Energy firms face capital adequacy squeeze

Impending regulation changes will have a profound impact on the operational side of the energy markets as energy companies face capital adequacy issues. Lianna Brinded investigates how companies will cope and what repercussions the changes will have on the markets

Proposed US and European financial market reforms are expected to profoundly effect the energy and commodities markets. The reforms – which include moving over-the-counter (OTC) derivatives trading to exchanges, and clearing through one central counterparty (CCP) – are set to cause cash collateral problems for most commercial end-users and therefore may impact on firms' ability to hedge and invest in future infrastructure needs.

The US Senate recently approved an extensive overhaul of financial sector regulation by calling for the installation of new regulatory bodies, while restricting the actions of banks and other financial firms.

The changes include the establishment of a new council of "systemic risk" regulators to monitor growing risks in the financial system and to give regulators new powers to oversee the derivatives market. These measures are intended to increase transparency by forcing most contracts to be traded through third-parties instead of only between banks and their customers.

"The regulatory principles for derivatives clearing organisations will impose margin requirements sufficient to cover potential exposures in normal market conditions", says Jason Daniel, senior counsel at the knowledge management team for law firm Akin Gump's investment funds practice. "Major swaps participants and swap dealers will also be required to collect margin. Margin would not be required for derivatives that are not cleared nor entered into through a contract market, so long as no counterparty to the swap is a major swap participant or a swap dealer."

The legislation still needs to be reconciled with a similar bill passed by the US House of Representatives in December 2009, before it can be sent to President Barack Obama to be signed in to law, but energy market participants fear that if OTC derivatives used by energy and commodities end-users are forced onto an exchange and have to be cleared by a CCP, they will not only face major capital adequacy issues, but all parts of the entity's business will experience a fallout.

"I think there will be wide-ranging effects on all aspects of business, including the operational and investment policies of firms," says Craig Pirrong, professor of finance, and director of the Global Energy Management Institute at the Bauer College of Business at the University of Houston. "In particular, on the investment side, if these financial regulatory reforms make hedging more difficult, then it'll be costly for long-life investments. Lenders will then realise more risk is involved and only lend on less favourable terms, which will mean less construction of infrastructure."

The reconciled legislation is expected to pass towards the end of July but market participants still have mixed views on the amount of end-users and what types of end-users will be exempt from having to trade derivatives products on an exchange.

On both sides of the Atlantic

In June, the European Commission (EC) published a consultation document on its long-awaited derivatives proposals, which tackles questions relating to the eligibility of derivatives contracts for clearing, the requirements for CCPs, interoperability between CCPs and reporting obligations for trade repositories.

The commission says it will be working with US regulators to converge on clearing requirements, to avoid loopholes and regulatory arbitrage.

Currently, energy companies sell power and buy fuel using derivatives contracts, mainly relying on letters of credit or asset lines as collateral. If OTC derivatives were forced onto an exchange, this dynamic would change, as the company would need to make sure it provides regulators with evidence that it has enough collateral in cash to cover the value of the products it intends to buy. This also applies to heavy energy users, such as industrials.

"At a cursory glance it means that the cash flow of transport companies will be affected because more funds will be tied up in collateral," says Nick Raffan, head mining analyst at investment research and advisory firm Fat Prophets. "Weaker players might decide not to hedge and greatly increase the risk to the company's revenue line."

While financial entities are used to buoying up their cash collateral balance sheet, the diverse nature of energy and commodity end-users have prompted energy companies to urge regulators to look again at the swap dealer definition in current proposals. Companies in the power sector need to use these products to hedge fundamental risk, they say.

While some market participants and lobby groups believe regulators will allow exemptions for some energy and commodity end-users, this is still not certain and it remains a cause for concern in the industry.

Pruning back on hedging

With the US and Europe looking to converge on strict derivatives trading rules, energy companies have several concerns.

The first major concern, following the proposed shift of OTC derivatives trading onto an exchange, is the amount of collateral a company will have to post in cash against the products it intends to buy for hedging purposes.

"People turn pale when this topic comes up," says Art Altman, who manages research in forecasting and risk management for the power markets at the Electric Power Research Institute. "Companies use creative forms of collateral right now, such as posting an asset, but if products were moved onto an exchange, then the companies would have to come up with cash. This will limit how much they can invest in infrastructure, as they will have to go through credit lines that will mean more active capital maintenance."

This in turn means that commercial end-users, such as utilities, will have to source cash in the form of credit from financial institutions. Not only is this considered against the ideal way of funding the purchase of hedging products, but it will also add to costs.

"At the moment, when dealers enter into OTC contracts with power companies or energy market firms, they are effectively extending credit implicitly through the derivatives deal by not requiring them to post collateral," says Pirrong. "What will end up happening is that this will create a business opportunity for the dealers' credit desks to potentially lend the money to post collateral. The fact that they have the opportunity to do this now but don't, only suggests that this is not the preferred option. This will impose additional costs on these companies - it will be constraining and it will lead them to hedge less."

Single CCP: increasing costs

Similarly, proposals for derivatives products to be cleared through a single CCP will add further costs for energy and commodity end-users. The growing checklist of cost concerns will mean it will be more expensive for companies to buy products to hedge their positions, and this is expected to lead to them to hedge less.

While the EC's consultation paper gives extensive details on requirements for CCPs that clear OTC derivatives, it stops short of explaining exactly how corporate users of derivatives might be treated in forthcoming legislation.

Clearing obligations for non-financial firms, arguably the part of the new legislation that market participants have been anticipating the most, is less clear. Corporate end-users have lobbied hard for exemptions since the Commission first published its position paper on reform of the derivatives market last year, claiming any mandatory clearing requirement would require them to eat into vital working capital to meet margin calls by CCPs.

