Both the EU and the UK have been fighting the energy crisis for a year. As the crisis has evolved both the UK and the EU have responded with measures designed to protect both consumers and businesses. In particular, a subset of the measures adopted or considered for adoption has been addressed specifically to financial markets, with the guiding intention being to preserve the current energy crisis from becoming a new global financial crisis. In this briefing note we focus on recent financial market related initiatives that the EU and UK have implemented to deal with the energy crisis and its implications.
Essentially the EU’s response is both targeted and time limited. In respect of measures focused on financial markets, the intention behind them has been to ease the liquidity stress that energy companies have faced when meeting their margin requirements, and on tackling extreme price volatility on energy derivative markets. The European Commission (Commission) has sought to achieve these aims by using legislation and its European Supervisory Authorities.
New EU legislation
In terms of EU legislation, the Commission issued on 14 September 2022 a draft Council Regulation implementing emergency temporary measures for EU energy markets. The proposed Council Regulation followed up on political guidance given by the Council in an extraordinary Energy Council on 9 September 2022. The aim of the draft Council Regulation is to mitigate the effects of high energy prices by adopting certain temporary measures.
The draft Council Regulation has four key elements being:
- Demand reduction: the proposed Council Regulation contains rules to reduce gross monthly electricity consumption (Article 3) as well to reduce gross electricity consumption during peak price hours (Article 4). The proposed target for the former is 10% compared to the average of gross electricity consumption in the corresponding months of the reference period, and for the latter at least 5% on average per hour. Member States are to choose the appropriate measures to reduce gross electricity consumption.
- Cap on market revenues: the proposed Council Regulation contains provisions on a mandatory cap on market revenues of infra-marginal electricity producers with low costs of production. Article 6 sets an ex-post cap of EUR 180 on revenues per MWh of electricity produced. The cap is to be applied to electricity sources from renewables, as well as nuclear energy, lignite, crude oil and other oil products (Article 7(1)). In addition, there are provisions concerning the distribution of surplus revenues, which Member States would use to finance measures in support of final electricity customers. Member States are relatively free to decide how to use surplus revenues to achieve this, but the draft Council Regulation contains examples of possible measures. Member States are to be allowed to share their revenues with Member States whose net imports of electricity are equal or higher than 100% (Article 10).
- Retail measures: the proposed Council Regulation provides for a possibility for Member States to introduce public interventions in price setting for the supply of electricity to small and medium-sized entities (Article 11). In addition, subject to certain conditions, Member States may set a price for the supply of electricity below cost price regulated prices, in connection with a public intervention (Article 12).
- Measures concerning the oil, coal, gas and refinery sectors: the proposed Council Regulation includes provisions on a mandatory temporary solidarity contribution based on surplus profits generated from activities in the oil, gas, coal and refinery sector (Article 13). Member States must introduce national measures to this aim by the end of 2022 and the mandatory temporary solidarity contribution is intended to apply from 31 December 2022 at the latest. The contributions are temporary and would only apply to surplus profits generated in the 2022 fiscal year (Article 17). The base and rate for calculating the solidarity contribution are contained in Article 14 and 15 of the proposal.
Following the publication of the draft Council Regulation, an extraordinary Energy Council meeting on 30 September 2022 adopted the proposed Council Regulation but with the following compromises:
- From 1 December until 31 March 2022, Member States would aim to reduce electricity demand by 10 percent, with a 5 percent reduction during peak demand hours.
- The proposed mandatory cap on market revenues of infra-marginal electricity producers with low costs of production would be at as an ex-post cap of EUR 180 on revenues per MWh of electricity produced. This is in line with the original Commission proposal. Member States would be free to only target 90 percent of the revenue above the EUR 180 per MWh cap, and Malta and Cyprus are excluded from the cap.
- The measures would expire in December 2023, and the Commission will undertake an interim review in April 2023 to consider whether amendments to the framework are required.
