Commodity and derivatives markets for power defy standardization. Market ret jormers should take heed. 22 cLectnic pensprctivescommodity isa commodity unless its electric power to be delivered in the United States. Similarly. lrivatives market isa derivatives ‘market, unless the derivative prod ‘ucts re linked to that electric power commodity. AS the Obama administration and Congress consider changes in financial market regulation, or & whole ‘ew structure for commodity and derivatives mar- kets, they must be sure to understand the nature of power markets. For most, the differences are not obvious or sig- nificant. In general, power markets are different around the elock, and yet cannot be stoed in commercial quandes—the laws of physics requite thatit be consumed atthe time itis generated. The physical commodity is generated and delivered e- onally, because electricity cannot be transmitted efficiently overlong distances. Also, power supply and demand can change instantaneously. As re sult, power market prices are volatile. And power derivatives are highly eustomized to meet indi vidual energy company needs. In addition, the electric power markets in the United States are heavily regulated at the federal and state levels. These markets did not develop ‘with afocus on financial market structure. For reg- ulators, the predominant goals in both wholesale ‘and retal markets are reliability and affordability. If policymakers regulate the markets for over: ‘the-counter (oTC) power derivatives with the same sweeping principles as they propose to establish for other commodity or derivatives markets, they must address the unique nature of the power markers. Otherwise, there may be unexpected and unpleas> ant consequences for the electric power industry ‘and Americas electric consumers—regulatory con- fusion, creased csi dd wo higle paver paces and extreme price volatility, an exponentially ex- ‘panded group of data and reporting requirements, ‘tiod-up operating cash, and the prospect of deliv cry interruptions. Rotorm vs. Construction ‘In August, the Obama administration published the Derivatives Markets Act its blueprint for regulating ‘the markets for near all commodities and deriva- {ives—from options on soybeans to interest ratepower and power deriva- tives are extremely volatile. swaps to the purchase and sale of electric power for future delivery. Each of the many commodity and derivatives markers today ave structured and regulated differentiy in recognition of the differ. lences in the types of market participants, the prod ‘uct characteristes, andthe rsks to be managed in ceach market. The market structures have evolved to meet the needs of market participants and the regulators articulated goals. (See the sidebar, “Mar ets Compared.”) Some derivatives are bought and sold by contract between oP i ore derivatives mar- kets, Other physical or financial derivatives have evolved to be so standardized that an exchange (regulated by the Commodity Futures Trading Com- mission—crrc) has defined standard product or contract terms and allows participants to rade such contracts direct, using the exchange as their counterparty In many Instances, clearing entities (also regulated by the CGrTO financially setle (that is, “clear” standard- ized products or contracts. taneous nature yer as a commodity the market prices for Intoday’s power mar- kets, energy companies ‘ean choose to manage their business rsks ei ther by using standard ized exchange-traded products orby contract ing in the ore derivatives market directly with an ‘ther company, subject to credit risk management choices and credit support requirements. OT de- rivatives are customized to manage (hedge) the companies’ commercial risks. Then the companies ‘can choose to clear their ransactions or to manage their credit risk in another way. The Derivatives Markets Act sets aside these :multiple marker structures and posits a new, oné size-flts-all market structure template, As @ tem: plate, the act becomes not so much market reform ‘or market regulation but market construction. Un- lr the act, the regulators charged with defining these new markets are the CFTC, the Securities and Exchange Commission (SEC), and (in certain instances) the banking regulators—not an energy regulator in sight. Yet the new market structure Pucricta Dondaile sa parner at Shi Mardin IEP Ta Chica. would dramatically change the way an electric utl- fiy’s power supply team or a merchant generator's sales team operates. eliminating risk management and hedging options and increasing costs. {All Power Derivatives Are Local A commodity derivative is definable