Richard McMahon, Alliance of Energy Suppliers, EEI, Washington, DC
After healthcare reform, Congress has made the restructuring of the nation's financial markets its key priority. Legislation is currently working its way through both the House and Senate, and the administration has already released its proposal for how to protect consumers against market manipulation and systemic risk.
The nation's electric utilities, along with a wide variety of energy organizations, agree that transparency and stability need to be improved to prevent excessive speculation in the derivatives markets. But we have come together to urge federal legislators to preserve the ability of electricity and natural gas providers to access the "over-the-counter" (OTC) derivatives and energy commodities markets.
Derivatives enable energy providers to manage or "hedge" against a variety of risks associated with energy production and fuel costs that are outside their control, such as the weather, changes in interest rates, future energy prices, or fluctuating currency exchange rates. Hedging benefits the energy customer and the provider: Customers gain some insulation against price volatility, and energy providers can stabilize their cash flows, which is vital in the capital-intensive energy business.
| "The high cash margin requirements of a clearinghouse or an exchange would significantly increase transaction costs…and would tie up needed cash at a time when the cost of capital is high, access to capital markets is uncertain, and our industries need to invest billions in new energy infrastructure." – Richard McMahon |
The proposals pending in Congress, while well intentioned, would require that instead of trading derivatives over-the-counter, energy companies would have to use a third party, such as a financial clearinghouse or an exchange. Clearinghouses and exchanges require a high level of standardization and liquidity in the derivatives and commodities products traded. This would greatly reduce the ability of many energy providers to find the customized derivative products they need to manage their risks.
For example, in the case of electricity, the prerequisites for standardized and centralized clearing are missing, since its unique physical nature precludes significant storage and requires that it be consumed when generated in hundreds of physical markets. Trading derivatives over-the-counter—in other words, directly between two parties—makes possible the customized solutions that each party needs.
The high cash margin requirements of a clearinghouse or an exchange would significantly increase transaction costs as well, and would tie up needed cash at a time when the cost of capital is high, access to capital markets is uncertain, and our industries need to invest billions in new energy infrastructure.
In addition, centrally-cleared exchanges strictly require that trades be backed by cash collateral. Individually negotiated OTC contracts, however, allow the parties to use alternative collateral structures such as asset liens, credit lines, or no collateral below agreed upon thresholds. This flexibility frees up scarce capital for investments in new energy infrastructure.
For utilities, the net result of trading derivatives on an exchange or clearinghouse would be an astronomical increase in costs. For an average-size utility, it would likely be in the neighborhood of hundreds of millions of dollars annually, which could result in many utilities opting not to protect themselves against all their financial risks.
While we support the goals of the Administration and the Congress to improve transparency and stability in OTC derivatives markets, it is essential that policy-makers preserve the ability of companies to access critical OTC energy derivatives products and markets. Our members rely on these products and markets to manage price risk and help keep rates stable and affordable for retail consumers.
When discussing any increased regulation of exchange and OTC derivatives markets, it is important to note that these transactions are not the source of systemic risk in the broader economy. In fact, the entire commodity market is less than 1% of the global OTC derivative market, and the energy commodity portion is yet a fraction of that 1%.
Therefore, Congress should maintain an appropriate balance between establishing market oversight rules that allow for prudent use of market-based risk management tools and providing regulators with the ability to establish a high level of transparency and the tools needed to protect consumers against market manipulation and systemic risk.
This balance can be accomplished by:
- Providing a clear exemption for end-users of OTC derivatives products, such as electric and gas utilities that use OTC derivatives markets to hedge against commodity price risk for natural gas and wholesale electric power. The hedging transactions of derivatives end-users do not contribute to systemic risk, and, therefore, should be exempted from the definitions of swap dealer and major swap participant.
- Promoting clearing of standardized derivatives between large financial dealers, where appropriate, through regulated central counterparties to reduce systemic risk and bring additional transparency through information regarding pricing, volume and risk. However, our members are opposed to mandates that would require all or most OTC derivatives transactions to be centrally cleared or executed on exchanges. The available evidence shows that clearing would not bring pricing benefits that would offset the cost of margining for gas and power derivatives, as some have suggested. In fact, the high cash margin requirements of clearing would significantly increase transaction costs for our members and, ultimately, their retail customers. In addition, it would tie up needed cash at a time when the cost of capital is high, access to capital markets is uncertain, and our industry needs to invest billions in renewable energy sources and new energy infrastructure. As a result, our more capital-constrained members may choose to hedge fewer of their transactions, thereby increasing their risks and passing potentially volatile pricing onto retail customers.
- Promoting greater regulatory oversight and transparency of OTC derivatives through increased financial reporting and authority to the Commodity Futures Trading Commission (CFTC) to prevent manipulation of the derivatives markets. We believe that this transparency can be achieved in a much more cost-effective way through mechanisms such as a central data repository, as opposed to mandatory clearing.
- Promoting the harmonization and clear delineation of regulatory authorities and functions among the Securities and Exchange Commission (SEC), the CFTC, the Federal Energy Regulatory Commission (FERC) and other federal agencies to ensure similar products are governed by similar standards. Accordingly, such harmonization should also work to minimize the burden and cost of compliance with regulatory oversight. As an example, we believe that all regional transmission organization (RTO) products and services provided under a FERC-approved tariff and subject to regulatory oversight by the FERC should be exempt from duplicative regulation by the CFTC.
- Amending the proposed definition of a swap to ensure that financially-settled physical transactions are excluded from the definition of swap. Amend the proposed exclusion from the definition of swap that currently reads "a non-financial commodity or security for deferred shipment or delivery, so long as the transaction is physically settled" to "a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction contains an enforceable delivery obligation." In order to avoid unnecessary costs (e.g., where a party sits in a chain between the producer and ultimate user of a commodity) and for administrative convenience, many physical transactions are settled through a book-out, which is an agreement between two parties to a forward contract to settle their respective obligations with a cash payment, as opposed to making and taking physical delivery. Book-outs have been exempted under CFTC rules since 1993.
It is important, too, to harmonize and clearly delineate the regulatory authorities and functions among the Securities and Exchange Commission, the Commodity Futures Trading Commission (CFTC), FERC, and other agencies to ensure that similar products are governed by similar standards. This harmonization would help to minimize the burden and cost of compliance with regulatory oversight.
Additionally, although we believe that competitive financial markets provide the best risk management tools, should Congress mandate limits on speculative positions, we urge legislators to allow the CFTC to set such limits in a reasonable manner that would ensure the necessary liquidity in a robust marketplace for legitimate risk management transactions.
EEI and the nation's major energy groups including the American Gas Association, American Exploration & Production Council, Independent Petroleum Association of America, and the US Oil & Gas Association have formed the Coalition for Energy OTC Derivatives End Users. Our mission is to work with Congress to create reforms that improve financial market transparency and improve overall market functions. At the same time, we want to prevent unintended consequences for the nation's energy providers and the consumers we serve. We encourage your support of our effort.
About the author
Richard McMahon is executive director of energy supply for the Edison Electric Institute and has responsibility over EEI's Alliance of Energy Suppliers. He directs EEI staff in advancing the public policy and commercial interests of member companies in issue areas that include power generation, natural gas, renewable energy, environmental issues, risk management, energy trading, and other regulatory and legislative issues. McMahon founded the EnviroTech Venture Capital Fund and sits on its advisory board and technical liaison committee. He holds BA and MBA degrees in finance.
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