The object of this article is to provide a first analysis of the possible characterization of carbon credits and derivatives relating to carbon credits under Swiss law. 

By François Rayroux / Delphine Meylan / Laure Prevignano* (Reference: CapLaw-2022-36)

1) Introduction

Carbon credits, also known as CCs, emission allowances or carbon offsets, were officially set up under the United Nations’ 1997 Kyoto protocol on climate change as an attempt to committing industrialized countries and economies in transition to limit and reduce greenhouse gases (GHG) emissions in accordance with agreed individual targets. 

Generally speaking, in the financial industry, a carbon credit is a “tradable permit or certificate that is issued by a government under an ETS. It provides the holder with the right to emit one ton of CO₂ or an equivalent amount of another GHG” (see the definition of the International Swaps and Derivatives Association (ISDA); ISDA, Report on the Role of Derivatives in Carbon Markets, p. 4).

In light of the growing importance of the fight against climate change, the carbon market, organised around the purchase, either on a mandated or voluntary basis, of these certificates, has experienced significant growth in size and sophistication. However, despite – and perhaps because of – such a rapid development, the regulatory approach of carbon credits across jurisdictions is considerably disparate. 

Whereas certificates issued under mandatory emissions trading schemes are regarded as financial instruments in some legal systems, i.e., a characterization which may trigger licensing requirements when such products are traded, carbon credits may be bought and sold with virtually no requirements in other legal systems. Similarly, the triggers of regulation regarding carbon credits also significantly vary amongst the various jurisdictions.

Interestingly, under Swiss law, the legal characterization of carbon credits is not – yet – addressed. However, this matter is of particular relevance as the Federal Department of Finance is expected to publish a draft revision of the Financial Market Infrastructure Act (FMIA) for public consultation by the end of the year, and this question will most likely be addressed in this upcoming revision. 

The Federal Act on the Reduction of CO₂ Emissions (CO₂ Act) defines emission allowances as tradable rights to emit GHG allocated or auctioned by the Swiss Confederation or by states or communities of states with emission trading schemes (ETS) recognised by the Swiss Federal Council (see article 2(3)). This definition stems from the Agreement between the European Union and the Swiss Confederation on the linking of their greenhouse gas emissions trading systems and merely characterizes an emission allowances certificate as a “document” attesting reductions in emissions achieved. Similarly, financial markets regulations such as the Swiss Financial Services Act (FinSA) or FMIA do not define the notion of emission allowances nor address their legal nature. Thus, for the time being, carbon credits are neither defined nor characterized within the current Swiss legal framework. 

In light of this lack of clarity, it is worthwhile examining how carbon credits as well as transactions on carbon credits such as derivative contracts would be analysed under Swiss law, in particular in comparison to their treatment within the European legal framework. Eventually, it may be upon the basis of these considerations that the Swiss legal framework will be further developed. That being said, an analysis of the existing Swiss and European legal framework also shows that there are strong rationale for the discrepancies between those two systems, which should not be overlooked.

2) Current Swiss Legal framework 

As a first step, the question arises as to whether carbon credits as such are to be considered financial instruments within the meaning of article 3 let. a FinSA. In particular, the question is whether these products would qualify as “securities” under Swiss law. 

Pursuant to article 2 let. b FMIA, in conjunction with article 3 let. b FinSA, securities are defined as any “standardised certificated and uncertificated securities, in particular uncertificated securities in accordance with Article 973c of the Code of Obligations (CO) and ledger-based securities in accordance with Article 973d of the CO, as well as derivatives and intermediated securities, which are suitable for mass trading”.

In view of this definition, one can legitimately doubt the fact that carbon credits certificates could be considered as “standardised”. As a matter of fact, they seem to be highly heterogeneous, since each credit has features and attributes which are associated with the underlying project or place where it was carried out. In that sense, one could rather characterize carbon credits as widely non-standardized. Additionally, it is worthwhile noting that the SIX Swiss Exchange currently considers that these products are not tradable on a Swiss trading venue. Generally, carbon credits cannot be characterized as securities under article 3 let. b FinSA.

Likewise, it appears difficult to subsume carbon credits as such under another alternative provided for in Art. 3 let. b FinSA such as structured products (article 3 let. a cypher 4), derivatives in accordance with article 2 let. c FMIA (article 3 let. a cypher 5 FinSA), or bonds (article 3 let. a cypher 7 FinSA), among others. 