and measur- able, Ics also interchangeable for another one of the same type—soybean future for soybean fu- ture, for example, or financial asset or index derivative, de- fined and accepted by an exchange. Ag- doultatal and energy fiatures markets con- template physical delivery and receipt of the product—like soybeans, Henry Hub natural gas, or electric power delivered into a regional transmission organization. Such markets also contemplate a limited range of deliv- ery disruptions—events thatare outside the control fof the contract parties, Due to the unique physical characteristics of electric power—it's not storable in commercial ‘quantities or easily transportable across distances ‘or traded in a market where supply and demand are stable—there are thousands of different de- rivative products for “electric power delivered” at various locations throughout the United States. ‘While there may bea modicum of standardization among power derivative contracts, their commer- cial ermsare customized tothe unique operational and risk management practices of power market partieipants—primarily power generators and local elecure distribution ulities (LDCs). ‘An LDC must address instantaneous and unex- pected supply and demand fluctuations immedi- ately—and, because electricity generated must be constantly in balance with the amount consumed, this presents physical challenges. The prospect of such instability also creates market challenges. In ther traded commodity markets, buyers and sell- ers can compensate for delivery interruptions by hedging against them—by storing the commodity somewhere close to the delivery point, like coal in the coalyard, for example. No party isin desperate straits due to a physical or market disruption. In power markets, however, interruption on the sellers end sends a desperate buyer into the whole- sale power marketplace. If that buyer is an LDC with public service obligations, it needs replace-ee are ust fw of he aifrencas in fnancial maket Siructure that eristn the comodty and derivatives ward ‘ovay, ‘Standardized Because They Were Created That Way! Many ofthe pysical and equlatory characteristics tha citin- ‘quis poner marks co nt exis inthe markets or oer financial ‘etnalves. The interest rte and inex derivaives trades on the Chicago Mercantile Bxctange ae standardized—they were crested ‘when the exchange wrote the produ dfnition. These cervatves _ate appropri for exchange trading because they hae identical ‘egal igh ana iss. rere are no physical ctr, perormance, ‘oc transportation concepts tht are relevant and noone "nee" ‘he undarvng reference asset. Sunply and demand ae relatively stable ina deep and liquid make environment. Typically, marke pattcinans are sophisticated an financially stron, Retail imes- tors participate in the marke through clearing members of the exchange, which have requirements The Commeatties Futures Trading Commission regulates market poessionals (brokers, dealer, and exchanges). and the exchange equates ts clearing members, so ha retail investors, a indirect participants, can rely onthe creditworhiness and transparency ofthe make. ic omn custoner credit risk ‘Affordable. Rollable Corn? ‘Agricultural commas als lack certain distinguishing characteristics of powe, Wholesale commodi= tis tke com or wheat are measurable, ungible goods wits few geographic limitations and no srvce- like characte, Nether suppynor drand can change nsanineously, Any market patcpant ‘an sor the physical commodiy to hedge aginst naira disasters or mathe cisuptons. And no State regulatory sructuce raquites these companies to maintain resource Teel orto supply retail ‘consumes with reliable and affordable com or wheat around the cock. Patipans havea choice as towhen, where, and whether fo ante the aricutraldrhatives markt ‘Natural Gas: A Simpler Energy Industry ‘Some view ne markt structure ofthe ratrl cas industry inthe United Sates as th most comparable to he power indastry, Each i equated by the Federal Energy Pogulatory Commission (FEC) and sae energy regulators ater al But, a reul of carain fron in physical inkasructure and regulatory juristiton, the wholesale mare stu {ure or natural gas s less complex han ta or power. Fist of al natural gas canbe stored at any point between production and the gas f= cal isibution compary (10). Second, he indus inkasrueture fs fail tnear—both intams of corporat structure and geography. One type of company owns te production (impor inftestructure. Another type owns the Fesc-equltd intestate pipelines. Once ‘he natural oa reaches 2 market area te state regulated LC then distributes natural gas. to end-use