Under EU law, European Union Allowances (EUAs) are classified as official financial instruments. Traded on exchanges within the European Union Emissions Trading Scheme (EU ETS) marketplace, EUAs have quantifiable financial characteristics just like other financial assets.
A cap-and-trade system, as its name implies, involves trading. Although it is fundamentally a regulatory tool designed to manage emissions, it depends on market mechanisms to establish an effective carbon price. To facilitate this, it requires a tradable financial instrument. EUAs were created for this very purpose, allowing the market to determine the price of carbon. Unlike a carbon tax system, where regulators set the price unilaterally, an ETS lets the free market establish the carbon price.
In the early years of the EU ETS, up until 2018, EUAs were only used for compliance trading. During this period, EUAs were mainly exchanged by industries and power producers that needed them to meet their emission reduction targets. They had less financial features and were not yet seen as the complex financial instruments that they have become today. Instead, their role was largely regulatory, focused on helping companies comply with emissions regulations rather than being as advanced of financial products as they are today.
EUAs came under the scope of the Markets in Financial Instruments Directive II (MiFID II) in 2018. This means that EUAs officially became financial instruments under European law.
MiFID II aims to make financial markets more transparent and protect investors. With this new framework, a wider range of participants were allowed to trade EUAs. This shift increased the liquidity and overall strength of the EU ETS market.
Since EUAs were brought under MiFID II, they have evolved into sophisticated financial tools. The market for carbon allowances now includes a wide range of participants, including investment firms and credit institutions, going beyond just industries and power producers. Starting in 2024, individual investors have also joined the EU ETS market.
EUAs are now analyzed using metrics like return on investment (ROI), volatility, market correlations, risk-reward measure... This has led to the development of technical trading strategies and specialized trading desks focusing on EUAs.
Carbon allowances have gone from simple compliance tools into elaborate financial assets bringing both returns and positive environmental impact.
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