On 6 October 2022, EU Member States formally adopted Council Regulation (EU) 2022/1854. The Council Regulation was published in the EU’s Official Journal on 7 October 2022 and entered into force the following day. Being a Regulation, it is directly applicable in Member States although as can be seen above the detail of some of the specific measures will need to be worked through in domestic legislation.
On 18 October 2022, the Commission adopted two Delegated Regulations amending the regulatory technical standards under EMIR regarding the clearing threshold for over the counter (OTC) commodity derivative contracts and other OTC commodity derivative contracts and temporary emergency measures on collateral requirements respectively. The Delegated Regulations:
- Increase the clearing threshold for non-financial counterparties to EUR 4 billion, with those below the threshold having an exemption from the margin requirements on their OTC energy derivatives.
- Broaden the list of eligible assets that CCPs may accept to cover their risks for one year, allowing non-financial companies as well as all market participants to use extra types of guarantees for meeting their margin calls.
On 18 October 2022, the Commission published another package of measures aimed at addressing the large volatility in the gas markets. The package includes a Communication and a proposal for a Council Regulation on enhancing solidarity through better coordination of gas purchases, exchanges of gas across borders and reliable price benchmark. The Communication sets out a number of measures aimed at addressing the high level of gas prices as well as the volatility in the wholesale gas markets.
These measures include:
- Joint purchase of gas (Article 5 – 11): The Commission proposes measures enabling EU Member States to jointly purchase gas. The goal of the joint purchasing programme is to increase leverage on the side of the Member States, which would lead to the import of gas into the EU at more competitive prices. More specifically, the Commission proposes to demand aggregation of gas demand at EU level, to impose a mandatory participation by Member States in this aggregation at 15% of their gas storage filling volume, and to set up a voluntary purchasing system that would allow companies to form European gas purchasing consortiums.
- New complementary benchmark for LNG (Article 18 – 22): The Commission proposes to develop a new complementary price benchmark for LNG to ensure a more accurate basis for LNG transactions. Under the current system, prices for LNG are influenced by the general gas prices reached on the Title Transfer Facility (TTF), which is the main European gas exchange. The proposed LNG-specific benchmark should become available in the beginning of 2023, and the European Union Agency for the Cooperation of Energy Regulators (ACER) should commence with the collection of data required for the creation of this benchmark by the end of this year. In the meantime, the Commission proposes a mechanism to limit prices via the TTF to be triggered when required, creating a dynamic price limit for transactions on the TTF (Article 23 – 24).
- Spike-cap mechanism (Article 15): To address extreme intra-day volatility, the Commission proposes to introduce a new temporary intra-day price spike cap mechanism that would be mandatory for trading venues on which energy-related commodity derivatives are traded.
On the same day, the Commission adopted two draft Commission Delegated Regulations in connection to clearing, which should support non-financial counterparties to address their liquidity strains as a result of margin increases occurring due to volatility in the energy markets:
- A Commission Delegated Regulation supplementing EMIR (Regulation (EU) 648/2012) to increase the clearing threshold for non-financial counterparties to EUR 4 billion.
- A Commission Delegated Regulation amending Commission Delegated Regulation (EU) 153/2013 to temporarily expand for a period of 12 months the pool of central counterparty (CCP) eligible collateral to uncollateralised bank guarantees for non-financial counterparties acting as clearing members and to public guarantees for all types of counterparties.
On 25 October 2022, the Energy Council did not deliver a lot of progress in reaching an agreement on the Commission’s proposals with regard to the gas markets. The main point of contention between the Member States was the proposed mechanism that would establish a dynamic price cap on TTF spot markets for natural gas during high price volatility. With regard to the proposed requirement for trading venues on which energy-related commodity derivatives are traded to set up temporary intra-day volatility management mechanisms to apprehend excessive price movements more efficiently, the Council is of the view that the mechanism should only apply to energy-related derivatives whose maturity does not exceed 12 months.
