressed due to the nature of emissions allowances.
These issues apply equally to all forms of financing structure although the documentation framework will be that which is usual for the product type namely:
- Secured loans: Loan agreement (e.g., LMA or similar) plus local law security agreement (designed for the location of the custody account or registry) or GMSLA adapted for cash loans plus local law security agreement;
- Repurchase transactions: GMRA adapted for emissions allowances; and
- Forwards, collars and total return swaps: standard ISDA Master Agreement, bespoke confirmations and, if emissions are provided as collateral, a Credit Support Annex adapted for emissions allowances.
Valuation of the collateral
As with all secured financing, the lender will be concerned about ensuring that it can accurately value its security and that valuations can be carried out at regular intervals.
The European Energy Exchange operates secondary markets for spot contracts relating to EUAs and EUAAs and ICE Futures Europe operates secondary markets for "daily futures" contracts relating to UKAs. Exchange-traded futures and options contracts on EUAs, EUAAs and UKAs are also available. These exchange prices may be used as price sources for valuing the lender's collateral.
Primary issuances of emissions allowances are also carried out via periodic auctions. The prices set through the auction process may also be used as a pricing source, although the auction price may not necessarily be reflective of the current spot price and auctions can be cancelled in certain circumstances. The infrequency means they cannot be used for daily revaluations and margin calls.
Lenders will need to give careful consideration as to how much of a haircut should be applied to the emissions allowances when deciding how much to lend. The price of emissions allowances has historically been volatile, so quite substantial haircuts may be imposed. Other relevant considerations may include the lender's assessment of the liquidity of the relevant markets and the availability of derivatives to hedge the price risk during the period from default until liquidation of the collateral.
The borrower may also want the flexibility to substitute one type of emissions allowance for another, or to substitute emissions allowances for a completely different type of collateral. This may be necessary where the borrower needs the emissions allowances in order to surrender them but wishes to maintain the financing. Alternatively, the return or release of emissions allowances in the absence of substitute collateral would need to be conditional on repayment of the financing.
Ordinarily in a repurchase transaction, the parties would periodically exchange margin to maintain the ratio of the lender's obligation to return equivalent securities to the borrower's obligation to pay the repurchase price as the value of the securities changes over time. However, the lender may want the ability to return purchased allowances in case they increase in value to that it does not have to lend more cash if the value of the emissions allowances increases.
Transfers of emissions allowances
Lenders will need to fully understand the mechanics for the transfer of emissions allowances. As discussed below, emissions allowances are dematerialised and only exist as credit entries on accounts maintained within the relevant registry. Transfers are therefore made by making appropriate credit and debit entries to the relevant accounts.
However, lenders will also need to understand the practicalities of making such transfers and the rules applicable to the relevant registry. The registry rules will detail matters such as:
- the length of a settlement cycle;
- any cut-off times for the receipt of transfer instructions;
- the times and days on which the registry is open and can receive instructions;
- when a transfer becomes "settled"; and
- the extent to which transfers can be challenged and potentially reversed.
Lenders will also have to be comfortable with any software or application programming interfaces ("APIs") used to interact with the registry.
Holding of emissions allowances
Lenders will need to consider how the emissions allowances will be held and by whom to ensure that they have sufficient control over them to be able to realise them in a default scenario.
The two main options are:
- for the lender to maintain its own account directly with the relevant registry and for the emissions allowances to be held in that account; or
- for a third-party custodian to hold the emissions allowances either on behalf of the lender or the borrower.
A third option is for the borrower to hold the emissions allowances in its own account with the relevant registry. However, lenders may not be comfortable that they can exercise a sufficient degree of control over the emissions allowances in these circumstances and effective security will not be possible unless a segregated account is created.
Events of default and mandatory prepayment events
Given the unique nature of emissions allowances as an asset class, lenders will need to consider whether any emissions-specific events of default or mandatory prepayment events should be included in the documentation.
Such events could include:
- suspension or closure of any relevant registry accounts;
- a suspension or shutdown of the relevant ETS as a whole;
- the service of a penalty notice on the borrower due to its non-compliance with the ETS;
- the borrower making material misstatements in its annual emissions report; and/or
- a regulatory or a registry administrator serves an enforcement notice on the borrower.
Similarly, lenders will need to consider whether any emissions-specific covenants or undertakings should be included in the documentation.
Such covenants and undertakings could include obligations to:
- generally comply with the relevant ETS and registry rules;
- keep and maintain a registry account at all times;
- not attempt to reverse or cancel any transfers of emissions allowances to the lender;
- not to "delete" any emissions allowances; and
- provide certain information to the lender regarding its obligations under the ETS.
