Energy companies moving forward with CFTC compliance despite uncertainties
By Thomas A. Utzinger (U.S.)
NEW YORK, May 31 (Business Law Currents) – Electric utilities and natural gas companies are facing new regulatory uncertainties involving the jurisdictional reaches of two agencies overseeing futures and derivatives trading as well as wholesale energy transactions: the U.S. Commodity Futures Trading Commission (CFTC) and the Federal Energy Regulatory Commission (FERC). Recent rulemaking efforts and litigation have raised questions as to the overlap and division of powers of these two entities over certain financial transactions and enforcement actions of interest to the energy industry.
DODD-FRANK REFORM AND EXPANDED CFTC JURISDICTION
The financial industry is witnessing a marathon of rulemakings required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). These actions include a new joint final rulemaking by the CFTC and SEC further defining and regulating âswap dealersâ and similar parties under Title VII of the Dodd-Frank Act (Swap Dealer Rule). The Swap Dealer Rule, recently published in the Federal Register on May 23, 2012, subjects these parties and related swap transactions to numerous registration and clearing requirements, and may have far-reaching effects on industries that make use of derivative transactions to hedge risks.
(The Dodd-Frank Actâs treatment of over-the-counter derivative markets and entities participating in those markets is described in more detail by energy investment companyÂ Energy Transfer Equity, L.P. in itsÂ Quarterly Report. In addition, the Swap Dealer Ruleâs new requirements were recently addressed byÂ Business Law CurrentsÂ inÂ Swap dealers, major swap participants and everyone else under Dodd-Frank: whoâs who and why we care.)
Historically, the CFTC has exclusive jurisdiction over accounts, agreements, and transactions involving contracts for sale of a commodity for future delivery (futures contracts). Futures contracts can include natural gas, electricity, or other energy products traded or executed subject to a designated contract market or other market or exchange under section 2(a)(1)(A) of the Commodity Exchange Act (CEA).
In turn, FERC has exclusive jurisdiction over the transportation of natural gas in interstate commerce and sales for resale of natural gas, under section 1of the Natural Gas Act (NGA). FERC also regulates the transmission of electric energy in interstate commerce and wholesale electric energy transactions by public utilities, under section 201 of the Federal Power Act (FPA). FERC maintains exclusive ratemaking jurisdiction over wholesale sales and interstate transmission of electricity under the FPA, as noted by Western-U.S. utilityÂ Black Hills Corporation in itsÂ Annual Report.
Given existing regulation of electric and natural gas energy futures trading, many parties feared that the finalized Swap Dealer Rule would be so broad in scope that previously unregulated swap transactions routinely employed by energy companies would become subject to the CFTCâs jurisdiction and its new registration and exchange requirements. While the energy industry functioned with the regulation of futures markets, the routine use of swaps to hedge market volatility due to weather, unforeseen demand, and other factors would be severely disrupted if regulated by the CFTC.
Energy companies use swaps with financial institutions and other commodity market customers to exchange floating price streams with fixed price streams. For example, as explained byÂ Exelon Corporation in comments submitted to the CFTC during the rulemaking process, an electric utilityâs annual revenue is based in part by the spot prices paid by a Regional Transmission Organization (RTO) or Independent System Operator (ISO) for the power generated. Without the swap, that annual revenue could vary widely based on demand. With a swap, however, the utility enters into an agreement whereby the variable price paid for the power generated (revenue) is transferred to another counterparty in exchange for a fixed revenue stream for the year, or vice versa depending on the specific circumstances.
Swaps work when counterparties have opposing views of the risks involved, and therefore agree to trade revenue streams. In the case of electric power, for example, the utility may believe that revenue in 2012 will be lower than average (and therefore the fixed rate it receives from the counterparty to the swap will be greater than actual revenue), whereas the counterparty believes that 2012 revenues will be higher than average (and therefore the revenues it receives from the utility will be greater than the fixed payments made to the utility). Utilities may also enter into opposite âfixed-for-floatingâ swaps to hedge against power generation unit failures and other situations in which it is preferable to receive payments based on floating spot prices instead of fixed revenue streams.
During the CFTCâs rulemaking process, energy companies were concerned that the final Swap Dealer Rule could categorize the companies making these daily swap transactions as âswap dealers,â subjecting them to mandatory capital, margin, and clearing requirements, as noted byÂ NextEra Energy, Inc. in comments submitted to the CFTC. The other concern was that the CFTCâs exemption of smaller âde minimisâ swap transactions would be set too low at $100 million, so that the total amount of a utilityâs swap transactions in one year would greatly exceed that exemption amount. NextEra noted in itsÂ Annual Report that the rules could negatively affect the companyâs ability to hedge commodity and interest rate risks.
Although the final Swap Dealer Rule raises the originalÂ de minimisÂ exemption from $100 million to a satisfactory $8 billion for âswap dealers,â falling to $3 billion within three to five years as noted by major Mid-Western electric utilityÂ PPL Corporation (PPL), energy companies remain cautious. Exelon Corporation, for example, states in its recentÂ Quarterly Report that the company is evaluating whether its derivatives activities will be regulated in any manner.
Similarly, many electric utility companies likeÂ NRG Energy, Inc. (NRG) andÂ Public Service Enterprise Group Incorporated (PSEG) are taking a cautious approach and further evaluating the rulemakings. NRG states in itsÂ Quarterly Report that the company is reviewing whether the Swap Dealer Rule applies to its business, while PSEG states in itsÂ Quarterly Report that the company is carefully monitoring the new rules as they are developed, to determine whether any impact on the companyâs swap and derivative transactions exist.
