Committee of European Securities Regulators Mr. Fabrice Demarigny Secretary General avenue de Friedland. F Paris

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1 Stellvertretender Hauptgeschäftsführer Committee of European Securities Regulators Mr. Fabrice Demarigny Secretary General avenue de Friedland F Paris Robert-Koch-Platz Berlin Telefon 0 30 / Telefax 0 30 / info@vdew.net Dr. Bernhard Walter Telefon 0 30 / Telefax 0 30 / Bernhard_walter@vdew.net 20. Januar 2005 BW/Meh VDEW Response to CESR`s Draft Technical Advice on Possible Implementing Measures of the Directive 2004/39/EC on Markets in Financial Instruments - 2 nd Set of Mandates - Consultation Paper - Ref.: CESR / Dear Mr Demarigny The German Electricity Association (VDEW) appreciates the opportunity to comment on CESR`s Draft Technical Advice on possible implementation measures of the Directive 2004/39/EC on Markets in Financial Instruments (MiFID) published in October 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. General comments: VDEW very much appreciates CESR`s work on providing technical advice on possible implementing measures of the MiFID. The introduction of commodity derivatives into the regulation regime of the MiFID has important implications for the energy industries. We therefore support the flexible approach CESR has taken, recognising the specific issues related with the energy markets. We also recognise the difficulty to transfer the rules designed for financial markets to commodity markets and particularly energy markets with its very unique characteristics such as non-storability, grid-bondage, obligations to 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 purchase renewable energy at specified prices, balancing power and security of supply. In order to avoid any disturbance in the further development of the European energy markets as set out in the so-called Barcelona-process, it is important to recognise and take into account these issues when implementing the MiFID. In this respect, it seems crucial to provide sufficient legal certainty to ensure equal treatment throughout the Member States. However, there needs to remain enough flexibility in order to ensure that the diversity of existing markets and products as well as potential innovations is not being constrained. Financial regulation must consider the provision of appropriate conditions to ensure unrestricted market access as one of the main objectives of the deregulation of European energy markets. We also like to state that the national implementation process of the MiFID should ensure equal applications of the definitions for financial instruments for the purpose of national licensing requirements. Otherwise, the effectiveness of the Directive in harmonising the European financial markets would be impaired. In the following, we like to comment on both the CESR draft advice on the definition of investment advice (Article 4, para 1, no. 4) and the CESR draft advice on the definition of financial instruments (Article 4 and Annex 1, Section C). Definition of Investment advice : Question 1.1: We agree that the advice on services, such as the recommendation to use a particular broker, fund manager or custodian, should not be covered by the MiFID. Investment advice should be limited to cover the personal recommendation in respect of transactions relating to financial instruments. Questions 1.2 and 1.3: We do not believe that sole bilateral communication between the investment firm and the client or potential client is sufficient to determine whether investment advice according to the Directive exists. It is important to differentiate between personal recommendations and general recommendations as well as marketing communications, information given to the clients or from clients, simple offers and the activities carried out by tied agents

3 The main criteria for investment advice is the fact that a personal recommendation is subject to a valuable customised recommendation/advice. Hence, the purpose is to provide the customer with an individual recommendation/advice regarding transactions relating to financial instruments. We propose that the criteria of personalised subjectspecific recommendation/advice as well as the condition that this recommendation/advice is provided to a specific addressee have to be given. We also believe that it is appropriate to restrict investment advice to recommendations of specific financial instruments listed under Annex 1, Section C and should not cover generic information such as financial planning and asset allocation services for financial instruments. List of financial instruments The nature of a derivative: We welcome CESR s recognition of the central relevancy of the meaning of a derivative, although technical advice on this issue is not explicitly asked for by the 2 nd Set of Mandates. It is essential in order to differentiate derivative contracts from transactions in the spot market and from simple agreements to supply particular quantities at agreed prices at some time in the future (that do not fall within the scope of the MiFID). Limiting criteria to define derivatives may include the following types of characteristics: - Possibility to participate disproportionately of price changes with a relatively low initial investment (leverage effect), - Risk of total loss of initial investment that exceeds the standard counter-party risk, - Risk of having to provide additional funds to cover liabilities, in contrast what has been originally anticipated

4 Definition of commodity: The treatment of intangibles / treatment of electricity: VDEW believes that commodities for this purpose should be limited to goods (question 2.1). Accordingly, we support CESR s draft advice to use the concept of goods for electricity and other energy supplies that they can therefore be considered as commodities. In this context we like to state that the scope of Annex I, section C (10) ( exotic derivatives ) should be an open-ended category being able to cover unspecified intangibles, if derivative transactions on such intangibles are treated as financial instruments (i.e. where they are not for commercial purposes and have the characteristics of other derivative financial instruments). The meaning of delivery: We support CESR s view that the term delivery can comprise a broad meaning including delivery by notification, scheduling or nomination to the operator of an energy supply network. Accordingly, we suggest that a contract that is delivered is considered as being physically settled within the meaning of Annex I, section C (6) and C (7). Trading: We do not believe that a requirement should be imposed that there must be a liquid market in the underlying, i.e. the commodity itself (question 2.5). We neither consider that there should be a requirement imposed that the underlying (i.e. the commodity itself) must be capable of being traded (question 2.6). Another question should be whether the transaction is a tradable contract (e.g. base-load, peak-load, off-peak, scheduled power ). Comments on draft level 2 advice BOX 2: We like to suggest the following amendments in paragraph (iii) of the definition of delivery: any other method of transferring ownership of the relevant quantity of goods without physically transporting them (including notification, scheduling or nomination to the operator of an energy supply network)

