Focus: Financial services licensing of carbon markets participants
12 April 2012
In brief: Recent amendments to the Corporations Regulations and guidance from the Australian Securities and Investments Commission establish the financial services licensing regime that will apply to carbon permits and derivatives over them from the commencement of the carbon pricing scheme. Partner Grant Anderson and Senior Associates Penelope Barclay and Simon Lewis report.
- Regulated emission units as financial products
- Interim arrangements
- New exemptions
- Emissions abatement projects
- Disclosure documents
- Next steps
How does it affect you?
- The carbon pricing scheme will commence on 1 July 2012.
- As from that date, carbon units issued under the carbon pricing scheme, Australian carbon credit units issued under the Carbon Farming Initiative, and certain international emissions units (such as Certified Emissions Reductions or CERs) will be financial products for the purpose of the Corporations Act 2001 (Cth) and so it may be necessary to obtain an Australian Financial Services Licence (AFSL) in order to deal in, advise on, or make a market for, these kinds of carbon permits.
- Under interim arrangements that expire on 31 December 2012, entities that would otherwise require an AFSL may be registered by the Australian Securities and Investments Commission (ASIC) and, on the basis of that registration, may provide financial services in relation to these kinds of carbon permits. However, such entities will need to obtain an AFSL in order to continue providing these services after 31 December 2012.
- Even though these kinds of carbon permits will only become financial products as from 1 July 2012, dealing in, advising on, or making a market for, derivatives over them prior to or after that date may require an AFSL (as the interim arrangements do not extend to such derivatives).
- The amended Corporations Regulations set out a number of useful exemptions from the requirement to hold an AFSL in respect of carbon permits and derivatives over them, however these exemptions include a number of conditions that need to be met before they can be relied upon.
- The ASIC Regulatory Guide 236: Do I need an AFS licence to participate in carbon markets? (the Guide) provides a useful starting point for understanding the financial services licensing regime that will apply.
In general, a person (or other entity) will require an AFSL in order to carry on a 'financial services business' in Australia that is, a business of providing financial product advice, dealing in a financial product or making a market for a financial product1. It should be noted that ASIC takes a very wide view of what is classified as 'carrying on a business' (for example, entering into a single transaction could, in certain circumstances, constitute carrying on a business) and that this view is, to an extent, supported by case law.
However, two important existing exemptions from the requirement to hold an AFSL are:
- the 'related body corporate' exemption an AFSL is not required to be held by a person to the extent the person provides such financial services only to its related bodies corporate2. This exemption does not apply where the entity receiving the service is not strictly a related body corporate, for example where it is an incorporated joint venture in which the corporate group of which the person is a member holds only 50 per cent or less of the shares; and
- the 'self dealing' exemption an AFSL is not required to be held by a person to the extent the person deals in (ie acquires, issues, varies or disposes of) a financial product on its own behalf. An exception is that, where the person acquires or disposes of an over-the-counter (or 'OTC') derivative, as opposed to an exchange-traded derivative, the self dealing exemption does not apply3.
Under the carbon pricing scheme, which is established by the Clean Energy Act 2011 (Cth), large greenhouse gas emitters in the stationary energy, industrial processing, resources and waste sectors, as well as natural gas suppliers, will be required to surrender sufficient carbon permits to the Clean Energy Regulator to cover the emissions for which they are responsible, failing which they will face a unit shortfall charge. There are three types of carbon permits that may be used for this purpose:
- Carbon units issued by the Clean Energy Regulator under the Clean Energy Act (carbon units) during the initial three-year fixed price phase of the carbon pricing scheme, liable entities will be able to acquire all of their carbon unit requirements from the Clean Energy Regulator at a fixed price (with these carbon units being subject to immediate and automatic surrender), so the only carbon units that will be able to be traded will be those that are issued for free to emissions-intensive trade-exposed industry participants under the Jobs and Competitiveness Program and to emissions-intensive coal-fired electricity generators under the coal-fired electricity generation assistance program. Even then, trading will be minimal because such units expire on the 1 February following their 'vintage' year and they can be sold back to the Regulator prior to that time. During the following floating price phase, carbon units will be supplied through auctions conducted by the Regulator, as well as through these industry assistance programs. Such carbon units will be able to be banked indefinitely and so can be traded on the secondary market.