Given thisÂ de minimisÂ exemption increase, PPL notes in itsÂ Quarterly Report that the âdefinition of swap dealer is an amount that would not currently result in the Registrants being deemed swap dealers.â However, the company cautions that there âare numerous other provisions in the Final Rule . . . that the Registrants have not yet analyzed that could result in their being subject to the more onerous compliance requirements applicable to swap dealers.â Furthermore, legal issues and challenges could arise with respect to thede minimisÂ levels set in the Swap Dealer Rule, as recently addressed byÂ Business Law CurrentsÂ inÂ CFTC and SEC swap dealer rule raises legal questions along with thresholds. One such issue is that the threshold for government-owned public utilities remains at a miniscule $25 million instead of $8 billion, which would severely limit swap deals with such companies.
In addition, electric utilityÂ Dominion Resources, Inc. proposes in its recentÂ Quarterly Report that if the companyâs derivative activities are not exempted from all the potential clearing, exchange trading, and margin requirements associated with the Dodd-Frank rulemakings, the company could become subject to higher costs. Likewise, independent power producerÂ Calpine Corporation, in itsÂ Quarterly Report, notes that a number of features in Title VII of Dodd-Frank could impact its energy business. Natural gas companies are also concerned, as seen in the recentÂ Prospectus Supplement ofWilliams Partners L.P., stating that the company makes extensive use of swaps and other hedging transactions to manage financial exposure.
While the end result of the Swap Dealer Rule may not be a sea change in energy company hedging transactions, the full extent of the Dodd-Frank reforms on the energy industry remain to be seen, as many rules remain in development. This causes a level of uncertainty as energy companies and other participants in electric and natural gas transactions move forward with regulatory compliance initiatives, preferring to know whether or not traditionally unregulated practices will be subject to CFTC requirements.
CFTC AND FERC ENFORCEMENT AUTHORITY
In an ongoing matter previously reported byÂ Business Law CurrentsÂ inÂ Amaranth settles class action market manipulation suit, a turf war between the CFTC and FERC with respect to market manipulation enforcement involving natural gas (NG) Futures Contracts has become the subject of extensive litigation currently in the D.C. Circuit Court of Appeals. At issue is the apparent overlap of the CFTCâs and FERCâs authority over manipulative trading of NG Futures Contracts.
NG Futures Contracts are standardized agreements to purchase or sell a volume of natural gas at a predetermined price in the future, and are bought and sold on the New York Mercantile Exchange (NYMEX). NG Futures Contracts specify delivery of 10,000 MMBtus of natural gas at the Henry Hub in Louisiana in the month in which the contract matures. Sellers of futures contracts have a short position, benefitting if the price of natural gas drops before the delivery date. Buyers have a long position, benefitting if the price increases. Traders also enter into swaps, in which a swap buyer agrees to pay a fixed price, and the seller agrees to pay a floating price which is the final settlement price of NG Futures Contracts.
Section 315 of the Energy Policy Act of 2005 added a market-manipulation provision to the NGA. Codified at NGA section 4A, the law prohibits âany entityâ from âdirectly or indirectlyâ manipulating the market âin connection withâ FERC jurisdictional transactions, such as sales of natural gas in interstate commerce for resale. FERC implements NGA section 4A in Order No. 670, âProhibition of Energy Market Manipulation,â set forth at 18 C.F.R. 1c.1, the Commissionâs Anti-Manipulation Rule. FERCâs civil penalty powers under the 2005 amendments to the NGA are described in further detail in theÂ Annual Report of independent oil and natural gas companyÂ Energy Partners, Ltd., and theÂ Amended Annual Report of exploration and production companyÂ Antero Resources LLC.
FERC originally determined that former trader Brian Hunter intentionally manipulated NG Futures Contract settlement process by selling large amounts of contracts in the final half-hour of trading on three occasions. This manipulation was intended to benefit Hunterâs opposing swap positions (i.e., a decrease in NG Futures Contract settlement prices led to gains in the swap transactions). The close relationship between the financial and physical natural gas markets meant that Hunterâs manipulation of the futures market (under CFTCâS jurisdiction) had a direct effect on the settlement price of natural gas going to delivery and price indices (under FERCâs jurisdiction).
Hunter and the CFTC contend that FERCâs interpretation of NGA section 4A conflicts with the CFTCâs jurisdiction under CEA section 2(a)(1)(A), which provides the CFTC with exclusive jurisdiction âwith respect to accounts, agreements [of various types] and transactions involving contracts of sale of a commodity for future delivery.â FERC argues, however, that its anti-manipulation authority coexists and complements the CFTCâs authority.
FERC rejects Hunterâs argument that the CFTC has exclusive jurisdiction that precludes FERCâs jurisdiction and enforcement action. The commission states that while FERC does not directly regulate NG Futures Contracts, the settlement price of those contracts directly affects the price of natural gas sales which are under FERCâs jurisdiction. Therefore Hunterâs trading activities fell under NGA section 4Aâs prohibition of natural gas market manipulation âin connection withâ FERC-jurisdictional sales.
At this time it is unclear whether both commissions may share authority when NG Futures Contracts, which are exclusively regulated by the CFTC, are manipulated in a manner affecting the larger wholesale natural gas markets regulated by FERC. This is important to many market participants, not only in the natural gas industry but also to electric power companies as well, because the two commissions maintain different priorities and objectives, and parties engaging in these transactions deserve to have certainty with respect to which entity, or both, can initiate and pursue enforcement actions.
(This article was first published by Thomson Reutersâ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online atÂ http://currents.westlawbusiness.com)