How banks could save energy companies from bankruptcy

The EU market watchdog is exploring ways to ease the obligation for energy companies to invest more and more liquidity to secure derivative contracts, a solution that leaves banks on the floor.

WHAT’S THE PROBLEM?

Energy companies have tried to protect themselves from rising prices through derivatives linked to the future cost of energy. But no one expected prices to skyrocket like they did.

Corporate derivatives, which were supposed to protect them from rising prices, could now be their loss.

To keep these contracts open, companies have to deposit a “margin” in cash, but this exploded with rising prices following the Russian invasion of Ukraine.

This margin is deposited with a clearing house, which holds the liquidity to support the functioning of the market.

Rising prices on positions held in clearing houses – and the liquidity demands it triggered – have left companies struggling to find the money, threatening their solvency.

HOW TO SOLVE THE PROBLEM?

The European Commission, which is expected to propose an emergency package on Wednesday, said the rules could be changed to ease the obligation to send cash. It could, for example, take a bank guarantee instead.

According to market players, the use of EU carbon allowances could also work. Each quota or permit to pollute, which can be exchanged between companies, is equivalent to one ton of carbon dioxide.

Meanwhile, many European countries are offering state-guaranteed loans and guarantees to help businesses until a regulatory solution is found.

The European Securities and Markets Authority is also evaluating the use of “automatic switches” or temporary interruptions in the negotiation of energy contracts after major price changes, to give the markets a respite.

DO BANK GUARANTEES WORK?

Only in derogation of the regulations in force.

Typically, a bank, for a fee, agrees to make a payment in the event of the bankruptcy of an energy company. It is similar to bank letters of credit widely used in physical oil trading in the United States.

EU rules on derivatives already allow bank guarantees as margin from some companies, provided they are backed by collateral. This makes them expensive.

A derogation from this rule expired in 2016. It should be reintroduced.

DON’T BANKS NEED MORE CAPITAL?

Guarantees should only be extended to energy companies and banks should not be allowed to use guarantees from other banks, a clearing industry official familiar with the discussion said.

Clarifiers may argue that this intervention will not harm banks because a simultaneous collapse of banks and energy companies is highly unlikely.

Banks should therefore be able to avoid heavy capital requirements to cover the collateral they offer, it argues.

In practice, however, much will depend on the European Central Bank, which regulates the largest creditors in the euro zone. If it is prudent, banks may be asked to provide more capital.

WHY ARE CLEARERS NERVOUS?

Clearing houses are concerned about any moves to weaken their defenses, especially after the London Metal Exchange’s clearing arm had to double its default fund earlier this year due to soaring nickel prices. .

Clearing industry officials say bank guarantees should only be offered if they are “fully committed” and “on demand,” which means a bank must agree to pay immediately to ensure the clearer doesn’t end up with the bill.

WILL THE EU MISSION QUOTAS WORK?

Until a certain point.

Odds are popular and hot swapped. Electricity companies need them to comply with EU carbon trading rules, which means there is a market for these allowances.

But the value of the EU benchmark quota contract fell nearly 30% last month, partly due to fears over the economic fallout from the war.

Politicians are already discussing selling more of these allowances to raise up to € 20 billion ($ 20.35 billion), in part to pay for alternatives to Russian gas.

But it would put more permits on the market, which would likely lower prices.

($ 1 = 0.9826 euros)

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