Energy brokerage in Germany – on the way to banking regulation
Evolution of the regulatory framework in the energy market is accelerating as liberalisation spreads across Europe. However, holes in coverage continue to appear as new products emerge
LIBERALISATION of energy markets in Germany and the formation of power exchanges have brought the activities of the energy broker under the Federal Banking Supervisory Authority. As European power markets liberalise and activities increasingly cross national borders, there are further regulatory hurdles. Additionally the trading of weather derivatives and the emergence of green certificates have created gaps in national and European legislation which have yet to be addressed by the authorities.
Some energy brokers and organisations need to apply for a licence from the Authority and, when energy companies trading in Germany fall under banking legislation, detailed planning is required. The judgement of whether an organisation falls under these regulations needs to be carefully considered before trading commences and an assessment has to be made on a case- by-case basis.
German Authority policy
In September 2000, the German Federal Banking Supervisory Authority stated that every company which arranges or trades power futures as proprietary traders for others, that is customer-driven trading, together with financial brokers, must have a licence and trade under the Authority’s supervision. Those which come from the energy sector may be surprised by the intensity of regulatory requirements. However, to benefit from the advantages of the enormous business opportunities available, the price of compliance within a strong regulatory environment has to be paid, including meeting many organisational requirements.
Liberalisation of energy markets
Energy brokerage is a spin-off from the liberalised energy market. The path to competition within the energy sector started when the 96192/EC Directive was passed by the European Parliament and the European Council. The Directive obligates Member States to liberalise their energy markets. In Germany it came into force in April 1998 in the form of the Act for Reorganisation of the Energy Market. This Act only provided a framework, so in December 1999 an Energy Agreement of the Associations was established between the Federal German Industry Association, the Industrial Energy and Power Economy Association and the German Electricity Economy Association. This agreement focuses on detailed rules for network access.
Other European countries
Liberalisation of the nordic energy markets in Norway, Sweden and Finland in 1991, 1996 and 1997 respectively, allowed energy trading through a pool, known as Nord Pool, and a single household can directly buy its required energy from the power producer. The Netherlands, liberalised since 1999, started with open market access for bigger consumers and in the same year created the Amsterdam Power Exchange (APX). England and Wales completed their open market with access for consumers in 1998, whilst Spain has also opened its market.
The pace of liberalisation in the last decade has increased the level of trading activities within the EU.
Formation of power exchanges
Following the liberalisation of the electricity market in Germany, the Leipzig Power Exchange (LPX) opened up its spot market in June 2000. The second German power exchange, the European Energy Exchange (EEX) in Frankfurt, opened its spot market in August 2000. More recently, the EEX opened a futures market for power. Despite the size of the German energy market, there is not enough room for two competitive power exchanges and therefore in October 2001 the LPX and EEX announced their merger which was approved by EEX on I March and is due to complete in early 2002. This new exchange, known as the European Energy Exchange, is based in Leipzig at the old HQ of the LPX. The aim of the new EEX is to increase the percentage of power sold via the spot market in Germany from 6.6 per cent to 20 per cent of the total power sold in the next three to five years. Owners of the new EEX are set out in Figure 1 below. On the spot market, the EEX will offer an auction market as well as continuous block trading. Quarter futures complete the product range of the futures market. Both partners intend to base developments for the futures market concept on the Eurex system.
Power market participants
Participants in the power markets are the trading floors of large electricity suppliers like Vereinigte Energiewerke (VEAG), domestic and foreign energy brokers such as E.On Trading, RWE Trading, Nordic Powerhouse or Austrian Power Trading (APT), and municipal electricity utilities such as Stadtwerke Diisseldorf.
Who Needs a Licence?
The German Banking Act, known as Kreditwesengesetz or KWG, requires a written licence from the Federal Banking Supervisory Authority for any organisation wishing to conduct banking business or to provide financial services in Germany, either commercially or on a scale which requires commercially organised business undertakings. For energy brokers the following services are usually carried out:
Arranging transactions involving the purchase and sale of financial instruments or their documentation (investment broking)
The purchase and sale of financial instruments in the name and for the account of others (contract broking)
The administration of individual portfolios invested in financial instruments on behalf of third parties and with the power to act on their behalf (portfolio management)
The purchase and sale of financial instruments on a proprietary basis for others (proprietary trading for others)
The purchase and sale of financial instruments in the institution’s own name but for the accounts of others (financial brokerage) If the energy broker provides financial services it is defined as a financial services institution, if it provides a banking business, it is a securities trading bank. Hereafter, both are referred to in short as institutions.
Energy brokers which deal in derivatives only in their own name and on their own account do not require a licence as long as the business is not customer driven. However, if before carrying out a deal the trader already has a client order and sells the derivative to this client at a fixed price, the trader is classified as a proprietary trader for others, and hence requires a licence.
A condition requiring a licence is when an object is traded – in banking business or financial services – it is a financial instrument. Financial instruments within the meaning of the Act are securities, money market instruments, foreign exchange or units of account and derivatives.
