Response to discussion on the potential review of the investment firms’ prudential framework
Q32: Should there be the need to introduce prudential requirement for firms active in commodity markets and that are not currently subject to prudential requirements? How could the existing framework for investment firms be adapted for those cases? If a different prudential framework needs to be developed, what are the main elements that should be considered?
Introduction
The EU Commission has the mandate to review the commodity derivatives regulation under Art. 90 (5) of the Markets in Financial Instruments Directive II (“MiFID II”). The review will cover inter alia the Ancillary Activity Exemption as well as position limits, position management controls and reporting requirements. This review should assess inter alia the impact of prudential requirements as set out in Regulation (EU) 2019/2033 (“IFR) and clearing, margining and collateralisation obligations as set out in Regulation (EU) No 648/2012 (“EMIR”) on specialised commodity and emission allowance firm, incl. Energy Market Participants (“EMPs”), if they were to be regulated as investment firms under IFR.
In parallel, Article 60 of IFR mandates the EU Commission to review the IFR regarding the prudential regulation for EMPs trading on commodity markets, i.e., whether and how the current prudential regime could be extended to these firms.
The reviews by the EU Commission must consider all dimensions of energy markets in a single regulatory, economic and environmental assessment
We are of the opinion that the above-mentioned reviews by the EU Commission and relevant technical advice from EU authorities must be performed as one single holistic and comprehensive review and not in isolation. Therefore, this holistic review must take into account the interdependencies between physical power and gas markets with energy derivatives markets and consider a holistic picture of the entire set of applicable regulation (in particular, MiFID II, MiFIR, EMIR, MAR, IFR/D and REMIT).
Therefore, we recommend merging both reviews under MiFID II and IFR into a holistic review, including the technical advice of EU authorities and subsequent EU Commission review under Article 60 of IFR and Article 90 (5) of MiFID II, as they should both not be performed as a stand-alone exercise.
Such a holistic review needs to consider the comprehensive set of legal review criteria mentioned in Recital 14 and Article 90 (5) MIFID II which are:
(i) liquidity and proper functioning of markets for energy commodity derivatives and physical power and gas; (ii) ability of the markets to withstand external shocks; (iii) prevention of market abuse and support for orderly pricing and settlement conditions; (iv) need to manage risks arising from energy business activities; (v) need to maintain competitive liquid markets for energy and energy derivatives that ensure the open strategic autonomy of the European Union (“EU”); (vi) facilitation of the energy transition and the delivery of the EU’s priorities on sustainable energy; (vii) ability of affected firms to effectively reduce risks directly relating to its commercial or treasury activity; and the application of requirements for investment firms under IFR and of the requirements for financial counterparties laid down in EMIR.
Support for Frontier Report on MiFID II commodities review
In this context, Frontier Economics (“Frontier”), with the support of Luther Lawfirm (“Luther”) performed the above-mentioned holistic review and published a comprehensive report (Frontier Economics / Luther Lawfirm (2024), “Principles of energy market regulation – securing efficient & resilient energy trading”; Link: Principles of Energy Market Regulation - Securing Efficient & Resilient Energy Trading – “Frontier Report”). We strongly support the findings and key recommendations of this Frontier Report.
1) Maintain Ancillary Activity Exemption for Energy Market Participants and no extension of prudential requirements to Energy Market Participants
The Ancillary Activity Exemption (“AAE”) that allows for EMPs to be exempt from MIFID II requirements (including authorisation as an investment firm and prudential requirements) for trading activity that is ancillary to their main business should remain in place. This is a proportionate regulatory approach allowing EMPs to undertake risk management in respect of the energy assets that EMPs own or operate, without having to be authorised as investment firms. It reflects the unique nature, business model and risk profile of EMPs, which is completely different to credit institutions that the MiFID II was designed to regulate. The AAE is a crucial exemption for EMPs risk management and is necessary to maintain liquid, competitive and efficient EU energy markets which are key to ensuring an affordable, secure and sustainable energy supply for the EU and its end consumers.
