Energy Industry Updates for July 2010

30 July 2010 Publication
Authors: Michael G. Bailey John T. Dunlap Heidi H. Jeffery Thomas McCann Mullooly Kathryn M. Trkla

Legal News: Energy Industry

Financial Reform Legislation Expands Regulation Over Derivatives

The historic Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law this month includes among its many provisions sweeping amendments to the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 (Exchange Act). Those amendments are included in Title VII, called The Wall Street Transparency and Accountability Act, and provide for comprehensive regulation of derivatives markets, including for the first time bi-lateral over-the-counter (OTC) transactions as well as new categories of regulated market facilities and regulated market professionals. The new law has potentially significant implications for the energy markets and market participants.

A summary of the provisions affecting derivatives trading activities is presented below. This summary focuses on changes to the CEA because they have the most direct impact on energy markets. This chart (http://www.foley.com/files/EnergyDerivatives2010.pdf) provides a more detailed analysis, including the expanded authority of the SEC.

Primary Federal Regulators. As a general matter, the CFTC is responsible for implementing the provisions pertaining to swaps other than security-based swaps, and the SEC is responsible for implementing the provisions pertaining to security-based swaps. The CFTC and SEC are given expansive authority to adopt rules and issue interpretations, including as necessary or appropriate to prevent evasion of the legislative objectives. Consistent with the prescriptive nature of the legislation, the amendments limit each agency’s authority to issue exemptions from statutory requirements. For certain matters, they are required to adopt rules jointly; for others, they are required to consult with one another and with the federal banking regulators before commencing a rulemaking or issuing an order to assure regulatory consistency, to the extent possible.

CFTC and FERC/State Regulatory Authority. The legislation affirms that the amendments do not affect the authority that the FERC or a state regulatory authority (as defined in §3(21) of the Federal Power Act) has over transactions entered into pursuant a tariff or rate schedule approved by FERC or a state regulatory authority. At the same, it also provides that the amendments do not limit the CFTC’s authority over such transactions. Thus, such activities would be subject to the concurrent jurisdiction of FERC or a state regulatory authority, on the one hand, and the CFTC, on the other hand. The CFTC, though, is authorized to exempt from CEA regulation transactions entered into pursuant to a tariff or rate schedule approved or permitted to take effect by FERC or by a state regulatory authority, or between entities described in section 201(f) of the Federal Power Act. The CFTC also is directed to grant such an exemption if it determines that such action would be consistent with the public interest and the purposes of the CEA.

The legislation also provides that the amendments do not limit FERC’s statutory enforcement authority under §222 the Federal Power Act and the §4A of the Natural Gas Act that existed prior to enactment of the legislation.

The CFTC and FERC are required to enter into a memorandum of understanding (MOU) to establish procedures to resolve conflicts concerning their overlapping jurisdiction and to avoid adopting conflicting or duplicative regulation. They also are directed to enter into an MOU for sharing information upon request when either of them is conducting an investigation into potential manipulation, fraud, or market power abuse in markets subject to their oversight.

Regulation of Energy and Carbon Markets. The legislation establishes a nine-member Energy and Environmental Advisory Committee to be appointed by the CFTC. The committee is authorized to conduct public meetings, submit reports, and make recommendations to the CFTC regarding energy and environmental markets and their regulation by the CFTC.

The legislation also creates an interagency working group directed to study oversight of existing and prospective carbon markets to assure efficient, secure, and transparent spot and derivatives markets for carbon. The working group is chaired by the Chairman of the CFTC; other participants include the Secretary of the Department of Agriculture, Secretary of the Treasury Department, Chairman of the SEC, Administrator of the EPA, Chairman of FERC, and Administrator of the Energy Information Administration. The working group is required to consult with exchanges, clearinghouses, self-regulatory organizations, major carbon market participants, consumers, and the general public as appropriate. It must submit its report to Congress within 180 days of enactment of the legislation, including recommendations for oversight of carbon markets.

