By: Rick Umoff,
What do the 2008 financial crisis, the Commodity Futures Trading Commission (“CFTC”), and renewable energy have in common? More than you might think. In July 2010, the CFTC was granted expanded authority under the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) to regulate the risky transactions thought to be at the heart of the financial crisis.[i] These transactions, including credit default swaps, collateralized mortgage obligations, and other derivatives labeled “swaps,” will be subject to a new regulatory regime. In its Notice of Proposed Rulemaking, the CFTC asked renewable energy stakeholders to comment on whether environmental commodities, such as renewable energy certificates and carbon offsets, should be regulated as swaps.[ii]
Instead of a clear, principles-based definition of “swap,” Dodd Frank includes a long list of transaction types2 that are swaps.[iii] In addition, Dodd Frank gives the CFTC broad authority to further define swaps and determine how they should be regulated.5 On its face, Dodd Frank does not list environmental commodities as swaps. However, the swaps definition is so broad and the CFTC’s rulemaking authority so vast that stakeholders have turned to regulatory exemptions, seeking to ensure that environmental commodities are not considered swaps.
If environmental commodities are brought under the swaps definition, they too will be subject to the new rules. These regulations include clearing and margin posting requirements for swap transactions, as well as extended requirements1 for parties trading swaps.[iv] In short, with the added time and paperwork required by the rules would drive up the cost of buying and selling renewable energy.
Stakeholders argue that environmental commodities fall under the forward contract exclusion, which exempts forward contracts from the swap definition.[v] Under this exclusion, any sale of a nonfinancial commodity or security for deferred shipment or delivery that is intended to be physically settled is exempt from being defined as a swap.[vi] Meaning the exemption has two key components: a transaction must be for a “nonfinancial commodity” and the transaction must be “physically settled.”[vii] The terms “nonfinancial commodity” and “physically settled” were not defined in Dodd Frank, and have not been defined by the CFTC.[viii] In fact, it is still uncertain what these terms mean.
Stakeholders are reacting to this vague terminology. First they argue that “nonfinancial commodities” should be defined in a way that does not include environmental commodities.[ix] It is likely that when Congress passed Dodd Frank it considered nonfinancial commodities to be physical commodities such as bushels of corn or barrels of oil.[x] In contrast, a financial commodity is a risk-shifting instrument, such as a “contract for differences,” that does not convey an ownership interest in an asset.[xi] Stakeholders argue that environmental commodities are nonfinancial because they are not purely traded as a means of shifting risk.[xii] For example, when a party buys a renewable energy certificate (“REC”), a type of environmental commodity, they gain title to the valuable environmental attributes associated with the production of a set amount of renewable energy.[xiii]
Second, stakeholders argue that environmental commodities are “physically settled.”[xiv] Although physical settlement has not been formally defined, it is generally thought that a transaction is physically settled when the parties perform actual delivery of the underlying commodity.[xv] For instance, a transaction for a barrel of oil in which the buyer takes title and delivery of the oil from the seller would be a physically settled transaction. Taking RECs as an example of environmental commodities, stakeholders argue that the majority of RECs are physically settled because title of a measurable unit of renewable energy is transferred from one party to another through an attestation or tracking system.[xvi] While the environmental attributes may not be as tangible as a barrel of oil, the transfer of title conveys an ownership interest in the underlying commodity (i.e. the renewable energy and its attributes), which is unique to the owner and can only be used by the owner (i.e. retired).[xvii]
Stakeholders in the renewable energy community are hopeful that the CFTC will agree the forward contract exemption applies to environmental commodities. Former CFTC attorney and the current counsel at environmental commodity trading, sales, and advisory firm 3Degrees3 stated: “Despite their intangible nature, environmental commodities, as they are most commonly traded in the market should be eligible for the forward contract exclusion. I am optimistic that the efforts of many folks in our industry to bring CFTC staff up to speed regarding environmental commodities and environmental commodity markets will result in environmental commodities being eligible for the forward contract exclusion.”
The CFTC was scheduled to issue its rules for swaps in January 2012. However, the agency has yet to issue final rules in this area. Keep an eye out to see whether the CFTC exempts environmental commodities, as these new regulations may have a significant impact on the future of renewable energy.
For more information, you can visit the Renewable Energy Markets Association at www.renewablemarketers.org.
2 Examples include: options on commodities contracts; financially settled contracts that do not convey an ownership interest in an asset; and contracts in which payments are exchanged based on the occurrence of a financial or commercial event.
1 Regulations on parties trading swaps include: net capital requirements; position limits; registration requirements for firms and individuals; reporting requirements; business conduct rules; and appointment of a Chief Compliance Officer.
[i] Dodd Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 (2010)
[ii] Further Definition of “Swap”, 76 Fed. Reg. 29818 (proposed May 23, 2011) (to be codified at 17 C.F.R. pt. 240).
[iii] Id.
[iv] Renewable Energy Markets Association, Dodd Frank and Renewable Energy Markets: Analysis and Response to Commodities Futures Trading Commission Financial “Swap”, at 10:43 (2011) http://vimeo.com/26718217.
[v] Renewable Energy Markets Association, Product Definitions, File No. S7-16-11, at 4 (2011) http://www.renewablemarketers.org/legislative/climatePolicy.asp.
[vi] Further Definition of “Swap”, 76 Fed. Reg. 29818 (proposed May 23, 2011) (to be codified at 17 C.F.R. pt. 240).
[vii] Id.
[viii] Steve Mickelsen, 3Degrees Group, Inc., Comment for Proposed Rule 76 F.R. 29818, at 10-13 (2011) http://comments.cftc.gov/publiccomments/viewcomment.aspx?id=47936.
[ix] Id. at 11.
[x] Renewable Energy Markets Association, Dodd Frank and Renewable Energy Markets: Analysis and Response to Commodities Futures Trading Commission Financial “Swap”, at 14:00 (2011) http://vimeo.com/26718217.
[xi] Id. at 24:30.
[xii] Id.
[xiii] Id.
[xiv] Renewable Energy Markets Association, Product Definitions, File No. S7-16-11, at 2 (2011) http://www.renewablemarketers.org/legislative/climatePolicy.asp.
[xv] CFTC v. Co-Petro Marketing Group, Inc., 680 F.2d 573, 577 (1982)
[xvi] Steve Mickelsen, 3Degrees Group, Inc., Comment for Proposed Rule 76 F.R. 29818, at 14 (2011) http://comments.cftc.gov/publiccomments/viewcomment.aspx?id=47936.
[xvii] Id. at 14.
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