HEDGE ACCOUNTING OR ACCOUNT FOR HEDGING?

HEDGE ACCOUNTING OR ACCOUNT FOR HEDGING?

HEDGE ACCOUNTING OR ACCOUNT FOR HEDGING?

From the memories of a risk manager turned accountant:

The concept of economic hedging (fixing a price over time in order to ensure predictability of future cash flows) is fundamental to a market risk manager’s job. My more than four years’ experience in this area did not prove an exception. Focusing on the financial side, I often regarded the accounting implications of a hedge as issues of fairly subordinate importance.
Enjoying the comfort of having an accounting department in the company, I conveniently limited my activities to “I told you there will be some Profit and Loss (P&L) impact of the hedge” and “We are not doing any hedge accounting by company policy, as it is complex to set up”, forwarding any further inquiries in this regard to my colleagues. As people say, God works in mysterious ways, and after years of deliberate ignorance (as a punishment or not), I was given a chance to fill my knowledge gaps and fight on the opposite side of the barricade. To put it straight, I joined the commodity accounting department of the Group.

Almost in the twinkling of an eye I experienced a total paradigm change. I no longer received calls from frustrated management claiming, that hedging generates losses or destroys the P&L of the business unit or asset (after the derivatives are marked-to-market or have reached payment). Professional arguments that the placed hedges are not justified, as they destroy value resp. generate no gains ceased. Such are often raised especially if incentives (bonuses) of operational managers are conditioned upon the business unit’s results for the respective period and frequently escalate to the highest level of the company. There was no need for constant replies that the purpose of a hedge is not to make money but to reduce the volatility of earnings. I stopped acting as an advocate for the hedging strategy, even though it has already been incorporated in the company policy. Discussions around why fair value is shown in P&L accounts and not directly on the balance sheet took a new dimension…

If my new occupation seemed quite tranquil, please keep reading on, as things got even more complex, as I’ve entered the world of hedge accounting.

As many may have heard, a convenient way to avoid direct P&L impact of derivatives mark-to-markets is the application of hedge accounting (term different from economic hedge). The latter is used to recognise the offsetting effect of hedges, especially if there is a difference in the accounting practices for hedge instruments and hedged items (e.g. fair value vs. cost accounting) and this difference influences the profit and loss statement.

Claiming “own use” exemption, provided by the International Accounting Standard (IAS) 39, avoids fair value accounting and eliminates the resulting P&L volatility, which comes from revaluations of hedge products. This especially holds for negative impacts, as positive values don’t usually give rise to major inquiries. To qualify for “own use” exemption derivative contracts should be entered into for the purpose of hedging underlying physical positions from core business activities and should satisfy some additional conditions. This special treatment allows fair values to be recorded on the balance sheet, typically under Other Comprehensive Income or OCI.

Exemption, however, is not granted freely. It requires testing of the designated hedge relationship effectiveness and mandatory hedge documentation, which may prove to be costly and difficult to implement. Not to mention, the company’s auditors become your best friends (a fact that proved not to be as bad as it seems after all), as hedge relationships are subject to alignment and frequent reviews. These considerations explain the reluctance of high-level management to apply “own use” accounting, especially if impacts of fair value movements of derivatives on the total company P&L are not regarded material. This evaluation takes place prior to deciding about the accounting treatment of hedge instruments.

For someone familiar with all the facets of hedging (which I was taught, if not the difficult, then definitely the long way), the trade-off between dealing with the complexity and cost of hedge accounting and bearing the P&L volatility is a major consideration. Although the implications of using fair value might not be significant on a company or group level, they might form a significant part of an asset’s or portfolio’s profit and loss statement. This often raises questions by those, whose incentives are based on the performance of a particular profit centre. If not explicitly taken into account, e.g. as adjustments, potential impacts of hedging have to be at least communicated and well understood in advance to avoid any issues and misinterpretations in the future.

Written by Konstantin Grigorov

OVER SUPPLIED BUT SHORT OF GAS – YOU ARE PROBABLY ITALIAN!

OVER SUPPLIED BUT SHORT OF GAS – YOU ARE PROBABLY ITALIAN!

OVER SUPPLIED BUT SHORT OF GAS – YOU ARE PROBABLY ITALIAN!

Snow is falling
all around me
children playing
having fun..”

