The ability test for "contracts which must be physically settled" (i.e. contracts falling under Sections C6 or C7 of the Annex I of the MiFID Directive, depending upon the place of execution) has taken its final - as it seems - shape.
Why bother? Indeed, sounds enigmatic for those not involved.
However, this is not an issue of minor importance for financial and energy EU regulators, considering visible disagreement between ESMA and ACER.
In essence, the problem may be categorised as the one delineating the scope of contracts on the energy market subject to financial regulation.
As can be expected, each regulator engaged in the defence of its own territory - ESMA's stance expressed it the Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA/2014/1569 (p. 406-408) and the ACER's in the Recommendation No 1/2015 of 17 March 2015.
In the meantime, ACER has gained significant allies in the Council of European Energy Regulators (CEER letter of 19 March 2015 to the European Commission, PR-15-05 of 20 April 2015) and in the energy industry (for example EURELECTRIC).
Feuding counterparties have been reconciled by the European Commission in Article 5 the Commission Delegated Regulation of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.
The said provision (still subject to non-objection by the European Parliament and the Council, potential application as from 3 January 2018) assumes as a starting point the ESMA's text of 19 December 2014, but includes - what can be assessed as the most vital innovation - an explicit clarification that the balancing agreement with the Transmission System Operator is considered a proportionate arrangement to make or take delivery of the underlying commodity (but only where the parties to the agreement have to ensure physical delivery of electricity or gas).
The role of operational netting in the energy markets has also been interpreted in the legislative text.
Does this make the the distinction between forward contracts that can be settled in cash or with physical delivery (which are derivatives) and forward contract that must be settled with physical delivery (which are not derivatives) more clear, as ACER expected in its objections to the ESMA's Final Report of 19 December 2014?
I'm afraid, not entirely.
But judge for yourself (the relevant provisions of the said Regulation are below in the box, more extensive comments on 'contracts which must be physically settled' are here).
Commission Delegated Regulation (EU) of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive
Recitals 3, 4
(3) It is necessary to further specify the criteria to determine under what circumstances contracts in relation to wholesale energy products must be physically settled for the purposes of the limitation of scope set out in Section C(6) of Annex I to Directive 2014/65/EU. In order to ensure that the scope of this exemption is limited to avoid loopholes it is necessary that such contracts require that both buyer and seller should have proportionate arrangements in place to make or receive delivery of the underlying commodity upon the expiry of the contract. In order to avoid loopholes in case of balancing agreements with the Transmission System Operator in the areas of electricity and gas, such balancing arrangements should only be considered as a proportionate arrangement if the parties to the arrangement have the obligation to physically deliver electricity or gas. Contracts should also establish clear obligations for physical delivery which cannot be offset whilst recognising that forms of operational netting as defined in Regulation (EU) No 1227/2011 of the European Parliament and of the Council or national law should not considered as offsetting. Contracts which must be physically settled should be permitted to deliver in a variety of methods however all methods should involve a form of transfer of right of an ownership nature of the relevant underlying commodity or a relevant quantity thereof.
(4) In order to clarify when a contract in relation to wholesale energy product must be physically settled, it is necessary to further specify when certain circumstances such as force majeure or bona fide inability to settle provisions are present, and which should not alter the characterisation of those contracts as 'must be physically settled'. It is important to also clarify how oil and coal energy derivatives should be understood for the purposes of Section C6 of Annex I to Directive 2014/65/EU. In this context, contracts related to oil shale should not be understood to be coal energy derivatives.
Article 5
Wholesale energy products that must be physically settled
(Article 4(1)(2) of Directive 2014/65/EU)
1. For the purposes of Section C(6) of Annex I to Directive 2014/65/EU, a wholesale energy product must be physically settled where all the following conditions are satisfied:
(a) it contains provisions which ensure that parties to the contract have proportionate arrangements in place to be able to make or take delivery of the underlying commodity; a balancing agreement with the Transmission System Operator in the area of electricity and gas shall be considered a proportionate arrangement where the parties to the agreement have to ensure physical delivery of electricity or gas.
(b) it establishes unconditional, unrestricted and enforceable obligations of the parties to the contract to deliver and take delivery of the underlying commodity;
(c) it does not allow either party to replace physical delivery with cash settlement;
(d) the obligations under the contract cannot be offset against obligations from other contracts between the parties concerned, without prejudice to the rights of the parties to the contract, to net their cash payment obligations. For the purposes of point (d), operational netting in power and gas markets shall not be considered as offsetting of obligations under a contract against obligations from other contracts.
2. Operational netting shall be understood as any nomination of quantities of power and gas to be fed into a gridwork upon being so required by the rules or requests of a Transmission System Operator as defined in Article 2(4) of Directive 2009/72/EC of the European Parliament and of the Council for an entity performing an equivalent function to a Transmission System Operator at the national level. Any nomination of quantities based on operational netting shall not be at the discretion of the parties to the contract.
3. For the purposes of Section C(6) of Annex I to Directive 2014/65/EU, force majeure shall include any exceptional event or a set of circumstances which are outside the control of the parties to the contract, which the parties to the contract could not have reasonably foreseen or avoided by the exercise of appropriate and reasonable due diligence and which prevent one or both parties to the contract from fulfilling their contractual obligations.
4. For the purposes of Section C(6) of Annex I to Directive 2014/65/EU bona fide inability to settle shall include any event or set of circumstances, not qualifying as force majeure as referred to in paragraph 3, which are objectively and expressly defined in the contract terms, for one or both parties to the contract, acting in good faith, not to fulfil their contractual obligations.
5. The existence of force majeure or bona fide inability to settle provisions shall not prevent a contract from being considered as 'physically settled' for the purposes of Section C(6) of Annex I to Directive 2014/65/EU.
6. The existence of default clauses providing that a party is entitled to financial compensation in the case of non- or defective performance of the contract shall not prevent the contract from being considered as 'physically settled' within the meaning of Section C(6) of Annex I to Directive 2014/65/EU.
7. The delivery methods for the contracts being considered as ' physically settled' within the meaning of Section C(6) of Annex I to Directive 2014/65/EU shall include at least:
(a) physical delivery of the relevant commodities themselves;
(b) delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned;
(c) other methods of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them including notification, scheduling or nomination to the operator of an energy supply network, that entitles the recipient to the relevant quantity of the goods.