More than any other market, the power and natural gas sector has been preparing for the implications of Dodd-Frank Wall Street Reform and Consumer Protection Act for the better part of a decade. The collapse of Enron in Decmber 2001, led to the no-nonsense implementation of measures such as centralised clearing in the trading of energy and power derivatives contracts as a matter of industry survival.
In the wake of the financial crisis, the industry is following suit implementing mechanisms that, thanks to Enron, have already begun to take hold in the natural gas and power derivatives markets. Today, a vast number of contracts in the sector in the US are cleared on CME’s CME Clearport, launched in May 2002, or via the Intercontinental Exchange’s clearing venues.
Natural gas and power derivatives markets, however, will not be left untouched by the impending Dodd-Frank legislation. While the practice of clearing such derivatives has been widely accepted and well established, many contracts are still traded over the counter.
ICE launched its cleared OTC energy contracts in 2002 in the wake of the Enron scandal to provide access to centralised clearing and settlement arrangements while aiming to reduce bilateral credit risk and capital required for each OTC trade. In 2002, 2% of OTC energy contracts were cleared. Today that figure stands at 96% and rising.
Qualifying as an end-user
Under the new world order, to continue to trade natural gas and power derivatives off-exchange companies will need to qualify for an end-user exemption. Although the rules are still to be finalised, many companies are currently undertaking preliminary research to find out whether or not they are likely to qualify for the exemption, and if they do not qualify, what they need to alter in order to do so.
“The end users are worried about having to post too much margin. For the healthy workings of the market, these end-users need to be able to trade where they currently trade and for those trades to filter through the market,” says Richard Giles, the head of energy at GFI Group.
For natural gas and power derivatives, there are exemptions for some products, mostly forward contracts pertaining to physical delivery. However, for swap contracts a participant must determine whether their activities categorise them as a commerical end user, a major swap participant or a dealer.
Naturally, a public utility whould expect to be an end user, being able to demonstrate that when they entering into the swap, it is for the purposes of bonafide hedging or mitigating commerical risk.However, it is not that simple.
Generally speaking, to qualify for an exemption from the clearing and exchange requirements, at least one of the counterparties to a swap must not be a financial entity, must be engaged in hedging or mitigating its own commerical risk, and must notify the CFTC as to how it meets its financial obligations associated with entering into uncleared swaps. In addition, a company wanting to qualify for end-user exemption will need to obtain the approval of its board of directors.
According to Andrea Kramer, a partner at law firm McDermott Will & Emery, utilities, energy trading companies and producers, are currently going through the process of identifying activities within their operations that might exclude them from the exempt ‘end-user’ category and categorise them as a non-exempt dealer once the final rules are implemented. “Doing this analysis now means that when the rules are finalised they will be able to circle back easily,” says Kramer.
Business reorganisation
The exempt end-user definition for some companies will have an impact on the bottom line as companies that currently use OTC contracts to trade fuel, power or emissions may be exposed to an increase in the cost of hedging under the new rules.
“I am talking with some companies that are willing discontinue business lines if it will help them to qualify for the end-user exemption,” says Kramer.
For example, an energy trading company that currently executes transactions on behalf of customers, might decide to discontinue this business line because it takes them out of the end-user and into the dealer category. On the other hand, companies that want to continue offering such services have started the process of creating a separate subsidiary through which to faciliate these activities.
“If there is a narrow interpretation of a hedger or a speculative trade, some customers will not be able to trade as many contracts as they have in the past,” warns Bob Yawger, the senior vice president of energy futures at MF Global.
Quite often, however, many are surprised to find that when the final rules emerge, they could fall into the end user category, says Kramer. This is because as the rules stand, the CFTC definition of a dealer includes activities that are proprietary in nature, which many believe should fall under the end-user exemption when the final rulings are made known. “It is something most people are hoping and expectant that the CFTC will change in their final rulings,” says Kramer.
Another possible exemption may occur where a transaction is already regulated through the Federal Energy Regulatory Commission (FERC), as is the case for power derivatives based on financial transmission rights. It is still to be announced whether such power derivatives which are traded via Independent Systems Operators (ISO) and Regional Transmission Organisations (RTO), already overseen by FERC, will also be overseen by the CFTC, and therefore be subject to Dodd-Frank. So far, the CFTC has indicated that an exemption is under consideration, but no final agreement has yet been reached.
According to Giles at GFI Group, one of the biggest changes that will emanate from Dodd-Frank in the energy markets will be the way contracts are traded, which will have a direct impact on the number of brokers able to continue operating in the sector.
