OTC electricity derivatives: Are your risk management policies up to scratch?

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Today, we continue our discussion about AFSL obligations looking at OTC electricity derivatives.

OTC- Over the Counter (Electricity Derivatives)

 

By Dr. Drew Donnelly, Compliance Quarter.

Last time we talked about the regulatory reforms to OTC derivative transactions that have occurred over the last five years or so in Australia. And in The AUSTRAC risk management tool: Are you meeting your obligations under the Anti-Money Laundering and Counter-Terrorism Financing Act 2006? we talked about risk management procedures in relation to the anti-money laundering and counter-terrorism regulatory regime. In today’s piece, our second article on the regulatory framework for derivatives in Australia, we discuss an Australian Securities & Investments Commission (ASIC) review of risk management policies and procedures for participants in the OTC electricity derivative market and look at a few of the areas identified in that review for improvement.

What is an OTC electricity derivative?

Recall from last time that a derivative is a financial instrument with an underlying asset. This asset could itself be a financial instrument like shares, but could also be a form of energy such as electricity or oil. An over-the-counter (OTC) electricity derivative is an electricity-based derivative that is traded person-to-person rather than through an established financial market.
This type of derivative is sometimes used by speculators, who are able to profit from changes in the underlying price of electricity. But as electricity markets can involve significant price fluctuations, OTC derivatives are sometimes also employed by businesses that use or sell electricity as a form of hedging; they can be used to offset those price fluctuations.

Regulation of OTC electricity derivatives in Australia

In Australia, dealing in derivatives related to the wholesale price of electricity requires the possession of an Australian Financial Services (AFS) licence and accompanying authorisations. This is significant as while the purchase and sale of certain derivatives used for hedging purposes are exempt from AFS licensing under the Corporations Regulations 2001, wholesale electricity markets are explicitly not included in that exemption.
As part of its wide-ranging regulatory reforms of OTC derivatives ASIC consulted on changes to financial requirements for participants in this market in 2012. ASIC decided at that time to defer any decision to change the financial requirements for these participants, but did express concern about the risk management processes being used in this area. Like all AFS licensees, buyers and sellers of these derivatives must comply with the requirement in the Corporations Act 2001 to ensure that they maintain adequate risk management systems (s912A(1)(h)).

In light of this, ASIC subsequently reviewed the risk management policies and procedures of market participants. Note however, that this was not a review of actual compliance with risk management policies and procedures.

The 2014 Review

In its report of April 2014, Review of OTC electricity derivatives market participants’ risk management policies, ASIC gave a relatively positive report of practices in the sector. In particular, ASIC identified corporate governance structures and policies for the reporting and escalation of any breaches as well-documented. However, there were several areas identified where participants could improve their policies and procedures. ASIC suggestions included:

• adding a requirement for daily valuation of derivative positions to risk management policies
• requiring the use of passwords and a system for reviewing them in order to authorise derivative transactions in the organisation
• using several methods of assessing credit risk of counterparties (i.e. not just using a public rating from a credit rating agency).

For further information see the full report at http://download.asic.gov.au/media/1344566/rep390-published-17-April-2014.pdf.
For professional advice on your risk management procedures and policies in the OTC electricity derivatives space, please get in touch with us.

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