The European Union energy sector is nearly eight months into Mifid II, two months into the General Data Protection Regulation, and several years into the European Market Infrastructure Regulation (Emir), the Regulation on Wholesale Energy Market Integrity and Transparency (Remit), and the Market Abuse Regulation (Mar). Is this the end of the regulatory turmoil for energy and commodities? Probably not, as existing regulations will always be subject to amendment and replacement. But a look at the recent past suggests some ways in which the implementation of future directives may be improved.
There has been too much of a ‘ready-fire-aim’ approach to regulation in our sector. Three recurring issues undermining its smooth implementation need to be resolved:
- the current engagement model between the politicians, the investing public, the regulators and the regulated fails to deliver full stakeholder participation and ownership;
- the jurisdictional boundary between financial market regulation and energy/commodity market regulation is in the wrong place; and
- regulation is hitting the wrong target, as the smaller companies that contribute least to systemic risk bear a disproportionately high cost of compliance, causing innovation to be at risk.
Four examples from the implementation of Emir, Mifid II, Remit and Mar in energy and commodities illustrate these shortcomings in terms of models of engagement, jurisdictional boundaries and misplaced applicability.
Emir and risk mitigation
Emir primarily targeted the ‘opaque’ over-the-counter derivatives market, introducing trade reporting, a move towards on-venue trading of ‘standard’ products, mandatory clearing and collateralisation, clearing thresholds and mitigation of operational risks, for example, by introducing electronic confirmations. Market participants were also classified as ‘financial’ or ‘non-financial’, and as subject (or not) to mandatory clearing.
Emir looked good on paper, but problems soon emerged. In the financial industry, a clear case could be made for the move towards mandatory clearing of ‘standard’ products. In energy and commodities, the case was weaker because ‘standard’ products do not hedge the risk profiles of market participants to the desired degree, so a brokered, bespoke OTC market remained an essential channel for risk management. A forced migration to on-venue trading would always be fiercely resisted. A lot of pain could have been avoided by a more measured approach to the use of OTC derivatives in this asset class.
Emir tried to introduce a fresh layer of credit security to an asset class that didn’t need its help
Mark Earthey, Maitland Energy Consulting
The clearing and credit aspects of Emir didn’t hold that much water either, cost considerations aside. As OTC instruments remain relatively more important to energy and commodity traders than to their financial counterparts, tightened credit controls to mitigate the risk of counterparty default were rapidly evolving even before 2008. Furthermore, in physical energy markets, where delivery default could destabilise the entire system, elaborate safety mechanisms were already in place to safeguard system integrity and ensure delivery from reserves. Emir tried to introduce a fresh layer of credit security to an asset class that didn’t need its help.
Even a non-contentious issue such as back-office confirmations became problematic. During the formulation of Emir Level 2 text and supporting regulatory technical standards, the wording changed from “trades will be confirmed electronically where possible” to ‘… where available’ – which was a real setback. The excuse given was that ‘where possible’ made it sound like adoption was compulsory, but this excuse was legal sophistry; if an action has to be taken in order for a process to be legal, the words ‘mandatory’, ‘compulsory’ and ‘must’ will show up somewhere in the text governing the process. All that was needed was some clarificatory text.
Mifid II: the ancillary activities exemption and imposition of position limits
Mifid’s message (I and II) is quite simple: if your business primarily involves trading financial instruments, then you need a licence to operate, and you need to respect position limits and obey the rules on market transparency, integrity and safeguarding client interests. Quite sensible when applied to a bank or hedge fund, but not good when applied to a company whose business involves substantial dealing in financial instruments in support of its primary business activity.
Mifid I’s ancillary activity exemption rule allowed all but the biggest energy and commodity firms to escape liability on the grounds their dealings in financial instruments were in support of their main business activities (“ancillary”), and not an end in itself. But Mifid II Article 2 (1)(j) swept this simplicity away.
