Fungibility Event - Emissions Annex Provision

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

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 is a highly remote contingency for a number of reasons.

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.

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.