The Federal Banking Supervisory Authority declared power as a commodity. Hence, when an energy broker trades power forwards, options or futures in Germany, they trade derivatives. Trading on the power spot market does not, however, require a licence. This is because these power contracts are not defined as forward transactions because the transaction date and the settlement date are the same. The spot market also views the trade day +2 days as the settlement period.
It is still possible to trade without a licence. These exemptions occur, for instance, when financial instruments are traded on an own account basis without third party involvement and in order to generate profit. Energy brokers which solely carry out such transactions as financial institutions, for example hedge or arbitrage transactions, are also exempt.
Furthermore, companies which are listed on a stock exchange as a market maker and which carry out this function only do not require a licence either. Companies which only conduct banking business or financial services for their parent company, subsidiaries and/or affiliated companies are also exempt, as are companies which provide brokerage services solely on an exchange on which only derivatives are traded for other members of that exchange and whose liabilities are covered by a system that guarantees the settlement of trades on that exchange. Companies whose main business is trading in commodities with similar companies, with producers or commercial users of the commodities are also freed from obtaining a licence. These companies must, however, only perform financial services for the above mentioned and only to the extent where it is necessary for their main business. The trading desk of power generating companies could fall into this category. The key point is that only by a review of the organisation’s business activities can a decision be made as to whether a licence is required or not.
It is not only power derivatives that can be the object of trading activities. Following international agreements such as the Kyoto Protocol and their impact on national environmental requirements, this has opened up the market for trading in emission permits and green certificates. Green certificates simply mean that the energy produced comes from renewable energy sources, for example wind, water and sun. Whether emissions and green certificates are to be classified as securities in a regulatory sense, and will therefore require a licence, is currently being discussed by the authorities.
Energy traders which trade in or act as a broker for power futures and do not meet any of the exceptions already mentioned must have applied for a licence at the Federal Banking Supervisory Authority before commencing business. If trading occurs before a licence has been granted, but where a licence is obligatory, the company concerned is liable to prosecution.
Compulsory licence implications
If an energy broker intends to carry out trades for which a licence is required, what should be considered? The main areas are the need to obtain a licence, structuring the company, accounting, auditing and reporting. The energy broker needs to apply to the Federal Banking Supervisory Authority stating each of the banking businesses and financial services that the company intends to carry out. The Authority will then proceed with the organisation ‘s application based on the following criteria:
Capital – own funds
The German Banking Act defines the contents of own funds and how to calculate them. It is necessary that the regulatory capital is readily available and it cannot originate from taking out a loan. Funds required to be available depend on the type of trading activity and vary between Euro50,000 and Euro730,000. Financial services institutions which trade in financial instruments on their own account and securities trading banks require capital of the equivalent of at least Euro730,000.
Requirements for directors
High requirements also apply to the managers of energy trading companies falling under the German Banking Act. Managers must have adequate theoretical and practical knowledge of the business concerned as well as possessing the professional qualifications necessary for managing a company.
If an energy trading company, falling under the German Banking Act, is part of a group of consolidated companies, then under certain circumstances the group might be classified as a group of institutions or a financial holding group with the consequence that the group itself is subject to banking supervision. In this case the group as a whole is obliged to have an adequate amount of its own funds. It is therefore advisable to address a group’s structure prior to carrying out banking or financial services activities.
An institution needs to adhere to specific organisational duties. There must be suitable arrangements for managing, monitoring and controlling risks. There also needs to be appropriate arrangements so that the company’s financial situation can be gauged with sufficient accuracy at all times. This means especially that, at the press of a button, the energy broker can provide information about positions into which they have entered and the risks involved, as well as the level of the company’s own funds. The company must also have records of executed business transactions.
With the copious amount of requirements, it is not uncommon for energy trading companies to outsource certain operational areas or required services to other companies. If operational areas are outsourced they must neither impair the orderliness of this business or service, nor must they affect the management’s ability to manage and control the outsourced activities. The outsourced areas must furthermore not impede the right of Federal Banking Supervisory Authority to audit or their ability to monitor.
Minimum requirements for trading
Institutions have to abide by the minimum requirements for trading activities in credit institutions as codified by the Federal Banking Supervisory Authority. The limiting of risk positions is a task for management. Management must ensure that employees possess a comprehensive knowledge in their area of responsibility, that traders do not conduct business from a third party trader’s or broker’s office, that deals are closed in line with market conditions and that internal controls are in place to check these market conditions. The risk control functions must be entrusted to persons who are independent from the trading department. A clear functional separation of trading, backoffice processing and control, accounting and monitoring is a basic principle which is also valid for energy brokers.
