What’s going on in the European arena? Regulators, trading venues, market participants, financial and commodity analysts and data reporting agencies are all debating on the legal and operational implications of the various recent financial and energy regulations in the EU, whose implementations are already in effect either fully or partly. The three burdensome regulations flapping commodity firms are REMIT (Regulation on Energy Market Integrity and Transparency), EMIR (European Market Infrastructure Regulation), and MiFID II (Markets in Financial Instruments Directive ). The three regulations have been injected to the EU venue during an intense regulatory period following the financial crisis of 2008/2009. They came into force in 2011, 2012 and 2014 respectively with a full implementation to be achieved in the coming years. The following table broadly describes the three regulations and their relationships to commodity companies.
Figure 1 - The table was developed by the author based on the above mentioned regulations.
The critics in this venue are aware of some possible unintended consequences of these regulations such as: 1) reducing market liquidity, 2) reducing the number of market participants (concentrated market), 3) risk of regulatory arbitrage, 4) increased cost of hedging, and 5) increased cost of regulatory compliance. Among other things, we notice that the last two points might trigger the first two points through a possible movement of M&As in the energy sector.
Big energy companies expressed their serious worries regarding the aforementioned implications. The lack a of clear conceptual framework and precise definitions of contracts, venues, hedging and market participants might trigger a wrong signal regarding the hedging activities of energy companies. In this regard, energy companies may fall under the spikes of the three regulations as follows:
They are considered market participants under REMIT if they trade wholesale energy products or derivatives given an EU impact (financial or physical).
They might be considered financial counterparties under EMIR, and consequently losing the non-financial counterparty exemptions of clearing obligations.
They can also fall under MiFID II if their trading activity is considered not ancillary to their main business, and consequently they are required to apply for an authorized investment activity under MiFID II. In this context, other financial regulations may apply such as Capital Requirement Regulation (CRR).
These are immense regulatory burdens pointed out by many many interested parties, including various market participants in the energy sector, which might hinder the functionality of the market.
The important issue here is this: what about small and medium size (S-M) firms in the energy sector which are more vulnerable to regulatory changes and are not capable of managing the complexity of the new regulatory paradigm?
From one side, we know that financial regulations aim at capturing large commodity firms trading commodity derivatives for non-hedging or speculative purposes that may contribute to the systemic risk in the market. However, there is a flood of regulations being injected into the EU venue, and S-M firms in the energy sector will be negatively affected by finding it hard to comply or simply to show that they are out of the scope of certain regulations.
For this reason, they may search for a shelter. This shelter could be a large energy or financial investment company that will also be found struggling to be exempted from certain regulations. They have to find a safe corner inside the cave to be able to discharge the loads of regulatory compliance. In this context, the question is this: are we heading towards a wave of M&As in the energy sector?
In the same vein and if we assume that the M&As will be triggered by heavy regulatory compliance costs, market functionality will be affected and a new market structure could be reshaped as shown in the following diagram:
Figure 2 - Author’s representation based on the above assumptions
The number of market participants (MPs) will decrease causing EU energy markets to be more concentrated.
Market liquidity will be negatively affected since the hedging cost is higher, and market participants are, in this regard, afraid to trade products that are not exempted from financial regulations (general anxiety prevails today in EU markets).
Consequently, more room for manipulative behaviors and prices will not fully reflect market fundamentals.
At the end, too much regulations is a fact observed in the EU. The purpose of any regulation is to achieve a level of efficiency not obtained by the free market in itself; however, in the current situation it is plausible that too much regulation is in place in Europe and that this is generating some unintended consequences and losses of economic efficiency.
In order to lessen such negative impact, EU financial and energy regulators have to provide clearer interpretations regarding various pieces of regulation and to provide more holistic and comprehensive cost-benefit analysis. By doing so, they may send a positive signal to markets and let them settle down.
Murad Harasheh, Research fellow: University of Pavia, Department of Economics and Management. He is also Research partner at Italian Authority for Electric Energy, Gas and Water System
* Disclaimer: the views expressed herein are from the author’s perspective and do not necessarily reflect those of the institutions to which he belongs.