European legislation introducing tighter regulation of financial trading – the Markets in Financial Instruments Directive II (MiFID II) – will come into force in January 2017. While the MiFID II Directive recognised reasonable exemptions for the energy sector by taking into account the difference between financial and physical trading, the consequent implementing rules now being developed by European financial regulator ESMA adopt a much stricter approach.
MiFID II redefines which companies and sectors are covered by previous financial regulation. Whilst the criteria proposed in the Directive to assess whether the trading activity of a company is ancillary to its main business seemed workable, ESMA’s proposed guidance on how to implement this exemption does not appear to meet the aims of the original text. Instead, it raises concerns from the perspective of energy market development and could ultimately lead to a deterioration, rather than an improvement, of energy market functioning.
In particular, ESMA’s draft Regulatory Technical Standards, which were consulted until early March, proposed two tests to decide whether trading activities should fall under MiFID: 1) capital employed in commodity derivatives trading will be exempt if it remains below 5% of a company’s total capital employed, and 2) the European market share of a participant’s trading activity in at least one of eight commodity asset classes (e.g. power, gas, coal, EUAs, etc.) must not exceed 0.5%. Companies would fall under MiFID if they fail either one of the tests.
Under this interpretation of the Directive, the vast majority of energy trading firms would be regulated as if they were investment firms, subject to detailed oversight by financial regulators and forced to comply with onerous and costly rules on licensing requirements, clearing and margining, capital and liquidity adequacy, etc.
There are also continued concerns regarding the definition of financial instruments, on which ESMA submitted final Technical Advice to the Commission in December. Special concern raises the introduction of an “ability test”, according to which market participants would need to prove that they have “proportionate arrangements” in place to settle their commercial trades. This would undermine the exclusion of physically settled gas and power contracts traded on organised trading facilities, set in the Directive. At least as importantly, the current definition would imply that bilateral contracts entered into by end-users would be unduly classified as financial instruments.
All implementing rules should be published in the Official Journal of the European Union by early January 2016. To meet this deadline, they will need to be adopted by the European Commission by the middle of this year, allowing for a scrutiny period of maximum six months for the Parliament and Council.