Leaked EU proposals show FRTB divergence on carbon trading

EC takes up Isda call to cut standardised risk-weight; unclear if it applies to non-EU markets

EU emissions

Leaked draft proposals on changes to the European Union’s prudential rules show the bloc intends to diverge from international standards by implementing lower capital requirements for banks trading in emissions allowance markets. But there is ambiguity about whether all carbon trading will benefit, or only trades on the EU emissions trading system (ETS).

The draft rules will follow recommendations made by the International Swaps and Derivatives Association rather than rules set within the final version of market risk capital rules – known as the Fundamental Review of the Trading Book – published by the Basel Committee on Banking Supervision in January 2019.

Under the FRTB, banks must calculate capital requirements for desks trading in financial markets using either their own models, if they pass a series of tests, or using a regulator-set standardised approach.

Under the standardised approach, bank exposures to emissions allowances fit into a 60% risk-weight bucket with electricity contracts. A study published by Isda on July 23 disputed the risk-weight, arguing that volatility in the market shows it should be closer to a 40% risk-weight.

A leaked draft of the third capital requirements regulation (CRR III) written by the European Commission and seen by Risk.net, states: “Under the final Basel III standards, emission allowances are assimilated to electricity contracts, which could be considered too conservative in light of historical data relevant to the EU market for emission allowances.”

It continues: “Indeed, the creation of the Market Stability Reserve by the commission in 2015 has stabilised the volatility of the price of ETS allowances. This justifies creating a specific risk category for ETS allowances under the A-SA [standardised approach], distinct from electricity, with a lower risk-weight equal to 40% to better reflect the actual price volatility of this EU-specific commodity.”

Going it alone

Companies are required to buy emissions allowances to cover the carbon emissions they produce. Banks act as intermediaries in the market, buying allowances at auctions and selling futures contracts to corporates to deliver allowances in the future.

The inputs for standardised risk-weights in the FRTB include the level of volatility in a given security. A higher risk-weight is set for products on which banks are more likely to make greater losses during a market downturn.

The Basel Committee set the risk-weight for emissions allowances in their first iteration of the FRTB, which was released in January 2016. Volatility for the risk-weight included the extreme market movements observed during the global financial crisis in 2008. The original FRTB risk-weight was also based on aggregated movements found in several jurisdictions’ markets.

Isda’s study worked out a risk-weight for carbon trading based on volatility observed only in the EU’s emissions allowance (EUA) market – the most developed allowance market in the world – and only since 2013. The paper argues the market is unlikely to go through the same volatility as was seen before 2013, due to measures implemented by European authorities to ensure the price of EUAs remain stable.

The European Banking Authority had expressed concerns that the different observation periods within the FRTB would create inconsistencies within the framework.

However, one industry source is uncertain about whether the lower risk-weight will apply only to the EUA market, or if other carbon markets are also covered. While the introductory section of the draft refers to “this EU-specific commodity”, the change itself – in article 325(as) – simply refers to a 40% risk-weight for “carbon trading” without specifying the geography.

Other emission allowance markets around the world lag behind the EU’s and are not as liquid nor have the same stabilisation mechanisms. A market risk expert at a non-EU regulator says Isda’s findings would therefore not be appropriate for allowance markets other than the EU’s, as it was a “geographic-specific result”.

No clean sweep

The European Commission hasn’t implemented all Isda’s recommendations. Isda’s study had recommended altering a tenor correlation parameter within the FRTB. This would make it easier to net the risk of different carbon emissions positions.

A tenor correlation of 99% is set for trades of the same type of commodity, but with differing maturities. Isda recommended allowing the use of a 99.6% correlation due to observing higher correlations between spot and futures of EUAs. For a typical carry trade, Isda’s study found that this change alone could reduce capital requirements by 40% compared with the Basel text. In a hypothetical trade, the combined relief from moving to the lower risk-weight bucket and the higher correlation parameter would result in a 60% decrease in capital.

The previous revisions to the CRR established the FRTB as a reporting requirement in Europe and set a 99% correlation parameter for all commodities. The leaked draft EU proposals do not make any amendments to the tenor correlation.

Turning the FRTB into a capital requirement is just one in a vast package of amendments contained in CRR III, which will incorporate the final elements of the Basel Committee’s reforms released in December 2017, including a floor on the capital discount banks can benefit from using internal models rather than standardised approaches.

The draft proposals dated October 20 will be included in the agenda for a meeting of the EC’s college of commissioners on October 27. If approved during the meeting, the draft proposals will be published shortly after.

Isda and the Basel Committee declined to comment on the development.

Editing by Philip Alexander

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