13 November 2009
The Commonwealth Treasury has recently unveiled draft Corporations Regulations amendments which will effectively ban forward trading in Australian emission units in Australia until at least after the first auction of AEUs is complete, which we think will have significant effects upon the market.
It is highly unlikely that the Treasury intended its proposed short-selling restrictions to have this effect, but if the Regulations are implemented as they appear in the draft, these unintended consequences will follow.
The proposal will effectively prevent operators of emission intensive trade-exposed activities (EITEs) offering to sell forward AEUs based upon their free emission allocations, until those allocations are actually issued by the Government (because their allocation from year to year is conditional on their production from year to year), and for similar reason will also prevent EITEs promising to deliver those free emission allocations in consideration of other services (such as in return for the provision of electric power at a carbon-exclusive price).
The proposal is also likely to prevent forestry operators from pre-selling AEUs based upon their expectation of earning AEUs from reforestation sequestration activities. Until now, we had expected that forestry operators would raise the funds required for planting forests by pre-selling their anticipated sequestration benefits. These pre-sales would be prohibited by the proposed restriction, because the entitlement to the AEUs is conditional on achieving the required sequestration.
How is this being done?
Section 1020B of the Corporations Act deals with short-selling of certain securities and financial products ("section 1020B products").
Under section 1020B(2), a person must only sell section 1020B products if at the time of the sale (which includes the time of the making of the offer to sell) the seller has a presently exercisable and unconditional right to vest the products in the buyer. In simple terms, the seller must already own the products (or own them subject only to payment and/or transfer conditions).
Under the draft Corporations Regulations amendments, "eligible emissions units" (that is, AEUs and eligible international emission units such as CERs and ERUs) will be added to the list of section 1020B products, by adding an additional paragraph to the list of prescribed financial products in regulation 7.9.80B.
The new regulations would become effective 28 days after the Carbon Pollution Reduction Scheme Act is passed by Parliament and receives Royal Assent.
Is this a good idea?
If trading in emissions units is subject to the Trade Practices Act and other rules against market misconduct and market manipulation, it is hard to see what additional benefit short-selling prohibitions would introduce, for what would be a significant inhibition on the development of market liquidity.
For instance, section 1041C already outlaws artificial transactions that have the result of depressing prices in the market.
Any attempt to come up with some new formulation of what is otherwise legitimate short-selling, within the next month or so, will be fraught with difficulty.
We note also that environmental products such as RECs, CERs and ERUs have been trading in significant volumes in Australia and elsewhere for nearly 10 years without any evidence that there are illegitimate gains to be made from illegitimate forward selling.
The key distinction between environmental products (and other commodities) and corporate securities is the underlying. In respect of corporate securities, the underlying asset (the company, its directors and its business) can be damaged and put under pressure by short-selling. The object of corporate securities is growth of the underlying.
In relation to environmental products, the object of the trading system is to find the least cost abatement, and so the intention is to promote low-cost abatement rather than promote an increase in value of the environmental product. A decrease in value of the environmental product will in fact allow greater abatement and greater improvement of the environment at less cost to the community.
There seems to be no clamour by industry for short-selling restrictions. Indeed, if short-selling restrictions are introduced, once there is a physical AEU available the restrictions are likely to be met and overcome by artificial techniques such as the borrowing arrangements that have arisen in the corporate securities market to overcome the short-selling restrictions imposed on corporate securities.
Environmental products are traded as commodities. We don't have short-selling restrictions in respect of other commodities (for instance gold, silver, wheat, oil). No case has been made out for carbon to be specially treated.
Australia would be the only jurisdiction in the world to have short-selling and inside information regulation of emissions markets. Both issues would only increase the cost of compliance for little or no benefit, and drive international traders and investors to other offshore markets, reducing the number of traders and the liquidity of the Australian markets and thereby making the Australian market more, rather than less, open to manipulation.
For similar reason, we would also exclude EEUs from the definition of financial products for the purposes of the inside information rules.
Submissions on Treasury's proposals close this Friday, 13 November.