Presentation to UH-GEMI Energy Trading Conference January 26, 2005 Legislative Environment Re: Energy Trading George D. Baker Partner Williams & Jensen,

Presentation to UH-GEMI Energy Trading Conference

January 26, 2005

Legislative Environment Re: Energy Trading

George D. BakerPartner

Williams & Jensen, PLLC1155 21st Street, NW

Washington, DC 20035

[email protected]

Recent Legislative Developments: Looking Back to 2005

August 2005: Energy Policy Act enacted

Key features: Substantial changes affecting broad spectrum of energy supplies

Traditional: Oil, Gas, Coal, Electricity, Nuclear, Hydro, PUHCA Repeal

Alternative: Ethanol, Bio-fuels, Wind, LNG, Solar, Hydrogen Major Energy Tax Provisions

Significant Energy Trading Provisions ofEnergy Policy Act:

• Mandated CFTC-FERC MOU re: information access/sharing between the two agencies to

facilitate respective regulatory missions

- MOU completed on October 12, 2005

• New FPA Prohibition on False Reporting to Federal Agencies

- Prohibits “any entity” from willfully and knowingly reporting any information relating

to the price of wholesale electricity or

availability or transmission capacity, known to be false at

time of reporting, to a federal agency with intent to affect the data being compiled by

the agency.

• Mandated new FERC Market Manipulation Rule affecting “any entity” in electricity and natural gas markets (Section 315 and 1283):

- FERC issued rule January 19, 2006

- Applies to both NGA and FPA

- Based on SEC rule 10b-5: expect carryover of SEC interpretations

• Key Provisions of New Market Manipulation Rule:

- Applies to anyone—NOT just jurisdictional players such as pipelines and utilities.

- Prohibits “any entity”, directly or indirectly, in connection with the purchase or sale of natural gas or the purchase or sale of transportation service subject to the jurisdiction of the

FERC, or in connection with the purchase or sale of electric energy or the transmission services subject to the jurisdiction

of the FERC from:

1. using or employing any device, scheme or artifice to defraud,

2. making any untrue statements of material fact or omitting to state a material fact necessary in order to make statements made, in light of the circumstances under which they were made, not misleading; or

3. engaging in any act, practice or course of business that operates or would operate as a fraud or deceit upon

any person.

• Enhanced fines and penalties for violations of Federal Power Act, Natural Gas Act and Natural Gas Policy Act (Sections 314 and 1284)

Criminal Penalties: increased from $5,000 to $1 million and from two

years imprisonment to five years

Fines: Increased from $500 to $50,000 for each day of

continuing violation of NGA and NGPA

Increased from $500 to $25,00 for each day continuing violation of FPA

Civil Penalties: Increased from $5,000-10,000 to $1 million for each

day of violation of NGA, NGPA or FPA

• FERC authorized to create electronic information system to provide FERC, state commissioners and public with access to information for facilitating price

transparency and participation in electric energy markets

(Section 1281)

Discretionary for FERC; Not mandated by Congress

FERC must consider price transparency provided by existing indexes and trade services and rely on them to maximum extent possible

FERC can exercise its authority to create its own electronic system upon determination that existing indexes and trade services are inadequate.

• Energy Policy Act addressed numerous issues in Senator Feinstein’s “Energy Markets Improvement Act’ (S 509):

Market Transparency

Prohibition of Round Trip/Wash Trading

Enhancement of FERC enforcement authority and criminal/civil fines and penalties for violations

• But the Energy Policy Act DID NOT contain certain other provision of S 509:

NO extension of CFTC jurisdiction to OTC energy trading wheresuch transactions perform a “significant price discovery function”

NO revision of CEA Section 2(h) to bring electronic energy trading systems (such as ICE) under CEA anti-fraud/anti-manipulation and record keeping/reporting provisions

NO Amendment of CEA Section 4b anti-fraud provision to extend to principal to principal OTC trading

BOTTOM LINE: Politics of California market scandals were not extinguished by Energy Policy Act and Feinstein is NOT going away.

• Nor did Energy Policy Act Satisfy Politics of Spike in Natural Gas and Gasoline Markets

Result: Evolution of Graves/Barrow legislative proposals demanding increased regulation of energy trading on NYMEX and OTC

energy trading.

Initial Key themes: Radical Approach seeking to:

- extend CFTC's jurisdiction to cover OTC natural gas trading and ICE

- amend the CFMA to:

eliminate NYMEX's self-certification of rules/products,

(treat energy products like ag commodities)

require NYMEX to have tighter trading limit rules, and

require daily reporting of gas storage info

With Energy Policy Act already enacted into law last summer, obvious legislative vehicle to address Feinstein and Graves/Barrow: CFTC Reauthorization

December of ’05: CFTC Reauthorization

House passes CFTC Reauthorization (HR 4473) :

Key Amendments to Commodity Exchange Act:

∙ PWG Package of Recommendations:

- Zelener fix for Retail FX contracts

- CFTC-SEC joint rules for Risk Based Portfolio Margining for Security Futures and Options, and Expanded Authority for Futures on Security Indexes.

1. Zelener fix: limited to Retail FX contracts

- Clarifies that CFTC has anti-fraud/anti-manipulation jurisdiction over futures and non-futures contract in FX that are:

offered to/entered into with non “eligible contract participant” (i. e. retail customers)

by someone other than an “otherwise registered” financial entity (not broker-dealer, insurance company, bank)

on a leveraged or margined basis

and is not a “security” or results in actual delivery within 2 days, or creates an enforceable obligation to deliver/acceptthe currency

- Requires registration of “Solicitors” of such retail FX contracts.

