Mrs. Anne Cools. Trading Book Review Directorate-General Internal Market and Services Unit Banking and Financial Conglomerates (H.

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1 Mrs. Anne Cools Trading Book Review Directorate-General Internal Market and Services Unit Banking and Financial Conglomerates (H.1) European Commission B-1049 Brussels Robert-Koch-Platz 4 D Berlin Telefon / Telefax / info@vdew.net Dr. Bernhard Walter Telefon Telefax bernhard_walter@vdew.net 27. Mai 2005 BW Belgium Commission Services Consultation Paper on Trading Activities and the Treatment of Double Default Effects, 8 April 2005 Dear Mrs. Cools The German Electricity Association (VDEW) appreciates the opportunity to comment on the Commission Services Consultation Paper on Trading Activities Related Issues and the Treatment of Double Default Effects. As the central trade association in Germany, VDEW represents more than 750 utilities including most energy trading companies covering all levels of the value added chain. In total, VDEW s member companies comprise more than 90 per cent of power generation and supply in the German electricity market. Please find enclosed our comments concerning the Commission Services third consultation paper. We hope that these comments are helpful for your work and remain at your disposal for any further questions. Yours faithfully Dr. Bernhard Walter VDEW-Vertretung bei der EU 148, Avenue de Tervuren bte. 17 B-1150 Brüssel Telefon 0032 / 2 / Telefax 0032 / 2 / VDEW-Büro Bonn Friedrich-Wilhelm-Straße 1 D Bonn Telefon / Telefax /

2 VDEW-Response to Consultation Paper on Trading Activities Related Issues and the Treatment of Double Default Effects 1. General remarks: With the introduction of commodities into the Directive for Markets in Financial Instruments (MiFID), regulated commodity firms (including energy trading companies) will also have to meet the requirements according to the Capital Requirements Directive (CAD). The main thrust of the Directive, however is aimed towards financial institutions such as banks. Currently, the Consultative Document does not consider any specific provisions for trading in commodities such as power and gas. As the structure of energy companies is very different to financial institutions, we like to point out that the application of the Basel II regulatory framework causes major difficulties for the commodity industry (including the energy sector). Since the start of the liberalisation process in 1998 the liberalised European power market has evolved at a rapid pace; as a parallel development of market places for trading in energy products have become a major cornerstone for the purchasing and selling strategies of energy companies. We like to point out that the financial markets are structured completely different from the commodities market. A major difference is based on the fact that the products are physically delivered. In power and gas markets a (constant) load is transferred through a period of time. Without rules that take the peculiarities of the energy markets into account, the risk exposure will be overstated resulting in too restrictive capital adequacy requirements for energy companies. Under the provisions of the MiFID, the number of commodity firms that have to comply with the regulatory regime may increase. In turn, these companies also need to comply with the respective capital adequacy rules set in the CAD. An unadjusted implementation of the existing capital framework may severely damage this evolving market and thus hamper the European Commissions objective to develop liberalised and functioning energy markets

3 2. General remarks regarding methods for Counterparty Credit Risk In paragraph 10, three methods for charging counterparty credit risk are stated which are intended to represent different points along a continuum of sophistication in risk management practices and are structured to provide incentives for banks to improve their management of Counterparty Credit Risk (CCR) by adopting more sophisticated practices. These three different methods for charging CCR are: 1. Current Exposure Method (CEM) 2. Standardised Method (SM) 3. Internal Model Method (IMM) Particularly the Internal Model Method demands very highly sophisticated requirements (including operational requirements). We feel that for many commodity firms this method may be impossible to fulfil. Therefore, it is crucial that adequate and differentiated procedures for the Current Exposure Method and the Standardised Method will be offered for different commodities. 3. Standardised Method (SM) The Standardised Method is relevant for regulated commodity firms which will not be able to implement the more sophisticated Internal Model Method In this context we are very concerned about the proposed Credit Conversion Factors for Other Commodities (excluding precious metals). The Standardised Method does not provide for a differentiation between commodities; neither does the Current Exposure Method. a) Credit Conversion Factors (CCFs) Our member companies have undertaken detailed calculations to analyse the volatility of different commodities, including silver, platinum, palladium, copper, aluminium, power (continental, UK, Nordic), UK-gas and -oil. The results give a clear indication that the volatility of energy products is by far overstated. Regarding power products, a common source for misleading results is the sole focus on prices for short term products (day-ahead, week-ahead, month-ahead). These data may show fairly high volatilities. However, they are irrelevant for counterparty exposure calculations as the portfolio of energy firms usually comprises forward deals for the coming 3-4 years. Day-ahead contracts only account for 1/365 of the annual portfolio and 1/1.460 of the total portfolio (time-span: 4 years). Thus, their contribution towards portfolio market value changes and therefore counterparty exposures is negligible. Analogously, focusing only at week-ahead or - 3 -