Therefore, we are of the view that, carbon credits certificates, as such, would neither characterize neither as securities nor as any other financial instrument defined in article 3 let. a FinSA, and, as a result, would not fall into the scope of the FinSA.

As a second step, it is relevant to consider the legal characterization of derivatives transactions relating to carbon credits certificates (such as forwards or options). In that context, it seems that such OTC derivatives transactions may be characterized as derivatives transactions as defined by article 2 let. c FMIA, that is “financial contracts whose value depends on one or several underlying assets and which are not cash transactions”. Hence, derivative contracts relating to carbon credit certificates would fall into the scope of the FMIA, triggering the application of the FMIA market conduct rules laid down in articles 93 to 117 FMIA, unless an exemption applies.

In addition, if the conclusion of derivatives on carbon rights is considered to be a financial service within the meaning of article 3 let. c FinSA, the financial service provider would be required to implement the FinSA rules of conduct and organizational measures (which will not be addressed in further details in this contribution). Of note, so-called proprietary trading activities (Gegenparteigeschäfte) are not considered to be a financial service under the FinSA and are, therefore out of the scope of the FinSA.

Regarding the implementation of the FMIA market conduct rules, one should examine whether an exemption provided by FMIA would be applicable to OTC derivatives transactions relating to carbon credits. In this context, three possible exemptions may spring to mind: spot transactions as defined in article 2 (3) let. a and para 4 FMIO, derivatives transactions relating to climatic variables pursuant to article 2(3) let. c FMIO, as well as derivatives transactions relating to commodities as defined in article 94(3) let. c FMIA.

– Spot transactions are deemed to be transactions that are settled either immediately or following expiry of the deferred settlement deadline within two business days, including transactions that are continuously extended without there being a legal obligation or without such an extension between the parties being usual (such as rolling spots). Since Spot transactions are not deemed to be derivatives pursuant to article 2(3) let. a FMIO, Spot transactions relating to carbon credits would be entirely out of scope of the FMIA requirements and conduct rules.

– Similarly, pursuant to article 2(3) let. c FMIO, derivatives transactions relating to climatic variables, freight rates, inflation rates or other official economic statistics that are settled in cash only in the event of a default or other termination event are not considered to be derivatives in the sense of the FMIA and are, hence, out of scope. 

– Derivatives transactions relating to commodities are considered to be derivatives as defined by article 2 let. c FMIA but are exempted from the FMIA market conduct rules (i.e., clearing, reporting and risk mitigation duties) if they meet the following cumulative requirements (article 94(3) let. c FMIA):

(a) The transaction is physically delivered,

(b) The transaction cannot be settled in cash at a party’s discretion, and

(c) The transaction cannot be traded on a trading venue or on an organized trading facility.

With respect to the exception of article 2(3) let. c FMIO, there is nothing under Swiss laws nor in the case law that would currently support a view that carbon credits would enter into the scope of this exception.

With respect to the commodities exception provided for under article 2 let. c FMIA, neither Swiss laws nor case law address the nature of derivatives relating to carbon credit certificates. However, Annex 2 of the FMIO – “Data to be reported to a trade repository” expressly lists “emissions” under the section “commodities underlying”. Based on this reference, it could be argued that the Federal Council considers that emissions are a sub-category of commodities when publishing its Ordinance. A historic interpretation of the law does not provide for any more guidance. Indeed, neither the explanatory material such as the Message of the Federal Council on the FMIA of 3 September 2014 nor the Explanatory Report on the FMIO of 25 November 2015 address the question of the legal nature of derivatives relating to carbon credits. From a teleological standpoint, there would be some merits in regarding emission allowances and carbon credit certificates as commodities in light of their similarities. 

Consequently, there are arguments to consider that derivatives relating to emission allowances and carbon credit certificates may be regarded as commodities under the FMIA. As a result, such transactions would certainly be considered as derivatives, yet would not be subject to the FMIA market conduct rules mentioned above. 

Thus, it seems worthwhile to considering and addressing the handling of carbon rights derivatives at the international level and to confronting the above-mentioned approach. 

Finally, it is important to specify that in a purely cross-border context, i.e., where entities not based in Switzerland trade in derivatives transactions on carbon credits (such as forward on voluntary emissions reductions), the rules of the FMIA are not applicable to the non-Swiss counterparty. Thus, in such a case, a non-Swiss counterparty wishing to enter into such derivatives transactions in Switzerland would not be subject to any rules as a matter of Swiss law.