The Frontier report also confirms this finding that the current scope of the AAE is appropriately calibrated to ensure such proper market functioning and enable efficient risk management by EMPs. One of the report’s key recommendations is to keep the AAE as is for EMPs.
Consequently, we do not support any investment firm status for EMPs which would subject these firms to prudential requirements under IFR, which we expect would be affected by revoking the AAE under MiFID II. Requiring EMPs to become licensed investment firms under MiFID II / IFR could trigger adverse and unintended impacts on energy markets, consumers, and the real economy. We elaborate on these adverse impacts in the last section 3 of our response.
2) No need to introduce prudential requirements for Energy Market Participants as investment firm status of EMPs would not address the energy crisis’ root causes
We support the finding of the Frontier Report that there is no need to introduce prudential requirements for Energy Market Participants:
• The Frontier Report shows that the recent energy crisis and related policy interventions provided a stress test which demonstrated the resilience of energy markets. Supply shocks (gas and power), in combination with a high concentration of gas supply, were the root cause for price spikes during the energy crisis in Europe during 2022. An investment firm status of EMPs would not address these root causes or mitigate any of their impact. It would not create more power generation capacity or additional natural gas / LNG supply. Similarly, it would not address EU energy security of supply, stabilise energy prices or support geopolitical stability.
• The central clearing system and margining process proved to be resilient in the energy crisis despite significant challenges. Industry has also worked hard to learn the lessons of the crisis and to improve risk management practices. Additionally, Energy Traders Europe is developing an industry standard for liquidity management and improved clearing and margining practices. Also, the EMIR 3 changes implemented already the lessons learned from the energy crisis by improving the transparency and predictability and recognising uncollateralised bank guarantees as eligible collateral for central clearing. Another useful development is that CCPs are working on adapting their margining models. Increased transparency on margining models and margin calls under EMIR 3 will aid EMPs to meet higher and frequent margins call in stressed markets with higher energy prices and volatility seen during the energy crisis. We view these initiatives as more targeted and effective to address the issues encountered in energy crisis than the potential imposition of prudential requirements. The EU Authorities, including. EBA and the EU Commission review, should take into account of these developments that are already in progress before considering any regulatory interventions such as the imposition of prudential requirements.
• In general, business models of EMPs are fundamentally different to those targeted by investment firm regulation where capital requirements serve not least as a way to secure depositors' money. Energy companies do not receive depositors' money. In addition, EMPs do not pose systemic risk in the same way as credit institutions. They are typically companies with long-term energy generation assets that need to manage the risks of such assets by long term trading, which is a typical action of the real economy. Consequently, unlike banks, they have no choice but to trade in the energy derivatives market for risk mitigation and hedging which is why the AAE is essential for them. In particular, power producers have to hedge its production long-term on power markets and secure its costs of the EUAs on financial markets. Introducing a prudential framework on EMPs would increase the costs and complexity of and introduce barriers to hedging, which is vital for risk management of EMPs. Conversely, prudential regulation would create additional financial burden and complexity for EMPs which may ultimately result in higher energy prices for end consumers. It is uncertain that financial institutions would provide the hedging services required to fill this gap, which may result in EMPs being exposed to market and price risk and ultimately having to exit the EU.
• Overall, an appropriate regulation should support resilient energy markets in periods of high price volatility. Existing instruments for crisis prevention and management are well suited to address regulatory concerns articulated in the energy crisis. On one hand, position limits prevent market cornering and may address excessive commodity price volatility. On the other hand, accountability limits and position management controls applied by exchanges limit the clustering of risks by individual market participants. In addition, circuit breakers are an existing emergency instrument to temporarily prevent fundamentally unjustified sharp price moves and to limit price volatility.
