Plenty of ink has been shed on the subject of regulation for the rail industry. But there is one emerging compliance area not likely to be high on the current boardroom agenda.
As you read this the EU is implementing legislation to improve accountability in wholesale energy trading markets. For UK and European rail operators hedging their fuel costs by purchasing energy commodities in volume, these rules add a new layer of regulatory risk.
There are two new rulebooks to follow: EMIR1, which governs energy commodity transactions and REMIT2, which covers physical fuel trades. Both arose from the fallout of the global financial crisis and moves by the G20 to improve transparency in over-the-counter derivative markets, mainly through the reporting of activities to trade repositories.
But even as the implementation mandates for EMIR and REMIT unfold, little clarity has been established. Deadlines have shifted, definitions have changed and the rail firms affected have been left wondering what to do next.
Most have hesitated to act for fear of investing in solutions that turn out to be expensive dead-ends. The alternative of abandoning fuel-cost hedging strategies altogether and capitulating to higher prices has seemed almost the lesser of two evils – remarkable given the impact of fuel costs on the bottom line. The British rail industry used 681 million litres of diesel in 2009/10, with freight using 199 million litres and passenger using 482 million.
Despite the uncertainty, some things are clear. The new rules will affect any rail company dealing in:
• energy-related options, futures and swaps on interest rates, securities, credit and indices
• energy commodity derivatives and derivatives on underlyings; including rates, freight rates, emission allowances and climatic variables
• contracts for gas and electricity, as well as pure transportation derivatives
Participants in the energy market, rail businesses which use these hedging techniques have now become ‘non-financial counterparties’. As energy trades in this category only need to be centrally cleared after a clearing threshold has been reached, an active monitoring capability is now needed to signal when the threshold is looming.
Companies also need to register with their national regulators, and implement a reliable means of reporting, clearing and demonstrating risk mitigation.
What rail operators can do to prepare
Despite ambiguities around rollout there are alternatives in terms of what the industry can do to get ready for EMIR and REMIT. Managing the process by spreadsheet is not one of them. There are electronic reporting and data storage requirements involved in each set of regulations that will quickly overwhelm manual processes.
Outsourcing the reporting function may be an option, but one that’s fraught with costs and risks. How active you are in the energy trading arena will determine your breakpoints financially. It’s worth bearing in mind that a third party provider would most likely not be held responsible for paying fines, should any errors or missed deadlines occur. And in an industry often under intense media glare, the reputational risks of a compliance breach need to be weighed carefully.
That leaves accepting higher prices by abandoning a hedging strategy altogether, or automating the process. The option for rail companies is clear. Automation is the best business decision.
Automating regulatory processes requires a basic commodity and energy trading and risk management (C/ETRM) system, which is a comprehensive regulatory solution for commodity trading and corporate financial compliance. C/ETRM is generally not a stand-alone application and needs to incorporate contract data, hedge accounting, revenue allocation, and the all important regulatory reporting requirements for your geographic markets.
In light of the evolving standards for EMIR and REMIT, you will want to choose a solution that allows you to upgrade and manage the regulatory compliance process quickly. Another qualifier to consider is the option to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract.
Core to any solution would also be direct connectivity to trade repositories, including all required regulatory identifiers and formats. The system should be able to simplify your threshold monitoring (as discussed above) and facilitate your risk mitigation obligations, including periodic portfolio reconciliations under the new rules.
Deadlines on the horizon
As the regulation clock continues to tick, the rail sector faces an uphill battle to understand and meet the obligations that EMIR and REMIT will impose. When the current ambiguities are cleared up and firm deadlines re-set, everyone will be expected to comply quickly. Failure to do so will be met with stiff penalties.
Any operator planning to maintain a hedging strategy to manage fuel costs will need to address this soon. An automated solution offers the best alternative to meeting the requirements, given the evolving standards and timelines that define the regulatory environment.
James Brown is senior energy consultant, EMEA for Allegro Development Corporation.