3) Overview of the European and International Legal Framework 

By international comparison, in several jurisdictions, carbon units tend to characterize as “commodities” with the result that most derivatives on carbon credits do not fall within the scope of the relevant laws. 

This seems to be the case in the United States, as VCCs characterize as commodities for the purposes of the Commodity Exchange Act (CEA), which defines VCCs very broadly (see Section 1a (9) CEA). As a result, the Commodity Futures Trading Commission (CFTC) enjoys enforcement authority over markets in VCCs and has taken various steps to assess its role in recent years (see ISDA, Voluntary Carbon Markets: Analysis of Regulatory Oversight in the US, p. 6). That being said, there currently is no overarching federal regulation that addresses the legal nature of VCCs in the United States (see ISDA, Legal Implications of Voluntary Carbon Credits, p. 14). In summary, swaps and options related to carbon credits certificate may trigger licensing requirements if cash-settled (irrespective of whether they are traded on exchange or OTC), while exchange-traded future contracts related to carbon credits are subject to regulation irrespective of whether cash or physically settled. In addition, contracts related to carbon credits falling within the forward contract exclusion from the swap definition do not trigger licensing requirements although they are subject to anti-manipulation requirements. 

Similarly, we understand that in Singapore, there is no specific legislation covering the trading of carbon credits. Thus, relevant transactions (including spot, forwards, options, swaps or futures) do not fall under the major relevant market regulation (for more information, see the National Climate Change Secretariat of Singapore’s website under: https://www.nccs.gov.sg/singapores-climate-action/carbon-services-and-climate-finance/).

By contrast, at the European Union level, when considering the regulatory treatment of carbon credit certificates, it is of primary importance to distinguish between mandatory and voluntary carbon credits. The former refer to emission allowances (EUAs) consisting of any units recognised for compliance with the requirements of the EU Emissions Trading Scheme (EU ETS), whilst the latter refers to all other CCs which can be acquired by entities wishing to voluntarily offset their emissions (EUVCCs). 

The first primary difference between VCCs and EUAs relates to their issuance process. On the one hand, EUAs are allocated through auctions organized directly by the EU ETS to which most categories of market participants can participate in (see also: https://www.epa.ie/our-services/licensing/climate-change/eu-emissions-trading-system-/auctioning/). Most of the EU member States have procured the German regulated market European Energy Exchange (EXX) as the common platform to hold those auctions. On the other hand, VCCS are generated by third organizations, who are often project developers who design and implement real-world carbon reduction projects, leading to a reduction of one ton of GHG from the atmosphere. There is therefore no statutory or either legal framework regulating the creation of voluntary carbon units, which leads to non-homogenous carbon credits, whose quality depends of the underlying project. 

The second significant difference between these two categories of carbon credits relates to their legal treatment. Generally speaking, the European carbon market is mostly regulated by the rules of the Markets in Financial Instruments Directive (MiFID), the rules of the European Market Infrastructure Regulation (EMIR) as well as the rules of the Market Abuse Regulation (MAR) (see Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments ; Regulation (EU) 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories; Regulation (EU) 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse).

Under the MiFID, spot transactions in carbon credits were not considered as financial instruments, whilst derivatives transactions relating to carbon credits could fall within the scope of regulation where “they must or may be settled in cash or have the characteristics of other derivative financial instruments”. This meant that market participants were subject to potential licensing when they traded carbon credits in the form of derivatives. 

However, since the coming into effect of the MiFID II in 2018, all EUAs are classified as financial instruments (see point 11, Annex I, Section C of MiFID II). The MiFID II classifies EUAs, i.e. carbon credits complying with the EU ETS, as a new type of financial instrument (see point 11, Annex I, Section C of MiFID II). What’s more, they are viewed and considered to be financial instruments irrespective of how or where they are traded or settled, and in particular irrespective of whether they are traded spot or in derivative format (see point 4, Annex I, Section C of MiFID II). Hence, market participants within the mandatory carbon market must meet reporting requirements under the MiFID II (see Art 26 Obligation to report transactions and Art 27 Obligation to supply financial instrument reference data of Regulation (EU) No. 600/2014 of the European Parliament and of the council of 15 May 2014).     

On the other hand, MiFID II does not classify EUVCCs as financial instruments. The voluntary carbon market indeed mostly functions independently of the compliance market and stays therefore largely unregulated. Nonetheless, although EUVCCs are generally not seen as financial instruments, derivatives on VCCs will be characterized as such if they meet the conditions of at least one of the categories of financial instruments listed out in Section C of Annex I to the MiFID II.