Liability for "excess emissions penalties"
If the borrower is an operator of an installation that is subject to the EU or UK ETS, it will periodically have to surrender eligible emissions allowances to meet its obligations under the ETS. Failure to surrender sufficient emissions allowances will result in the borrower incurring a fine for each emissions allowance that was not surrendered when it should have been. These fines are referred to as "excess emissions penalties".
Given that the borrower may be reliant on the lender to return or release emissions allowances in good time to allow the borrower to surrender them, the borrower may seek to make the lender liable for excess emissions penalties imposed on it because of the lender's failure to return them when required to do so. The borrower may also seek indemnities for costs associated with remedying the lender's failure, such as the costs of carrying out a buy-in (in a similar way as applies to securities which are not delivered when required).
Lenders agreeing to take such liability will want to pay close attention to the degree of causation between its failure and the imposition of excess emissions penalties and the borrower's duty to mitigate the effects of the failure.
Regulatory treatment of emissions allowances
As emissions allowances are regulated products in the EU and the UK, firms operating in those jurisdictions need to understand the financial services regulatory implications of their activities. This is also case where those firms could be dealing or arranging deals in the emissions allowances connected with the financing arrangements.
The key regulatory considerations are set out below.
Regulatory treatment in the EU
In the EU, emissions allowances are a type of "financial instrument" that is regulated by MiFID II. However, the only emissions allowances that fall within scope are those recognised for compliance with the requirements of Directive 2003/87/EC (the "EU ETS Directive").
This means that the only types of emissions allowances that are currently financial instruments ("EU Allowances") are:
- European Union allowances ("EUAs");
- European Union aviation allowances ("EUAAs"); and
- Swiss emissions allowances ("CHUs").
Other types of emissions allowances and carbon credits (effectively non-EU allowances and all voluntary carbon credits) are not currently subject to financial services regulation at an EU level.
At present, emissions allowances created under the UK ETS cannot be used for compliance with the EU ETS and are not therefore financial instruments for EU purposes. However, it is possible that this will change and the Trade and Cooperation Agreement requires the UK and the EU to "give serious consideration" to linking the two systems.
Firms that carry out investment services and activities on a professional basis with respect to emissions allowances that are financial instruments need to be authorised as investment firms under MiFID II unless an exemption applies.
Regulatory treatment in the UK
In the UK, emissions allowances are a type of "specified investment" that is subject to financial services regulation.
Article 82B(1) of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the "RAO") provides that emissions allowances will be specified investments where they are either:
- units recognised for compliance with the requirements of the EU ETS Directive; or
- created under Article 18 of the Greenhouse Gas Emissions Trading Scheme Order 2020 (the "GHG ETS Order").
This means that the only types of emissions allowances that are currently specified investments in the UK ("UK Allowances") are:
- EU Allowances; and
- United Kingdom allowances ("UKAs").
As in the EU, other types of emissions allowances and carbon credits are not currently subject to financial services regulation in the UK.
UK Allowances are slightly unusual as they will only be considered regulated products where certain specified types of person perform certain types of activity with respect to them. This would include a firm that is carrying on investment services and activities on a professional basis with respect to them. Such persons would need to be authorised and regulated by the Financial Conduct Authority (the "FCA") as an investment firm under the UK's implementation of MiFID II unless an exemption applies.
Loans secured by emissions allowances
In the EU, lending to corporate borrowers is not a regulated activity at an EU-wide level, although individual EU Member States may regulate such activities at a national level and many do (e.g., France, Germany and Luxembourg). As such, lenders will need to consider whether providing loans secured on emissions allowances constitutes a regulated activity in the relevant jurisdictions.
In the UK, lending to corporate borrowers is not a regulated activity, and so the position is more straightforward.
If the loan is secured by EU Allowances or UK Allowances, consideration will need to be given to the enforcement mechanism as dealing in the emissions allowances as part of the enforcement process might involve the performance of regulated activities in the EU or the UK, respectively. Appointing a third-party broker to buy the emissions allowances from the lender upon a default, or to arrange their sale to another person, may assist with keeping the lender outside the regulatory perimeter.
We would note, however, that the EU and UK positions might differ if the loan takes the form of a debt security or a loan note, which we assume is not the case.
Repo of emissions allowances
In the EU, MiFID II does not specifically list "repurchase transactions" as a type of financial instrument. However, where the emissions allowances in question are EU Allowances, repos of those allowances will be subject to regulation under MiFID II as they will involve the lender engaging in investment services and activities – specifically, dealing on own account and the execution of orders on behalf of clients – with respect to a financial instrument. The borrower may also be engaging in investment services and activities. Both parties will need to consider the extent to which they may be carrying on any regulated activities and whether any exemptions may apply.