consumers, “These companies function independent of one another, regards of corpora a= Ailton. does nol regula ale nthe wholesale markets fri saes. For sub ‘sequent ransactons, FERC grants sells, by regulation “blanket” marketing crificates and as no authori thereat to review the reasorableess of aes. FRCS regulatory juistition doesnot reach othe ‘ates charged to end-use consumers, 8 does nth jusk and reasonable rats” jurisdiction inthe Federal Power Act ‘Many electric companies partici inane, two, rll thee segment of ther inusty (generation, transmission, and dlstribution}—Fen has not mandate the same lve of funcional unbundling in the electic busines ha Ita in ‘he natural gas business. Regulatory overlap is compounded forthe electri industry by he fac that in some instances, single power company ay hae slaleeneray regulator rom multiple sales. Geographical, the power industry in- ‘rasucture isan interconnected gid rahe ran a lnear pipeline transportation system from wellhead to burner tp.:ment power now itis in the market in order to avoid power disruptions in its service territory. The instantaneous nature of power as a commod- fty means the market pries for power and power derivatives are extremely volatile, Doctining Reserve Margins, Increasing Price Volatility Of course, the LDC could hedge, however imper fectly, with reserve generation. Historically, LDcs ‘maintained generation reserve capacities of 20: plus percent of anticipated peak power needs, in Order to meet regulatory requirements for resource adequacy. fa supply for demand ulstup, tion occurred, the 1D¢ ramped up its reserve generation unit Over the past 10 years, reserve mar gins have shrunk, ddue in part to rising power demand and regula: tory, environmental, and other restrictions on building new generation. Contributing to that, and as a result, LDCs have relied ‘more and more on power deriva- tives (primarily forward power supply contraets and options) to ‘meet their public service obliga. tions and provide ‘paper reserves” With no choice but to participate in these markets if they are to Fulfill ‘those obligations, LDCs rely on the power markets to hedge their power needs. Existing Energy Regulation and the Power Markets In addition to being an industry where the derivatives products are highly customized, supply and de- ‘mand are not stable, prices are ex ‘raordinarily volatile, and hedging is dificult, energy companies and the purchase and sale of physical power and power derivatives are heavily regulated by the Federal Energy Regulatory Commission (enc) and state public utility com. ‘missions. FENC's regulatory charge fs to provide reliable electric power to companies and consumers at just and reasonable rates—an un- usual statutory/regulatory focus for ‘commodity market regulator. The state energy regulator's mission isto provide reli able electric power at affordable rates to that state's retail energy consumers. nother commodity and derivatives markets, the market regulator does not also regulate rates that selected market participants charge to consum. cers Nor do market regulators judge the reason. ableness of such rates (or market prices that may affect them) or review some market pattcipants) projected business plans (as state commissions do publicly). The CFTC focuses on financial market structure, participant behavior in the particular regulated market, and equal access to relevant his ‘orieal pricing information. ‘The Spectrum of Power Markets Electricity in the United States has many markets, (See the sidebar, “What Do Utilities Trade?") Physi- cal electric power is traded for future delivery in three types of orc markets. ‘Tariffs. These are one-way, sales-only regulatory filings that provide the terms under which a FERC: regulated entity sells power, Wholesale power tariffs are relatively new, having been a part of FERC’ late 1980s deregulation ofthe electric power industry.‘Markets organized by regional transmission or- ganizations, An RTO, comprised of stakeholders in a vansmission market (generation owners. trans- ‘mission owners, LDCs with assets inthe region, and others}, manages the power flows within and be- ‘ween geographic regions and among geographic ‘market participants, These are regional markets, unC-regulated and focused on reliability; they are neither CFTC-regulated exchanges nor clear ing organizations. In general, an RTO's credit risk ‘management rules are far less compechensive than the dally mark-to-market margining required for cleared derivatives products Bilateral contract markets. These developed as lulies waded wholesale power anv daeselves to fill emergency