Swaps. The “swap” definition is important because it defines the expanded range of derivatives over which the CFTC has jurisdiction. The definition covers options, traditional swap structures where a fixed payment is exchanged for a floating payment on one or more scheduled dates, event contracts, instruments that become commonly known in the trade as swaps or by more specific names linked to an underlying physical commodity or other reference, and combinations or permutations of, or options on, the foregoing. The broad definition describes derivatives that are economically equivalent to traditional futures contracts, but at the same time excludes futures (and options on futures) from the definition.

The swap definition contains other exclusions. Of note for commercial users, transactions for the sale of a nonfinancial commodity or security for deferred shipment or delivery are excluded if the parties intend to physically settle the transaction. This appears to be a variation of the forward contract exclusion, which excludes deferred shipment commercial merchandizing transactions where delivery routinely occurs between commercial parties from regulation as futures under the CEA. This separate exclusion, along with other provisions added to the CEA regarding retail commodity transactions, raise issues whether commercial merchandizing transactions may now have to meet multiple delivery tests to safely fall outside the scope of the CEA.

Swap Dealers and Major Swap Participants. Persons acting as a swap dealer or major swap participant will have to register with the CFTC and will be subject to various requirements, including business conduct practices, capital requirements, margin requirements for uncleared swaps, swap documentation practices, and requirements to designate a chief compliance officer. The CFTC has to adopt registration rules within one year of enactment.

A person is a swap dealer if it holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps for its own account in the ordinary course of business; or engages in activities causing the person to be commonly known as a dealer or market maker in swaps. A person may be a swap dealer for a single type, class, or category of swap and not for others. This broad definition could potentially ensnare commercial entities that offer swap hedging services to parties with which they have other commercial dealings.

A person is a major swap participant if it is not a dealer, but (i) it maintains a substantial position in outstanding swaps for any major swap category, excluding positions held for hedging commercial risk or, in the case of an employee benefit plan under ERISA, for hedging risk associated with the plan’s operation; (ii) its outstanding swaps create substantial counterparty exposure that could have a serious adverse effect on the financial stability of the U.S. system or financial markets; or (iii) it is a financial entity that is highly leveraged relative to the amount of capital it holds, it is not subject to capital requirements established by a federal banking agency, and it maintains a substantial position in outstanding swaps for any major category of swap. A person may be designated as a major swap participant for one or more swap categories.

Mandatory Clearing and Centralized Trading. It is unlawful for a person to enter into a swap that is not submitted to a clearing facility, if the swap is required to be cleared, unless the end-user exception described below is available. Mandatory clearing will not happen immediately and will likely be implemented incrementally, but that will depend upon how the CFTC exercises its new regulatory authority. A particular swap or group, category, type, or class of swap is subject to mandatory clearing only after the CFTC has determined that it should be. The CFTC may reconsider a mandatory clearing determination on its own initiative or upon application of a counterparty, and the clearing requirement is stayed during the reconsideration process. Before those provisions are implemented, the CFTC has to adopt the requisite procedural rules, and has one year to do so.

Once mandatory clearing is implemented for any swap or group, category, type, or class of swap, transactions in that instrument must be traded on a CFTC-regulated exchange (designated contract market) or swap execution facility, unless no such centralized market exists offering the instrument for trading.

End-User Exception. Once mandatory clearing applies to a particular swap, transactions in that swap may nonetheless be exempt from clearing and centralized trading requirements pursuant to an end-user exception. The exception is available if one of the parties is not a financial entity; it is using swaps to hedge or mitigate commercial risk; and it can demonstrate to the CFTC how it generally meets its financial obligations under its non-cleared swaps. For purposes of the exception, a financial entity is a person that is a swap dealer or security-based swap dealer; a major swap participant or major security-based swap participant; a commodity pool; a private fund under §202(a) of the Investment Advisers Act; an employee benefit plan under §§3(3) and (32) of ERISA; or a person predominantly engaged in banking or financial activities as defined under §4(k) of the Bank Holding Company Act.

