Mrs. Nathalie de Basaldua Lemarchand Head of Unit DG Internal Market G.3 European Commission Rue de la Loi 200. B-1049 Brussels

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1 Deputy General Executive Robert-Koch-Platz 4 D Berlin Germany Mrs. Nathalie de Basaldua Lemarchand Head of Unit DG Internal Market G.3 European Commission Rue de la Loi 200 B-1049 Brussels Phone+49 (0) 30 / Fax +49 (0) 30 / info@vdew.net Dr. Bernhard Walter Phone Fax bernhard_walter@vdew.net 12 August 2005 BW Consultation on the Draft Commission Working Document on the MiFID (ESC/23/2005) Dear Mrs. de Basaldua Lemarchand We very much appreciate having the opportunity to discuss the issues related to possible implementation measures of the MiFID that are relevant for the energy industry at our meeting on 22 August The German Electricity Association (VDEW, Verband der Elektrizitätswirtschaft), representing more than 750 utilities (including most of the German energy trading companies) covering more than 90 % of the German electricity market, has continuously provided input to the CESR - consultation process. With our letter dated 20 June 2005, we have already commented CESR's Final Technical Advice on possible implementation measures of the MiFID, in which we have expressed our general support of CESR's work. Meanwhile, the Draft Commission Working Document on conduct of business rules, best execution, client order handling rules, eligible counterparties, clarification of the definition of investment advice and financial instruments (working document ESC/23/2005) has been published together with the explanatory note (working document ESC/24/2005). VDEW-Representation to the European Union 148, Avenue de Tervuren bte Brüssel Belgium Phone +32 (2) / Fax +32 (2) / VDEW-Office in Bonn Friedrich-Wilhelm-Straße Bonn Germany Phone +49 (0) 2 28 / Fax +49 (0) 2 28 /

2 We also like to provide a first response to the Draft Commission Working Document prior to our meeting on 22 August The enclosed paper addresses some issues that in our view are key for the energy industry. We are looking forward to discussing these issues with you in Brussels. Meanwhile, for any further questions, please do not hesitate to contact Dr. Bernhard Walter (bernhard_walter@vdew.net; phone ++49/ ). Sincerely, Roger Kohlmann - 2 -

3 VDEW-Comments regarding the Draft Commission Working Document on conduct of business rules, best execution, client order handling rules, eligible counterparties, clarification of the definition of investment advice and financial instruments (working document ESC/23/2005) After several consultations, CESR has published its Technical Advice on Possible Implementation Measures of the Directive 2004/39/EC on Markets in Financial Instruments (MiFID). VDEW has actively participated in this consultation. We strongly support the Commission s view to pursue a harmonised approach at EU level as we also see the danger that additional regulation at national level or differentiated national approaches could negatively affect the correct functioning of the single market. It is a key issue to ensure a level-playing field for all market participants throughout all EU jurisdictions. The Draft Commission Working Document provides implementing measures with respect to various provisions of the MiFID. Before commenting on the issues that are relevant for the energy sector, we like to provide a short answer on the questions raised in the Explanatory note (ESC/24/2005) to the working document ESC/23/2005. In relation to Article 28 of the working document, the Commission brings the following two questions for discussion: Q1: Is the market test that we are proposing sufficiently restrictive to include only those derivatives that, although traded OTC, are traded in a manner similar to that of other more organised venues such as RMs and MTFs? A1: We believe that the proposed market test is not sufficiently restrictive to achieve the intended limitation of the scope of the MiFID. The criteria provided under paragraph (1) (b) i-vi of Article 28 may lead to incorrect results (i.e. being against the aim of the MiFID to exclude contracts that are concluded with the purpose of physical delivery). Hence, under the proposed market test, so-called physical futures that have to be physically fulfilled and which are traded on OTC-markets would qualify as a financial instrument and fall under the provisions of the MiFID. In our view this is not intended by the MiFID. Also, according to the provisions under Annex I section C no 7 a main criteria whether a financial instrument is given (falling under No.7) is whether the derivative contract relating to commodities is made for commercial purposes or not. Therefore, the purposes of the involved parties and their status are also to be taken into account (i.e. intention to deliver). We provide a more detailed discussion below. 1

