The Role of Banks in EU Emissions Trading.

• Author: Cludius, Johanna

1. INTRODUCTION

   The theory of emissions trading generally focusses on the trading activities of regulated entities. In reality, however, non-regulated entities are also actively involved in the market for emission allowances. They often act as intermediaries and can improve market efficiency by reducing transaction costs (Stavins, 1995). Both in the theoretical and empirical academic literature, the role of the financial sector--in commodity markets in general and in emissions trading in particular--is under-exposed, and there seems to be limited analysis into the roles banks play in those markets.

   Our aim was to better understand the importance of banks involved in EU emissions trading, especially as trading partners of companies regulated under the EU Emissions Trading System (EU ETS), the so-called regulated companies. A better understanding of the role of banks in emissions trading is important, not only in an EU context. In some countries engaging in emissions trading, policymakers are becoming reluctant to facilitate the involvement of non-regulated entities (see the Korean ETS, International Carbon Action Partnership, 2018).

   To address this issue, we formulated the following research questions: 1) What are the different roles of banks in EU emissions trading? 2) How important are banks as trading partners for different types of regulated companies? To answer these research questions comprehensively, we employed two different approaches. First, we investigated the roles of banks in EU emissions trading, combining descriptive analysis of data covering the years 2005-2013 with semi-structured interviews. Second, we used regression analysis to investigate the determinants for regulated entities to choose banks or other types of financial players as trading partners during the first trading period of the EU ETS.

   The remainder of this paper is structured as follows: Section 2 provides a literature review and identifies possible research gaps. Section 3 presents the methods applied and describes the main data source, namely the European Union Transaction Log (EUTL). In Section 4, we analyze the data descriptively, linking it to interview outcomes in order to shed light on the different roles of banks in EU emissions trading. We also discuss regression results on the decision of regulated entities to interact with banks or other financial players. We summarize our findings and draw conclusions concerning policy implications in Section 5.

2. LITERATURE REVIEW

   Several studies have analyzed the data of the EUTL to gain general insights into trading activities under the EU ETS or have linked it with other data sets to understand the impact of the EU ETS in various areas. Conducting a cluster analysis of the EUTL dataset, Betz and Schmidt (2015) found that the vast majority of market participants are rather passive and that there is a small and diverse group of active participants, a large share of which are non-regulated entities. Other authors have used EUTL data to examine the influence of the EU ETS on emissions and investment behavior (Jaraite and Di Maria, 2016) or innovation (Calel and Dechezlepretre, 2016), assess its impact on company performance (Abrell, Faye, and Zachmann, 2011) or company share prices (Jong, Couwenberg, and Woerdman, 2014), as well as the joint impact on emissions and economic performance (Dechezlepretre, Nachtigall, and Venmans, 2018).

   Martino and Trotignon (2013) did an extensive descriptive analysis of the EUTL dataset and provided important insights into how the forward and future markets work and the role of clearing houses, while Ellerman and Trotignon (2009) used the EUTL to track the export and import of allowances out of and into national registries (using surrender data before transfer data became available). Borghesi and Flori (2018) applied network analysis to the EUTL data at country level and found that non-regulated entities have played a prominent role in the transaction of allowances and influenced the configuration of the system significantly, suggesting further research on this topic.

   Another strand of literature has looked more specifically at trading practices in the EU ETS. A paper by Jaraite-Kazukauske and Kazukauskas (2015), which is closely related to the regression analysis carried out in this paper, assesses the impact of transaction costs on trading in the EU ETS. In this context, they also examined the determinants of firms to trade only indirectly (i.e., with non-regulated entities) compared to those trading directly (with other regulated firms). They found that companies with more than one installation are less likely to trade only via intermediaries. This was also found to hold for companies that are large in terms of their emissions, a result echoed by Heindl (2012a), who--using outcomes from a survey among German companies--determined that regulated companies with larger trading volumes are more likely to trade directly with other companies, while those with lower trading volumes make use of intermediaries.

   Jaraite-Kazukauske and Kazukauskas (2015) discovered that firms in the electricity sector are more likely to trade indirectly, even after controlling for size, which they explained with the importance of hedging for these companies. Schopp and Neuhoff (2013) assessed the hedging behavior of electricity companies based on interviews and found that financial players are often used as partners in such hedges. The carbon market is a compliance market where the government is the original seller or issuer of the product (i.e., carbon allowances). Therefore, the market lacks typical sellers who want to hedge against falling prices of allowances and would act as the counterparties for buyers wanting to hedge against increasing prices (Schneck and Monast, 2011). In the EU carbon market, the financial sector, and banks in particular, have assumed the role of hedging partner.

   Based on this research, Neuhoff et al. (2015) projected developments with regard to the demand for allowances taking into account the hedging behavior of electricity firms. Also using EUTL data, Zaklan (2013) looked at company-level determinants for trading and also addressed the question whether companies are more likely to shift allowances internally or trade them on the open market. He determined that active trading of EU allowances is driven by the size (measured by turnover) of a company, its sector and ownership structure, as well as the level of free allocation.

   Cludius (2018) investigated the drivers for gains and losses made on the EU emissions market and found that the level of excess allocation as well as the choice of when to enter the market are important in driving gains and losses of regulated companies. She also discovered that large companies (both in terms of their emissions and the number of accounts held) and companies short on trading allowances were more likely to become active during the first period of EU emissions trading.

   There is also literature that assesses the role of different players in EU emissions trading. Balietti (2016) analyzed the influence of different market participants on volatility using data from the EUTL and found that the financial sector is active during times of particularly low and high volatility, reflecting its important role as a service provider. Also using data from the EUTL, Fan, Liu, and Guo (2016) examined the influence of the trading behavior of regulated companies and financial intermediaries on the carbon price and established that such behavior is significant in explaining price movements and variance. While these two studies examine the importance of the financial sector for carbon price movements, they do not look into the different services that financial players such as banks have offered to regulated companies and how those services have influenced their trading decisions.

   Overall, the focus of the empirical literature on trading activity under the EU ETS to date has been on regulated rather than non-regulated entities. In this context, non-regulated entities are often treated as a group and not differentiated further. This differentiation, however, is important as new regulations affecting trading in the EU--in particular the Markets in Financial Instruments Directive (MiFID) II, which came into force in January 2018--apply to banks, but not to other financial entities.

   With this paper, we add to the literature by describing the particular role of banks compared to other financial intermediaries in more detail. We explicitly modelled the choice of regulated companies to interact with banks or other types of financial actors. Our aim was also to understand how banks differ from other financial intermediaries such as brokers and exchanges.

   According to more general literature not related to the EU ETS, the key role of intermediaries is in reducing friction, such as the transaction costs of finding trading partners or evaluating assets, and in reducing asymmetric information (Leland and Pyle, 1977). Taking a functional perspective, Allen and Santomero (1998) differentiated three functions of general intermediaries: i) supporting distribution, ii) origination and servicing (e.g., commodity measurement or evaluation of creditworthiness), and iii) allocation of risk at minimum cost. In their empirical analysis, Allen and Santomero (1998) showed that risk management activities in particular become more important in financial markets over time as intermediaries increase their share in trading derivatives at exchanges or OTC, while direct participation by individuals declines significantly.

   These results may be explained by the work of Pirrong (2014), who argued that the transaction cost-reducing rules of exchanges, such as mandatory membership to reduce counterparty risk and the use of clearing houses, allow exchanges to exercise market power and derive monopoly rents by limiting market entry. As a result, trading for...