"Contracts which must be physically settled" fall under Sections C6 or C7 of the Annex I of the MiFID Directive, depending upon the place of execution (ESMA's Consultation Paper on MiFID/MiFIR of 22 May 2014 (ESMA/2014/549), p. 281).
The definition of 'contracts which must be physically settled' is harmonised in the European Union under MiFID to avoid distortions in competition and regulatory arbitrage amongst the EU Member States.
This is also to ensure certainty as to which contracts are exempted from and which are covered by the scope of MiFID.
MiFID II treatment - ability test
Section C6 Annex I MiFID II
Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled.
Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA/2014/1569 (p. 406-408) proposed to frame the scope of "contracts which must be physically settled" as follows:
- For the purposes of further specifying:
- wholesale energy contracts under Section C 6 (REMIT carve-out), and
- C 6 energy derivatives contract,
a contract must be physically settled if:
i. 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;
ii. it establishes unconditional, unrestricted and enforceable obligations of the parties to the contract to deliver and take delivery of the underlying commodity;
iii. it is not possible for either party to replace physical delivery with cash settlement; and
iv. 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.
2. Operational netting in power and gas markets shall not be considered as offsetting of obligations under a contract against obligations from other contracts as described in 1 iv and does not preclude a contract from being considered as must be physically settled.
3. Operational netting shall be understood as any nomination of quantities of power and gas to fed into a gridwork upon being so required by the rules or requests of a Transmission System Operator as defined in Article 2 No. 4 of Directive 2009/72/EC or an entity performing an equivalent function to a Transmission System Operator at the national level. Any nomination of quantities based on operational netting must not be at the discretion of the parties to the contract.
4. The existence of force majeure or bona fide inability to settle provisions do not prevent a contract from being characterised as "must be physically settled" for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.
5. Force majeure should be understood as an 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 and which prevent one or both parties to the contract from fulfilling their contractual obligations. Force majeure characteristically provides for a temporary suspension of contractual obligations while the force majeure event or set of circumstances is in place rather than an outright termination of the contract and for the contract to be set aside when the fulfilment of the contractual obligations becomes impossible.
6. Bona fide inability to settle should be understood as any event or set of circumstances, not qualifying as force majeure, which are objectively measurable as reasons defined in the contract terms for one or both parties to the contract not to fulfil their contractual obligations. Bona fide inability to settle clauses also characteristically provide for a temporary suspension of contractual obligations while the relevant event or set of circumstances is in place rather than an outright termination of the contract and for the contract to be set aside when the fulfilment of the contractual obligations is excluded by contractual terms.
7. 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 should not prevent the contract from being characterised as "must be physically settled" for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.
8. Contracts that are physically settled can have a broad range of delivery methods including the following:
i. physical delivery of the relevant commodities themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned (such as a bill of lading or a warehouse warrant); or
iii. another method 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.
The above ESMA's analysis became the law, with only minor modifications, with the adoption of the Commission Delegated Regulation (EU) 2017/565 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 - see Article 5 and Recitals 3 and 4.
Physical players effectively churn (buy and sell) contracts without effectively delivering them physically
(the EU 2013 figures - the European Commission's data):
Volumes, Power: - physically delivered derivatives: 5,779,940 GWh - consumption: 2,064,000 GWh
Volumes, Gas: - physically delivered derivatives: 25,693,877 GWh - consumption: 2,685,000 GWh
Value of derivatives trading that (can/must) be physical delivered: ca 936 billion Euros.
The European Commission's additions to the ESMA's text of 19 December 2014 cover:
- 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 only where the parties to the agreement have to ensure physical delivery of electricity or gas,
- stipulating the metric of the "exercise of appropriate and reasonable due diligence" to avoid force majeure,
- for the bona fide inability to settle to qualify under C6, the event or set of circumstances must be expressly defined in the contract terms, and the party to the contract must act in good faith.
Commission Delegated Regulation (EU) 2017/565 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.
Definition of the "proportionate arrangements" to be able to make or take delivery of the underlying commodity
The first condition for the wholesale energy products to be considered as physically settled requires the parties to the contract to ensure the have proportionate arrangements in place to be able to make or take delivery of the underlying commodity.
Commission Staff Working Document (Impact Assessment Accompanying the document Commission Delegated Regulation supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions {C(2016) 2860 final} {SWD(2016) 156 final}, 18.5.2016, SWD(2016) 157 final) refers to this issue explaining that in the electricity markets "mandated bodies who coordinate the electricity provision (such as Transmission System Operators (TSOs)) often ask energy companies to net out contracts and not to take full delivery in order to respond to market demand and to grid constraints".
This was the reason ESMA considered operational netting does not preclude a contract from being physically settled.
Commission Delegated Regulation of 18 May 2016 also refers to the role of the balancing agreements with the Transmission System Operators in the assessment whether the wholesale energy products can be considered physically settled.
Such balancing agreements (which may be concluded by market participants with the Transmission System Operators either directly or through a Balance Responsible Party (BRP)) make sure that in case a contractual party fails to meet its delivery (or off-take) obligation, the TSO would physically deliver (or take off) the contracted amount to ensure overall system balance.
