Alignment Needed Between Capital Rules and Carbon Certificates

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Throughout the evolution of Basel III, policy-makers have had to strike a balance in setting risk-based capital requirements. Rules need to be tough enough to promote financial stability, but not so punitive that they risk choking off banks’ ability to support the real economy. Recent analysis has shown that excess conservatism in parts of the capital framework could hamper efforts to transition to a carbon-neutral economy, which is an outcome we must avoid.

The issue lies in the section of Basel III known as the Fundamental Review of the Trading Book (FRTB), which sets stringent capital requirements for market risk and is due to be implemented in January 2023. In its current form, the FRTB would lead to disproportionately high capital requirements for carbon certificates, which would constrain banks’ ability to support the global reduction of emissions.

Trading of carbon certificates, both through regulated emissions trading systems (ETS) and voluntary markets, is a critically important mechanism that will enable countries around the world to efficiently reduce their net emissions in the years to come. In a typical ETS, a cap is set on the level of emissions and carbon certificates can be traded to comply with that cap in the most economically efficient way.

As countries around the world push harder to reduce emissions, demand for carbon trading is certain to increase. Banks will play a key role in supporting the growth of the market, so it is vital that the regulatory framework does not impair their ability to act as counterparties in the buying and selling of carbon certificates.

ISDA’s analysis has identified two particular issues with the calibration of the FRTB. First, under the FRTB’s standardized approach, carbon certificates would attract a 60% risk weight. This is twice that of crude oil, for example, and ISDA’s analysis of volatility during periods of stress suggests the risk weight should be 37%. Reducing the risk weight to this level could reduce capital charges by nearly 40%.

Second, the FRTB applies a correlation of 0.99 between spot and forward positions, but using data on EU allowance trades shows this correlation should be around 0.996. The difference may seem small, but in a typical carry position the higher correlation could lead to a 40% drop in capital requirements.

A new ISDA paper presents our analysis of the impact of the FRTB on carbon trading. It proposes that the risk weight for carbon certificates should be reduced to 37% and a tenor correlation parameter of 0.995-0.999 should be adopted for carbon certificates to reflect the findings. It’s important to stress that this remains a conservative calibration. We are not advocating for special treatment for carbon certificates, but rather risk-appropriate capital requirements that support rather than constrain the growth of the market.

Ultimately banks will make their own decisions about the businesses in which they are active. But if the regulatory framework penalizes them with unduly high capital requirements for the trading of carbon certificates, they will naturally retreat from that market. Policy-makers tend to agree that carbon trading will be central to the success of the global drive towards net zero in the years ahead. Basel III must be appropriately calibrated to avoid thwarting progress on climate change.

To read the ISDA paper, Implications of the FRTB for Carbon Certificates, click here.

Documents (0) for Alignment Needed Between Capital Rules and Carbon Certificates