5 Commercial purpose and characteristics of other derivative financial instruments General approach: Generally, we believe that it is essential to define the conditions under which a derivative contract relating to commodities can be determined not to be for a commercial purpose, as the majority of the business activities of energy companies are done for commercial purpose and hence do not fall within the scope of Annex I, section C (7). The traditional day-to-day business of energy companies is to provide energy products to their customers. Due to e.g. specific regulations such as unbundling obligations, the valuecreation chain in the electricity industry may be longer than in other industries including the units generation, trading and sales, distribution (e.g. via regional distribution companies), co-operation of public utilities for joint procurement purposes, end customers/users and grid operators. Downstream transactions with physical fulfilment along this value-creation chain should generally be considered to be for a commercial purpose. Examples where business activities that may involve derivative contracts related to energy products are for commercial purpose include: public utilities often act as a distributor for end-customers; activities within the scope of so-called asset management activities, i.e. the optimisation of the usage of the generation assets of an energy company; offering of generation capacities to the market. 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. Each party s intention should only be decisive for the party itself. 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). We also like to stress that financial instruments may also be subject to a contract for commercial purpose when taking transactions for risk management purposes into account, as these transactions can be subject to both physical and financial instruments

6 The main purpose for the parties to enter into such a risk management transaction is that of limiting the extent to which their business will be affected by any identifiable risk. With the opening of the European energy markets, companies are subject to the risk of volatile markets due to the specific characteristics such as the non-storability of electricity. Hence, as most trades are in fact done for risk management purposes, it seems vital to ensure that the conclusion of derivative contracts for risk management activities are not subject to licence requirements. A limitation of these activities, due to licence requirements, would not only hamper the liquidity of such markets but also may drive companies to reduce their risk management activities. This would consequently reduce the level of investor protection and be against the general thrust of the MiFID. We therefore support CESR s approach on page 21, para 7 of the Draft Technical Advice to separate all trading activities that are entered into for the purposes of risk management activities in order to manage costs or other risks of the party and that are not generated by speculative trading in such contracts but by the position of the party as a part of the value-creation chain. However, we consider CESR s approach to jointly determine the conditions under which a derivative contract related to commodities is not for a commercial purpose together with the conditions when a derivative contract has the characteristics of other derivative financial instruments as not appropriate as it may lead to false results. Following the meaning of Annex I, section C (7), we believe that they are two separate tests, while both have to be satisfied cumulatively. A transaction may have the characteristics of other derivative financial instruments, but will not be a financial instrument if it is made for commercial purposes. Respectively, a contract may be regarded as not made for commercial purposes, but will not be a financial instrument, if it does not have the characteristics of other derivative financial instruments. Thus, we recommend to keep a two-step test: First, to determine whether a derivative contract relating to commodities is to be regarded as not made for commercial purposes while taking the intention of each party and the particular contractual facts and circumstances into account ( subjective criteria ). Second, if the conditions for noncommercial purpose are given, to determine whether the derivative contract has the characteristics of other derivative financial instruments ( objective criteria ). As already mentioned above, limiting criteria to define derivatives may include the following types of characteristics. Possibility to participate disproportionately of price changes with a - 6 -

7 relatively low initial investment (leverage effect), the risk of total loss of initial investment that exceeds the regular counter-party risk and the risk of having to provide additional funds to cover liabilities, against what has been originally anticipated. Spot transactions: Generally, spot transactions are in no way derivatives, because they are not agreements to supply particular quantities at agreed prices at some time in the future in terms of the description on page 20, para 2, sentence 2 of the Draft Technical Advice. Following CESR s discussion on the meaning of derivative contracts, transactions in the spot market contemplate that settlement will occur as soon as it is usual for the relevant property. Consequently, such transactions do not to fall within one of the three categories stated by CESR, namely options, futures, contracts for differences and are therefore neither within the scope of Annex I, section C (7) nor C (6.). We strongly support CESR s view that there should be an initial filter, before applying the tests under Annex I, section C (7), to exclude contracts which are likely to be spot contracts (question 2.7; first part). However, we do not agree with the proposed approach of excluding contracts whose settlement period does not exceed the lesser of two business days and the generally accepted settlement period in the relevant market (question 2.7; second part). For example, due to the non-storability of electricity, it is traded from one day-ahead up to one week-ahead of the actual delivery date. As a consequence, we strongly suggest that CESR s advice should refer to the longer of the two periods. For consistency reason, we suggest to clarify that the spot transaction filter should also be applied as an initial filter for contracts falling within Annex I, section C (6). Third country markets: We agree that there should no discrimination be made where a contract is traded on a third country market that is equivalent to a regulated market or MTF as defined under the MiFID