Commission Delegated Regulation in that regard stipulates that 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".
It follows as regards the "proportionate arrangement" condition and the consequent assessment of the wholesale energy products as physically settled that:
- firstly, that the said balancing agreements are not sine qua non element thereof and,
- second, that only balancing agreements ensuring physical delivery of electricity or gas will qualify.
The option requiring such balancing agreements to be in place without further stipulation as regards their content was also considered, but finally rejected, as this "could easily be abused by market participants to cash-settle contracts".
It is noteworthy, the Commission Delegated Regulation of 18 May 2016 refrained from setting further parameters restricting the legal meaning of the said 'proportionate arrangements' for the purposes of excluding contracts that must be physically settled from the scope of financial instruments.
In particular, the terms of contracts which may benefit from the exemption need not to refer to the technical or operational capacity of participants to take physical delivery, like for example licenses to operate in the physical markets, or a generic requirement to have adequate production, storage or consumption facilities in relation to their commercial activities (Commission Staff Impact Assessment of 18 May 2016, p. 49).
There are also no quantitative thresholds linking the sum of obligations to be physically settled to the total production, storage or consumption capacities (like, for example, that the obligations to be physically settled should not exceed 200% of production capacity at any time, etc.).
Liquidity is in this respect a major concern as it may be impaired if more restrictive measures were adopted, in particular the requirement for sufficient production/consumption capability, which the majority of intermediaries are lacking.
In such a case, customers would need to rely on electricity products offered by producers only, while intermediaries would not be able to use the exemption - hence, intermediation would be restricted to investment firms subject to financial regulation.
Another consequence would be limited product diversification, restricted hedging, no consistent forward curve and inefficient price signals.
It is possible this relaxed legal set-up will occur only temporary since it is assessed optimal to keep the flexible wording for the initial application of the legislation only.
As the said Impact Assessment of 18 May 2016 elaborates, legal framework adopted in the Commission Delegated Regulation of 18 May 2016 may be complemented at a later date with Level 3 measures which would benefit from specific concerns arising from the implementation of the exemption. The legislator's assessment is currently it is not possible to specify further elements without possibly harming market liquidity and the aims of the Energy Union.
MiFID I approach
Section C6 Annex I MiFID I
Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF
It is noteworthy, in the course of public consultation preceding the ESMA's Guidelines on the application of the definitions in Sections C6 and C7 of Annex I of Directive 2004/39/EC (MiFID) of 6 May 2015 (ESMA/2015/675) - followed by the Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341) - ESMA asked market participants, whether they "agree with ESMA's approach on specifying that C6 includes commodity derivative contracts that "must" be physically settled and contracts that "can" be physically settled".
ESMA noted that a significant number of respondents "agreed with ESMA's distinction in confirming that the existing definition of C6 covers both contracts that "must" be physically settled and contracts that "can" be physically settled. Some respondents considered that to highlight the distinction was unnecessary as contracts that "must be physically settled" is a concept that only stems from MiFID II."
Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341)
"Application of C6 of Annex 1 of MiFID I
1. ESMA considers that definition C6 of Annex 1 of MiFID applies in the following way:
a. C6 has a broad application, applying to all commodity derivative contracts, including forwards, providing that:
i. they can or must be physically settled; and
ii. they are traded on a regulated market and/or an MTF.
b. "Physically settled" incorporates a broad range of delivery methods and includes:
i. physical delivery of the relevant commodities themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned (such as a bill of lading or a warehouse warrant); or
iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of commodities 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 commodities.
Application of C7 of Annex 1 of MiFID I
2. ESMA considers that definition C7 of Annex 1 applies in the following way:
a. C7 forms a category that is distinct from C6 and applies to commodity derivative contracts that can be physically settled which are not traded on a regulated market or an MTF providing that the commodity derivative contract:
i. is not a spot contract as defined under Article 38(2) of Regulation 1287/2006/EC;
ii. is not for the commercial purposes described under Article 38(4) of Regulation 1287/2006/EC; and
iii. meets one of the three criteria under Article 38(1)(a) and also the separate criteria under Article 38(1)(b) and 38(1)(c) of Regulation 1287/2006/EC.
b. "Physically settled" incorporates a broad range of delivery methods and includes:
i. physical delivery of the relevant commodities themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned (such as a bill of lading or a warehouse warrant); or,
iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of commodities 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 commodities.
3. Physically settled commodity derivatives which do not fall within the definition of C6, i.e. are not traded on a Regulated Market or an MTF, may fall within the definition of C7 and the definitions of C6 and C7 form two distinct categories as C7 applies to commodity derivatives "that can be physically settled not otherwise mentioned in C6".
4. The other characteristics of commodity derivatives under C7 - "not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls" - are further defined under Article 38 of Regulation 1287/2006/EC.