Yeah, the winter is coming…

I spent the last few of those in Italy as an end consumer and a power trader. Apparently, I have remained oblivious to the challenges of the deregulation progress in another segment of the energy market – natural gas. If you are like me, see below what we have missed.

February 7th, 2012 is an emblematic day for the Italian natural gas sector. A record volume of 465,9 mcm has been consumed. The intense cold weather in Europe caused a sharp increase in the gas demand in Italy.

In 2012, the country had a total import capacity of 120.5 Bcm, which was 62% more than the level of its gas consumption (74.3 Bcm). The country was mostly supplied via long-term contracts, which amounted to approximately 110 Bcm (48% above gas demand). The fast rising supply and the decline in gas consumption since the mid-2000s led to a situation of oversupply in the Italian gas market.

Why, then, this paradox – Italy is at risk of periodic gas shortages every time the temperatures are low?!

While the gas sector has been open to competition since 2003, the Regulator has reported little competition on the supply side. Among the main reasons is the lack of access to gas import and storage capacity to new entrants.

Three important steps could improve this situation – construction of new pipelines, LNG terminals and storages.

The access to the national transmission is regulated and transparent but shippers find it hard to get the not used capacity in the import pipelines. To alleviate this, since 1 January 2014, the Secondary Capacity Market started on PRISMA for transactions at the interconnected points with foreign transportation systems. However, despite these measures the problem with the access is still not completely gone.

According to the Legislative Decree no.164/00, firm capacity at entry points interconnected to import pipelines is to be granted in relation to import contracts on a multi-year basis (up to 5 years) and firm capacity at other entry points (and exit points) is to be granted on yearly basis. From 116 Bcm total import capacity in 2011, 103 Bcm of gas were reserved for priority access for long term contracts, leaving only 13 Bcm of unreserved access. Since 2002, total import capacity has increased by 32 Bcm, but unreserved capacity has increased by less than 9 Bcm due to projects that have been developed with long term contract commitments, which has resulted in the reservation of the available pipeline capacity and, as a consequence, blocking others to use that capacity.

Storages provide another way to get access to flexible supplies or alternative supply in case of interruption of imports in order to meet gas demand fluctuations. However, the rapid decline of gas volumes in the storages at times, when cold temperatures persisted raised concerns about the potential ability of these storages to deliver enough gas in the event of a sudden peak in the daily demand.

New storage capacity should help to solve this problem but the long authorization process, together with environmental impact assessments, and macroeconomic conditions since 2008 have become major barriers to creation of new storage capacity.

The draft of the National Energy Strategy (published in 2012) envisaged a development of 18 new storage projects by 2020. This would lead to an increase in national storage capacity to 26 Bcm/y by 2020 (an increase of 73% on current available capacity). Operators’ access to storages would also be liberalized through a market-based system of capacity allocation. In the early 2013 the Government provided a package of reforms towards the liberalization of the sector. This package included storage also measures for allocation of gas capacity. Following this about half of the commercial existing capacity (i.e. 4.2 Bcm) is auctioned and the remaining storage capacity will continue to be allocated under existing procedures.

Apart from new pipelines and storages, the construction of new LNG terminals could improve supply security. However, despite the price and supply diversity advantages it could bring, LNG is likely to continue to struggle to make major inroads against piped supplies. A number of new LNG terminals have been proposed but are put on hold. The oversupply issues have put new projects on the back burner, even though the volume of existing contracted piped supplies is set to fall.

Now, given the situation we have, the key questions are: will Italy be able to upgrade its pipelines infrastructure? Will Italy be able to build new regasification plants and storages? If we look at Italy’s past energy history, we should answer with ‘yes’ to the first question and with ‘no’ to the second one. In the past years, Italy demonstrated a strong capacity of building pipelines but new projects for LNG and storages have always been rejected due to the opposition of local population. Nowadays, it seems that inside the political parties there is a push to remove all kinds of obstacles to the realization of plants supplying energy to the country. The future will show whether or not such a push really exists and weather it would be successful.

Written by Valentin Pavlov

MAR AND HOW DOES IT FIT IN THE REGULATORY FRAMEWORK OF THE EUROPEAN UNION

MAR AND HOW DOES IT FIT IN THE REGULATORY FRAMEWORK OF THE EUROPEAN UNION

MAR AND HOW DOES IT FIT IN THE REGULATORY FRAMEWORK OF THE EUROPEAN UNION

One of the latest EU regulations came into force on the 3rd of July 2016. As many such regulations it is a quiet revolution attracting the attention of only people directly affected by it. For the rest, it is another convoluted text intended to strengthen the EU regulatory power and to prevent market distortions from market abuse (i.e. insider trading and market manipulation).

