Risk & Operations

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Currently energy trading in the United States, both physical and financial, is regulated by the federal government. One of the theories behind such regulation is to facilitate just and reasonable rates for the trading of energy commodities and determine the propriety of any exemptions. Even with exemptions, however, the regulation of financial trading of energy commodities requires participants to ensure that their actions are carried out in a manner that accurately reflects market prices, as well as supply and demand. Therefore, U.S. regulators have called for, and industry participants have voluntarily agreed to, the creation of some form of energy trading compliance programs for businesses engaging in energy trading.

In most instances, especially in those cases dealing with the financial trading of energy commodities, U.S. regulators have not required a particular type of compliance program, and industry participants are quite happy without such requirements. However, without specific requirements, such programs tend to vary greatly in form, function, size and scope.

Even with such variances, there are a few common components for an effective energy trading compliance program. These include:

• A clear distinction, or separation, between an ethics-based compliance program and a program focused directly on energy trading compliance
• Independence of the energy trading compliance program from the trading business
• The development of compliance manuals to be used as points of reference, enabling energy trading personnel to raise questions prior to engaging in activity that may run afoul of regulations
• The development of policies and procedures to guide those engaging in energy trading activities, coupled with regular reviews, updates and archiving
• A consistent means of communicating to energy trading personnel about the regulatory requirements and any changes, coupled with an archiving system that allows for quick retrieval as to whom, when and what topics were communicated
• Regular communications with senior management regarding the development and implementation of the energy trading compliance program, which at a minimum includes scheduled meetings, systematic record-keeping of these discussions and any action items, and an annual supervisory assessment of the program
• A system to monitor and survey energy trading activity
• The development of an energy trading risk assessment program
• Access to energy trading industry groups and regulators
• The development of a robust and diverse training program on a regularly-scheduled and ad hoc basis
• A systematic method to track inquiries received from energy trading personnel, coupled with the ability to use this data in further developing the compliance program
• An energy trading compliance Web page or Intranet that allows personnel to electronically access compliance policies, procedures and manuals; request information or obtain updates on energy regulatory developments; and seek guidance from the energy trading compliance group.

Additionally, if the industry participant is a U.S. financial institution, or the industry participant is conducting regulated activity in the United Kingdom, there would likely be another basic component to the energy trading compliance program to cover counterparty due diligence or know-your-customer requirements.

Although these components provide a good foundation, the proposed increase in industry regulation may require participants engaging in energy trading to not only implement and support this foundation but build on its structure. Such additions will, more likely than not, decrease the variances among energy trading compliance programs.

Most of the proposed legislation is centered on the decrease or removal of the regulatory exemptions for the financial trading of energy commodities. In general, the proposals call for an increase in regulation by including provisions for all, or a combination of, the following:

• Requiring the trading of energy commodities on regulated exchanges or clearing to regulated exchanges
• Requiring electronic trading facilities to register with regulators, and to create and impose rules as if the electronic trading facility was a regulated exchange
• Redefining categories into which industry participants engaging in certain types or levels of financial energy trading would fall, thus subjecting such industry participants to commodities and/or securities type regulation
• Imposing position limits on the number of financial energy contracts a market participant may trade and/or hold
• Restricting hedge activity
• Imposing reporting requirements
• Imposing capital, and/or margin requirements, as determined by the federal government.

These proposed increases in regulation have caused many energy trading compliance professionals to reassess the basic components of their program in order to determine what, if anything, needs to be added or modified to ensure compliance. Although at this point in time it is difficult to determine what additional components will be needed, a review of the proposed regulations suggests that certain additional components are likely to be included in the new framework of an energy trading compliance program.

Energy trading compliance programs may be required to implement policies and procedures to ensure that energy trading personnel are properly vetted and trained prior to granting permission to such trader to engage in energy trading activities. Such policies and procedures would have to, at minimum:

• Create a systematic and ongoing method for the update of training materials and training of the traders
• Develop a method for the safe and secure storage of vetting documents
• Obtain the waivers and/or approvals required to vet prospective energy traders, particularly if traders are located in different states and/or countries

In addition, energy trading compliance programs may need to implement policies and procedures to ensure that energy trading personnel are properly registered with, and authorized to transact, through exchanges or regulated electronic trading facilities.

Other changes that may be required include:

• Implementing a system to monitor energy trading positions across the legal entity and monitoring these positions according to their relative limits. Such a system may include a notification mechanism so that compliance personnel can request exemptions from such position limits, if exemptions are permitted, in a timely fashion.
• Monitoring energy trading positions should be able to run historical analysis on positions held, so that such positions may be related to any physical commodity held, in order to properly and accurately reflect future hedge exemption needs.
• Building systems, and corresponding policies and procedures, to gather information for any required compliance reports for accurate and timely submission to the regulator.
• Working with financial staff members to ensure the proper policies and procedures are in place to meet the regulatory thresholds placed on the company and those of the company with which it trades.
• Working with trading personnel to implement polices and procedures that may include the standardization of energy trade blotters, time stamping requirements, and the mandatory archival of electronic communications, including but not limited to instant messages used for trade negotiation. This would also likely require ongoing monitoring and surveillance of energy trading records to ensure compliance.
• Training energy traders about the mandatory disclosure requirements relative to the risks and other characteristics of a trading transaction, and monitoring to ensure that such disclosures are being made and made properly.
• Creating business conduct standards for all energy trading activities, with a system to document how the trading activities are being supervised.

In summary, although energy trading compliance programs have been in existence for quite some time and industry participants probably have some variation of a program incorporating these basic components, major changes are on the horizon. The scope of these changes and when they may occur will depend on the legislation actually adopted, the state of the economy and the appetite of industry participants to continue its participation in energy trading, especially given the increase in investment needed to properly implement an energy trading compliance program.