Should energy companies be regulated like banks?
MiFID II raises the regulatory bar (again) for Europe’s commodity traders
For energy traders, the growing compliance burden in Europe and America created by the financial crisis is set to intensify with the introduction of MIFID II in 2017. It is still uncertain as to how the directives may be implemented by Europe’s nation states, and there is doubt over the future of regulatory exemptions presently relied on by the industry. As a result, the MIFID II consultation process that will take place over the next three years will prove critical, but companies can’t afford to wait and see to decide how best to address the likely increase in regulatory risk. Understanding the variables today -- and planning accordingly -- is essential.
A changing regulatory landscape
EU regulators created the Markets in Financial Instruments Directive (MiFID) to increase competition and consumer protection in banking and equity-related financial services. In commodity markets they created two regulatory regimes - EMIR and REMIT - to address potential manipulation in derivatives and physical trading respectively. These are rolling out now but even as they complete their implementation phase an extended set of MiFID rules – MiFID II – is expanding beyond its banking scope to take in aspects of commodity trading as well, with far reaching implications for energy market participants.
For energy traders, a key concern with MiFID II is the potential loss of exemptions from financial services rules enjoyed by energy trading firms, and new position limits for commodity derivatives.
Companies that deal in commodity derivatives currently benefit from a number of MiFID exemptions from rules aimed at banking, on the basis that they do not pose a comparable systemic risk. In MiFID II, however, these exemptions have been narrowed. Without being able to make use of such exemptions, energy trading firms could end up being treated as de facto financial institutions.
This could be seen as a re-categorisation that misrepresents the true nature of their business activities. If the energy trading arms of large manufacturers, for example, were to be regulated in the same way as banks, it would mean having to abide by rules such as minimum capital requirements.
On paper there is a MiFID II exemption for firms that provide investment services for commodity derivatives, emissions allowances or emissions derivatives; to customers or suppliers of their main business. However, to qualify for the exemption these activities must be considered “ancillary” to that company’s core business.
The risk therefore is that companies seen to be providing investment services, acting as a market-maker in commodity derivatives, or making use of algorithmic or high-frequency trading, might not qualify. Companies trading on own account to optimise their physical energy assets, ‘should’.
So MiFID II will, in theory, create a hedging exemption that ensures the trading arms of manufacturers and energy companies remain exempt. But size matters here. The larger a group’s ancillary trading operation overall, the harder it could be to benefit from these narrowed exemptions.
A further worry for companies that might find themselves re-categorised under MiFID II is overlap with the still-new EMIR (European Market Infrastructure Regulation) regulatory regime. It could mean that these companies would be treated as financial counterparties under EMIR, subjecting them to more rigorous standards in areas such as clearing, reporting and risk mitigation for OTC trades.
The issue of reporting trades to a trade repository under EMIR has already compelled energy market participants across the board to up their IT investments significantly. More generally, EMIR compliance has caused no end of managerial headaches, not least by the number of re-thinks and changes to definitions and timelines that have plagued its rollout.
There is also a question mark over MiFID II’s treatment of physical energy forwards, which could see them defined as OTC derivatives. Should that happen they would be subject to EMIR’s trading thresholds as well, which, in certain scenarios, require both clearing and margining.
Under MiFID II all energy market participants will be required to comply with position limits, e.g. limits on the net position firms can hold in commodity derivatives across the EU. That means exchange and OTC commodity derivatives trades would both be limited to prevent the creation of market distorting positions.
The hedging exemption I referred to earlier could, on current guidance, apply to position limits as well -- so long as a company is a non-financial entity taking positions deemed to be directly reducing the risk of commercial activities.
However, the way the exemptions and limits will work in practice is still subject to a lengthy industry consultation begun in May. The European Securities and Markets Authority (ESMA) which administers both MiFID and EMIR, released a consultation paper and a discussion paper that laid out its current thinking on MiFID II implementation and asking for industry input. The two documents encompass a whopping 864 pages, so plenty of questions linger about how the new regime will eventually work in practice.
Making it work
MiFID II consists of a directive, which must be implemented by each EU Member State (a process meant to take another two years); and a regulation which is applies across the EU. As with EMIR and REMIT, technical standards and other secondary legislation will need to be drafted, agreed and adopted by ESMA before the new legislation is implemented. Realistically, we are advising our customers to prepare for final MiFID II readiness by 2017.
That means uncertainty for at least the next three years – and given the experience of EMIR and REMIT, potentially longer. Over the next 18 months, here are three key things to watch for:
- Clarity on the exact definition of hedging, which will be extremely important for companies hoping to make use of the ‘hedging exemption’
- Clarity over how a market participant’s positions will be aggregated and netted. The issue of economically equivalent contracts and how the characteristics of an individual commodity will factor into the calculation
- Whether physical forwards will be treated as OTC derivatives
Taking steps to prepare now
Energy market participants now need to look ahead to late 2016/17 and build increased regulatory risk into their trading decisions. A good place to start may be to consider how changes in the regulatory interpretation of different transactions could affect a given portfolio, especially with regard to non-hedging activities.
Hedging and risk management strategies will clearly need to be adapted. Although it is too soon to make major changes, there are things you can do now to mitigate exposure to regulatory risk within MiFID II.
One way may be to trade on proprietary portfolios via a regulated market. Because they are established and fully regulated, regulated markets could provide a measure of regulatory certainty about the classification and treatment of transactions.
Also consider beefing up your roster of compliance specialists, and have traders undergo rigorous training to understand the current EMIR & REMIT regimes, and the implications of MiFID II.
Technology investments can also help mitigate regulatory risk by surfacing exposures and providing quick assurance that trades and related activities are compliant. This has already been shown through EMIR and REMIT, which compelled many companies to invest in or revisit their Energy Trading and Risk Management (ETRM) systems. MiFID II will almost certainly necessitate another round of IT upgrades, particularly in the in the area of reporting to trade repositories.
While it is still too soon to make firm or detailed ETRM recommendations, beginning the due diligence process with trusted vendors should begin now. A regulatory solution for commodity trading and corporate financial compliance is generally not a stand-alone application. Contract data, hedge accounting, revenue allocation in line with new regulatory reporting requirements and other special functions do not happen in a vacuum. It is also vital to consider factors such as the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud. Direct connectivity to trade repositories should also be a core capability.
Drawing on experience of EMIR and REMIT, the overriding requirement really has to be flexibility. Given that MiFID II has so many evolving dimensions, it is essential to be ready with a solution that will allow you to upgrade and manage your regulatory compliance process quickly.
|James Brown is Senior Energy Consultant, EMEA for Allegro Development Corporation. He has over 8 years’ experience in the energy sector and is an expert in European electricity markets. He regularly writes on EMIR and REMIT for many relevant publications. James joined Allegro Development in 2012 as Senior Solutions Consultant for EMEA. Prior to joining Allegro, James was Electricity trader at Shell in London, where he was responsible for the negotiation of standard and structured products for the German electricity market.|
Allegro Development Corporation is a developer of software tools for energy trading and risk management.