“Around the globe, initiatives to price carbon, including cap-and-trade systems, are proliferating at a rapid pace. The shifting evolution of carbon markets, including potential new markets, market mechanisms, and market participants is occurring at an almost dizzying rate, including across Canada.”
The Environmental Finance Advisory Committee (“EFAC”) of the University of Toronto held an all day session on Friday June 3rd, 2016 on new developments in the carbon markets. Barbara Hendrickson spoke at the session and the following is a summary of her speaking notes:
CARBON TRADING REGULATION in CANADA: THE BASICS
I wanted to say a few words to you about the application of the Ontario securities and commodities regimes to trading the allowances and offsets created under the Ontario Climate Change Mitigation and Low Carbon Economy Act (“Act”).
Before I do that I should note that the Ontario provincial government has included in the new cap and trade legislation several provisions that mirror aspects of securities regulation and which will apply to all trades in credits and emission allowances under the Act. I am not going to cover those here as they will be reviewed later this afternoon. A discussion of those provisions is also included in the comment letter that EFAC submitted to the Ontario government during the consultations on Bill 172. A copy of this letter can be found on the EFAC website.
In addition, I would also like to note that my comments here are limited to Ontario securities and commodities laws. Please keep in mind that trades in Ontario offsets and allowances may be subject to the securities laws of other provinces. As you are likely aware, we have 13 regulators in the securities / commodities area in Canada. While, securities and commodities rules across Canada are similar, there are some important differences.
As you are likely aware carbon based products such as offset credits and allowances are traded in at least three ways:
• through accounts;
• through exchanges;
• over the counter or OTC.
In Ontario the Ontario Securities Commission (“OSC”) regulates the trading of securities and commodities through the Ontario Securities Act (“OSA”) and the Commodity Futures Act (“CFA”).
There are at least three ways that a trade in Ontario involving an offset credit or allowance could be caught by the OSA and or the CFA.
• Trading through Government Accounts – This is the trading of allowances and offset credits through accounts set up under the Act to evidence the ownership of those credits and allowances. These trades will not likely be subject to securities and commodities legislation in Ontario unless these products are considered to be “securities” under the OSA.
• Trading through Exchanges – The trading of carbon based futures contracts and options on future contracts on an exchange will be regulated in Ontario under the Commodity Futures Act.
• Trading OTC or over the counter (not on an exchange) – OTC trading of carbon based forward contracts will likely be considered to be a “derivative” under Ontario securities laws and will be subject to certain securities requirements. An OTC forward trade may also in some circumstances may also be considered to be a “security” under the OSA and therefore subject to securities regulation.
Commodity Futures Act
The CFA covers exchange traded commodity futures contracts and options on commodity futures contracts which are carbon based. The OSC in 2004 passed OSC Rule 14-502 which recognizes that “a product based on environmental quality including emissions or emission credits” could be a commodity. Currently there are no exchanges for carbon products in Ontario.
Certain OTC forward trading relating to allowances and offset credits may be considered to be derivatives for the purposes of Ontario securities laws. The definition of derivatives includes a “commodity contract” and the OSC has recognized that “commodities” include certain intangible commodities such as “carbon credits and emission allowances.”
I just want to emphasize that definition of “derivatives” catches trades in carbon based products sold on a forward basis and not on a spot basis. The definition of derivatives expressly excludes a contract where it is intended by the parties that the commodity is to be “delivered” and does not allow for cash settlement in place of delivery.
Generally, “delivery” for a carbon product such as an allowance or offset credit is considered to be effected when the allowance or credit is transferred in an account or registry.
Therefore, trading carbon between accounts would not likely be caught by the definition of derivative (although it still could be a “security” under the OSA in some circumstances.)
There are a number of areas of regulation of derivatives under the OSA including:
• market manipulation,
• marketing, and
• insider trading and tipping.
Importantly in Ontario “derivatives” are covered by the prospectus rule. The prospectus rule specifies that you cannot trade in a security or derivative unless:
• you file and receive a receipt for a prospectus, or
• you trade under an exemption from the prospectus requirements such as the accredited investor exemption or the minimum investment exemption ($150,000).
Currently in Ontario, the advisor and dealer registration requirements do not apply to derivatives. However, Ontario intends to introduce legislation that would make trades in derivatives subject to the dealer registration and advisor registration requirements.
In addition to certain provisions of the OSA, there are a number of new rules that either have been and will be passed to regulate trading in derivatives to avoid a reoccurrence of the 2008 meltdown. These include rules respecting the regulating the derivatives industry:
• reporting trades in derivatives;
• trade repositories,
• clearing and
• counterparty collateral and positions.
In some circumstances a trade in a carbon based product such as an offset credit or an allowance could be considered to be a “security” and therefore subject to the full impact of the Ontario Securities Act.
This is where the product falls under the definition of a “security” in the OSA which includes
• an investment contract;
• a document evidencing an option in or to a security;
• a document, instrument or writing commonly known as a security.
To be clear the trading allowances and offsets through government mandated accounts will not likely be subject to securities legislation as “derivatives” as it is generally considered that the transferring of allowances and credits in these government mandated registries is the equivalent of physical delivery and therefore a spot trade. However, trading in allowances and credits whether on a spot or forward basis may be subject to securities regulation if the Ontario Securities Commission deems that it is in the public interest to do so.