needs or maintain required serve margins before a new plant came online. No exchange rules or binding or consistent market practices govern behavior in these markets. There are certain standard product definitions and mas: ter agreement templates available. But the par ties establish their unique agreement within legal contract principles, agreeing to produc, delivery point, quantity, price, and any excuses for perfor See es volatity, keep erry ndash ow a. fe power and power derivatives, wise se ein ( | asco rafned produ (6.0. Saonensere ten uu dioxide nd enon mena products (2.9. renewable enory ced). ‘Taree types of financial matkets for power d "ivatives have also developed-—where the underly ing commodity (rom which thederivativesmarket “derives” its value) is physical Power delivered. In these markets, the counterparties havens expects tion atthe time of contract that physical power wil be delivered or received. The markets are cash-set= ded. Lbs participate in financial power derivatives markets often {o hedge the price or availability risk oftheir furure physical power supply needs, crrc-regulated markets. The New York Mercantile Exchange ‘and the Intercontinental Exchange permit trading in certain power lrivatives products that the ex- ‘changes have defined in standard- ized, identical commercial terms. Ambiguities would ereate tisk for the exchange, which acts as buyer for all sellers and seller to all buy: crs. Exchange-traded power deriv tives are relatively new and have ‘relatively short time horizon, m0 derivatives markets Various sroshave created markets for what are essentially financially settled power derivatives. For example, certain R10 markets allow the pur chase and sale of “virtual” powerRUC lm tlsupply or demand, so participants ean manage the differ. ence in availability and price of power in the RTO’s day- ahead and real-time ‘markets In some RTO ‘marks, participants can also trade finan- cial transmission rights or congestion ‘management rights to hedge the cost, of power delivered There is no physical delivery component to these transac- tions. (Orc markets for financially settled power derivatives, The bilateral contract markets for power deriva- tives are vas, varied liquid, and opaque. Many of the products are not, by any definition, standard- ized. In fact, for many types of financially settled power deriviatves, rue trading mazkets are non- existent. The buyer and sellers rights, risks and re- sponsibiltes vary tremendously, from the simple (power forwards, index swaps, and options) to the complex (cross-commodity spread transac: tions and tolling agreements). Some transactions reference rT0 locational marginal pricing nodes, weather, or products inked to the power produced by identified power facilities or systems. Poner derivatives are not routinely traded in financial markets or cleared, primarily because the vast majority have been developed and evs: tomized according to the particular needs of the ‘market participant and thelocal geographic power market. Beyond Customized ‘The Derivatives Markets Act proposes that all “standardized O1C derivatives be traded on CrTC- regulated exchanges. Bu the vast majority of power derivatives waded in today's markets contain highly ‘customized terms: Quantity depends on genera ton performance or power requirements: delivery point is nota trading hub but a particular node or busbar; the transaction term may be an hout, bal: ‘ance ofthe day, peakor offpeak, of as long as 10-20 ‘years; contract pricing may be hourly or seasonal In current commodity and derivatives markets, exchanges can precisely define derivatives with identical commercial terms. Market participants can then choose ‘to manage busi- ness risks by using those exchange traded products or customized OTe derivatives. ‘The Derivatives ‘Markets Act how= ever, would im- pose a mandatory exchange trading requirement, Pol icy makers would Uetine what Is standardized, and only the regulator could exempt a customized prod: uct. Under such a structure, the LDC's decision to buy a customized product would become, for all practical purposes, a complex and risky proposi- tion. Tomake sureit did notoverlooka standardized product to meet its particular and acute hedging need, the util- ity would have 10 be aware of all power de. rivative prod- The Derivatives Markets Act di- vides regulatory jurisdiction over the derivatives markets among the ucts offered ‘on exchanges. Since that could prove Impossible, the LD¢ then must dete ‘market regulator would decide, fa transaction was either similar « traded product or was sufficentl an LDC can‘ wait, it runs