Non-Cleared and OTC Transactions. Transactions that are not cleared must be reported to a swap data repository registered with the CFTC or to the CFTC if such an entity is not available to accept the transaction report. The counterparties to transactions permitted to occur on a non-cleared, OTC basis must be eligible contract participants under the CEA definition.

Transition Issues for Existing Swaps. The mandatory clearing provisions will not apply to existing OTC swap transactions that may still be open when those provisions are implemented, provided that the transactions are reported to a swap repository or, in the absence of one, to the CFTC. It appears that margin requirements for uncleared swaps applicable to swap dealers and major swap participants will apply to any open swap positions they have when the requirements are imposed, even if the swaps were entered into prior to enactment of the legislation.

Centralized Trading of Energy Contracts: Implications for ICE. The Intercontinental Exchange (ICE) has been operating under the CEA as an exempt commercial market for trading various energy-related contracts. Those provisions have been eliminated from the CEA. For ICE to continue operating as a centralized market, it will have to register with the CFTC as a designated contract market or as a swap execution facility. However, it may petition the CFTC within 60 days of enactment of the legislation for approval to continue operating under the prior CEA provisions for exempt commercial markets, which the CFTC may grant for up to one year.

Position Limits for Contracts on Energy Commodities. The CFTC is required to establish position limits for futures, options and options on futures on energy commodities, and other physical commodities, including agricultural commodities, along with aggregate limits on such contracts and on swaps that are economically equivalent to such contracts. The CFTC has to establish limits on contracts on energy commodities (and other exempt commodities such as metals) within 180 days of enactment and on agricultural commodities within 270 days of enactment.

If ICE continues to operate as an exempt commercial market for up to one year, the position limits or position accountability standards it has adopted for the energy contracts it offers that have been designated by the CFTC as significant price discovery contracts will likely continue to apply, at least until such time as the CFTC may impose its own limits on such contracts.

Effective Date. Unless otherwise specified in a specific statutory provision, the amendments take effect on the later to occur of 360 days after enactment or, where rulemaking is required, no sooner than 60 days after publication of the final rules.


Illinois Acts to Extend Wind Energy Property Tax Law Through 2016

Legislation extending the expiration date for a state property tax law that seeks to encourage wind development was signed by Illinois Governor Pat Quinn this month. First enacted in 2007, the law takes the task of assessing wind energy property out of the hands of local assessors and, instead, creates a uniform, statewide formula for valuing wind generation equipment for property tax purposes. Under the law, the assessed value of “wind energy devices” is based on a set value per megawatt of nameplate capacity and adjusted, over 25 years, for depreciation, down to 30 percent of the original assessed value. Previously, the law was scheduled to expire after the 2011 assessment year, at which point wind energy property would again be subject to valuation by a myriad of local taxing authorities. Under the new law, House Bill 4797, that sunset date is extended through 2016, giving developers five additional years of certainty.


FERC Approves SPP’s Integrated Transmission Plan

A modified transmission planning process, the Integrated Transmission Plan (ITP), was approved this month by FERC for inclusion in Southwest Power Pool, Inc.’s (SPP) Open Access Transmission Tariff. The ITP will be utilized to determine transmission needs for maintaining reliability and providing economic benefits in the SPP region. The ITP includes 20-year, 10-year, and near-term assessments. The 20-year assessments will be initiated every three years and will be used to develop an extra high voltage backbone network of 300 kV and above facilities. The 10-year assessment also will be conducted every three years and will be used to identify 100 kV and above solutions to issues not resolved in the 20-year assessments, including meeting such needs as (1) elimination of criteria violations; (2) mitigation of known or projected congestion; (3) improved access to markets; (4) backbone expansion staging; and (5) improved interconnections. The near-term assessments will be performed annually and will focus primarily on analyzing SPP’s transmission systems to find solutions to violations of reliability standards.