5. ESMA notes that the conditions defined in Article 38 of Regulation 1287/2006/EC, are to be applied cumulatively."
However, while responding to the aforementioned remarks ESMA observed:
"ESMA's aim is to clarify that the existing definition is an inclusive term, and that in confirming there are two elements within the existing definition, ESMA hopes this should assist in the understanding of the transition to the modified C6 definition that will take effect under MiFID II."
So, it follows, in spite of the fact, the mandatory physical way of settlement is not explicitly mentioned in Sections C6 and C7 of Annex I to MiFID I, the European financial regulator includes this type of settlement into both above MiFID I Sections by way of interpretation.
Hence, the practical meaning of the exact delineation of the scope of the term: "contracts which must be physically settled" is not restricted to the Section C6 of Annex I to MiFID II and the specific MiFID II approaches to wholesale energy contracts under Section C6 (REMIT carve-out), as well as the C6 energy derivatives contracts (where "contracts which must be physically settled" were expressly named), but is equally important for the actual scope of Sections C6 and C7 of MiFID I.
Book entries
In its Guidelines (which are aligned with the text used to define methods of physical delivery in the ESMA Technical Advice to the European Commission in respect of MiFID II) ESMA, moreover, added that the term: "physically settled" when referring to "another method of bringing about the transfer of rights of an ownership nature" also includes book entries.
Operational netting in energy markets
Operational netting is mentioned in the Technical Advice to the European Commission in respect of MiFID II to clarify that it does not constitute offsetting in a way which would render a contract as "not must be physically settled" which is an important clarification for the application of the specific "C6 exemption" included in MiFID II.
ESMA explained that for the purposes of MiFID I the process of nominating to a TSO is explicitly caught by alternative iii. of the Guidelines (another method of bringing about the transfer of rights of an ownership nature).
The term operational netting, in ESMA's view, describes a type of settlement that occurs only on a net basis if the TSO so requires.
Therefore ESMA does not consider it is an additional type of physical settlement and has not done so in its Technical Advice to the European Commission in respect of MiFID II either.
Portfolio compression
A portfolio compression has been also analysed as the separate delivery method in the above context since market participants expressed views that practices like portfolio compression should also be mentioned explicitly as type of physical settlement in the Guidelines.
However, ESMA considers portfolio compression to be a risk reduction technique applied to a contract, which does not change the legal nature of a contract and its specifications, and cannot be described as a "delivery method" from the outset. Therefore ESMA does not treat portfolio compression as a separate delivery method.
Energy regulators' and the electricity producers' voice
The interpretation of the term "must be physically settled" in the above context has sparked a vivid discussion between the ESMA and the Agency for the Cooperation of Energy Regulators (ACER).
As ACER indicated in its Recommendation No 1/2015 (ACER's Recommendation No 01/2015 of 17 March 2015 on the regime applying to the derivative contracts referred to in Section C.6 of Annex I of MiFID II which have the characteristics of wholesale energy products that must be physically settled according to Article 4(1)(2), second subparagraph, and Article 89 of MiFID II), the Agency is concerned that the explanatory text could lead to a misinterpretation of the ESMA's Technical Advice if it were to require that only the counterparties with production, consumption or storage capabilities may enter into "must be physically settled" contracts.
Such misinterpretation could have several adverse impacts and undermine the concept of intermediation at the basis of the liberalisation of financial markets.
ACER believes, moreover, that sometimes 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) is not yet spelt out properly.
Referring to ESMA's requirements addressed in the Guidelines, ACER recommended that:
1. The European Commission's delegated acts clarify that the 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 or "another method 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", as indicated by ESMA's Technical Advice, suffice to guarantee the physical delivery of the commodity.
2. The Commission's delegated acts clarify that if a wholesale energy derivative contracts traded on the OTF cannot be settled in cash, it must be settled physically and therefore this is falling outside the scope of Annex I C.6 of MiFID II.
3. The Commission's delegated acts clarify that forward contracts that must be settled with physical delivery (which are not derivatives) don't fall under the scope of Annex I C.6 of MiFID II.
The aforementioned ACER's views are shared also by the Council of European Energy Regulators (CEER letter of 19 March 2015 to the European Commission, CEER Press Release (PR-15-05) of 20 April 2015).
The industry has also taken part in this argumentation - see for example EURELECTRIC concerns regarding proposed MiFID II implementing rules of 10 April 2015. Eurelectric, in particular, supported the ACER's view that "the only criterion to consider whether a contract "must be physically settled" is whether the market party is or not party to a balancing or settlement agreement with a TSO".
The aforementioned text of Article 5 of the Commission Delegated Regulation of 25.4.2016 proves that the postulates of ACER, CEER and the energy industry have only partially been satisfied by the European Commission.
For the broader context of regulatory treatment for physically settled commodity derivatives under MiFID II see here.
See here for more extensive comments on:
- contracts having the "characteristics of other derivative financial instruments",
- the third limb of the trading criterion of the financial instrument's definition 'contracts equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue'.
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Documentation |
Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341)
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Links |
C6 energy derivatives contracts
C6, C7 - financial market secret code