European Supervisory Authorities
On 15 September 2022, the Commission issued a letter to both the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) asking for a response to excessive margin levels and volatility in the energy derivatives markets. In particular, the letter noted that energy companies had been required to post higher amounts of cash collateral to CCPs given that margin calls had risen in line with prices. This in turn resulted in problems of liquidity in EU energy companies, which some Member States had addressed through public guarantee schemes although this had also led to calls for amendments to the rules governing collateral requirements for margin calls. The letter also observed that non-financial counterparties faced difficulties accessing cash or other types of high-quality liquid assets they could post as collateral for their energy derivatives cleared activities.
ESMA issued its response to the Commission’s letter within a week and provided a high-level assessment of possible measures to limit excessive volatility, also known as circuit breakers, and CCP margins and collateral.
In terms of measures to limit excessive volatility, ESMA suggested that the Commission consider a temporary trading halt mechanism for the energy derivatives markets. The parameters for the mechanism would be set at the EU level and apply to all trading venues that offer trading in energy derivatives. Should there be extreme market volatility that could lead to disorderly trading conditions, a temporary halt would be put in place.
ESMA also confirmed in its letter that it had already started a review of its existing rules to clarify existing concepts such as static circuit breakers and reduce, where justified, the level of discretion left to trading venues on which mechanisms to have in place.
As for margin and collateral, ESMA expressed the view that increased margin requirements have led some market participants to reduce their hedging activities. It also considered temporarily expanding the list of eligible collateral by non-financial counterparties active on the gas and electricity regulated markets by including EU bonds, commercial bank guarantees backed by public entities and commercial paper. In contrast, ESMA raised concerns about the possible inclusion of uncollaterised commercial bank guarantees and emission allowances. This recommendation has been endorsed by the Commission, which adopted a Commission Delegated Regulation to this end on 18 October 2022 (see above).
ESMA’s letter to the Commission also covered three specific issues:
- Commodity clearing thresholds. ESMA asked the Commission to consider and adopt draft regulatory technical standards that would increase the commodity clearing threshold from EUR 3bn to EUR 4bn, which it published in June 2022. The Commission endorsed this recommendation and to this end adopted a Commission Delegated Regulation on 18 October 2022 (see above).
- Improving regulatory reporting on commodity derivatives trading. ESMA asked the Commission to consider introducing minimum reporting requirements for energy derivative products, such as transaction reporting and daily position reporting.
- Regulating and supervising commodity traders acting like investment firms. ESMA stated that it would be useful to amend the so-called ‘ancillary activity exemption’ so that it would no longer be applicable to the biggest non-financial entities that trade and provide investment services in commodity derivatives.
In its response the EBA felt that the EU’s prudential framework is built for normal, as well as more challenging times such as the current situation and overall it was working as designed. Notwithstanding this the EBA added that support from banks to energy firms had grown rapidly with banks reaching a point where internal risk limits were beginning to bind. Given the support already provided, additional bank capacity would likely be more limited should the levels of market stress in energy derivatives exceed those observed in August. In terms of liquidity management, the EBA reported that banks were facing significant liquidity draws during significant market movements and efforts to provide more transparency around margin calls would be welcomed.
On 18 October 2022, ACER and ESMA announced that they were strengthening their cooperation to further improve information exchange and avoid potential market abuse in Europe’s spot and derivative markets. ACER and ESMA have established a joint task force to reinforce their cooperation and enhance coordination in respect of the exchange of data and knowledge among their staff and respective national authorities. This enhanced coordination will support investigations and enforcement so that rules are applied with vigour.
The UK Government made a commitment in its British Energy Security Strategy to undertake a comprehensive review of Great Britain’s electricity market design to ensure that it is fit for purpose. On 18 July 2022, the UK Government launched its Review of electricity market arrangements (REMA) consultation, the first step in a process towards a new set of electricity market arrangements, intended to ensure that the UK meets its commitment of fully decarbonising the power system by 2035, subject to security of supply. The REMA consultation closed on 10 October 2022 and the Government’s response is expected this winter.
