In October of this year, the Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia (together the Regulators) released a joint report in respect of proposed reforms to the Australian over-the-counter derivatives (OTC Derivatives) market (Report).
The release of the Report follows the introduction into the Commonwealth Parliament of the Corporations Legislation Amendment (Derivative Transactions) Bill 2012 (Bill).
The Bill will effect various amendments to the Corporations Act 2001 (Corporations Act), which amongst other things, will allow the Minister for Financial Services and Superannuation to determine whether certain classes of OTC Derivatives should be subject to more stringent regulatory oversight, including the possibility of implementing trade repositories, central clearing platforms and/or trading platforms.
The Report and the Bill form part of a reform package proposed by the Regulators, to meet commitments made by Australian in relation to OTC Derivatives at the September 2009 G-20 summit. The overall aim of the reform package is to improve the transparency, stability and efficiency of the domestic OTC Derivatives market and the Australian financial market more generally.
However, a number of participants in the National Electricity Market (NEM), as well as members of the coalition senate committee, have criticised the implementation process of the proposed regime and highlighted the possible negative implications that the regime will have on participants in the NEM. In particular, submissions made to the Regulators argue that the proposed reforms are unnecessary in respect of the OTC Derivatives in the NEM, as there “is no evidence that this market poses a risk to national or global financial stability”.
Introduction to the NEM and OTC Derivatives
Introduction to the NEM
The NEM is a wholesale exchange for electricity, where the sale and purchase of electricity occurs in the spot market. The spot market instantaneously matches electricity supply from generators with the demand from electricity retailers through a centrally-coordinated process operated by the Australian Energy Market Operator (AEMO).
AEMO uses the spot price to settle financial transactions for electricity traded by generators and retailers in the NEM. Generators receive the spot price for all electricity they sell on the spot market for each relevant trading interval and retailers pay the spot price for all electricity that their consumers use during each relevant trading interval. The dispatch price of electricity (that is, the price of electricity derived from the prevailing supply and demand) is determined every five minutes, with six dispatch prices averaged every thirty minutes to determine the spot price for electricity.
The spot price for electricity is highly volatile, reflecting shifts in supply and demand conditions for electricity throughout a day. The spot price can vary from $12,900 per megawatt hour to -$1,000 per megawatt hour.
OTC Derivates and NEM participants
Participants in the NEM, including the majority of electricity generators and retailers, currently utilise both OTC Derivatives and exchange markets to manage their risk exposure to movements in the spot price and other risk exposures in the NEM.
OTC Derivates generally take the form of a bilateral contract negotiated between parties, customarily between a generator and a retailer of electricity. In its simplest form, a contract price for electricity is agreed between the parties to such a contract and the retailer (or its agent) then buys electricity from the spot market at the prevailing spot price. However, if:
- the spot price is lower than the price agreed in the contract, the retailer will normally pay the difference in the two prices to the generator; and
- the spot price is higher than the price agreed in the contract, the generator will pay the difference to the retailer.
OTC Derivatives in the NEM offer participants an opportunity to hedge risk that is tailored to the specific needs of their business (in particular with respect to the counterparty credit risk which a participant is willing to take on) and may take the form of a swap, cap, floor or option, all of which have the effect of smoothing out fluctuations in the spot price.
The proposed legislative framework
The legislative framework effecting the reforms to the OTC Derivatives market, will occur via amendments to the Corporations Act.
Under the new legislative framework, the Minister for Financial Services and Superannuation has the power to determine whether a certain class of OTC Derivatives should be made subject to derivative transaction rules (DTRs) and may also exclude certain transactions, entities or persons from complying with the DTRs.
The DTRs in respect of a particular class of OTC Derivatives may make it compulsory for that class of OTC Derivatives to:
- report transactions involving OTC derivatives through trade repositories;
- use a Central Clearing Platform (CCPs) – a process whereby derivatives are cleared by a single central counterparty, rather than bilaterally between parties to OTC Derivative contracts; and/or
- execute derivatives through centralised trading venues (such as exchanges).
