Fungibility Event - Emissions Annex Provision

EU Emissions Allowance Transaction Annex to the 2005 ISDA Commodity Definitions →Go uptown From the EU ETS: Article 13: Validity of allowances 1. Allowances shall be valid for emissions during the period referred to in Article 11(1) or (2) for which they are issued. 2. Four months after the beginning of the first five-year period referred to in Article 11(2), allowances which are no longer valid and have not been surrendered and cancelled in accordance with Article 12(3) shall be cancelled by the competent authority. Member States may issue allowances to persons for the current period to replace any allowances held by them which are cancelled in accordance with the first subparagraph. 3. Four months after the beginning of each subsequent five-year period referred to in Article 11(2), allowances which are no longer valid and have not been surrendered and cancelled in accordance with Article 12(3) shall be cancelled by the competent authority. Member States shall issue allowances to persons for the current period to replace any allowances held by them which are cancelled in accordance with the first subparagraph. Index: Click ᐅ to expand: ISDA Emissions TOC EUA Annex - Premium Emissions Pro tip: for tons of information about EU ETS and EU financial services regulation see Michał Głowacki’s magnificent emissions-euets.com website. Emissions trading documentation ISDA: EU Anatomy • EU Wikitext • EU Nutshell (premium) • UK Anatomy • UK Wikitext (to be merged into EU Anatomy) IETA: IETA Master Agreement • IETA Wikitext • IETA Nutshell (premium) EFET: EFET Allowances Appendix • EFET Allowances Wikitext • EFET Nutshell (premium) Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

Part of the extended fan fiction universe, a “Fungibility Event” is something that someone in the market, well, made up.

Following an announcement, change in law and, as the case may be, or regulation and/or confirmation by the European Council or Commission, Allowances allocated in Phase 3 or Phase 4 of the EU ETS will not be eligible for compliance with obligations under Phase 4 of the EU ETS (such event a “Fungibility Event”)

This is the fanciful contingency that the Seller is holding Phase 3 Allowances and that, by regulatory decree, they are unexpectedly rendered ineligible for surrender, especially past a point in time later than now but before the maturity of the contract in question.

This was the case with Phase 2 Allowances — all of which are now goneski — and perhaps this drafting is scar tissue of that scarier, uglier time. But times have changed, and a “Fungibility Event”, however you describe it, is a highly remote contingency for a number of reasons.

If it happened it would crash the market

Firstly, practically, futures contracts referencing Allowances don’t differentiate between Phase 3 and Phase 4, so market participants can’t control which Phase they are delivered, and it would be perverse and counterproductive behaviour for ESMA — and, okay, no-one is denying regulators do ill-advised and counterintuitive things, but still — to suddenly deem part of the market ineligible.

The EU ETS explicity provides that Allowances will be valid indefinitely

Secondly, the present drafting of the EU ETS says exactly the opposite. Technically Allowances to expire, after eight years, but you are entitled to exchange them for new ones if they do: Article 13 of the EU ETS Directive requires Member States to issue replacement Phase 4 Allowances to those poor souls stuck with stale Phase 3 Allowances — they are generally valid for eight years from issue). The result, as the Michał Głowacki’s excellent site remarks, is

“Emission allowances will no more be replaced between periods, but will be valid indefinitely.”

Therefore, elaborate provisions providing for what would happens in an Allowance Option or Allowance Forward should Phase 3 Allowances become ineligible (we have seen this described, oddly, as a “Fungibility Event” though clearly it is not that — the instruments are not and never have been “fungible”) feel to us to be the product of a surfeit of caution. An over-egging of a flummery that has quite enough eggs in it already.

But we don’t think that is it: for one thing, if that event happens there will almost certainly be plenty of notice. Phase 3 and Phase 4 Allowances currently trade as if fungible. They will rapidly decouple, and the best mechanism would be for Buyers — whom we expect to be end users, right? — to accelerate delivery of expiring Phase 3 Allowances so they can surrender those first. Sellers — financiers in the main — won’t wildly care as long as their funding break is taken care of. In any case having to wait until final settlement, and then being discovering tendered Allowances are worthless, seems a bit of a head-in-sand tactic.

There’s no easy solution to this, which makes us think that even if the EU regulators do such a silly thing, they will quickly change their minds when they see the resulting market confusion and dismay.

One — even the most chicken-lickenish legal eagle — generally does not cater in one’s contracts for future changes in law, unless there is a real apprehension that the change is in contemplation and likely to come about — if legislation is before the house, or a case on appeal to the Supreme Court: that sort of thing.