Minimum internal audit requirements
Institutions also need to observe requirements for the internal audit. The internal audit function is an instrument of, and is required to report to, the entire management. In particular, the internal audit department has to audit and assess the following features:
The efficiency, effectiveness, viability and adequacy of the internal control system
The application, viability, effectiveness and adequacy of the risk management, control systems and reporting
The compliance to existing legal and banking supervisory provisions as well as other regulations, operational guidelines, instructions and rules as well as the orderliness of all operational and business procedures and the rules and precautions taken to protect assets. Outsourcing the internal audit function to an external body, for example to accounting firms, is permissible where in smaller organisations the audit function would be inadequate, given the size of the organisation.
German Money Laundering Act
Energy brokers also need to comply with the German Money Laundering Act. This means, among other things, that when they receive or pay out an amount of more than Euro15,000 in cash, securities or precious metals, the respective persons) need to be identified and recorded. This also applies to situations where suspicion has arisen, although the amount may be less than El 15,000. A report then needs to be handed in to the responsible law enforcement agency.
As a broker or proprietary trader of energy derivatives the company is classified as an investment firm. In this case, certain rules and regulations according to the German Securities Trading Act (including behavioural and organisational obligations) need to be fulfiled. Conflicts of interest are to be resolved. The organisation needs to be correspondingly structured to ensure a proper monitoring of the execution of securities services. For the monitoring activities a compliance role needs to be established. This encompasses the control of the functional and physical division of confidential areas, for example between the customer’s and own trading activities, including entry restrictions to the confidential areas and rules for accessing data.
From a number of regulations there are various reporting obligations with which energy brokers, being institutions, have to comply, for example large exposure reporting and reporting concerning the fulfilment of solvency and liquidity ratios. Energy brokers falling under the German Banking Act, proprietary traders included, need to deliver statistical reports for the German Central Bank, the Bundesbank.
Furthermore, energy brokers which are permitted to trade on a domestic stock exchange need to report to the Federal Securities Supervisory Authority on their securities and derivatives trading.
There are also a number of notifications required by the Federal Banking Supervisory Authority, for example in the case of takeovers, selling participations or when a quarter of liable capital is lost.
Together the German Handelsgesetzbuch (German Commercial Code) and the Accounting Ordinance for Banks and Financial Services Institutions set out accounting regulations specifically for institutions. The balance sheet and profit and loss account formats differ from the ones used by other companies. It is obligatory to adopt the specific forms and valuations.
Extended audit obligations
Regardless of their size, energy brokers are put on a par with large public limited companies and the degree of the detail of the audit report is significantly higher compared to other companies which do not fall under the German Banking Act.
Furthermore, there is also the possibility that special statutory audits will be carried out in accordance with the Banking Act or the Investor Compensation Act.
Once the Federal Banking Supervisory Authority stated that energy is a commodity, many questions appeared relating to the regulatory treatment of energy brokers and their activities. However, several questions still remain unanswered.
The Federal Banking Supervisory Authority has not officially declared up to which point in time spot trading remains licence-free. Currently spot trades, for example settlement at trade day +2, are licencefree. But how will power trades be dealt with that will be fulfiled next week? Will these be classified as forward transactions? The format of calculating regulatory capital from own funds or energy brokers has also not fully been tackled by the Authority.
Since energy has been declared a commodity, the issue of weather as a commodity has also arisen. How are weather derivatives – which are still not traded on exchanges – to be classified? Are these instruments – the wagering on temperature and rainfall, which resemble a type of insurance – to be dealt with as derivatives? Should temperature and rainfall be classified as commodities in this sense, which would imply that their trading activities would will also require a licence?
The energy market is no longer purely isolated in Germany. The markets have opened and energy brokers are active in numerous international markets, including energy exchanges. It poses the question of whether energy brokers which are based in other EU states need apply for a licence in each EU country. Energy brokers would benefit from using a so-called `EU Passport’ which would only need to be applied for and granted in one country to allow access to the whole European energy market.
The EU Passport for investment firms derived from a directive from the European Council in 1993. In this guideline the passport is, however, only relevant for the specific activities described in that directive. Subsequently, institutions whose banking business or financial services activities solely concentrate on energy derivatives cannot make use of the passport. They therefore currently need to be registered separately in every one of the 15 EU states.
The rules concerning the regulatory treatment of energy brokers are not yet methodologically sound. In order to further the needs of energy brokers in the European Union and allow them to engage in the trade of power on various energy exchanges the ball is now in the hands of national authorities and European legislators who will need to adjust the regulations accordingly.
By Dirk Auerbach Et Sabine Forster KPMG
Dirk Auerbach is a partner at KPMG and is based in Frankfurt, Germany. He is a certified accountant, tax advisor and a published author. Providing advisory, accounting and assurance/audit services in a number of areas, Dirk is also a university lecturer at the University for Banking Business. For more information Dirk may be contacted on, email@example.com, or via telephone on: +49 69 9587 2793. Sabine Forster is a lawyer and former financial services supervisor of the German Banking Supervisory Authority. She may be contacted on, firstname.lastname@example.org or via telephone on +49 69 9587 4260.
This is an amended version of an article that first appeared in World Power 2002, sponsored by KPMG.
Copyright Wilmington Publishing Ltd. Apr 2002
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