QUERY: Is scope (limited to FX) adequate? Extend to energy related products?

(PWG Package Cont’d)

2. Mandate CFTC-SEC joint rules on Portfolio Margining and Broad-Based Security Indexes:

Allow Risk Based Portfolio margining for Security Futures Products and Security Options by September 30, 2006

Allow Trading of Futures on Broad-Based Security Indexes (foreign equities; corporate/sovereign bond indexes) by

June 30, 2006

Amendment to CEA Section 4b:

- Extend CFTC anti-fraud authority over principal-to- principal trading of futures, including “excluded/exempt” energy products whether transacted OTC or on a derivatives transaction execution facility

- Increases civil penalty for CEA violations to greater of $1million or triple monetary grain from violation

- Increases criminal penalty to $500,000 fine and 10 years in prison

• Compromise Re: Energy trading (Graves/Barrow)

- Mandate to CFTC to increase natural gas Market Surveillance to deter and detect manipulation and

increase transparency

- Special CFTC Review when natural gas futures exchanges experience “significant and highly unusual change in

settlement price”

- Require CFTC to require reporting by large natural gas position holder regarding “ANY RELATED CONTRACT, AGREEMENT OR TRANSACTION IN NATURAL GAS TO WHICH THAT PERSON IS A PARTY”

Senate still must pass its bill (S 1566):

∙ Key features of ‘Consensus” Ag and Banking Committee bill:

- PWG Recommendations: Zelener fix, CFTC-SEC joint rules re: Risk Based Portfolio Margining and Broad Based Indexes

- Amend Section 4b re: anti-fraud jurisdiction

- Increased Civil and Criminal Penalties

- plus -

- ”Clarify” Section 9 re: CFTC Civil Enforcement Authority for False Reporting.

Amendment to CEA Section 9

- “Clarifies” CFTC’s civil enforcement authority to pursue certain civil cases under existing criminal provision (Section 9)

- Section 9 makes it a felony to knowingly make false, misleading or inaccurate reports regarding the price of any commodity, including electricity and natural gas

- CFTC has used Section 9 in over 30 recent monetary settlements for “false reporting” by energy trading firms or their traders involving fictitious transactions, or reporting of altered or false data on transactions to index publishers in attempt to manipulate the indexes.

Controversy: whether CFTC can use Section 9 on transactions otherwise “excluded” from its jurisdiction under CEA 2(g). Recent court cases say CFTC can do so.

So what will happen on CFTC Reauthorization?

Lots of Consensus Exists on Most Provisions

BUT,

Biggest Political Problem: Energy Trading Issues

Politics of Energy Trading Issues in CFTC Reauthorization in 2006:

- 2005 Energy Bill did not adequately address price and supply in the short run

∙ Claims that energy cost spikes are causing

- demand destruction

- decreased US industrial competitiveness

- US unemployment job/plant migration abroad seeking lower cost energy

- increased cost of fertilizer and farm chemical/fuel inputs

∙ Proponents claim that rise in energy prices is manipulated:

who is to blame?

- Accuse hedge funds/speculators for preying on markets and injecting artificial “demand” and artificial price premium.

- Accuse regulated energy exchanges of failing to protect markets from manipulation by hedge funds and speculators

- Accuse regulators of failing to protect markets from manipulation by hedge funds and speculators

Political Impact:

∙ Members of Congress show sympathy for their constituents’ complaints re: cost and impacts of high natural gas and gasoline prices, but not clear how to help:

- political frustration

∙ Members of Congress do not show sympathy for energy traders, speculators, hedgers, but they

generally want to avoid undue market interferenceand don’t want to impede healthy markets.

- political frustration

Result: Political frustration breeds risk of political response in this Election Year

Organized lobbying by industrial gas users dovetails with residual distrust of Wall Street and energy markets from “Enron” era scandals:

∙ Demands for Response have included:

- Roll back CFMA reforms:

Exchange self-certification

Treat energy products like agricultural commodities

Mandate CFTC regulation of OTC energy markets/ ICE

Modify “exempt” status under CEA

Mandate tighter trading limits by exchanges

Prohibit speculator/hedgers from energy markets

View of Prospects in 2006:

Query: Impact of energy politics in an election year tinged with scandal?

Since House has passed its CFTC bill, all eyes are on the Senate

Question: What will Feinstein amendment be?

Feinstein has not revealed the substance of her amendment

Likely focused on extending CFTC jurisdiction to OTC energy trading: target 2(g) and 2(h) “loopholes”

Feinstein has a commitment from Republican Leadership to allow her to offer her amendment

Question:

Will Other Democratic energy amendments arise?

Cantwell: Address energy price gouging

Reid: Address cost of natural gas (industrial gas users)

Question:

Will Senate Republicans agree to allow such other Democratic energy amendments (besides Feinstein) to be considered on the floor?

Some Republicans are strongly opposed to ANY energy amendments being considered other than Feinstein’s.

This view is strongly supported by ISDA, SIA, BMA and others

If not, will CFTC Reauthorization founder for 2006?

Question:

Will Senate defeat the Democratic amendments, including Feinstein, this time around?

Questions:

If Senate passes a bill without any energy amendments will the House drop its own “Graves/Barrow” compromise provision in conference?

If Senate can’t pass a bill without an energy trading amendment, will there be a conference with House?

What will happen in conference (and when)?