In the UK, the position is similar to the EU position. Again, the RAO does not specifically list "repurchase transactions" as a type of specified investment, but repos of UK Allowances will be subject to UK financial services regulation as they will involve the performance of regulated activities – specifically, dealing in investments as principal. The borrower may also be engaging in regulated activities. Both parties will need to consider the extent to which they may be carrying on any regulated activities and whether any exclusions may apply.
The classification of the borrower as either a retail client, a professional client or an eligible counterparty will also be a relevant consideration for a repo structure. MiFID II and the Client Assets sourcebook of the FCA Handbook prohibit firms from entering into title transfer collateral arrangements – such as those found in industry-standard repo documentation – with retail clients in connection with certain types of regulated business.
Derivatives on emissions allowances
In the EU, cash settled and physically settled forwards, futures, options and other derivatives on EU Allowances are financial instruments pursuant to C(4) of Annex I to MiFID II. Derivatives on other types of emissions allowances and carbon credits may also be financial instruments.
In the UK, cash settled and physically settled forwards, futures, options and other derivatives on UK Allowances are specified investments pursuant to Articles 83, 84 and 85 of the RAO. Derivatives on other types of emissions allowances and carbon credits may also be specified instruments.
Exemptions from authorisation as an investment firm
Firms carrying out investment services and activities in connection with emissions allowances financing (such as dealing on own account or the reception and transmission of orders) need to be authorised as investment firms unless an exemption applies. There are only two exemptions that are specifically relevant to emissions allowances:
- the exemption for operators of installations; and
- the ancillary activities exemption.
Operators of installations that are subject to compliance obligations under the EU ETS or the UK ETS are exempt from the requirement to become an investment firm in the EU or the UK, respectively, when they deal on own account in emissions allowances, provided that they do not otherwise carry out any investment services and activities and do not use high-frequency algorithmic trading techniques. This exemption is unlikely to apply to a provider of finance.
The ancillary activities exemption allows firms to deal on own account in emissions allowances and derivatives on emissions allowances in the same way as it applies to commodities. It only applies where the person does not execute client orders and/or carry out other investment services and activities relating to emissions allowances and derivatives on emissions allowances and where it only does so in relation to the "customers" and "suppliers" of its "main business". The exemption only applies where those activities are "ancillary" to the person's main business (at individual and group level), the main business of the group is not the provision of investment or banking services, the person does not apply a high-frequency trading technique, and the person's competent authority is notified. This exemption is primarily aimed at commercial and industrial groups.
Firms that are already authorised
Even firms that are already authorised to conduct investment business will need to consider whether their current regulatory permissions are broad enough to cover their activities relating to emissions allowances.
Legal nature of emissions allowances
Given the relative novelty of emissions allowances as an asset class, lenders need to understand the legal nature of emissions allowances and the consequences from a legal perspective that may flow from their characterisation. This will include matters such as the types of security interest that can be created over them and the perfection requirements, how title can be transferred, and whether transfers could be unwound or subject to claw back if the borrower becomes insolvent.
Under the EU ETS, Commission Delegated Regulation (EU) 2019/1122 (the "Registry Regulation") describes the legal nature of EUAs and EUAAs as "a fungible, dematerialised instrument that is tradable on the market". EUAs and EUAAs are entirely electronic. They only exist as credit balances on accounts maintained in a registry. There is no title document or other physical evidence of their existence.
The legislative framework for the UK ETS does not, however, directly address the legal nature of UKAs in the same way. The English courts have considered the legal nature of EUAs in 2012 and have held that they are a form of intangible property, but did not decide whether EUAs are a chose in action or another form of intangible property as it did not matter in that case. However, our view is that they would not be a chose in action (and would fall into the "other" intangible property category) as they do not give the holder a "right" to emit a certain quantity of greenhouse gasses that can be enforced by taking action. Instead, they represent an exemption from the imposition of a fine for emitting those gasses. In this sense, they are analogous to fishing quotas or export quotas, which have been given judicial consideration and found to be "other" intangible property.
Other types of emissions allowances have not been considered by the English courts, but we would expect it is likely that UKAs would be regarded similarly given the strong similarities between the UK and EU ETS.
Transfers of title to emissions allowances
Where emissions allowances are subject to title transfer collateral arrangements, the key questions that lenders will need to consider is how they can obtain good title to the emissions allowances and whether there are any applicable settlement finality rules or whether they could be subject to claw back.
Emissions allowance are dematerialised instruments which are issued, held and transferred in and between account holders within a relevant registry. It is therefore clear that transfers of emissions allowances can be effected by debiting and crediting the relevant accounts.
Under the EU ETS, an electronic database known as the Union Registry holds all of the accounts containing EUAs and EUAAs. The Union Registry is maintained and operated by a central administrator, but each EU Member State has a national administrator that administers accounts in the Union Registry for persons within its jurisdiction. The central administrator directly administers certain types of account.
