Market participants worry for European energy liquidity

Banks, energy firms and regulators expressed concern about the impact of regulation on EU energy market liquidity at Energy Risk Summit Europe on June 24 and 25

Jonathan Whitehead, SG CIB

The prospect of new financial regulation hurting liquidity in the European Union energy market was high on the agenda at Energy Risk Summit Europe, with several speakers giving dire warnings about the consequences of the second Markets in Financial Instruments Directive (Mifid II), in particular.

Jonathan Whitehead, global head of commodities at Societe Generale Corporate and Investment Banking, said financial regulators are trying to increase transparency in energy markets, but that some of the measures being implemented will harm liquidity. "I have participated in markets which frankly probably needed more regulation… But [today's environment] is driving the cost up significantly,” said Whitehead, speaking in an onstage interview at the London conference on June 25.

In the past few years, EU energy market participants have faced a wave of new regulation. This includes the European Market Infrastructure Regulation, which requires derivatives to be reported and centrally cleared; the Regulation on Wholesale Energy Market Integrity and Transparency, which seeks to curb manipulation in wholesale power and natural gas markets; and revised market abuse legislation that increases the power of financial regulators in relation to commodities.

But most of the focus was on Mifid II, a package of updated financial markets legislation that is set to be implemented in January 2017. Mifid II plays a critical role in determining which entities and transactions can be considered ‘financial’ and therefore fall within the scope of financial regulation. That has sparked concerns that a greater number of energy trading firms might be regulated as financial entities and become subject to stricter rules in a range of areas, possibly including minimum capital requirements.

“It is not across the whole of the energy markets, but there are certain markets that – with the imposition of increased burdens of capital [and] the imposition of a number of other regulations – are in the process of dying, especially in the back end of the curve,” said Whitehead.

There are certain markets that... are in the process of dying, especially in the back-end of the curve

Energy traders, such as utilities and oil and gas producers, already complain of low liquidity, especially in longer-dated markets, due to the retreat of major investment banks. Banks have also been hit hard by regulation since the 2008 financial crisis, and have cited developments such as tightened Basel III capital rules to justify decisions to close or downsize their commodity trading businesses.

“We have seen a big drop of liquidity, especially out on the curve,” said Andrea Ottaviani, senior power trader at Eni Trading & Shipping, the trading arm of the Italian oil and gas producer, during a panel discussion about electricity markets on June 25. “What we see now is more hedge funds are coming into the power market, but their style is much more different – so they’re more active once, for a big volume, and they go.”

Peter Biltoft-Jensen, head of regulatory affairs at Danish energy company Dong Energy, highlighted an apparent conflict in the aims of financial and energy regulators. Across Europe, energy regulators are focused on the need to build more integrated, secure and liquid markets that can accommodate increases in renewable generation. But the imposition of financial rules will stunt the growth of energy markets, which were “the backbone of the energy transformation we are trying to achieve in Europe today”, he said, speaking during another panel discussion on June 24.

Legislation such as Mifid II has been formulated with the relatively liquid energy markets of northwest Europe in mind, said Biltoft-Jensen. But such laws will hamper market development in other parts of the EU, where energy markets are not as deep. “The drive with the financial regulation is to standardise, and for that, you need to put margins on trading; make it a lot more costly and more complex,” he said. “How do you then ensure the development of the traded markets elsewhere in Europe? The direction of the financial regulations drives across the overall aim of establishing a well-functioning term market for energy.”

The issue is “something regulators really need to pay attention to”, added Biltoft-Jensen.

Some regulators are also concerned. In an interview at the conference on July 25, Alberto Pototschnig, director of the EU Agency for the Cooperation of Energy Regulators (Acer), said the agency had issued a recommendation in March calling for physical energy forwards to be more clearly excluded from Mifid II.

“When it comes to physical transactions, or even physical forward transactions in the energy market, we don’t think there is the same level of systemic risk that would justify the same type of regulation that we see from financial markets,” said Pototschnig. “We believe that this should be looked into and that physical forwards should not be considered as derivatives and therefore not be subject to financial market regulation.”

Extending financial regulation to physical forwards could set back the work of EU energy regulators trying build a more liquid internal energy market, he added. “We would run the risk of reducing liquidity in the energy market – something that we are trying to promote exactly now, because one of the challenges of integrating the internal energy market is actually to create well-functioning markets, and liquidity is clearly a fundamental aspect.”