NZ ETS governance – financial markets regulation proposed for NZU markets

The proposal features in a fresh round of consultation on the market governance framework for the New Zealand Emissions Trading Scheme (NZ ETS). If implemented, the changes would materially impact many businesses and financial entities involved in the trading of NZUs.

This targeted engagement is a continuation of the consultation initiated by MfE in July 2021 on the market governance risks and proposed solutions for a governance framework for the ETS (see our 2021 article for more information).

In its latest November 2022 discussion document MfE has invited feedback on four topics:

• regulating the NZU market based on existing financial markets legislation;
• regulating NZU financial advice, transactional and/or custodial services;
• improved transaction reporting; and
• applying the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 (AML/CFT Act) framework.

This consultation may be of interest to organisations that engage in NZU trading (whether as emitters, forestry participants or financial investors) and will be of particular interest to operators of NZU market platforms as well as other participants such as brokers and custodians. MfE’s proposals may require such organisations to comply with additional obligations under New Zealand’s existing financial markets legislation framework in respect of NZU trading related activities.

Interested parties have until 11.59pm on 24 December 2022 to make submissions.

Proposal to treat NZUs as a financial product

MfE proposes to treat NZUs as a financial product to bring the NZU market within the scope of the existing financial legislation framework. It is seeking feedback on the following options for regulating market conduct for the trading of NZUs:

1. Crimes Act. The status quo. Limited insider trading protections, and no laws against market manipulation (that is, reliance on general Crimes Act prohibitions on fraudulent conduct without any NZU or financial markets specific prohibitions).
2. Financial Markets Conduct Act with suitable modifications. Prohibition of insider trading and market manipulation of NZUs. NZU market operators must hold a licence and comply with the obligations that apply to operators of financial product markets under the Financial Markets Conduct Act (FMCA).
3. Crimes Act and market manipulation prohibitions. Key Crimes Act provisions apply. Market manipulation prohibited using similar FMCA provisions. No requirement for NZU market operators to be licensed.

Option two is MfE’s preferred option. If this proposal were adopted, the regulatory reform would result in the application of insider trading and market manipulation rules under the FMCA to NZU transactions (noting that some modification to the existing rules may apply for NZU trading). Of particular interest will be MfE’s approach to what constitutes ‘material non-public information’ in the context of an instrument that more closely reflects a commodity than a traditional financial product issued by a particular company or issuer. MfE is proposing a narrower and more tailored definition of material information to be limited to non-public information on government policy.

It would also result in the introduction of an optional centralised NZU exchange and market rules (which has already been agreed by the Government in-principle). MfE are considering options in terms of establishing a clearing and settlement system for the trading of NZUs. Such a proposal could address credit and counterparty risk present in bilateral NZU transactions but would likely involve cost in establishing / extending existing financial market infrastructure to NZU trading.

Finally, NZU market operators would be required to hold a licence to operate (which would include ongoing obligations in terms of monitoring compliance of trading on such market). The financial product market licensing regime which is proposed to be extended to NZU markets is a complex regime with material time and cost (upfront and ongoing) involved in obtaining a licence. Only a limited number of licences and exemptions from this regime have been issued in the past. This aspect of the reforms would have a particular impact on the operators of existing platforms for the trading of NZUs.

Proposal to regulate NZU advice, transactional, custodial services within financial markets

MfE is seeking feedback on the following options in terms of regulating NZU financial advice, transactional and/or custodial services:

1. Existing legislation. The Fair Trading Act 1986, Forests Act 1949, FMCA and Financial Service Providers (Registration and Dispute Resolution) Act 2008 partially protect market users from poor or misleading advice, alongside private remedies.
2. Regulation within the existing financial markets regulatory regime. NZU advisers, brokers and custodians are regulated in a similar manner as under the FMCA.
3. FMCA wholesale client settings. Settings under existing financial markets legislation that apply to the provision of financial advice, brokerage and custody to wholesale clients would only apply to such services provided in respect of NZUs (regardless of whether the client is wholesale or retail).

MfE proposes to progress with option two. If this proposal is adopted, it could have material implications for NZU advisors (being any person who, as part of their ordinary course of business, makes recommendations or gives an opinion about acquiring, disposing of, or holding NZUs) providing regulated financial advice. Such implications could include:

• a requirement for any person who gives regulated NZU financial advice to retail clients to hold and operate under a licence granted by the Financial Markets Authority (FMA) and belong to a mandatory dispute resolution regime;
• a requirement for all NZU financial service providers to register on the Financial Service Providers Register;
• the application of the FMCA fair dealing rules (i.e., the prohibitions on engaging in misleading or deceptive conduct) to the such services provided in respect of NZUs;
• the application of other statutory duties (e.g., the exercise of care, diligence and skill and obligations to prioritise client interests); and
• additional fees and levies payable to the FMA, as well as related compliance costs.

Likewise, MfE is considering whether regulations applying to “client money and property services” (broadly, regulation of brokers and custodians) should extend to entities that provide such services in respect of NZU transactions.

Proposal to improve transaction reporting

MfE is seeking feedback on the following options for increasing trade reporting obligations for NZU transactions:

1. Current reporting obligations. Basic information (parties, number of units, date and time of transaction) reported but no visibility on price and value information.
2. Improved transaction reporting. Parties to all NZU trades must submit additional reporting fields on:
   • price and value information;
   • whether the trade is with someone else or between one’s own accounts; and
   • the transactor’s primary reason for holding an account.
3. Full transaction reporting. Additional reporting fields required which replicate obligations in the AML/CFT Act.

MfE favours the improved transaction reporting approach. For over-the-counter trades of NZUs, these additional fields would be manually disclosed to the New Zealand Emissions Trading Register when completing a transaction report. This would result in increased transparency in the market and subsequently increased detection of misconduct. The discussion document does not address how such trade reporting obligations would apply in respect of more ‘bespoke’ transactions such as offtake arrangements and forward contracts or derivative transactions.

If you are a NZU secondary market user this would require you to report additional transaction details.

Proposal to maintain AML/CFT Act obligations

As part of this consultation, MfE highlights how the AML/CFT Act already applies and will continue to apply to the NZU market. Not all who give financial advice (including in relation to NZUs) are captured, but if you provide a service that is investing, administering or managing money on a client’s behalf you may be considered a “financial institution” under the AML/CFT Act and be required to comply with basic obligations (e.g., annual reporting, written risk assessments and customer due diligence etc.).

Summary of key changes proposed

If you would like assistance considering and providing feedback on the options outlined by MfE in its paper, and how they would impact your business, please get in touch with the contacts listed or your usual Bell Gully advisor.

Disclaimer: This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.