- Australian carbon credit units (ACCUs) generated by land-based carbon sequestration and offset projects under the Carbon Farming Initiative a liable entity will be entitled to use Kyoto-compliant ACCUs to acquit up to 5 per cent of its annual emissions liability during the fixed price phase of the carbon pricing scheme and to acquit an uncapped amount of its annual emissions liability during the floating price phase of the scheme. This will encourage trading in Kyoto-compliant ACCUs throughout both phases of the carbon pricing scheme.
- Certain prescribed international emissions units (such as Certified Emissions Reductions, or 'CERs', which are issued under the Kyoto Protocol Clean Development Mechanism) (eligible international emissions units) while eligible international emissions units cannot be used to acquit a liable entity's emissions liability during the fixed price phase of the carbon pricing scheme, during the floating price phase a liable entity will be able to acquit up to 50 per cent of its annual emissions liability using such units. This will encourage trading in such international emissions units during the floating price phase of the carbon pricing scheme.
Of course, it is not only the physical carbon permits that will be traded. In order to hedge their carbon price risk under the carbon pricing scheme, liable entities will buy and sell derivatives over floating price phase carbon units, as well as Kyoto-compliant ACCUs and eligible international emissions units. Traders and other financial intermediaries will also participate in the purchase and sale of both the physical carbon permits and derivatives over them.
Finally, non Kyoto-compliant ACCUs (see our Focus articles: Carbon pricing scheme and Carbon Farming Initiative legislation passed) and and eligible international emissions units can be traded on the voluntary market (eg they may be purchased by corporate social responsibility buyers), and eligible international emissions units may be purchased for trading in overseas markets. Again, this will entail trading in both the physical carbon permits and derivatives over them, albeit not for the purposes of the carbon pricing scheme.
Given the expected importance, in particular, of OTC derivatives over carbon permits that may be used to acquit emissions liabilities under the carbon pricing scheme, it is appropriate that the Government has provided for additional exemptions to apply so as to avoid the need for an AFSL to be held where the purpose of dealing in the carbon permits and derivatives is to manage obligations under the carbon pricing scheme.
Having said this, the exemptions come with a number of conditions that will need to be satisfied before they can be relied upon. While specialist legal advice should therefore be sought, anyone proposing to be involved in carbon markets (especially those new to the regulation of financial products) will find it helpful to read the Guide as a first step.
Carbon units, ACCUs and eligible international emissions units (referred to in the remainder of this article as regulated emissions units) are deemed to be financial products as from 1 July 2012 (when the carbon pricing scheme comes into operation)4. In addition, ACCUs and eligible international emissions units are deemed not to be financial products until that date.
There are other emission and environmental instruments traded in Australia and overseas (for example, renewable energy certificates) which, at least in ASIC's view, are not financial products as they are ordinarily acquired to prevent a particular outcome (for example, paying a charge), rather than to manage financial risk5. Carbon units would fall within this category, as they are acquired so that they can be surrendered in order to avoid a unit shortfall charge, and so it appears that it is indeed necessary to expressly provide for carbon units (as well as the other kinds of regulated emissions units) to be financial products.
No such deeming is necesary for 'derivatives' over regulated emissions units or other emission and environmental instruments to be financial products. Generally speaking, a derivative is defined as arising if there is a contract (or other arrangement) between two or more parties under which an amount is payable at a future time and that amount (or the value of the arrangement) is ultimately determined, derived from or varies by reference to the value or price of something else6. Recent case law has confirmed that this definition is not to be read down, even in situations where it seems inappropriate that the arrangement in question be regulated as a derivative.7 So, for example, a contract to acquire regulated emissions units (or any of these other market-traded emission or environmental units) in the future, or an option to do so, could be a derivative8. This means that, even if the subject of the derivative is not a financial product, the derivative itself will be, and so an AFSL will be required now to permit dealings in derivatives over regulated emissions units (and other market-traded emission or environmental units) unless a relevant exemption applies.
In recognition of the imminent commencement of the carbon pricing scheme, and the time that it takes to be issued with an AFSL, the amended Corporations Regulations provide for an interim registration scheme under which entities that provide financial services in relation to regulated emissions units, and that would otherwise be required to hold an AFSL for that purpose, may be registered by ASIC and (on the basis of that registration) will be authorised to provide those services up to 31 December 2012 without actually holding an AFSL. All such registrations will automatically expire on 31 December 2012. After that date, an entity that wishes to continue to provide these financial services will need to hold an AFSL. Indeed, a condition of being able to take advantage of these interim arrangements is that the entity must have applied for an AFSL by no later than 31 October 2012. Applications for registration may be made between 1 May 2012 and 30 June 20129.