4 month-ahead products would generate a heavily biased picture of counterparty exposures. When computing volatilities the maturity of the markets and the liquidity of the product itself have to be considered. Hence, it is extremely difficult to calculate reasonable volatilities in such a young market like the market for emission allowances. The data sets currently available (time-span: 2 years) constitute no representative data-base for respective calculations as the legal framework has been implemented only recently and trading volumes are constantly increasing. Taking the dependence between emissions and power production into account we suggest a relatively low add-on (see following table). Broad commodity type Commodity buckets EPE based multipliers [1] Energy Crude and Crude Derivatives 8% Natural Gas 7% Coal 6% Power 3% Emissions 6% Metals Gold 3% Precious Metals excl. Gold, incl. Nickel 8% Base Metals 5% Agricultural commodities Sugar 9% Cocoa 11% Coffee 12% Edible Grains and Cereals 6% Meats and Livestock 10% Other Agriculturals 10% (treated individually for netting purposes) Other commodities e.g. Freight 12% (treated individually for netting purposes) [1] For each of these risk buckets, the EPE based add-on is defined as a simple function of price volatility: Multiplier = 0.26 x volatility (1 year)

5 To ensure that the capital framework is aligned with the intended risk management practices of the respective company as well as to enable the differentiation of products, commodity firms should be allowed to use their own volatility estimates to calculate the Credit Conversion Factors (CCFs). b) Beta-factor The Beta-factor is crucial for calculating the counterparty credit risk factor for the Standard Method. Depending on the level of the beta-factor, commodity firms will be penalised if they use the Standard Method. One result of our studies show that a beta-factor close to 1 would be reasonable. A beta-factor of 2 is very unfavourable for portfolios which are deep in the money. As the market value of one-sided portfolios diverges farther from zero over time than diversified portfolios. Consequently, commodity firms, medium and small sized banks and investment companies with onesided portfolios will be penalised by a beta of 2. We also believe that the alpha-factor should not be the floor for the betafactor. Otherwise this would imply that Internal Model Method and Standard Method are nearly identical and only differ in the alpha- and beta-factor; this is, however, clearly not the case. Consequently, we strongly recommend that the relevant authorities define an adequate beta-factor before determining this variable for the Standard Method

6 4. Current Exposure Method (CEM) Based on the results discussed above, we propose to adapt the table applied for the Current Exposure Method (CEM) as follows: - As the same volatility can be observed, power should be treated like FX/gold: Consequently, an add-on of 3% seems to be justified. - A new category for non power Energy Commodities should be introduced. Maturity One year or less Over one year to five years Over five years Interest rates FX/ Gold Power Energy Commodities* (except Power) Equities Precious Other Metals Commodities (except Gold) 0% 1% 1% 4% 6% 7% 10% 0,5% 5% 5% 6% 8% 7% 12% 1,5% 7,5% 7,5% 8% 10% 8% 15% * Energy Commodities are Crude and Crude Derivatives, Natural Gas, Coal and Power. Due to low liquidity, the time buckets "1 to 5 years" and "> 5 years" are difficult to capture. This does not only hold for power but also for base metals and precious metals. Similar add-ons for energy commodities have already been suggested in the TB working document of the European Commission (see: table 1a page 11). Accordingly a new risk bucket for energy commodities should be introduced