4 Q2: Should there be any probability of delivery test (paragraph (1)(a) of Article 28)? A2: We believe that a probability of delivery test could be an initial filter to exclude those contracts where under the terms of the contract physical delivery will not be made within a specified time. Companies concluding such contracts without having the ability to fulfil them are likely to use these contracts for speculative purpose. Such conditions include that the counterparties are actually capable to deliver/to take the contracted quantity (e.g. having the respective capacities, contracts with grid operators, customer basis or necessary licenses/permits). In deviation to the Working Document we like to propose a more detailed test below 8 (Article 28). Regarding the Draft Commission Document (ESC/23/2005), the following provisions are relevant for the energy sector: Article 2: Definitions VDEW welcomes the definitions in Article 2 regarding commodity (no.1) and delivery (no. 3) which basically follow CESR's recommendations. Regarding the definition for spot contracts, we believe that the definition needs to be more precise in order to achieve an unambiguous result. Particularly, it is not clear what is meant by as soon as reasonably practicable after the contract is made as it does not provide any indication for whom practicability should be given. Furthermore, due to the non-storability, electricity is traded from one day-ahead up to one week-ahead prior to the actual delivery date. We therefore propose to amend the provided definition with the following specification: 1. spot contract means a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made at a time that is, having regard to the characteristics of the commodity, asset or right and the practices prevalent in the market for a commodity, asset or right of that kind, within the longer of (i) two business days and (ii) the period generally accepted in the market for a commodity, asset or right as the standard delivery period. Article 17: Investment advice VDEW welcomes the provisions regarding the definition of investment advice and particularly the proposed approach to differentiate between personal recommendations and generic advice. In this respect, the Draft Commission Working Documents adopts CESR s level 2 advice. 2

5 Article 28: Characteristics of other financial instruments Regarding the characteristics of other derivative financial instruments, the Draft Commission Working Document deviates in parts from CESR's final Technical Advice. CESR proposed a concept of determinative and indicative factors for determining whether a derivative contract in relation to commodities is made for commercial purposes and has the characteristics of other derivative financial instruments. This concept has not been adopted by the Commission. Rather, it appears that each of the criteria proposed under paragraph (1) (b) of Article 28 is a determinative factor itself (if the contract is not a spot contract). We believe that such an approach would lead to results that are not in line with the intention of the level 1 text of the MiFID. One example refers to criteria (iv), according to which a contract qualifies to have the characteristics of other derivative financial instruments if it is cleared by a clearing house. However, the level 1 text in Annex I Section C no. 7 MiFID clearly states that this criteria is only one out of a set of criteria ( inter alia ). Furthermore, the Draft Commission Working Document does not include some factors that are in our view also important aspects in order to achieve useful results. One such aspect is the intention to deliver test that was proposed in CESR's final Technical Advice but has not been adopted in the working document. For the determination whether a derivative contract related to commodities is entered into for commercial purposes, we strongly support CESR s approach to take the intention of the contractual parties to the contract at the time of its conclusion into consideration, i.e. the specific circumstances and features of the individual transaction. Accordingly, a contract may be regarded as made for commercial purpose if under the terms of the contract physical delivery is to be made within a specified time while certain conditions need to be met. Such conditions include that the counter-parties are actually capable to deliver/to take the agreed quantity (e.g. having the respective capacities, contracts with grid operators, customer basis or licenses/permits). In this respect we fully agree with CESR s analysis that the characteristics of OTC physically settled contracts mean that it is necessary to consider the purpose for which the particular contract is entered into by the parties in addition to its other characteristics. We also agree on CESR s statement that in many cases, the purpose for which the particular contract is entered into is a more substantial criteria than the particular type of contract that is used. Quoting from CESR s Feedback Statement (Ref.: CESR/05~291b): While avoiding a consideration of the purpose of the contract would provide greater certainty as to whether a particular contract falls within or outside of the scope of the Directive, it would also result in an approach that includes contracts that should not be included within the scope of the Directive and excludes those that should not be excluded. It would also risk creating perverse incentives for parties to modify their behaviour. We also like to state that the Directive refers to the term purpose [ not being for commercial purpose C(7)] which is also a clear indication that according to the level 1 text, it is necessary to consider the purpose (intention) of the contract together with its other characteristics. 3

