Naulty: APPA supports Dodd-Frank goals, but public power needs relief from 'special entity' provision in CFTC swap dealer rule
Originally published March 18, 2013
APPA supports the goals of the Dodd-Frank Act, but Congress needs to pass the Public Power Risk Management Act, H.R. 1038, to allow government-owned utilities "to hedge against risks on a level playing field with other utilities," Owensboro, Ky., Municipal Utilities General Manager and CEO Terrance Naulty told the House Agriculture Committee March 14. The need for legislation arises because the Commodity Futures Trading Commission’s swap dealer definition regulation "will substantially hinder government-owned utilities’ ability to hedge against operational risks," said Naulty, who testified on behalf of APPA.
The Agriculture Committee is scheduled to mark up the bill on March 20.
Under the CFTC, most entities with swap dealing activity in excess of $3 billion ($8 billion during a phase-in period) must register and thus be regulated as swap dealers. However, a sub-threshold for "special entities"—a category that includes public power and public gas utilities—is only $25 million. The $25 million sub-threshold "is smaller still when you consider that it is the aggregate of a swap partner’s transactions with all special entities during a 12-month period," Naulty said. "As a result, nonfinancial entities (such as natural gas producers, independent generators, and investor-owned utility companies) that do not want to be swap dealers will severely limit their swap-dealing activities with government-owned utilities to avoid exceeding the $25 million threshold."
Electricity markets are regional and there are a limited number of counterparties for any particular operations-related swap sought by a utility, Naulty said. Each counterparty "brings important market liquidity and diversity," he said. "The greater the number of counterparties, the greater the price competition. Conversely, reduced price competition necessarily increases prices."
Owensboro Municipal Utilities sells excess power from its coal-fired power plant to offset the fixed costs associated with surplus capacity and uses financial transactions in the forward market to lock in the best price for its sales, Naulty said. The forward market transactions also allow OMU "to reduce its market risk, to stabilize revenue and, most importantly, to provide rate certainty to its customers/owners," he said. Prior to the establishment of the $25 million sub-threshold, OMU dealt with a limited number of counterparties using agreements that did not require the utility to post collateral unless it exceeded a specified credit limit, he said.
However, since the CFTC’s implementation of the sub-threshold, "two of OMU’s three largest counterparties, which are both utility-affiliated trading companies and not ‘swap dealers,’ are no longer willing to do business with OMU," Naulty told lawmakers. "They cite the compliance risk and lack of internal systems to keep track of special entity transactions and that they do not exceed the threshold." Swap dealers are now the only entities willing to enter into swap transactions with Owensboro and the utility "has seen the bid-ask spread from swap dealer counterparties widen."
The utility has been forced to move most of its hedges to the ICE platform and can no longer take advantage of its negotiated collateral agreements, Naulty said. As a result, OMU has established reserves of $10 million to ensure it can meet margin calls associated with its hedged positions. If the $10 million were to come from OMU’s customers/owners, "the result would be an approximate 10 percent rate increase," he said.
The Dodd-Frank Act does not require or even mention special protections for special entities in regard to the swap dealer definition, Naulty said. "Government-owned utilities understand the operations-related transactions they use to manage their commercial risks and do not need the special protections provided by the $25 million sub-threshold," he said. "In fact, and ironically, these ‘protections’ are likely to limit the ability of these utilities to hedge operational and price risks rather than to protect these utilities and their customers from risk."
A CFTC "no action" letter upping the sub-threshold for government-owned utilities to $800 million "has failed to provide nonfinancial counterparties with the assurances they need to enter into swap transactions" with public power utilities, Naulty said.
The Public Power Risk Management Act, H.R. 1038, would provide narrowly targeted relief for operations-related swaps for government-owned utilities and "should provide the certainty to nonfinancial entities that they can enter into swap transactions with government-owned utilities without fear of being deemed a swap dealer," Naulty said.
The bill, which was introduced by Rep. Doug LaMalfa, R-Calif., was one of seven legislative proposals to make discrete changes to the Dodd-Frank Act that were the subject of the March 14 hearing.
"We’ve heard from public power companies that might not be able to hedge against volatile energy prices because their counterparties are walking away," said Agriculture Committee Chairman Frank Lucas, R-Okla. "As a result, energy prices could rise for millions of Americans—an unacceptable result that was certainly never contemplated when Dodd-Frank was written to reform our financial system." He described the legislation as a common sense tweak to ensure Dodd-Frank is implemented in a way that does not disrupt markets or harm the economy.
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