Right now, most contracts are transacted over the phone or via Bloomberg. However, under Dodd-Frank, these days look set to be numbered. With RFQ (Request For Quotes) emerging as a likely key component of the new market structure, electronic trading will become a requirement of doing business going forward. Natural gas markets will be among those significantly impacted by such a requirement.
There are currently 70 firms brokering natural gas options in the US, few of which are currently operating via screen-based trading. “The barrier to entry for natural gas options brokers has been close to zero for many years, but we are now going to see this rise considerably, which will lead to a lot of broker consolidation in that market,” says Giles. Comparatively, the electricity options space with only five brokers currently, will be less impacted.
Exchange committment
According to Bradford Leach, director of energy research and product development at CME Group, the exchange’s electricity product complex will continue to grow from 249 contracts, made up of 232 futures and 17 options. Contracts reflect differing variables whether it be peak or off-peak, or varying durations.
Over the last few years, the focus at CME has been on the ISO/RTO markets, with contracts financially settled using day end and real time prices. “In markets that have ISO pricing, there is very little issue as to what the real time/day ahead prices are, and there is substantial liquidity that is solidly grounded in commercial use,” says Leach.
On October 14, the CME Group reached a record for open interest in power contracts. At the close of trading, open interest reached 1,001,362,363 Megawatt hours (MWh), breaking the one billion MWh threshold for the first time.
“As the power industry continues to evolve and seeks new types of hedging products that match the unique needs of the electricity markets, we have worked with producers, marketers and other market participants to launch innovative new contracts that have offered our clients a new way to manage risk,” says Bryan Durkin, chief operating officer and managing director, products and services at CME Group.
Contributing to the record level of open interest is the success of recently launched contracts including swaptions, strips of options contracts extending over several months, calendar spread options and capacity swap futures, which are contracts that allow market participants to hedge for the maximum amount of power that could be used at any point of time, rather than for the consumption that is used over a period of time. “We’ve seen strong commercial interest for the capacity swap futures since they launched,” says Durkin.
Over at the ICE, the most popular energy complex products are its thirteen SPDC, Significant Price Discovery Contracts - a term created in the 2008 Farm Bill. On November 7, 2011, ICE will begin trading seven new cleared OTC contracts for North American power and a further two contracts for natural gas. This takes the ICE’s offering to over 600 cleared OTC energy contracts.
According to Yawger from MF Global, the demand for natural gas contracts is strong despite reduced volatility. “Wild swings were characteristic of the sector, however, since the explosion of shale gas about a year and a half ago, prices depressed considerably and led to a decrease in volatility. This has really changed the way natural gas options traders trade,” says Yawger.
Changing their spots
While it seems the physical side of the commodities derivatives market will not be overly affected by Dodd-Frank, players in this market - most notably Nasdaq OMX - believe their members will be indirectly impacted.
“We believe that alot of our members’ other businesses will be regulated by Dodd-Frank, and in that way, it can have an impact on our existing business,” according to Geir Reigstad, senior vice president of Nasdaq OMX Commodities.
In the US, Nasdaq OMX Commodities Clearing Company acquired the North American Energy Credit and Cleaning in March 2010. The NOCC has cleared more than 5,000 physically delivered OTC electricity and natural gas contracts worth about $5 billion since 2006. This is significant to the exchange in leveraging its investment in Nord Pool ASA, the Nordic Power Exchange.
According to Reigstad, Nord Pool is the global benchmark for any financial power markets, because it is the most liquid energy marketplace and the connection it provides between the physical, day ahead markets and the financial futures forwards markets.
“There is alot of liquidity in the German and US markets, but the activity in the Nordic market is the best you can find on a single exchange for the time being,” says Reigstad.
Nasdaq OMX has first endeavoured to leverage its activity in the Nordic markets in the UK, and now in the US. Firstly, it is developing niche products like a clearing service of physically delivered products in certain areas of the US, including the most important US electricity grids -((ERCOT Texas, PJM (Pennsylvania, New Jersey Maryland) and CAISO (California).
“In my view there are a couple of ways the market might move forward: the physical part of the market can grow on its own, but we think it will have to adopt changes and adapt to the Dodd-Frank environment. Delivering security in the electricity grids, people are looking for more transparency, more liquidity, and cheaper end user products,” says Reigstad.
Whether it be physical or cash settled natural gas and power derivatives, the market is still growing with increased volumes and product offerings. As Dodd-Frank rules continue to be debated, both the exchanges and electricity and natural gas producers are readying themselves to approach the new environment with the best foot forward.