Whilst the REMA consultation is wide ranging, the turbulence in energy markets has led the UK Government to move forward with additional new schemes. Like the EU response, these schemes focus on liquidity stress faced by energy companies when meeting margin requirements and volatility in energy prices.
Energy Markets Financing Scheme
On 17 October 2022, HM Treasury and the Bank of England (BoE) launched the ‘Energy Markets Financing Scheme’ (EMFS). The EMFS is broadly similar to schemes launched in Germany, Finland and Sweden and is designed to help firms facing temporary short-term financing problems. The EMFS is open to firms of good credit quality playing a significant role in UK energy markets, such as generators, shippers or suppliers. They must currently operate in the UK energy market and must be, or have an entity which is, Ofgem-licensed. Such firms will need to demonstrate they are facing large liquidity needs from margin calls when hedging their energy price risk. Under the EMFS such firms will be able to apply for government-backed guarantees to secure commercial financing and meet large margin calls from energy price volatility. Firms have three months to apply and once approved will be able to benefit from a guarantee for a further 12 months.
The EMFS comes on top of the Energy Bill Relief Scheme, for all eligible non-domestic customers, and the Energy Price Guarantee, which will ensure that a typical household in the United Kingdom pays around £2,500 a year on their energy bill, depending on their use, from 1 October 2022. Both the Energy Bill Relief Scheme and the Energy Price Guarantee, along with various others, were given legislative footing in the Energy Prices Act 2022, which received Royal Assent on 25th October 2022.
CRM and the EMFS
On 18 October 2022, the Prudential Regulation Authority (PRA) published a statement on credit risk mitigation (CRM) eligibility, risk-based capital treatment, and leverage ratio treatment of guarantees under the EMFS.
The statement sets out the PRA’s observations on the capital requirements relating to firms’ exposures under the EMFS, particularly eligibility for recognition as unfunded CRM under the UK Capital Requirements Regulation (CRR). The statement also sets out observations of the treatment of exposures under the UK leverage ratio framework.
Key points include:
- CRM eligibility of EMFS guarantees – The PRA considers that the terms of the guarantee provided under the scheme do not contain features that would render the guarantee ineligible for recognition as unfunded credit risk protection under the CRR, and the effects of the guarantee would appear to justify such treatment.
- Observation on the EMFS scope of protection – The EMFS guarantee does not cover funds advanced after the lender learns of a use of funds previously advanced for a non-scheme purpose, or of a downgrade in the borrower’s credit rating to below the scheme minimum. Sums advanced in these circumstances are consequently not guaranteed and should be assigned the risk weight of the obligor. There is an exception for further advances made in these circumstances with the guarantor’s consent.
- Firms applying the Standardised Approach (SA) for credit risk – The portion of an exposure benefiting from the protection of a guarantee provided by the BoE under the EMFS should be assigned the relevant central bank risk weight prescribed by the SA. Any residual part of the exposure that is not covered by the guarantee should be assigned the SA risk weight that would apply if the exposure were not guaranteed.
- Firms applying an Internal Ratings based (IRB) approach for exposures to be obligor, with a permanent partial use (PPU) exemption for exposures to the guarantor – The portion of an exposure benefiting from the protection of a guarantee provided by the BoE under the scheme would be assigned the relevant central bank risk weight prescribed by the SA. Any residual part of the exposure that is not covered by the guarantee should be risk weighted according to the relevant approved IRB approach as if the exposure were not guaranteed.
- Firms applying an IRB approach for exposures to the obligor and for exposures to the guarantor – Firms should adopt an approach to reflect the effect of the guarantee provided by the BoE that is consistent with their approved IRB models and their IRB permissions.
- Leverage ratio treatment of exposures under the scheme – Firms should include exposures relating to the scheme in their leverage ratio total exposure measure, as calculated in accordance with the Leverage ratio (CRR) part of the PRA Rulebook.