THE DELTA REPORT
On April 4, 2016, the Commodity Futures Trading Commission ("CFTC") and the Securities Exchange Commission jointly proposed guidance ("Proposed Guidance") relating to the exclusion of certain electric power and natural gas products from the definition of "swap" under the Commodity Exchange Act ("CEA"). Under the Proposed Guidance, (1) certain capacity contracts for electric power and (2) certain peaking supply contracts for natural gas would not be considered "swaps" under the CEA. The Proposed Guidance is complementary to the trade options final rule removing end-user reporting and record keeping requirements, all intended to reduce the burden for end-users addressing commercial risk in the derivatives market.
The Proposed Guidance is based on the CFTC final rule further defining the term "swap" (the "Products Release") in which customary commercial arrangements entered into by commercial or non-profit entities are considered not to be swaps.8 The Products Release had provided a non-exhaustive list of specific contracts that constitute customary commercial arrangements (such as purchase and service contracts) and a list of characteristics and factors common to such agreements: (1) they do not contain payment obligations that are severable from the agreement; (2) they are not traded on an organized market or over the counter; and (3) are entered into by commercial or non-profit entities as principals (or by their agents) to serve an independent commercial, business or non-profit purpose, other than for speculative, hedging or investment purposes. Market participants had commented that certain products commonly used in the electric and natural gas markets meet the described factors and thus should not be regulated as swaps.
In the Proposed Guidance, the CFTC acknowledged the comments and stated its preliminary belief that the two contracts described below should be considered not to be swaps because they meet the interpretation of commercial arrangements set forth in the Products Release.
(a) Capacity contracts for electric power: These capacity contracts are used by load serving entities and load serving electric utilities to secure grid management and on-demand deliverability of power (pursuant to regulatory requirements from state public utility commissions). The initial payment covers the entire fixed cost of supplying the electric power, rather than separately paying an option premium and then the market price of electric power upon exercise of the option. These capacity contracts are treated by purchasers as a purchase of a supplier’s capacity so as to ensure appropriate supply, rather than a purchase of a financial instrument or a hedge.
(b) Peaking Supply contracts for natural gas: These peaking supply contracts are entered into by electric utilities to purchase natural gas from another natural gas provider on days when its primary, local natural gas distribution companies have service disruptions due to regulatory commitments to prioritize residential gas demand. These contracts cannot be financially settled or re-sold. The exercise right to take delivery under these contracts are practically limited to events of service interruption.
The public comment for the Proposed Guidance is now closed. If the Proposed Guidance is adopted, the electric power and natural gas contracts described above would not be regulated as swaps.
8 Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48207, 48246 (Aug. 13, 2012).
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