8 Intention to deliver / producers, users and commercial merchants: We welcome CESR s approach to apply an intention-to-deliver-test where the seller delivers or intends to deliver the property and the purchaser takes or intends to take delivery of it. Therefore, in regard to question 2.8, we recommend that the status of the parties to the contract should be taken into consideration as an indicative factor to determine whether or not a commodity derivative is existent as opposed to a commercial contract for the supply of commodities; applying this test only to determine whether the exemptions in art. 2 (1) (i) and (k) are given would be an inappropriate limitation. Referring to CESR s point that such a test often depends on observing the pattern of behaviours of the parties, we like to stress that a party to a contract can not assess (and cannot be asked to assess) the status or intention of the counter-party; it can only have regard to its own intention. Regarding question 2.9, we suggest that commercial merchants are not limited to rely on the intention to deliver test alone, but they should also be able to apply the producer and user indicating factor. Again, the intention to deliver test would be an indication to differentiate between commercial merchants and speculators. Regarding question 2.10, we like to state that only the status and/or intent of the party considered should be taken into account when determining the licensing requirements according to MiFID. Other factors: We support CESR s approach that the use of a clearing house or margining is not conclusive as to the commercial or investment nature of a contract according to Annex I, section C (7) (as indicated in the 2 nd set of Mandates). Otherwise, this would indeed drive companies to reduce their risk management activities, as mentioned in the Draft Technical Advice, which would ultimately lead to reduced investor protection which in turn would be against the main thrust of the MiFID. Comments on draft level 2 advice BOX 3: Additionally to the comments made above, we like to make the following remarks: - Paragraph (1) (a): We suggest the following amendment: delivery is to be made within the longer of (i) two business days; and (ii) the period generally accepted in the relevant market as the standard deliver period

9 - Paragraph (2): For the reasons stated before, the two tests whether a contract is to be regarded as not made for commercial purposes and factors determining whether a contract has the characteristics of other derivative financial instruments need to be assessed sequentially. Also, as stated before, only the legal capacity and the necessary permits/licenses of the party whose contractual agreement is being assessed should be taken into account as the party cannot know the intention of the counter-party. On the other hand, we like to suggest that the existence of necessary permits/licenses to make or take delivery of the commodity to which the contract relates indicates that the contract is made for commercial purposes. - Paragraph (3) (a): This paragraph should also include the term commercial merchant as this is also a member of the value-creation chain (irrespective whether it is a marketing/trading or sales company in charge of a producer, a regional distribution company, a co-operation of public utilities for joint procurement purposes, a public utility or a grid company). This recommendation would also allow that those energy trading units that are part of the value-creation chain of an energy group, which includes at least the units generation, trading and retail sales, would fall within the interpretation of the term producer, as this structure (i.e. unbundling) is required by the Directives on the Internal Electricity and Gas Market. - Paragraph (3b) (iii) and (iv): We consider the history of behaviour and the course of dealings between the parties not as conclusive to determine the intention to deliver at the moment of formation of the contract being assessed. If no delivery has been made in the past does not automatically mean that the party to the contract being assessed does not generally intend to deliver and vice versa; therefore we suggest to delete lit. (iii) and (iv). - Question 2.11: If both elements of (3) are present (and the commercial merchant is added to the list in 3a) then this is conclusive. If only one element is present then this is indicative. - Following CESR s comments on page 29/30 regarding risk management purposes, we suggest to add a new paragraph to cover explicitly these transaction

10 Comments on draft level 2 advice BOX 4: We agree with CESR s draft level 2 advice regarding the terms used in Annex I, section C (10) that there is no need for explicitly defining them. Comments on draft level 2 advice BOX 5: We agree that derivative contracts relating to emissions allowances that are settled by amendment of the parties positions on the applicable register of emissions allowances should fall within Annex I, section C (10). We also support the list in paragraph 1 to 4 in Box 5 covering other categories not otherwise mentioned in section C, where derivative contracts relating thereto should fall within Annex I, section C (10). Comments on draft level 2 advice BOX 6: We strongly support the approach to apply the structure of section C (5) - C (7) to the category of derivatives relating to a specified other underlying (section C (10)). Although there is no express reference to the commercial purpose test in section C (10), it is important that this test should also be applied. In line with the comments to Annex I, section C (7), a transaction is not considered to be a derivative financial instrument unless it is not for commercial purposes and has the characteristics of other financial instruments. We would very much appreciate if CESR takes our comments into consideration when developing its advice to the European Commission. In case of any queries, please do not hesitate to contact Dr. Bernhard Walter (bernhard_walter@vdew.net; phone ++49/ ). Sincerely, Roger Kohlmann