3) Extending prudential requirements to EMPs will lead to adverse unintended consequences on EMPs and EU energy markets
Requiring EMPs to become licensed investment firms could trigger adverse and unintended impacts on EMPs, energy markets, consumers, and the real economy. The report by Frontier demonstrates that a narrower AAE exemption (i.e. require EMPs to have a MiFID II investment firm licence and consequential comply with prudential capital requirements) would not have helped during the crisis but would have exacerbated the situation. Larger energy traders would have faced even more severe liquidity strain from prudential regulation and mandatory collateralization of bilateral trading have been forced to exit the market due to the increased costs, which would have drained even more liquidity out of the wholesale market during a challenging period.
The Frontier Report explains the adverse consequences in more detail, and we share these concerns. In detail:
a) Investment firm status is disproportionate to the business model of market participants
• Material prudential capital requirements under investment firm status
In order to comply with an investment firm status, EMPs would either require additional capital resources to continue business activities as usual, or those activities would need to be curtailed. A six-month survey led by Energy Traders Europe, held among the largest European energy market participants, shows that the investment firm status would result in average capital requirements of more than EUR 3 billion for survey participants, and an average capital deficit of EUR 910 million (see Appendix C in Frontier report).
The investment firm regulation would adversely impact overall market liquidity and efficiency, with the capital required to comply with financial regulation being “trapped” and therefore unavailable for investments which are critical for the energy transition.
Additionally, liquidity requirements under the IFR do further not assess the cash needs for each EMP in the ordinary course of business (e.g., for margining of cleared transactions), but what cash would be needed for a potential orderly wind-down scenario (IFR caters for going concern liquidity requirements). The liquidity requirements address the minimum levels of cash or near-cash instruments an authorised IFR firm must hold to meet regulatory requirements from a potential wind-down scenario to mitigate the risk to customers and market participants. It does not capture the true cash liquidity risk faced by EMPs which arises from the need to post margins on their cleared commodity futures positions (and is linked to market price levels and volatility). The survey showed that the participating firms showed a mean liquidity surplus of EUR 1.88bn per firm. This implies that firms hold sufficient cash reserves under IFR to meet future margin calls.
• Organisational restructuring
Business models of EMPs are fundamentally different to those targeted under investment firm regulation such as banks. An investment firm status would require EMPs to reconsider their whole group structure for their ancillary trading activity, with the sole purpose of complying with investment firm regulation. In particular, there are several areas where current systems of EMPs would need to be significantly changed to perform ongoing capital and liquidity calculations under investment firm regulation (e.g., IT systems, operational organisation, etc.), which would result increased burden and costs form EMPs, as well as require further require specialist resources.
• Knock-on effect under EMIR for EMPs
Investment firm status under MiFID could result in EMPs gaining the status of "Financial Counterparty" under EMIR resulting in additional cash burden, to comply with the requirement for mandatory OTC collateralisation for derivatives with an initial margin of around EUR 180 million per survey participant on average, up to EUR 1 billion for one firm.
Consequently, after becoming investment firms, EMPs would face extended reporting obligation as the former legal delegation to potential financial counterparties would fall apart and, in addition, they had to overtake this responsibility towards any remaining residual non-regulated counterparty. Furthermore, EMPs would need to apply extended risk mitigation techniques (i.e. the entire set of obligations regarding collateralisation of counterparty risk would apply) which would represent significant additional liquidity constraints to EMPs especially in volatile market conditions.
• IFR not fit-for-purpose for EMPs
The IFR definitions for the calculation of own funds requirements for commodity positions do not consider the specific characteristics of commodity and commodity derivatives markets, and of the non-financial firms active on these markets. Therefore, it would not be appropriate nor proportionate to apply them to EMPs.
The market risk own funds requirement determined via K-NPR which references the non-internal models approaches of CRR is based on the respective position in a certain commodity times the spot price in that commodity. This is not a good proxy for calculating the prudential requirement for market risks of commodity dealers. With commodity prices showing strong seasonality, the spot price is therefore not a good proxy for the value of a term product. Therefore, using the forward curve prices instead would more accurately reflect the true commodity price risk.
