by Kenneth W. Irvin, McDermott Will & Emery LLP
Energy traders never have an easy job, and today’s market and regulatory conditions make the trading environment even more challenging. On the one hand, the market is rife with price volatility, credit problems and turmoil. Throughout the hydrocarbon and commodities markets, once proud and successful companies have been hit hard by the recession, the credit freeze and the resulting loss of confidence. Yet on the other hand, commodities regulators seem committed to policies that could create even more difficulties. President Obama’s choice to head the Commodity Futures Trading Commission has indicated that among his policy priorities for the CFTC will be “appropriate capital requirements and business conduct standards,” position limits on futures trading and greater scrutiny of electronic market operations.
Energy traders are now in much the same position as power companies after a hurricane hits: even in a disaster beyond their control, they must still clean up and manage the aftermath. When energy prices were rising, traders developed hedging strategies that were designed to manage market risk. But the question now is whether these will be sufficient to help traders avoid problems similar to those that hit the major investment banks in 2008? The bankers had highly sophisticated hedging strategies, yet today many of their traded financial products are virtually worthless. Like mortgage derivatives, energy derivatives can trade in illiquid markets with high volatility. Perhaps, underlying energy assets may be managed more successfully than subprime mortgages, but now, with strained credit supplies and regulatory uncertainty, hedge participants face new rules of the road.
Hedging and credit risk
The International Swaps and Derivatives Association (ISDA) Master Agreement, Schedule and Credit Support Annex together form the customary documentation for hedging arrangements. Other agreements may certainly be used, but they all share an Achilles heel: The credit risk mechanism has not served parties well and will not suffice without adjustment for the new economic landscape.
Looking back, we know now that a significant misapprehension existed in the premise on which the usual ISDA hedge was negotiated. Until recently, the market assumed that a margining trigger below investment grade would provide sufficient indicia of a counterparty’s credit and liquidity risks. Hedge participants who accepted the hard-line positions of financial institutions that seemed “too big to fail” have recently found themselves stuck. The “triggers” used left parties unable to issue margin calls until too late. The loss of credit suffered by hedge providers happened so fast that the usual triggers were essentially meaningless.
Undoubtedly, credit assessments offer an important tool, but by themselves they have proven inadequate to the task of providing advanced warning (especially where the proverbial run-on-the bank can kill your counterparty). Because ratings agencies far too often either deal the fatal blow or only confirm the death of the rated entity, prudence dictates finding alternative means for early warning.
How, then, do we gauge a counterparty’s performance risks when hedging? Conduct due diligence to investigate the level of interconnectedness your counterparty has. Consider “macro” issues, including market sentiment. And, never underestimate the value of continually monitoring exposure to counterparty risks. Indeed, the increasing discovery of incidence of fraud should surprise no one considering the current economic environment.
One obvious benefit of credit ratings is their objective measurability. In comparison, the natural gas trading agreement published by the North American Energy Standard Board Inc. (NAESB) allows margining when a counterparty has “reasonable grounds for insecurity.” Though relatively subjective, the NAESB approach would have offered more symmetry in negotiations between borrowers and hedge providers over the past several months.
As the market seeks alternative methods by which to evaluate credit risks, one lesson is that a single form of measurement will not fit all. While a ratings trigger may constitute cause for assurances in relation to a corporation, the same measure could constitute a systemic failure for an investment bank. Whatever criteria the market favors in the future, expect that credit and margining provisions will become tightly tailored and more complex as hedging parties try to make sure exogenous events do not ruin their future plans.
Hedging and regulatory risk
Just as volatile financial market conditions can have unanticipated impact on hedging strategies, so too can unexpected regulatory upheavals. The speed and impact of regulatory change on the energy markets increasingly illustrates this fact. The likelihood noted earlier for tighter controls on commodities trading are part of a general regulatory transformation as the Obama administration pursues greenhouse gas (GHG) restrictions, a cap-and-trade system for carbon emissions allowances, and a variety of other regulatory actions. For example, look at charges being considered in PJM and ISONE to their respective capacity markets.
Such regulatory changes may not prevent performance or render a contract void in a hedging transaction, but they can nonetheless alter the parties’ economic expectations severely. If parties elect to enter into hedging agreements, it is prudent, therefore, to identify at the time of contract formation how the parties will allocate the burden of intervening regulatory change. Far too often parties to energy contracts do not, at the time of formation, make a thoughtful allocation of who bears the burden of intervening regulatory change, and instead devolve into disputes and litigation when confronted with change. This is true for all forms of energy products, and will be especially apt for emissions and REC contracts.
The key to surviving regulatory instability and ensuring a durable agreement is to identify the regulatory construct on which contractual expectations rest, and then to negotiate the cost of compliance with existing and future requirements. In a transformative era full of uncertainty, common sense dictates including a “regulatory change” provision in hedging contracts. Such provisions prescribe remedies following legal, regulatory or governmental action that (while not rendering a market illegal) eliminates or alters the value of the underlying product. A contract might expressly state which party bears the risk of regulatory change, or specify that the price fully contemplates compliance with future regulatory duties. Looking at RECs, for example, take care to ensure your seller commits to deliver a product that complies — at the time of delivery — with all the applicable requirements.
The mechanisms used for grappling with intervening regulatory change offer the tools for ensuring realization of the parties’ intent. Mediation, for example, is not just boilerplate put in by the lawyers at the end of the deal. While less definitive than an express allocation of risk, a requirement that parties negotiate in good faith — upon the occurrence of regulatory change to establish an equitable adjustment to their agreement consistent with parties’ initial expectations — might provide the means by which a durable agreement survives regulatory change and litigation, or it might so lose if it gives too much leeway and thus fosters litigation.
Sophistication and flexibility
As energy markets demand more sophisticated risk management strategies, energy traders must continue to adapt their hedging approaches to new realities. The demands of today’s energy trading risk management requirements cannot be underestimated. There is no standard methodology or measure that would predict the impacts of every potential market upheaval. Hedging will remain an effective strategy to manage risk, but it is not a guarantee to eliminate risk. The most practical response is developing the sophistication and flexibility to anticipate and provide for contingencies from unexpected market or regulatory developments.
Kenneth W. Irvin is a partner in the Washington, DC office of global law firm McDermott Will & Emery. A member of the firm’s Energy and Derivatives Markets and Global Renewable Energy, Emissions and New Products Practice Groups, he represents clients on federal and state commodity and energy matters, including hedging and credit risks, contract structuring and disputes, arbitrations, and regulatory issues involving energy and commodities trading, market regulation and structured transactions.