The Union Registry is created by and operated in accordance with the Registry Regulation. All transfers between Union Registry accounts are checked, recorded and authorised by the European Union Transaction Log (formerly known as the Community Independent Transaction Log). The Registry Regulation lays down rules regarding evidence of title to emissions allowances, providing that the Union Registry records are "prima facie and sufficient evidence" of title to an allowance. Additionally, transferees of EUAs and EUAAs acting in good faith will acquire good title to those allowances free of any defects in the title of the transferor. The Registry Regulation also addresses certain issues of settlement finality relating to transfers of emissions allowances.
Again, the legislative framework for the UK ETS does not expressly address these issues and so they will need more careful consideration.
The GHG ETS Order establishes the UK Registry, which is similar to the Union Registry in that it acts as a register of accounts to which UKAs are credited, and appoints its administrator. However, the legislation simply states that UKAs "may be transferred from one account to another" but this does not directly address how and when title to UKAs will pass from the transferor to the transferee. The matter has also not received any judicial scrutiny, which is unsurprising given that UKAs are a relatively new creation. There therefore remains a degree of uncertainty as to whether title to UKAs will pass once a transfer has been reflected in the relevant accounts, and whether the accounts in the UK Registry will act as a definitive record of title to the UKAs.
Security interests over emissions allowances
The legal nature of emissions allowances, their "location" and the relevant governing law will directly inform the types of security interest that a lender can take over emissions allowances and how they can be perfected. How the emissions allowances are held (e.g., directly in a registry account or indirectly via a third-party custodian) will also be relevant to this question.
Under the EU ETS, the Registry Regulation provides that accounts held in the Union Registry are governed by the law of the EU Member State of the account's administrator. The account also falls under the jurisdiction of that EU Member State and the EUAs and EUAAs credited to the account are considered to be "situated" in that territory.
The legal framework for the UK ETS does not address this issue specifically, but we would expect that UKAs would be considered as being "located" in the UK as the registry and the accounts holding the UKAs are located and operated in the UK.
Where an English law security interest is used, we would typically expect this to take the form of a charge or a legal mortgage. A legal mortgage will offer the lender the greatest level of protection as the emissions allowances are held in the lender's name. If the emissions allowances continue to be held by the borrower, at most the lender will likely only be able to take an equitable and floating charge over the emissions allowances due to practical difficulties with obtaining sufficient control over the borrower's registry account to obtain a fixed charge.
Where a third-party custodian holds the emissions allowances, the custodian will hold them in an account at the relevant registry in its own name pursuant to the terms of a custody agreement. The lender will take security over the borrower's rights against the custodian, typically using an assignment by way of security over a segregated account in which the allowances are held. A triparty account control agreement may also be put in place that would govern the borrower's and the lender's ability to direct the custodian both pre- and post-default.
Lenders will need to satisfy themselves that the scope of their legal opinion coverage with respect to any netting and collateral arrangements is broad enough to capture financing transactions and/or collateral involving emissions allowances. If it is not, additional opinions may be required to give lenders sufficient legal certainty that their close out netting and/or collateral arrangements (as the case may be) will continue to be enforceable notwithstanding the inclusion of emissions financing transactions and/or allowances as collateral.
Firms subject to Regulation (EU) No 575/2013 ("EU CRR"), the on-shored UK version of EU CRR ("UK CRR"), Regulation (EU) 2019/2033 ("IFR") or the UK's Investment Firms Prudential Regime ("IFPR") will want to ensure that netting remains effective with respect to financing provided by way of repo and OTC derivatives on emissions allowances.
However, they will not be able to recognise collateral arrangements involving emissions allowances as a form of credit risk mitigation as emissions allowances are not an eligible form of collateral for these purposes even if they have opinions which state that the collateral arrangements are legally enforceable.
Financial collateral arrangements
Emissions allowances are not an eligible type of "financial collateral" for the purposes of the UK Financial Collateral Arrangements (No. 2) Regulations 2003 (the "FCARs") or Directive 2002/47/EC (the "EU Financial Collateral Directive"). This means that any title transfer or security interest arrangements relating to emissions allowances will not benefit from the enhanced protections afforded to financial collateral arrangements. Additional legal due diligence may be required in the relevant jurisdictions to ensure that these protections are not critical to the effectiveness of the relevant netting and collateral arrangements.
Uncleared Margin Rules
Emissions allowances are not recognised under the EU and UK mandatory margining rules for uncleared OTC derivatives as eligible forms of collateral. Any emissions allowances exchanged as collateral will have to be disregarded for the purposes of those rules.2
 Armstrong DLW GmbH v Winnington Network Ltd  EWHC 10 (Ch).
 For example, Attorney General of Hong Kong v Nai-Keung (Daniel Chan)  1 W.L.R. 1339.
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