Companies now have to quantify their dealing in financial instruments as a proportion of their commercial activities, and of the underlying market as a whole. Under earlier iterations of the exemption, a small company could become Mifid II-liable if its financial instrument trading was a relatively high proportion of its commercial activities, even though that activity was absolutely low in terms of total market size.
A more fundamental issue was that one of the calculations involved knowing total market size. Nobody knew this number because nobody ever needed to know it in the past. In any case, the true value may have been unknowable simply because of the large rump of OTC trades occurring in private. Esma initially argued that determining the number was beyond the limit of its authority, but eventually published an opinion based on trade data from Emir trade repositories. Time will tell if this latest opinion is fit for purpose, but the main lesson for the future is that, if there is a critical calculation that determines compliance liability, regulators should ensure the method of calculation and the data are fully available first, and that the calculation accurately reflects the intent of the regulation as to whom it captures.
The definition of position limits did not progress smoothly either. Some specialised commodity markets (such as propane), which contain a small number of players such that anyone could be accused of holding a dominant, even abusive, position when a financial market definition is used. Elsewhere, big financial positions might simply reflect the hedging of big physical positions, with nothing sinister or abusive intended. Again, given what Mifid II is trying to achieve, next time round (Mifid III?) more detailed attention needs to be paid to the workings of individual markets before resorting to the use of ratios and number of lots. Nestlé and the hedge fund manager Antony Ward may have had similarly-sized positions in the cocoa market, but their commercial intentions were poles apart, and easily differentiated by an alert regulator.
Given what Mifid II is trying to achieve, next time round (Mifid III?) more detailed attention needs to be paid to the workings of individual markets before resorting to the use of ratios and number of lots
There remains a final sting in the Mifid II tail: obtaining a licence causes an immediate promotion to the grade of ‘financial counterparty’ under Emir, opening the floodgates to compliance with its strictest provisions, including mandatory clearing and migration to venues. This is little or no deterrent to the largest companies, which can restructure themselves to optimise both Mifid II and Emir compliance, but is a costly overhead to a smaller company stumbling into Mifid II liability on other criteria. The law of unintended consequences is an overworked cliché but not, it would seem, when applied to Mifid II and Emir.
Remit, Mar and market abuse
Ensuring market integrity across all asset classes is essential, so at first glance it is entirely appropriate for regulators to insist on common classifications of market abuse across financials, energy and commodities. Thus Remit applied financial market abuse cases and prohibitions to physical energy, and Mar filled in the gaps for the other commodities regarding trading in financial instruments and their underlyings. Under Remit, the European Agency for the Cooperation of Energy Regulators (Acer) has taken great pains to define inside information in the context of physical energy, and has implemented the means for making inside events public, such as ‘Urgent Market Messages’ for unscheduled outages.
Physical electricity and gas also have additional defences against market abuse not enjoyed by the financial sector – they have transmission system operators, market operators who have a statutory obligation to manage physical energy flows and maintain the integrity of the system. TSOs have increasing powers to amend or disallow any transaction that threatens system stability, so anything appearing remotely abusive gets interrogated and can be blocked, independent of what any financial rules say.
This financial market approach to combating abuse probably works best with power and gas trading within the EU and North America. Elsewhere it encounters problems. Most oil and commodity companies can only survive because they have access to privileged information that they take great pains to gather and maintain. The last thing they want to do is broadcast it Remit-style to their competitors, and this is accepted by all market participants.
On that basis, it’s unlikely that Mar will become the Remit of reporting inside events occurring in the wider commodity space, so a purely financial-market approach to inside information cannot work across energy and commodities. This leaves physical commodity companies outside of Remit in something of an operational vacuum for managing inside information. A Remit-style clarification is needed, itself justifying the creation of a separate, broad-church regulator for energy and commodities.
Lessons to be learned for the future implementation of regulations
Can we do better next time? For the answer to be ‘yes’, there needs to be some improvements in the implementation of future directives.
1. Change the engagement model between the regulators and the regulated
For energy and commodities, the engagement model between the regulators and the regulated needs to be made more consultative so special cases are identified earlier.