"We see a politicisation about the location of depositories and CCPs, and there are going to be questions about the basis of recognition and non-domestic clearing houses, which is a critically important issue," says Anthony Belchambers, chief executive of derivatives lobby group The Futures and Options Association (FOA). "You have got to get the balance right, such as the tests of eligibility [for exemptions] and obviously deal with the tension of who licenses CCPs, who regulates them, who has the ultimate word in whose contracts should go through CCP clearing or not. The tensions in this debate between public policy on one side and risk aversion on the other are going to be quite significant."

Risk management concerns

With mounting pressure on companies to stump up more cash or hedging instruments, risk managers say this all leads to significant risk management concerns in the longer term.

"We are still facing an unprecedented level of regulatory risk," says Vincent Kaminski, professor at Houston-based Rice University's Jesse H. Jones Graduate School of Management. "The industry is concerned about the availability and cost of different hedging instruments. Given that the financial institutions may be obligated to spin off their swap desks, it may affect the availability of the price level of different hedging instruments."

As experts point out, this is the second significant notch in energy risk managers' concerns. If companies choose to hedge less, because they have to drum up more cash for collateral and increased all-round business costs, the risk factor rises dramatically.

"This is like throwing a pebble in the pond and having ripple effects through all aspects of the businesses of these companies," says Pirrong. "There are no free lunches. So if you impose a constraint on them, like saying you have to post more cash in this part of your business, then that will lead you to hedge less and then that will need to be priced into your products and therefore there maybe a cut back in hedging."

In addition to this, lawyers say that worries over company hedging methods will also lead to a natural pruning of the amount of products available.

"One of the major challenges for the energy and commodities markets is the politicisation of specialist markets," says Doron Ezickson is head of International Energy & Commodities Advisory practice in London at McDermott Will & Emery."The main question surrounding this issue is: will energy trading come under regulatory constraints that will strangle market liquidity and innovation?"

If overall issues regarding capital adequacy and costs mount up for major energy end-users and if there are less derivatives instruments available for hedging, experts say that there will also be a huge increase in the possibility of operational risk as companies will have less cash to invest in infrastructure.

Power generation could be badly hit. "This scenario would not only put pressure on capital adequacy, but also on power generation and therefore prices," says Altman. "There is a lot of building that needs to take place in the industry at the moment, in order to generate more electricity. However, if capital adequacy becomes a major issue then this could be very much affected."

Examining exemptions

Many market participants are gloomy about the outlook for energy and commodity end-users, but many also hope there will be widespread exemptions. If this happens, companies will not face increased costs and therefore there will be less likelihood of a cull in hedging products.

FOA's Belchambers says that regulators on both sides of the Atlantic are looking into introducing exemptions. He says the US is currently trying to see what non-financial entities would qualify on the basis of how risk-exposed they would be if they were to adopt the proposed changes in OTC derivatives trading and clearing.

Indeed, regulators across the globe are still looking into how to decide what types of companies should be exempt from the reforms.

"I do expect to see some sort of exemption to this rule," says Ted Kury, director of energy studies at the University of Florida. "I think that the exemption will either be based on the type of business or the size of the business. If it is based on the type of business, then I expect that end-users, however they end up defining that term, will be exempt from the rule. I don't think that the regulators want to curtail the ability to hedge."

Concerns over the major end-users having to use CCPs also seem exaggerated say some experts. While lobby groups like the FOA say exemptions are likely, some market participants say that even if these firms were to use CCPs, the markets could actually benefit rather just simply face extra costs.

"This is usually a knee-jerk reaction – that costs will increase if any change is made to regulation," says Andrew Moorfield, head of oil and gas at Lloyds Banking Group. "However, if the trades go through a truly transparent exchange and one that deals with large volumes, the additional costs will likely be minimal. Trading will also be electronic, so timing wouldn't be impacted. And finally, although these instruments are going through a CCP, the risk is actually being diversified across tens of thousands of counterparties. The real risk is the need for creditworthy counterparties to hold the margin payments."

Analysts say there are always going to be market risks and although some of these will be exacerbated by regulatory reforms, there will always be people willing to stump up the cash. Companies with weak credit ratings are still able to buy derivatives products to hedge their positions, even though it may be more expensive. Lastly, the regulations are intended to minimise risks not increase them.

"If you have hedgers who are willing to spend money to diversify risk, then you probably need people who are willing to accept money to take on risk, or the whole market breaks down," says Kury. "If the exemption is based on size, then I expect that companies below a certain asset threshold will be exempt from the requirements. Again, I don't think regulators would want to deny small utilities the option of hedging risk."

Ready for the reforms

The scale and scope of US and European financial reforms being proposed has not been seen for years, but some participants believe the markets are well equipped to tackle the challenges.

"Energy markets have pre-empted regulatory activity through self-regulation around central clearing for years," says Jason Tudor, Head of Commodities, EMEA at Nomura. "So although the pressure is increasing, it is not the same paradigm shift as for other financial asset classes such as credit or interest rate derivatives. We do not see this as likely to cause a significant change in activity."

Other market experts say that only positive news can come out of the situation.
"Economic uncertainty and swings in sentiment are having a major impact on energy products, increasing volatility. This itself increases counterparty risk and further strengthens the attractiveness of cleared exchange products," says Jon Page, head of energy structuring and generation services at UK energy company npower.

So, while on the surface the regulatory reforms will present challenges for the energy and commodities markets, the likelihood that there will be exemptions for major commercial end-users means they may well escape most of the potential drawbacks feared over capital adequacy.