6 We therefore propose the following provisions for Articles 28 and 29, that are in its core in accordance with the respective provisions proposed in CESR s technical advice: Article 28 Characteristics of other derivative financial instruments 1. For the purposes of Section C(7) of Annex I of the Directive, if any one or more of the following conditions are met, a contract shall be considered as made for commercial purposes and as not having the characteristics of other derivative financial instruments: a) If the contract is a spot contract. b) The contract is entered into with or by the operator of an energy transmission grid or pipeline network, and is either for the purpose of ensuring security of energy supplies or is necessary to keep in balance the supplies and uses of energy at a given time. c) The seller intends to deliver the underlying and the purchaser intends to take delivery of it, where any such intention should be determined in accordance with paragraphs 5 and For the purposes of Section C (7) of Annex I of the Directive, if any one or more of the following conditions are met, a contract, other than a spot contract, shall be considered as not made for commercial purposes and as having the characteristics of other derivative financial instruments: a) Each party lacks the legal capacity or any necessary permit or licence to make or take delivery of the underlying. b) The seller does not intend to deliver the underlying and the purchaser does not intend to take delivery of it, where any such intention should be determined in accordance with paragraphs 5 and For the purposes of Section C(7) of Annex I of the Directive, in determining whether a contract, other than a spot contract, is made for commercial purposes and does not have the characteristics of other derivative financial instruments, the following indicative factors should be considered, having equal weight: a) One or more of the parties is a producer of, or commercial merchant in relation to, the commodity or uses it in his business. b) The seller intends to deliver the underlying or the purchaser intends to take delivery of it, where any such intention should be determined in accordance with paragraphs 5 and 6. c) The price, the lot, the delivery date or other terms are determined by the parties for the purposes of the particular derivative contract and not by 4

7 reference (or not solely by reference) to regularly published prices, to standard lots or standard delivery dates. 4. For the purposes of Section C(7) of Annex I of the Directive, in determining whether a contract, other than a spot contract, is not made for commercial purposes and does not have the characteristics of another derivative financial instrument the following indicative factors should be considered, having equal weight: a) The contract is traded on a third country marketplace or trading facility that is equivalent to a regulated market or an MTF. b) The contract is expressed to be traded on a regulated market, an MTF or an equivalent third country marketplace or trading facility or is expressed to be equivalent to such a contract (even though not traded on such a market or facility). c) Performance of the contract is enforced by a regulated market, an MTF or an equivalent third country marketplace or trading facility or a clearing house. d) There are arrangements for the payment or provision of margin in relation to the contract. e) Neither party is a producer, of, or commercial merchant in relation to, the commodity nor uses it in his business. f) Neither party intends to have an obligation for immediate physical delivery of the commodity at any time determined in accordance with paragraphs 5 and 6. g) The price, the lot, the delivery date or other terms are determined solely by reference to regularly published prices, to standard lots or standard delivery dates. 5. The intention of the parties in relation to delivery of the underlying should be determined as at the moment of formation of the contract. 6. Amongst other things, the following may be used for the purpose of determining the intention of the parties in relation to delivery of the underlying: a) the terms of the derivative contract as set out explicitly between the parties; b) any other terms of the derivative contract, whether implicitly agreed between the parties or implied by law or custom or practice in the relevant market; c) any course of dealings between the parties; d) any history of behaviour in relation to equivalent transactions with other parties; and e) the parties' direct ownership positions in the underlying. 5

8 Article 29 Derivatives within Section C(10) of Annex I to the Directive 1. For the purposes of Section C(10) of Annex I of the Directive, a derivative contract, other than a spot contract, relating to the underlyings mentioned in that Section or relating to any of the underlyings mentioned in paragraph (2) of this Article will have the characteristics of other derivative financial instruments if: a) it is settled in cash or may be settled in cash at the option of one or more of the parties (otherwise than by reason of a default or other termination event); or b) it is traded on a regulated market or an MTF; or c) it is not a contract for a commercial purpose and has the characteristics of other financial instruments, where both conditions are interpreted in the same way as for Article 28, with the necessary modifications where the underlying is intangible. 2. For the purposes of Section C(10) of Annex I of the Directive, a derivative contract, other than a spot contract, relating to any of the following underlyings will fall within that section if the other conditions set out in paragraph (1) of this Article are satisfied in relation to it: a) telecommunications bandwidth; b) commodity storage capacity; c) transmission or transportation capacity relating to commodities, whether cable, pipeline or other means; d) an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources; e) a geological, environmental or other physical variable; f) any other asset or right of a fungible nature (other than a right to receive a service) that is capable of being transferred; or g) an index or measure related to the price or volume of transactions in any asset, right, service or obligation. 2. For the purposes of Section C(10) of Annex I of the Directive, a derivative contract, other than a spot contract, relating to emissions allowances that is settled by amendment of the parties' positions on the applicable register of emissions allowances will fall within that section if the other conditions set out in paragraph (1) of this article are met in relation to it. 6