The impact of financial market regulation on energy trading and power prices
Press briefing from RWE on financial market regulation.
• The European Commission has proposed new regulatory rules for the financial over-the-counter (OTC) derivatives markets which also affect European energy trading markets
• The energy trading market does not pose systemic risk to the global financial system. In past energy market crises - such as the Enron and TXU Europe insolvencies - no customer went without electricity or gas; no bank customer lost their life savings and no one needed to be bailed out by taxpayers.
• In the power and gas sector, one of the main aims of the reforms – improving market transparency and integrity – is best achieved by CESR (Committee of European Securities Regulators), ERGEG (European Regulators' Group for Electricity and Gas) and DG Energy’s proposals for a tailor-made EU energy market transparency and integrity regime.
• The EU "one-size-fits-all" to OTC derivatives risks undermining the development of effective competition and liquidity in the European wholesale power and gas markets.
• Consumers will be facing increased power and gas prices as a result of higher costs both for hedging energy-related positions and providing financial margin for energy-related transactions.
• Overall, a like-for-like application of financial markets’ regulation to the energy trading markets would reduce the liquidity of OTC markets and the extent and efficiency of risk-reducing hedging activity. This in turn could trigger energy market consolidation – with a consequent decrease in the number and
diversity of market players – which would stifle competition.
• This would not only raise the volatility of energy prices, the costs to end consumers of additional margining and collateralisation could easily run into tens of billions of Euros.
RWE fully supports rules which improve the transparency and integrity of the EU energy markets. The Group has been one of the first companies across Europe fully committed to increasing the transparency of fundamental supply and demand data. RWE is actively engaged in the process of establishing a level playing-field across Europe, in the interests of promoting greater transparency and common rules for trading transactions.
Energy trading does not pose any systemic risk to the wider financial system and significantly reduces energy price and delivery risks. Energy sector crises - for example the collapse of Enron and TXU - have not led to cascading failures across the financial system and have not affected energy consumers or bank savers at all. Similarly, financial crises – eg, the collapse of Lehmann – did not imperil the delivery of energy to consumers. To be effective, financial regulatory reform therefore needs to account for the subtleties and differences between radically different derivative markets.
In the power and gas sector, one of the main aims of the reforms – improved market transparency and integrity – is best achieved by ERGEG (European Regulators' Group for Electricity and Gas) and DG Energy’s proposals for a tailor-made EU energy market transparency and integrity regime. This regime will provide more public information on market fundamentals and traded volumes and prices and adopt
a market abuse regime (prohibitions on market manipulation and insider dealing) which mirrors the standards adopted in the financial markets, but takes account of energy market specifics.
DG Energy’s regime will provide regulators with all the tools and information required to safeguard fair competition and trading practices and to monitor the emergence of any future problems in these sectors. In accounting directly for the needs of the energy markets, the regime will avoid the unintended and material adverse effects of a one-size-fits-all approach on the further development of competition in the internal energy markets and the delivery of its benefits to consumers.
The European Commission has proposed new regulatory rules for the financial over the counter (OTC) derivatives markets which require central clearing of all eligible derivatives and an obligation to report OTC trades to trade repositories. The European Commission’s "one-size-fits-all" approach risks undermining the development of effective competition and liquidity in the European wholesale power and gas markets and consumers face increased power and gas prices as a result of higher costs both for hedging energy-related positions and providing financial margin for cleared energy transactions.
Subject to the approval of the European Parliament and EU Ministers, the European Commission would like to see all eligible OTC derivatives cleared by central counterparties (Central Clearing Parties/CCPs or clearing houses). In addition, trade repositories – or databases – should be set up to collect and analyse data on the status of derivative contracts.
We believe this proposal is in danger of imposing new costs for European energy traders running into billions of euros: in terms of the cost of additional collateral margins and the related processing and documentation requirements. This is turn would lead to the exit of a range of smaller and medium-sized market players – and a less competitive European wholesale energy market overall.
It is also likely to imperil the advances made by the industry to date: for example, the tremendous improvement in liquidity, which has given hundreds of market participants the opportunity to hedge the risks underlying their energy transactions. Energy trading in many parts of Europe has developed very rapidly and positively since the process of liberalisation was initiated. A fully functional market with competitive exchanges and a dynamic OTC sector now exists, resulting in transparent pricing based on market-driven supply and demand mechanisms. In electricity trading markets alone, trading volumes have almost trebled in the last six years – demonstrating clearly that the market is working efficiently.
Power and gas markets face massive challenges elsewhere in the regulatory landscape; from the challenge in some markets of achieving any level of workable competition at all in the underlying product – never mind derivative – markets; the challenge of delivering effective cross-border harmonisation and competition; and the delivery of market price signals and investment to achieve wider energy security and environmental goals. The risk of serious unintended consequences from illfitting financial market reforms amid these challenges is great indeed; especially for smaller market participants like municipalities and industrial energy users. Nor is it necessary to take that risk. Energy markets differ crucially from financial derivative markets in two important ways: First, energy markets have a diverse range of participants including energy suppliers, power producers, energy trading companies, banks and large industrial corporations.