Derivatives on VCCs will usually meet these requirements and therefore become regulated financial instruments (see ISDA, Legal Implications of Voluntary Carbon Credits, p. 11). In this constellation, regulatory requirements under MiFID II and EMIR will consequently apply. 

4) Brief Comparative Analysis

In light of the above, considering the international characterization of these products, and more precisely the European legal system’s approach of carbon credits and transactions relating to carbon credits against the Swiss legal system, two main distinctive features that can be noted.

First, one of the major distinctions relates to the division between voluntary and mandatory carbon emissions. For instance, this segregation plays a key role within the European financial architecture, given that the legal approach to carbon credits actually depends on it, as outlined above. By comparison, this differentiation is absent from the Swiss legal system, which does not provide for any specific treatment of carbon credit certificates as such as well as OTC derivatives transactions relating to carbon credit certificates.

Another relatively striking difference between the Swiss and European framework linked with the treatment of carbon credit certificates relates to their characterization as financial instruments. Once again, while European law views mandatory and, in some instances, voluntary carbon credit certificates as financial instruments, this is not the case under Swiss law, which does not currently provide for any specific treatment of these products and thus, does not approach them as financial instruments. 

Consequently, at first glance, one might wonder whether it would not be appropriate to draw inspiration from the European legislation and to characterize carbon credits as well as derivatives on carbon credits as financial instruments under Swiss law. However, it should be noted that the somehow more stringent rules applying within the European Union are particular to the European system: they stem from its specificities. What’s more, as mentioned above, carbon credits appear to fall outside the scope of the relevant laws both in the United States and in Singapore. In particular, they are not characterized as financial instruments.

By contrast, at the European level, the classification of carbon credits as financial instruments is made for the purposes of application of the EU financial markets regulation. It is not aimed to address the legal nature of carbon credits per se. This classification was primarily intended to reduce the risks around market abuse, to improve the efficiency of and accessibility to the carbon market as well as to strengthen investor confidence. Despite the material policy considerations behind MiFID II, the main policy drives relating to the European treatment of carbon credits appear to have evolved around market abuse, whose regulation is structured in a significantly different way than in Switzerland.

In short, most of the parameters that led to the regulation of EUAs are specific to the EU legislative architecture and political environment. They do not necessarily represent a set of universally applicable policy principles that mandate the trading in EUAs as a licensable activity. For all those reasons, not only the rules regarding carbon credits, but also their origin, nature and the whole financial architecture in which they are rooted profoundly differ between Switzerland and the European Union.

As a result, it would be simplistic to draw directly on the European legislation. Under Swiss law, as outlined above, there are good grounds for assuming that derivative contracts related to carbon credit certificates can be considered as commodity derivatives exempt from the market conduct rules under the FMIA, as they seem to be exempted from the relevant laws in the United States or Singapore. This approach to carbon rights is thus corroborated by a broader systematic interpretation. 

5) Conclusion 

The Swiss legislation is currently silent regarding the treatment of carbon credits. The uncertainty thereby generated may be detrimental to a rapidly developing market and to the competitiveness of Switzerland as a major financial centre. Thus, in the context of the upcoming revision of the FMIA, new specific rules related to the trading of carbon credits may be added. However, for the reasons mentioned above, it seems that it would be inappropriate for the Swiss legislator to follow the European rules without making necessary adjustments to Swiss specificities. 

For instance, the notion of financial instrument as conceived within the European Union does not have the same rationale and origins as the Swiss one. Furthermore, it is important for the competitiveness of the Swiss financial centre to maintain certain distinctive features as regards the regulatory treatment of carbon credits. These arguments will probably be heard during the upcoming revision of the FMIA. 

Besides, for the reasons mentioned above, derivatives transactions relating to carbon credits could already fit into the current legal framework and be treated as derivatives relating to commodities.

Such a solution seems to represent a proper response in view of the international developments and the particularities of the Swiss financial system. In any case, there would be a great value in preserving some flexibility for the carbon market within the Swiss legal framework. 

François Rayroux (francois.rayroux@lenzstaehelin.com)
Delphine Meylan (delphine.meylan@lenzstaehelin.com)
Laure Prevignano (laurehelene.prevignano@lenzstaehelin.com)

* The content of this article is the personal opinion of the authors. This opinion is not necessarily identical with the position of Lenz & Staehelin.