The Corporations Regulations have been amended to include two significant new exemptions.
The first exemption is that a person is not required to hold an AFSL to the extent that the person is dealing with (eg acquiring or disposing of) a regulated emissions unit on behalf of a related body corporate or an associated entity that is a liable entity under the carbon pricing scheme10. An associated entity includes an entity over which the person has control or a significant influence11. So, for example, a company will not be required to hold an AFSL where it buys and sells carbon units on behalf of group members that are liable entities, thereby enabling the trading function to be centralised in one group member. This is so whether those regulated emissions units are being used to acquit an emissions liability under the carbon pricing scheme or are being traded for 'speculative' purposes.
The second exemption is that a person is not required to hold an AFSL to the extent that the person is dealing only in regulated emissions units, derivatives over them and/or foreign exchange contracts for regulated emissions units and the following conditions are met:
- the service does not involve the making of a market;
- the dealing is entered into for the purpose of managing financial risk in relation to the surrender, cancellation or relinquishment of regulated emissions units by the person or its related bodies corporate or associated entities;
- such dealings are not the principal activity of the person's business; and
- the dealing is entered into on the person's own behalf or on behalf of a related body corporate or associated entity12.
This will allow a person to buy and sell OTC derivatives over regulated emissions units without being required to hold an AFSL where the purpose of that trading is to manage the carbon price risk that it, or a related body corporate or associated entity, faces in dealing in regulated emissions units for the purpose of acquitting emissions liabilities under the carbon pricing scheme. For example, it would allow the purchase and sale of forward contracts and options used to hedge that exposure. However, there are two important limitations to this exemption:
- the principal activity of the person's business must not be dealing in regulated emissions units, derivatives over them or foreign exchange contracts for them this is a more generous threshold than the requirement that such dealing must not be a 'significant' part of the person's business as is required elsewhere13, but it still means that it will not be possible to rely on this exemption where such dealings are centralised in a special purpose group member; and
- the purpose of the dealing must be to manage financial risk in relation to the surrender, cancellation or relinquishment of regulated emission units this is somewhat narrower than the purpose of merely managing a financial risk that arises in the ordinary course of a business14, and would not be satisfied where the purpose is 'speculative' trading, although it arguably should be satisfied where derivatives over regulated emissions units are acquired to manage the carbon price risk associated with acquiring regulated emissions units for surrender under the carbon pricing scheme but it transpires that not all of those units are needed for that purpose (eg because emissions are lower than expected)15.
It should be noted that these two exemptions only relate to dealing. They do not extend to exempt a person from the existing requirements in relation to the provision of financial product advice (ie providing a recommendation or opinion that is intended to, or could reasonably be regarded as intending to, influence another person's decision about a financial product16) or the making of a market (ie regularly quoting the prices at which the person is willing to trade in financial products on its own behalf17). However, a further exemption is provided for the recipients of free carbon units under the Jobs and Competitiveness Program and the coal-fired electricity generation assistance program. The recipients of these units are able to state the price of their units without that constituting the making of a market18.
To the extent a person is required to hold an AFSL, a useful summary of what is involved in obtaining and operating under an AFSL is provided in Part F of the Guide.
Projects that are approved under the Carbon Farming Initiative may create both Kyoto and non-Kyoto compliant ACCUs, and projects that are approved under the Clean Development Mechanism may generate CERs (a specific type of international emissions unit). It is not uncommon for such projects to be financed through the forward selling of the units from the project at a fixed price (with either the seller or the buyer taking volume risk). Such forward selling may prima facie constitute a derivative because the value of the arrangement depends on the market price of the units at the time they are created and transferred to the buyer.
However, it is also possible that the arrangement will constitute a 'managed investment scheme'. Broadly speaking, a managed investment scheme can arise when someone arranges with others to pool money or other assets and uses those assets to gain a benefit for those involved19. The pooling of contributed money or other assets to establish an emissions abatement project which then generates regulated emissions units that are purchased by the contributor(s) could fit within this definition20. The significance of this is that such an arrangement is then excluded from being a derivative21, with the result that normally there will be no requirement for the investors (as opposed to the project manager) to hold an AFSL. In addition, if retail clients are involved, there are other onerous requirements that managed investment schemes must comply with.