Second, the products traded in energy markets fundamentally differ from those in purely financial markets, not least when it comes to mechanisms for physical settlement. While clearing obligation may help to reduce systemic risks to the financial system in some asset classes dominated by financial companies (eg, creditdefault swaps), they have no benefit – and significant costs to competition and liquidity – when applied to energy trades and energy traders which pose no threat or “systemic risk” at all to the wider global financial system. Moreover, power and gas market participants and their regulators in DG Energy and ERGEG are already working towards a tailor-made market transparency and integrity framework to promote increased confidence and trust in the markets by shedding increased light on market activity and price formation and to provide regulators with the information
to respond to emerging problems.
As a result, the blanket application of general financial market regulation to energy markets, and derivatives trading specifically, would stifle the dynamism of this most spectacularly successful example of market liberalisation. Simply transposing financial market rules onto energy trading is neither necessary nor desirable, and does not address the unique characteristics of the energy market.
Q & A
Does energy trading pose any risk to security of supply?
• No. Energy trading promotes security of supply. Trading in liquid, competitive markets with prices reflecting the balance between supply and demand ensures that energy flows to where it is needed, when it is needed.
Does the energy sector pose any systemic risk to the wider financial markets?
• No. Energy traders do not pose systemic risk to the global financial system. The collapse of even large, high profile energy traders such as Enron and TXU had no wider impact on the global financial system and neither collapse resulted in any shortage or interruptions in the supply of energy to end consumers nor any dramatic prices shocks to consumers. European regulators such as CESR (Committee of European Securities Regulators) and CEBS (Committee of European Banking Supervisors) - and the European Parliament - all agree that energy traders pose only very limited and contained systemic risks to the wider financial system. • Energy traders don’t affect the stability of the wider financial system. The energy sectors and its trading activities were not implicated in the recent
financial and subsequent economic crisis. Given both their size and the nature of their business, energy traders simply do not threaten the stability of the wider financial system – and certainly don’t fall into the much talked about ‘too big to fail’ category. Energy traders did not suffer unduly in the last financial crisis. No energy trader required a government bailout - and the default of even the largest energy traders would be most unlikely to affect the stability of the global financial system as a whole. Experience provides evidence in support of this: Enron’s collapse didn’t jeopardise the global financial system as a whole – likewise, the demise of Lehman Brothers had no tangible impact on the energy industry, energy prices and the security of energy supplies to consumers.
• Energy commodities are not the same as financial products.
There’s a fundamental difference between financial products and the commodity derivatives traded in energy markets. Financial products do not directly represent tangible assets such as raw materials, power plants or distribution networks. This is why the collapse of an energy trader – such as Enron or TXU Europe – did not lead to a shortfall in energy supply – distribution networks and power stations continue to operate regardless. Energy prices aren’t detrimentally affected, because the price of commodities largely reflects day-to-day physical demand and physical supply.
What specific impact would the proposed legislative initiatives have on energy trading businesses?
• The Mandatory central clearing of OTC contracts would lead to higher energy prices and reduce the diversity of market participants. Market participants would have to pay fees for registration, licensing and clearing. Producers and consumers will also have to post margin on hedge positions, even if market prices move in favour of their underlying physical positions being hedged (eg, power producers have to post margin on forward derivative sales when prices rise and power consumers have to post margin on forward purchases when prices fall, even though both producers and consumers remain neutral or “hedged” on their overall position). Estimates of the additional costs to the European energy trading industry run into tens of billion euros which would translate into substantially higher wholesale energy prices.
• Under the proposed MIFID regime (Markets in Financial Instruments Directive) energy traders would effectively be required to establish banks to manage their trading activities. If implemented fully, this would call for a considerable investment of additional capital running into tens or hundreds of millions of euros. This would stifle further – much needed - entry into the market and precipitate the exist of many smaller firms which are vital to maintaining the diversity of energy market participants and, with it, energy market liquidity.
• Short selling prohibitions and position limits for gas and power markets would distort the functioning of energy markets, jeopardising risk management options and reducing liquidity.
In general terms, what would be the overall impact of applying the “one-size fits all” reforms on the structure and development of energy markets? And how would this affect end consumers?
• Such an approach would hinder the further positive evolution of Europe’s energy market – and result in increasing power prices and a dilution of vital investment in infrastructure, such as new power stations.
The recent history of the European energy trading industry is an impressive story – with the demonstrable benefit of a competitive market, characterised by transparent and reasonable price building mechanisms.
Milestones in this evolution include:
1. A tremendous growth in liquidity, providing hundreds of market players with a range of opportunities to hedge the risks underlying their energy transactions and portfolios.
2. A fully functional market with competitive exchanges, and a dynamic OTC sector; both of which contribute to transparent price building mechanisms - and prices based on actual supply and demand for power.
3. This liquidity is built on a number of factors: the high quality of information available to market participants - and particularly the wide distribution of their data - also their fully functional exchanges, and the equitable trading terms that prevail across markets. Overall, like-for-like application of financial markets regulation to the energy trading markets would reduce OTC market iquidity and limit the extent and efficiency of hedging activities. This in turn could trigger energy companies to consolidate and integrate their activities - to avoid the increased transaction costs - rather than using the market to optimise their production/consumption and buying/selling decisions at arm’s length across the value chain. The inevitable result is fewer, less diverse, market participants and reduced, more constrained, competition and liquidity. This would not only raise the volatility of energy prices – it could also result in
significantly increased costs to end consumers – costs that in the longer run could amount to many billions of euros. Indeed, additional hedging, margining and collateralisation costs are likely to run into tens of billions of euros.