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UK market-making costs could be 'far in excess' of estimates

19 Jun 2013 17:04:43 | edem esgm

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Britain's energy traders could be hit by costs "far in excess" of those initially calculated by regulator Ofgem under its electricity market liquidity drive because of an overlap with upcoming EU regulation, market participants say.

As a result, the regulator told ICIS on Monday it wants market participants to get in touch with information regarding such costs.

Under its proposed secure & promote (S&P) licence condition, Ofgem plans to force the country's "Big Six" suppliers to place bids and offers on forward-curve products up to two years ahead in an effort to boost liquidity, possibly starting from early next year (see EDEM 12 June 2013).

But concern has risen because trades executed while market-making do not count as hedging under the European Market Infrastructure Regulation (EMIR), and therefore count towards a non-hedging threshold, which, once passed, will see companies required to clear all over-the-counter (OTC) derivative deals - a potentially costly process.

Ofgem is consulting on the S&P condition until 9 August. But its paper does not account for costs that could be incurred as a result of clearing under EMIR: "We would assume that the obligated firm would choose to contract out its [clearing] obligation and would therefore not face this cost," it said, with no reference to the potential cost of contracting out this action.

A spokesman for the regulator said on Monday these costs will be taken into account, but not until later in the process - which raises the likelihood of the market-making proposal proceeding without utility clearing costs being considered.

"If traders have information on those costs, we would welcome receiving it during the consultation period so that we can consider it as part of the final impact assessment," the spokesman said.

Threshold

The annual threshold for commodity derivative contracts will initially be set at €3bn in gross notional value of the trade. The requirement to calculate thresholds began on 15 March, and British firms are required to notify the Financial Conduct Authority on the first day that the level is exceeded.

Non-hedging electricity trades will be counted in addition to other OTC commodity deals including any natural gas derivatives.

Even if this threshold is not surpassed, participants will be required to apply risk mitigation to all OTC derivative contracts - including deals entered into while market making - as well as any OTC derivative contracts that are not subject to the clearing obligation.

"It may mean that the market maker is automatically caught under EMIR and needs to clear or margin all trades. This will add costs far in excess of those [Ofgem has] calculated," one concerned trader said.

Hedging is defined as a trade that is intended to reduce the potential change in the value of the commodity. A deal is also deemed hedging where the accounting treatment of the derivative contract is that of a hedging contract under the International Financial Reporting Standards (IFRS) principles.

The criteria determining how contracts are specified under EMIR was prepared by the European Security and Markets Authority (ESMA) and endorsed by the European Commission last December.

The costs

According to Ofgem estimates, the cost of market making under S&P will be around £1.6m/year (€1.9m/year) per firm, with a one-off set-up cost of £300,000.

This is the regulator's best estimate, with the low case at £100,000 to set up with £900,000 annual costs, and the high case at £500,000 with £2.9m in annual costs.

This includes transaction fees on trades that would not otherwise have been carried out, and costs related to open positions that develop because of market making.

S&P includes other, less expensive cost estimates that, when combined with market making, add up to £4m to comply across the entire market, and £14m/year ongoing.

This, it estimates, will translate to a £0.04/MWh premium on wholesale power prices. The "high case" translates to a £0.08/MWh premium, while the "low case" indicates a minor £0.02/MWh premium.

However, should the market making cost "far exceed" Ofgem's estimates as some fear, the premium on power prices would by extension also exceed these estimates.

Ofgem said any power price premium will be more than offset by downward pressure placed on the market by increased competition. But this premise too has been questioned by the electricity market, which closely follows Britain's NBP:

"What is their economic basis for this?" one trader asked. "If gas goes up, we could have 1,000 counterparties but the price is [still] going up."

The Ofgem spoksman said: "There is a lot of pressure on prices from various sources, not least wholesale gas. It is therefore all the more important we ensure competition works effectively so that customers pay no more than they need to for energy." Jamie Stewart

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