Do New Dodd-Frank Regulations Impact REC and Allowance Markets?
Submitted by Claire Kreycik on Mon, 02/28/2011 - 10:59am
Financial reform is pervasive in the news as the government goes about implementing the Dodd-Frank Act—passed last July. A few months ago on this blog, Paul Scharfenberger reported on some of the most important potential repercussions of financial reform on the renewable energy industry, particularly in regards to tax equity project finance. Today, I will expand upon the issue of the swap clearing requirement that he mentioned. That is, will environmental commodities, like renewable energy certificates (RECs) and tradable emissions allowances, be regulated as securities under the Dodd-Frank Act?
Let me explain. The Dodd-Frank Act calls on the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) to craft regulations defining such terms as “swap,” “swap dealer,” and “major swap participant.” Additionally, the Dodd-Frank Act requires all derivatives and over-the-counter trades that are considered “swaps” to be cleared on an exchange. This requirement was set up to reduce the risk that one or more derivative dealers will fail to honor their trade settlement obligations.
Market Implications of the Clearing Requirement
It is possible that the clearing requirement could impact project economics for large and small developers, the development of REC and allowance markets, and the effectiveness of state renewable portfolio standards (RPS).
In a clearing house or exchange, participants are required to post collateral deposits to back up their traded commodities. At the project level, the clearing requirement would mean that a project LLC would need to tie up money as collateral if it relies on RECs or allowances as a revenue stream. This requirement could negatively impact project economics and the project’s competitiveness as compared with a project that does not rely on revenues from REC sales.
In future markets, this minimum margin requirement is typically from 5%–15% of the contract’s value. Imagine that a 100 MW wind farm (capacity factor 30%) trades a 5-year stream of RECs for $2/MWh. Using the range above, the collateral requirement for the trade could be between $130,000 and $395,000.
Furthermore, due to these additional transaction costs of the clearing requirement, smaller project developers may be barred from entry into the markets. In some jurisdictions, incentive programs for customer-sited solar projects based on the value of RECs have emerged (for example, New Jersey’s solar REC-only incentives). This type of incentive structure may not be as attractive if the transaction costs and complexity of selling RECs were increased. Additionally, the Environmental Marketing Association (EMA) further argues that the clearing requirement may“inhibit or stymie” the benefits of market-based renewable energy programs implemented by states (read: RPS) and may negatively impact the young environmental commodity markets.
End-user Exception
One final point to mention is Dodd-Frank end-user exception. Clearly laid out in the “Dodd-Lincoln Letter,” end users often use swaps to hedge or mitigate commercial risk, and the intent of the legislation is not to require such transactions to be cleared in an exchange. Since utilities are required by regulators to obtain RECs, bilateral REC trades with utilities as the counterparties would not need to be cleared on an exchange. The same is likely true of carbon allowances and verified emissions reductions if they were to be regulatory requirements.
Regulations in the Making
Final rules have been posted by the CFTC, but there is no clarity on whether or not RECs and allowances are classified as swaps, which would impose this “clearing requirement” on environmental markets. In the comment phase of the CFTC rulemaking last September, several parties argued that RECs and environmental allowances be excluded from the rule. EMA lawyersargued that these commodities do not fit the definition of a swap and should not be regulated as such.
It is unlikely that the CFTC and SEC will explicitly clarify whether these environmental markets are implicated by the clearing requirement in subsequent rulemakings. However, if the EMA’s legal argument is upheld, it would be unlikely that RECs and allowances will be considered swaps. Down the road, the issue may be resolved in the courts.
Submitted by Claire Kreycik on Mon, 02/28/2011 - 10:59am
Financial reform is pervasive in the news as the government goes about implementing the Dodd-Frank Act—passed last July. A few months ago on this blog, Paul Scharfenberger reported on some of the most important potential repercussions of financial reform on the renewable energy industry, particularly in regards to tax equity project finance. Today, I will expand upon the issue of the swap clearing requirement that he mentioned. That is, will environmental commodities, like renewable energy certificates (RECs) and tradable emissions allowances, be regulated as securities under the Dodd-Frank Act?
Let me explain. The Dodd-Frank Act calls on the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) to craft regulations defining such terms as “swap,” “swap dealer,” and “major swap participant.” Additionally, the Dodd-Frank Act requires all derivatives and over-the-counter trades that are considered “swaps” to be cleared on an exchange. This requirement was set up to reduce the risk that one or more derivative dealers will fail to honor their trade settlement obligations.
Market Implications of the Clearing Requirement
It is possible that the clearing requirement could impact project economics for large and small developers, the development of REC and allowance markets, and the effectiveness of state renewable portfolio standards (RPS).
In a clearing house or exchange, participants are required to post collateral deposits to back up their traded commodities. At the project level, the clearing requirement would mean that a project LLC would need to tie up money as collateral if it relies on RECs or allowances as a revenue stream. This requirement could negatively impact project economics and the project’s competitiveness as compared with a project that does not rely on revenues from REC sales.
In future markets, this minimum margin requirement is typically from 5%–15% of the contract’s value. Imagine that a 100 MW wind farm (capacity factor 30%) trades a 5-year stream of RECs for $2/MWh. Using the range above, the collateral requirement for the trade could be between $130,000 and $395,000.
Furthermore, due to these additional transaction costs of the clearing requirement, smaller project developers may be barred from entry into the markets. In some jurisdictions, incentive programs for customer-sited solar projects based on the value of RECs have emerged (for example, New Jersey’s solar REC-only incentives). This type of incentive structure may not be as attractive if the transaction costs and complexity of selling RECs were increased. Additionally, the Environmental Marketing Association (EMA) further argues that the clearing requirement may“inhibit or stymie” the benefits of market-based renewable energy programs implemented by states (read: RPS) and may negatively impact the young environmental commodity markets.
End-user Exception
One final point to mention is Dodd-Frank end-user exception. Clearly laid out in the “Dodd-Lincoln Letter,” end users often use swaps to hedge or mitigate commercial risk, and the intent of the legislation is not to require such transactions to be cleared in an exchange. Since utilities are required by regulators to obtain RECs, bilateral REC trades with utilities as the counterparties would not need to be cleared on an exchange. The same is likely true of carbon allowances and verified emissions reductions if they were to be regulatory requirements.
Regulations in the Making
Final rules have been posted by the CFTC, but there is no clarity on whether or not RECs and allowances are classified as swaps, which would impose this “clearing requirement” on environmental markets. In the comment phase of the CFTC rulemaking last September, several parties argued that RECs and environmental allowances be excluded from the rule. EMA lawyersargued that these commodities do not fit the definition of a swap and should not be regulated as such.
It is unlikely that the CFTC and SEC will explicitly clarify whether these environmental markets are implicated by the clearing requirement in subsequent rulemakings. However, if the EMA’s legal argument is upheld, it would be unlikely that RECs and allowances will be considered swaps. Down the road, the issue may be resolved in the courts.