the risk legal offexchange derivative trans ‘The act also proposes that all sta derivatives be cleared by a C#IC-rez ‘Historically, as commodity and derivatv have developed, clearing entities have offe 2a fee} clearing services for products that the entity determines ate identical to one another. Market participants can then choose to use the clearing services to reduce credit risk or not. The act takes away this choice. It would require that standard- ized derivatives be cleared. And for customized derivatives, the act may require LDCs to tie up large amounts of cash in capital and margining require- ‘ments. (See the sidebar, "Meeting Margin.”) In s- sence, market participants have pay eliminate credit risk see, the cFT¢, and banking regulo-‘The act assumes that there will be a clearing ‘entity available for every standardized exchange- traded derivative and thet regulators ean thus re- ‘gute LDCs 6 comply Buta clearing entity can also As it stands, the Derivatives pracaedarard Markets Act does not provide for Geriauve prod, how the new regulatory structure uct, orchoose 0 will be applied to existing deriv. requiresubstan- atives and markets and to com- _ ta fees, capital, mercial companies that have ele traded long-dated transactions. gin for is clear ing services. Gearing isnot universally available and can be an ‘capeisive isk unniagennei elviee “The act also would have all major swap partici pants (not just dealers) register with the CFTC and be subject to capital and margin requirements, business conduct rules and disclosure standards, record-keeping and reporting standards, position limits, and other business restrictions. The defini- tion of “major swap participant” includes any per jth a "substantial nt position,” but thereisno ‘on what constitutes such a position and for hedging for business or financial ‘evalzd clearing of pone derivative xod- os requires the iy to post cash or cash ‘cuivaents s margin, For specific pes of ‘products, exchanges o clearing nites set the margin ‘amounts and determine wrt canbe used 25 collateral {nil arin eaitemens ar typical parentage ‘ofthe tansacto’s nominal amount. Uilites enter into ten of billns of dls of derivatives transactions annual, most of which arent exchange-traded but ‘ve the counter, requng minimal margin. With ‘mandatary cetalzed cleating, atypical ‘ity woud te up hundreds of ‘lions ot ors. Also, fo compen sal for mart moves, ‘karin nites may eauireice-daily margin adjustment, Power der tvatvs contra ae often ‘oustanding for wens, mons, ‘ot years and poner pies te volatile Ui would have to ‘maintain huge amounts of aaiable ed pls, te administrative costs would be considerable. Customer rates ‘woul el the impact in higher power prices. tisk management purposes if the derivative does not fit within the hedging rules for U.S. generally _accepted accounting practices (CAAP) ‘The factis, energy companies often make hedg: ing decisions that n't meet the strict GAAP rules— there are many types of non-GiaP hedges that are bona fide business decisions and not in the least speculative. Moreover, LDCs often maintain in their supply portfolios multi-year derivatives (forward contracts and options). Those derivatives would be costly hedging choices ifthe LDC werea majorswap participant and subject to the capital and margin« ing burdens forall non-GAAP hedges. ‘The Derivatives Markets Act divides regulatory jurisdiction over the derivatives marketsamong the Sc, the CFTC, and banking egulators. Policymakers ‘must also harmonize FERC jurisdiction and FERC's cstablished n10 market structure. Federal and state energy regulators focus on reliable electric service at reasonable, affordable rates; and their report- ing and other regulatory requirements reflect that. ‘Such goals may be inconsistent with the proposed derivatives market structure. Lbs should not be responsible to comply with potentially competing ‘and overlapping regulatory structures. Finally, energy companies need clarity for ‘existing long-term hedges. As it stands, the Derivatives Markers Act does not provide for hhow the new regulatory structure willbe ap- plied to existing derivatives and markets andto ‘commercial companies that have traded long- dated transactions. The act includes transition periods of 180 days, without grandfthering provi- sions for ong-dated derivatives. The LDCs did not cause the financial market ci ses of 2008, LDCs are not Wall Stret—rather, they provide the power that lights Main Street. A new financial market structure should not prevent the Dcs fom fulfilling theie public service obligations or impose significant and unnecessary costs. #