The financial services regime distinguishes between 'wholesale' and 'retail' clients, providing a higher standard of consumer protection to 'retail' clients (eg dispute resolution and compensation procedures are required to be put in place for retail clients). There are a number of criteria used to determine whether a person is a 'retail' client, including if they receive a financial service in relation to a financial product whose value exceeds a prescribed threshold (presently, generally $500,000). It seems likely that trading in regulated emissions units for compliance purposes will occur in contract sizes exceeding this threshold and it is not expected that there would be a sizeable retail market for these kinds of units. However, this might not be the case in respect of regulated emissions units that are traded for voluntary purposes or that are created as part of Carbon Farming Initiative or Clean Development Mechanism projects.
Ordinarily a Product Disclosure Statement (PDS) must be issued to a retail client in connection with the issue of a financial product, setting out the key features of the financial product; however, the Corporations Regulations provide an exemption from this requirement in respect of regulated emissions units22. Instead, it is provided that a retail client must be directed to a description of each of the types of the regulated emissions units, prepared by the Clean Energy Regulator, where a PDS would ordinarily be needed. However, a PDS will still be required for derivatives over regulated emissions units or for an interest in a managed investment scheme that relates to regulated emissions units.
In light of the fact that regulated emissions units are relatively novel financial instruments that have not previously been regulated by the Corporations Act, ASIC has amended Regulatory Guide 146: Licensing: Training of financial product advisers, which applies to holders of AFSLs. Under Guide 146, regulated emissions units will be treated as more complex Tier 1 products (as opposed to the more simple Tier 2 products), requiring a higher standard of training for advisers who deal with retail clients.
Because the Australian financial services regime is quite complex, we suggest that you seek legal advice in determining whether or not any activities you may undertake in connection with regulated emissions units or derivatives over them require you to hold an AFSL or fall within the conditions for an exemption from that requirement.
- Corporations Act, s766A(1)(a)-(c). Other activities that require an AFSL include providing a custodial or depository service, eg holding a financial product on trust for a client or the client's nominee.
- Corporations Act, s911A(2)(i).
- Corporations Act, ss761E(5), 766C(1), (3).
- Corporations Act, new s764A(1)(kaa) (which comes into effect on 1 July 2012; Corporations Regulations, reg.7.1.07I.
- The Guide, pars 69-72.
- Corporations Act, s761D(1) and Corporations Regulations, reg.7.1.04. There are some exceptions in the definition. For example, a contract to buy 'tangible property' where the contract cannot be cash-settled will generally not be caught.
- International Litigation Partners Pte Ltd v Chameleon Mining NL  NSWCA 50. This case is presently on appeal to the High Court.
- Regulated emissions units and other market-traded emission or environmental units are not tangible property cf Corporations Act, s761D(3(a) and Corporations Regulations, reg.7.1.04(4).
- Corporations Regulations, reg 7.6.02AGA
- Corporations Regulations, reg.7.1.35C.
- See Corporations Act, s50AAA.
- Corporations Regulations, reg.7.6.01(1)(ma).
- Cf Corporations Regulations, reg.7.6.01(1)(m)(iv).
- Cf Corporations Regulations, reg.7.6.01(1)(m)(iii).
- Cf the Guide, par.123.
- Corporations Act, s766B.
- Corporations Act, s766D.
- Corporations Regulations, reg.7.1.08A.
- Corporations Act, s9.
- Another example is where the pooled money is used to trade in regulated emissions units, with the proceeds (in the form of money or units) being returned to the investors; see also the Guide, pars 100-105.
- Corporations Act, ss 761D(3)(c), 7764A(1)(b), (ba); Corporations Regulations, reg. 7.1.04(7).
- Corporations Regulations, reg.7.9.09A-7.9.09C, Part 19 of Schedule 10A.
- Andrew MansourPartner, Sector Leader, Power & Utilities,
Ph: +61 2 9230 4552
- Penny NikoloudisPartner,
Ph: +61 3 9613 8816
- John BeckinsalePartner,
Ph: +61 7 3334 3520
- Geoff SandersPartner,
Ph: +61 3 9613 8673
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