Pursuant to the ITP, SPP will conduct transmission planning forums with its stakeholders to define the scope of each assessment. Once the scope of each assessment is defined, SPP will analyze any potential alternatives for improvements to its transmission system that may be proposed by SPP or stakeholders. Specifically, in addition to recommended upgrades, SPP will consider any alternative proposals that could include generation options, demand response programs, “smart grid” technologies, and energy efficiency programs. SPP will assess the cost effectiveness of proposed solutions in accordance with the ITP Manual, developed by SPP and its stakeholders. The ITP Manual will set forth the factors that shall be considered in the cost-effectiveness analysis. The analysis will include quantifying benefits resulting from dispatch savings, loss reductions, avoided projects, applicable environmental impacts, reduction in required operating reserves, congestion reduction, and other benefit metrics. After SPP completes its studies and analyses, SPP will prepare a list of proposed projects for review and approval by SPP’s Markets and Operating Policy Committee and Board of Directors.

The ITP’s effective date is July 17, 2010, subject to SPP’s submission of a compliance filing identifying, among other things, when the ITP Manual will be made available on SPP’s Web site.


Political Support for Great Lakes Offshore Wind

Ohio Governor Ted Strickland, U.S. Sen. Sherrod Brown, and Pennsylvania State Rep. John Hornaman each addressed the Freshwater Wind 2010 Conference in Cleveland this month. The first-of-its-kind conference brought together industry participants, including developers, equipment manufacturers, boat builders, agency staff, policy makers, and others. The elected officials each saw the potential for progress and job creation.

Conference Chair and Foley Partner Mary Ann Christopher described the event as key stepping off point for development of the industry:

Offshore wind projects are in advanced stages off the East Coast, where the states have actively laid the foundation and where we are now seeing approvals for power purchase agreements that will allow the first projects to begin construction. In the Great Lakes, the feed in tariff in Ontario and a demonstration project off Cleveland are leading the way. With the converging themes of job creation, a cleaner, greener energy economy, and a steady supply of wind located near load centers, Great Lakes wind projects are looking more and more attractive to citizens, lawmakers, and developers.

Earlier this year, Sen. Brown introduced the Program for Offshore Wind Energy Research and Development (POWERED) Act of 2010, S. 3226, which would spur research on potential offshore wind projects, expand incentives for offshore wind development, and require the Department of Energy (DOE) to develop a comprehensive roadmap for the deployment of offshore wind.

Governor Strickland discussed activity in Ohio, where a process is underway to review existing laws and regulations to give wind developers the site control they need while still protecting Lake Erie. Ohio continues to work with developers and manufacturers to create responsible state incentive packages to make sure this industry grows within the state.

Rep. Hornaman introduced H.B. 2343, unanimously passed in the Pennsylvania State House, that opens the door for harnessing wind energy via off-shore wind turbines in Lake Erie. Each Great Lake state owns the lake bed under the lake to the Canadian border. H.B. 2343 would allow Pennsylvania to lease that space to potential wind development companies.


Legal News is part of our ongoing commitment to providing legal insight to our energy clients and our colleagues.

Please contact your Foley Energy attorney if you have any questions about these topics or want additional information regarding energy matters.

Authors and Editors:

Ronald N. Carroll
Washington, D.C.
202.295.4091
rcarroll@foley.com  

Thomas McCann Mullooly
Milwaukee, Wisconsin
414.297.5566
tmullooly@foley.com  

Kathryn M. Trkla
Chicago, Illinois
312.832.5179
ktrkla@foley.com  

John T. Dunlap
Milwaukee, Wisconsin
414.297.5020
jdunlap@foley.com  

Heidi H. Jeffery
Chicago, Illinois
312.832.4518
hjeffery@foley.com  

Michael G. Bailey
Chicago, Illinois
312.832.4504
mbailey@foley.com  

Svetlana V. Lyubchenko
Washington, D.C.
202.672.5492
slyubchenko@foley.com 

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