Energy and commodities companies have always found themselves on the periphery of the drafting of the new financial regulations that impacted them, and found it hard to get their voices heard. To give Esma its due, the value (and thus systemic risk) tied up in equities, currencies and interest-rate products dwarfs that in energy and commodities. With limited resources in an area not of its primary expertise, Esma decided to focus on what it knew best: a ‘general applicability’ model based on financial regulations.
Companies subject only to Remit had a better engagement model as Acer was fully focused on the power and gas sector, and could afford to be more consultative on its primary area of expertise. The European Federation of Energy Traders also provided a powerful lobbying group on behalf of the industry, so discussions were – though slower – more evenly balanced and produced greater engagement.
It’s unlikely that Mar will become the Remit of reporting inside events occurring in the wider commodity space, so a purely financial-market approach to inside information cannot work across energy and commodities
2. Change the current regulatory jurisdictional boundaries
There is a strong case for moving the EU jurisdictional boundary between financial, energy, and commodity regulators to allow the creation of a regulator dedicated to energy and commodities markets, even where these markets trade financial products. Regulation should be asset class-based to take into account the peculiarities and nuances of the market in question, rather than relying (mistakenly) on the general applicability of financial market regulations across asset classes.
In order to prevent regulatory arbitrage, a set of binding principles should be agreed so that instruments and products common to all asset classes are treated equally. Under this approach, a company could not secure an advantage by trading financial products posing as a commodity company, as opposed to trading as a financial company. At the same time, any necessary restrictions placed upon its trading would be determined in the context of the asset class.
In the EU, this approach would allow Esma to divest itself of its ‘problem child’ of energy and commodities. In turn, Acer could be expanded to encompass all of energy and commodities, or be subsumed within a new, broader co-ordinator. EU member states would have to do likewise by redrawing their NCA/NRA jurisdictional boundaries – but, as problems with the Esma/Acer boundary are reflected at national regulator level, they might welcome this change. Non-energy commodity companies would also be greatly relieved, as their regulation would have a clear focal point for drafting and enforcement.
3. Introducing lighter regulation for small players
The dilemma here is that in the case of physical commodity trading, the underlying business process is the same independent of the size of the market participant. This is a fact of life, but should it apply to regulatory compliance, given that the smallest company can be in a large breach of the law?
Smaller companies pay a disproportionately higher cost of compliance; to new entrants, often the source of innovation, the costs can be prohibitive. Assuming an improved engagement model and a shift in the jurisdictional boundaries, it would be appropriate to determine if there was some kind of de minimis threshold below which small companies become exempt from full regulation. We are seeing attempts to simplify Emir reporting and Mifid II exemptions for smaller companies, but even so, this has occurred after smaller companies had to meet the cost of compliance with the original text, or made the decision to exit the market.
The answer may lie in making regulators more nimble when it comes to the scrutiny of smaller companies. A ‘regulation-lite’ regime may be allowed, but at the expense of closer inspection of ‘small’ operations.
The new regulations probably score an A+ for their laudable intentions, but a C– for their implementation. This does not augur well for the future implementation of new regulations. That said, it’s good to see a general commitment on the part of regulators and the regulated to making things work. And there are still a number of important lessons we can draw upon to improve the design and implementation of future legislation:
- the financial market-led ‘one-size-fits-all’ approach to regulation should be abandoned;
- regulations and regulators should be asset class-based, not instrument-based;
- the engagement model between the regulators and the regulated needs to be improved, with an emphasis on aligning the ‘spirit’ of the regulations with the specifics of the asset class; and
- there should be a separate regulator for energy and commodities, based on the Acer model with its greater stress on consultation with market participants.
Market participants are now all too aware that managing regulatory risk is as important as managing the more quantitative aspects of the value chain. If the olive branch of greater consultation and engagement in the regulatory process is offered, they should grasp it with both hands.
Mark Earthey is the chief executive of Maitland Energy Consulting.