ASIC will be responsible for drafting and implementing the DTRs applicable to that class of OTC Derivatives. However, as part of the implementation process, ASIC is required to consult with the public, APRA and any other person or body, which is required to be consulted by virtue of a regulation on the form of the DTRs.
ASIC is only permitted to implement the DTRs with the consent of the Minister.
Failure to comply with the DTRs, once in place, will trigger the civil penalty provisions under the Corporations Act and may result in the court imposing a fine on the defaulting corporation or person. Regulations made under the Corporations Act may also require a defaulting party to pay a penalty to the Commonwealth, institute remedial measures, accept sanctions (other than the payment of a fine) and/or enter into legally enforceable undertakings.
Are DTRs required for the OTC Derivatives in the NEM?
The proposed legislative framework and reforms to the OTC Derivates market more generally, if implemented in respect of OTC Derivatives in the NEM, are likely to have a significant impact on NEM participants.
In particular, compliance with the proposed DTRs will likely increase the cost of business for existing generators and retailers alike by instituting additional compliance systems and reducing the flexibility of current OTC Derivatives in the NEM. One of the intentions of recent reforms to the Australian energy market, including the roll out of the National Energy Customer Framework, is to decrease the administrative burdens and costs to market participants. However, in stark contrast, the possible introduction of DTRs in the NEM will likely result in further administrative reporting requirements and will at least partially negate the potential benefits to be realised by market participants from the current Australian energy market reforms.
These increased costs will also heighten the barriers to entry into the market for new participants (both retailers and generators), which may ultimately decrease the level of competition in the NEM and possibly have negative pricing implications for end users of electricity.
A number of large private electricity generators have also argued that the proposed reform package is unnecessary for OTC Derivates in the NEM, given that this market has little or no potential to impact of the stability of financial markets in Australia or globally. This position is generally supported by the findings of the Australian Energy Market Commission (AEMC) in their ‘NEM financial market resilience’ issues paper , where AEMC states that “the financial relationships and markets that underpin the efficient operation of the NEM are generally robust, which means there is likely to be a low probability of financial contagion occurring in the NEM.”
Furthermore, there is an argument that successful mitigation strategies already exist in the NEM which significantly decrease the risk of large scale financial instability in participants. Notably:
- internal risk management measures have been taken by many participants, including the introduction of appropriate corporate governance structures and policies, and the introduction of standards for the management of counterparty credit risk; and
- external risk management measures, including compliance with the ASX listing rules for listed participants and in certain circumstances, the requirement to hold an Australian Financial Services Licence (which require energy businesses to comply with various financial capacity measures);
- risk management measures specific to the NEM, such as the requirement for provision of credit support to AEMO.
However, as AEMC notes, NEM participants have complex financial relationships with each other and there is scope in the NEM for financial instability in circumstances where:
- a large generator fails and that generator has a high degree of interdependency with retailers or is a vertically integrated generator; and/or
- a large retailers fails and the retailer of last resort provisions apply (meaning that another retailer is required to take on the failed retailer’s customers). In these circumstances, the retailer may require entry into new OTC Derivatives or be required to provide further credit support to AEMO. If the retailer is unable to obtain the required support, it may also fail, which in a worst case scenario would cause a cascading ‘failure effect’ through to other retailers.
- AEMC is continuing to investigate the possibility and perceived impacts of ‘financial contagion’ in the NEM, recently publishing an Option Paper on 9 November 2012, in respect of the possible option for mitigating risk arising from the financial distress of a large retailer. AEMC also anticipates releasing an interim report in early 2013 to the Standing Council of Energy and Resources in relation to the risks of ‘financial contagion’ following the financial distress of a large retailer, including any recommended new mechanisms to mitigate those risks.
It remains to be seen whether the Minister and ASIC will declare electricity market OTC Derivates subject to more stringent regulation under the proposed legislative framework.
However, based on the correspondence to date between the Regulators and participants in the NEM, it is certain that any implementation by ASIC of DTRs in respect of NEM OTC Derivatives is likely to face strong opposition from NEM participants.
At the end of the day it will be necessary that all implications for the NEM and its participants of instituting DTRs in respect of NEM OTC Derivatives are considered and weighed against the perceived financial stability that the DTRs will offer.