Far-curve power and gas trade threatened by physical forwards advice

Market participants are worried the current working definition of physical forwards will see far-curve trades captured by stringent EU financial regulation, and lead to liquidity being sucked from power and gas over-the-counter markets across Europe from next year.

A political agreement in January 2014 led to physical power and gas forwards being exempted from the updated Markets in Financial Instruments Directive (MiFID II).

Many in the energy industry were happy with the exemption, because they argued physical power and gas forwards were not suited to being treated as financial derivatives.

But the political agreement needs to be translated into technical language. Participants are worried the proposed technical advice defining what a physical forward is could lead to trades on the far curve being considered financial derivatives, because of the narrow definition of physical delivery. Prompt and near-curve contracts would probably remain exempt, but contracts from two years out could be captured, for example.

Several industry insiders think the proposed advice is not in line with the political agreement for the directive. It had been thought any over-the-counter trades underpinned by industry-standard contracts would be exempt. And sources argue it could chase trading companies without assets like power stations from trading longer-dated contracts, removing a swathe of risk takers from over-the-counter markets, a group already whittled down given the mass exit of many banks from power and gas markets.

Far-curve trade could be restricted to utilities trading a multiple of their assets, regulatory sources at utilities have said.

“They [authorities] are looking for a stronger correlation between physical assets and trading behaviour,” said Simon Tywuschik, energy expert consultant with PA Consulting Group. ”Putting any trading beyond that point against rigorous exemption tests, thereby limiting proprietary trading at non-financial companies to certain threshold levels.”

The updated directive comes into force at the start of 2017. The liquidity effect could happen earlier, because company positions in 2016 will be used to measure if they breech various thresholds that would push them into MiFID.

If physical forwards only includes trades closer in on the curve, it could mean energy companies’ far-curve trades count towards a threshold of €3bn, which if breeched would require companies to centrally clear trades or post certain collateral to back up deals under the European Market Infrastructure Regulation or EMIR.

Another worry is that many energy companies will be unable to apply for an exemption from the directive, because of the uncompromising line on the combination of exemptions companies must jump through to avoid being caught in MiFID.

If a company is caught, then it must apply for a licence and will come under onerous capital requirements, similar to those in place for banks.

Regulatory sources suggested even some relatively small, ‘simple’ utilities might be forced into getting a MiFID licence because of the wording, which would massively increase costs to run the business.

Having a licence would mean a company’s operational costs would rise, and increase the amount of capital it has available – quite a change for companies whose capital is often chewed up in physical assets.

While the effect on liquidity could be stark, utilities might find it harder to invest in energy infrastructure, because of the cost and complexity created, one regulatory head at a large utility said.

The European Securities and Markets Authority is due to submit its final technical standards in July. The standards must be adopted by the European Commission and approved by the EU Coucil and Parliament. Some market participants hope a more flexible definition of physical delivery will emerge out of the process. Fionn O’Raghallaigh