Since physical assets (e.g., power plants, wind/solar parks) are subject to market price risk, the IFR should allow for this risk to be taken into account in order to offset the market price risk arising from transactions that constitute an effective hedge of these assets. Thought further, conceptionally the principle of the Trading Book may not apply well to positions held to hedge assets and consumer portfolios (which both may be conceptually closer to ‘banking book’ positions). A dedicated IFR ‘banking book’ regime might therefore be advisable – in its simplest form it would exclude hedge transactions from own funds requirements.
EMPs are often holding positions in instruments which foresee a physical commodity delivery over a longer period of time with periodical payments. This intricacy is not appropriately considered in IFR so that own funds requirements for credit risk, K-TCD, do not reflect the true credit risk from these positions.
b) Investment firm status would limit market resilience, in particular in crisis situations
• No impact on physical energy shortage and security of supply
Extending the scope of prudential capital requirements to energy traders, by revoking the AAE, would not address the root cause of the energy crisis (physical scarcity of gas and power), nor high energy prices. Prudential capital requirements are designed to ensure firms hold sufficient capital to cover potential losses due to adverse market developments but do not result in additional generation capacity or LNG supply.
• Adverse impact on risk management and market liquidity
On the contrary, larger energy traders would have either faced an even more severe liquidity burden (from mandatory collateralisation of OTC derivatives trading) or would have exited the market due to the barriers and burden imposed by prudential requirements, further reducing liquidity in the energy wholesale market which was already low during the energy crisis (for exactly this reason). This could have caused the quality of the price signal to deteriorate and made it more difficult for EMPs to find willing counterparties for risk management (e.g., hedging assets or retail customer contracts). The leap to investment firm status would also cause regulatory disadvantages for energy market participants operating in the EU compared to other jurisdictions, as this status for energy market participants in Europe is unprecedented in other leading global markets. This would cause energy market participants to abandon trading activities in Europe and focus on non-EU jurisdictions with more lax regulatory frameworks. In other words, the market liquidity would be offshored, as energy companies would go to less regulated markets where it would be easier for them to develop their activities. All in all, imposing prudential requirements could result in EMPs no longer being able to trade -off their market cash liquidity and credits risk according to their individual EMP needs and choices, which was a key mitigating measure during the energy crisis.
c) Adverse impact on the EU’s Competitiveness
The regulatory framework for Europe must ensure a level playing field and market stability and avoid regulatory arbitrage with other international jurisdictions. European regulation for energy trading should align with internationally acknowledged regulatory principles by the International Organisation of Securities Commissions. The AAE under MiFID II is key for a competitive EU energy market and there is no precedent for treating EMPs as investment firms in other key jurisdictions (including the United States). Requiring investment firm licences and imposing associated prudential capital requirements for EMPs would put at risk the international competitiveness and attractiveness of European markets and undermines the ability to maintain European market liquidity and to attract the huge investment required to deliver the energy transition. This may result in EMPs exiting the EU and moving to jurisdictions where they would not be subject to prudential requirements. It could also lead to higher costs for end consumers.
d) Investment firm status stands in contrast to the regulatory objectives for energy commodity derivatives set out in the EC’s review mandate under Article 90 of MiFID II
Overall, when compared to the EC’s review mandate for the commodity derivatives regulation in Article 90 (5) of MiFID II, the investment firm status of EMPs and loss of the AAE is not a proportionate approach and would not address any of the root causes or issues that arose during the energy crisis. It would result in less liquid and less efficient energy markets, with reduced hedging opportunities for energy market participants and contradict EU policy goals as it threatens to undermine investment in renewable assets, reduce security of supply and hinder the energy transition foreseen under the EU’s Green Deal.