Companies faced with continuing regulatory change around consumer market reform, affordable energy and security of supply are about to be hit by yet further regulation, this time of energy trading. The European Commission, concerned by the market’s lack of transparency and as a consequence of the financial crisis, has set out a legislative process that will seek to enhance regulation in the financial service sector but also bring commodity and energy trading activities into its scope.
The key pieces of new European legislation that may affect energy companies include the Regulation on Energy Market Integrity and Transparency (Remit), the Markets in Financial Instruments Directive II and Regulation (Mifid and Mifir), the European Markets Infrastructure Regulation (Emir) and the Capital Requirements Directive (CRD).
Remit sets up a consistent framework for monitoring wholesale energy markets at a European level and defines prohibitions on insider trading and market manipulation. Its scope covers commodity and derivatives contracts for the supply or transportation of electricity or natural gas, and covers electricity or natural gas produced, traded or delivered in the EU. Remit is consistent with the Market Abuse Directive, which is currently in operation.
Mifid II builds on the original Mifid directive by promoting competition in the European securities market, modernising market structures, increasing transparency, reducing data fragmentation, enhancing investor protection and providing further harmonisation of regulatory regimes within different jurisdictions.
The review extends the current Mifid regime from primarily an equities focus to include other product classes, including over-the-counter (OTC) derivatives and fixed income products. Exemptions, such as those granted to commodities traders under Mifid, will be more narrowly defined under Mifid II, leading to the revision or removal of existing exemptions.
Emir is designed to provide increased stability for the trading of OTC derivatives, through a requirement for all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms.
The final key piece of legislation is CRD, which establishes a minimum standard for the management of capital on a more risk-sensitive basis. It also increases the responsibilities and levels of discretion for supervisory review and control and expands the content and transparency of financial disclosures to the market.
The legislative timetable is set out in the timeline table. The pending regulation is still in various stages of draft, but implementation is likely to have a significant impact on energy traders. Companies should not see it as purely a tick box exercise because compliance is not about companies’ ability to “manage” the regulator, but touches on all areas of their business.
One of these is business strategy. Mifid II, if implemented in its proposed form, is likely to increase trading costs significantly because of the requirement for central clearing and associated margin requirements. The increased costs involved will be a drain on capital and may reduce the ability of physical market participants to hedge their positions effectively.
The greater disclosure of data on the operation of physical assets (as required by Remit) will also allow market participants to gain a more detailed understanding of price dynamics and volumes. This presents an opportunity to develop competitive advantage by understanding the impact of this information on market prices. At the same time, companies with asset-heavy positions will wish to understand the extent to which any change in the dynamics of market price affects the value of
their portfolio.
Another business area that will be affected is people and processes. Commodity trading functions have been exempt from regulation to date and may need to consider following the lead and structure adopted by financial institutions. This would include: increasing the remit and skills of the compliance function; establishing appropriate policies, processes and reporting to manage the risk; and considering how the change can be managed through existing technology.
Another area is data assurance. Given the increased reporting internally and externally to the regulator and market, appropriate governance and IT will be required to check and verify information. It is critical to make data a priority to avoid errors or overdue cost.
Then there are systems to consider. Companies will need to consider how the change can be managed through existing technology and to plug any gaps. The combined impact of regulatory change and specific guidance at this stage will mean this is likely to be a time intensive and costly exercise.
So, how should companies approach the change? Given that the expected change is likely to be significant, those who act now will ensure they meet the regulator’s requirements and avoid financial or reputational risks. They must first understand the regulation. This will be a time-consuming exercise and will involve interaction with legal resources, given the complexity of the changes. They must then baseline existing process to understand gaps compared to requirements. Gaps are likely to be around governance, data assurance and IT.
They must then design a regulation-compliant model that meets businesses objectives and a plan to move forward on the gaps identified. Key areas of focus will include senior stakeholder involvement where strategic changes are proposed, buy-in for functional changes and support for IT budget, if significant. Construction and implementation will focus on rolling out the policies, processes and systems changes. This is likely to be the longest phase of any plan.
Finally, companies must operate and review. It is advisable to internally audit or have an independent third party review the model before and after go-live, given the significance of the change project. In short, energy traders will need to fundamentally change how they manage regulatory risk. While this will result in increased compliance issues and potential costs, there are also benefits to be achieved if companies embrace the change. Those who act now will be able to capture potential strategic market opportunities, standardise and automate reported information, plan proactively for the required business restructuring and minimise the cost of change.
Paul Ward is director within the commodity trading team within PwC.
This article first appeared in Utility Week’s print edition of 17 February 2012.
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