Letter on the proposed market correction mechanism

By on November 21, 2022 0

Europex broadly welcomes the Commission’s proposals on joint purchasing, efficient operation of gas infrastructure, reduction of gas demand and improvement of security of supply, as set out in the draft regulation of the Council aimed at strengthening solidarity through better coordination of gas purchases, cross-border gas exchanges and reference prices. We believe that the above measures can be implemented effectively to alleviate the current energy crisis caused by the reduction of Russian gas supplies to Europe.

However, we are deeply concerned about the development of the market correction mechanism as set out in Article 23 of the draft Council Regulation and further described in a recent non-paper from the Commission1.

Gas derivatives, such as the first-month TTF futures contract, are a crucial tool for producers and consumers, including energy-intensive industry, to hedge against the risk of changes in future prices at counting gas. If a change in future supply or demand becomes apparent, market participants must be able to immediately reconsider their open contracts in order to remain properly hedged.

If a maximum price cap for the TTF front-month contract becomes applicable without prior assessment of the safeguards set out in Article 23(2), we see major risks to financial stability and security of supply.

1. Financial stability:

If the actual price of gas rises above the artificially capped price of the pre-TTF month futures contract, market participants will immediately move trading into the bilateral OTC space. Such a move would not only lead to a significant decrease in transparency, but would also pose serious risks to financial stability. As the European Central Bank warned in its November 2022 Financial Stability Review: “A greater shift of utilities and energy companies to the OTC space would entail greater risks for counterparties and the financial system. Non-centrally cleared contracts require less collateral for trading firms, but involve higher counterparty risk and less transparency for the market as a whole. Additional concerns stem from the fact that the partial shift to the OTC space is occurring in an environment of higher volatility and therefore increased risk of counterparty default.

Moreover, the proposed mechanism is incompatible with the primary obligation of an operator of a MiFID regulated trading platform, namely to ensure fair and orderly markets. Market participants holding an open interest would be exposed to incalculable uncertainty. Since a market participant holding an open interest has an obligation to make or take delivery, the triggering of a price limit would lock the market participant into an obligation, since he could no longer have the possibility of change its position. Strict price caps on energy derivatives markets will therefore fundamentally compromise their proper functioning.

The mechanism would also immediately pose serious risks to the CCP’s clearing of these markets, the continuous margin of open positions, and the management and control of any defaults. It is also likely to significantly increase margin requirements on EU gas and electricity derivatives.

2. Security of supply:

Alternatively, when the mechanism is triggered, market participants can decide to no longer hedge their production or consumption in the front-month TTF contract. Instead, they will balance their positions by trading in the spot market. This would put immediate and considerable pressure on spot prices, with no certainty that it would not affect security of supply.

With specific regard to LNG, the EU must ensure that it remains competitive to avoid that LNG shipments are simply redirected to destinations that are willing to pay the real price for the goods. Frontier Economics explains in more detail the implications of a wholesale gas price cap as proposed by the Commission in its paper “A Wholesale Gas Price Cap in Europe”. The paper concludes that “the risks of any wholesale price cap approach […] – namely reduced supply, increased demand and the need for non-price rationing – also apply to the ‘gas market correction mechanism’ as proposed by the Commission. […] Before taking such a measure, it will be crucial that its design and impacts are assessed more thoroughly, in order to avoid significant unintended negative consequences.

Finally, the implementation of a price cap will be a direct intervention in the stock exchange’s matching engine. Any such invasive intervention will need to be properly designed and implemented, and rigorously tested, including through market consultation, to ensure that changes do not adversely affect the

the proper functioning of markets and the ability of market players to use them. It is unrealistic to assume that this can be achieved in a short period of time and certainly not before the end of this winter.

In conclusion, the mechanism proposed by the Commission does not take into account the above-mentioned risks and, when implemented, it can indeed be triggered without any guarantees or substantial impact assessment. The fact that the mechanism can simply be suspended by the Commission after it has been triggered will lead to irreversible damage. To ensure financial stability, an ex ante assessment should be carried out by the ECB. Similarly, conditions related to security of supply should be assessed by ACER and ESMA before the mechanism is applied.

We are convinced that the proposed market correction mechanism will not achieve its main objective of lowering energy prices, but will seriously threaten the EU’s security of supply and introduce serious risks for financial stability in Europe. Moreover, it will have serious and potentially irrevocable negative effects on the functioning and competitiveness of the European wholesale energy market which could last well beyond the current crisis.

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