The questions, which most often came to mind, when the press releases hit are: What has changed and how does the EU regulatory framework on market abuse look like now?

What has changed with MAR entering into force?

MAR or Market Abuse Regulation is the updated version of MAD, the Market Abuse Directive (2003/6/EC). The purpose of MAR is to address some failures of MAD in serving as effective deterrent to market abuse. Some of these failures are tackled by MAR alone, while others together with the Directive on Criminal Sanctions for Market Abuse. What needs to be mentioned is MAR’s alignment with MiFID II, which enters into force in 2017. MAR is also complemented by the Directive on criminal sanctions for market abuse. Hence, we are having a revamp of the old legislative framework governing financial and commodity markets with a newer set of regulations, which are more up-to-date with the recent market and trading developments and which are stronger and more consistent across the Union on sanctions.

• Broader scope

The scope of the market abuse regime has been widened by including financial instruments traded on multilateral trading facilities (MTFs), other organized trading facilities (OTFs) and some over-the-counter activities (e.g. credit default swaps).

The regulation has been adapted to new technologies, by prohibiting certain high frequency trading (HFT) strategies.

Furthermore, MAR prohibits the manipulations of benchmarks because of the widespread use of the latter in pricing of financial instruments. The EU Commission identifies benchmarks as having a pronounced impact on market confidence and their manipulation is meant to have further reaching consequences. To put it simply, in addition to all platforms for all financial instruments, MAR covers benchmarks.

The regulation not only prohibits market abuse, but the attempt of market abuse as well.

• Stronger sanctions

Apart from widening the scope of the previous legislation i.e. MAD, MAR increases the sanctions for violations under it. The regulation expects that offenders will be fined according to the seriousness of their actions, while taking into consideration any mitigating or aggravating factors. Still, to ensure a greater harmonization across EU administrative sanctions, MAR has set the minimum fine of EUR 5 million for natural person and EUR 15 million or 15 % of the total annual turnover for legal persons for insider dealing and market manipulation. Still, sanctions have to be specified in the national laws of Member States by the relevant competent authorities.

How does the EU regulatory framework on market abuse look like after MAR?

MAR interacts with MiFID II and the Directive on criminal sanctions for market abuse.

MAR is based on some of the definitions (e.g. organized trading facilities (OTFs)) and regulations included in MiFID II, meaning that the latter need to be transposed into national laws for MAR to function effectively. MiFID II latest deadline for transposition is 3rd of July 2017.

The Directive on criminal sanctions for market abuse has been published in 2014 and requires transposition until beginning of July 2016. Becoming effective around the same time (at least for countries which have transposed the Directive) MAR and the Directive on criminal sanctions for market abuse are intended to work in parallel. While MAR is defining administrative sanctions, the Directive is introducing criminal sanctions. The Commission considers criminal sanctions necessary, for they express social disapproval on a whole new level, namely at least four years for market manipulation, insider dealing and any recommendations/inducement to engage in insider dealing. The Directive makes benchmarks manipulation a criminal offence as well.

On a final note, MAR is an attempt to build upon the observed results from MAD, close all loopholes left for market abuse and make sure there are deterrent sanctions in place for all Member States. There is still clearly a long way to go before the EU intended framework begins to function similarly across the Union, nevertheless there is some progress with MAD.

Written by Snezhina Mileva

JOINING AN EXCHANGE IN SEE? YOU HAVE SOME SOFTWARE TO DOS

JOINING AN EXCHANGE IN SEE? YOU HAVE SOME SOFTWARE TO DOS

JOINING AN EXCHANGE IN SEE? YOU HAVE SOME SOFTWARE TO DOS

With the approach of the First Energy Software Day SEE, some side events are happening which require attention and fit the theme of the conference. One such key event is the start of trading at the IBEX (the Independent Bulgarian Energy Exchange) on the 19th Jan. The early days will be a chance for participants to test out their readiness for this new trading environment. Exchange trading typically poses several interesting challenges for a company’s transaction lifecycle management:

  • Deal capture and STP. Ideally, straight through processing (STP) should happen within a well round IT solution. This means that from the click of the trader on a certain position bid or offered on an exchange screen or the closing of the deal in a different manner, the flow of the deal to the system of the trader, the consequential events of physical settlements, payments, and wherever applicable on an exchange – the margining and closeouts – should happen automatically. Why? Reason is simple: exchange trading follows strictly defined rules. And strictly defined rules are a situation where IT systems easily replace manual work. Do it well, and your life will be far easier.
  • Cash flow management. One of the main benefits of exchanges is the function of clearing which removes the credit risk between counterparts. This is related to strict rules about collaterals or other ways of warranting the meeting of delivery or settlement obligations, as well as strict rules for settling current obligations. For a company – especially in an environment where intercompany indebtedness is high – good cash flow management in an environment requiring quick cash settlements will be crucial for ensuring the viability of the business.

The reaction or the pro-action of companies in addressing these among other challenges will be a differentiating factor in a highly competitive industry like the electricity markets of SEE.

For more insight on this, among other key topics in the region, join us the First Energy Software Day SEE via http://seeenergysoftwareday.com

11 JAN А COMPETITIVE EDGE AT THE FRONTIERS OF ENERGY TRADING BUSINESS

11 JAN А COMPETITIVE EDGE AT THE FRONTIERS OF ENERGY TRADING BUSINESS

11 JAN А COMPETITIVE EDGE AT THE FRONTIERS OF ENERGY TRADING BUSINESS

Check out the hows at the First Energy Software Day SEE

The SEE region poses a unique “at the frontiers” atmosphere giving amble opportunities for profit and loss. At the frontiers for several reasons:

  • Geographical – the obvious one (at least if you have a map in front of you 🙂 )
  • Emerging organized markets: the exchange in Romania, the new one in Bulgaria, and the continuing opening of the markets in Turkey, Serbia, and Macedonia can be captured in one key word: transition.Transition means a lot of problems to solve and an exciting present and future for the involved people.
  • Little time to catch up with EU (for the last union entrants and the candidate states): energy regulations leave some space for country regulators to catch up. However, progress has been slow, and there will have to be a condensed process of catching up on liberalization, renewables entering the market, and regulatory reporting.

The insides of a company are to a large extent driven by the regulatory and market frameworks – and these are in constant flux for energy traders. This means that a company needs to be very organized in managing its data and know-how and still be able to very quickly adapt to new conditions and requirements.

A key part of success will be keeping track of data and actions: this will enable the ever more complex regulatory reporting and at the same time enable business analytics. If this is in place, the second part is to build on it to get great decision support.

A company’s traders are there to execute judgement. Basing it on the right analytics and the right input data is something which will enable them to do this successfully and cost efficiently. The how to is hidden somewhere in a technology mix. Join the First Energy Software Day SEE to get a glimpse into the drivers and the ways to identify the right mix and manage it effectively over time.

See you on the 28th January!

EXPERTS PUT SOFTWARE ON TOP OF THE ENERGY BUSINESS AGENDA IN SEE

EXPERTS PUT SOFTWARE ON TOP OF THE ENERGY BUSINESS AGENDA IN SEE

EXPERTS PUT SOFTWARE ON TOP OF THE ENERGY BUSINESS AGENDA IN SEE

At this first of its kind Energy Software Day for Southeast Europe, ROITI is leveraging on the support of some of the biggest names in the industry for this region to make a compelling case for why well-informed decisions is the way to succeed in this market. We’ve joined hands together with Yana Dimitrova, Maria Popova and Fuzun Yaman, speakers with extensive experience and knowledgeto create a discussion platform on the role of energy software in business. From the organizers’ side Ventsislav Topuzov and Snezhina Mileva will round up the list of speakers.

Atanas Georgiev, the editor-in-chief of “Utilities” magazine and online portal ‘Publics.bg.’ will set the scene with the latest market trends in the region. He will be followed by Ventsislav Topuzov, partner in ROITI, who will explain how to do less and still live longer in such market conditions. Ventsislav has spent the last 10 years in consulting wholesale and retail energy companies on software projects.

Yana Dimitrova, the executive director of Energy-Pro Trading will share with us the peculiarities of implementing software solutions and how at her company, they manage to meet the short-term business requirements, without disregarding the long-term structural market changes.

Fuzun Yaman, Director at Bizzle Consulting will address the topic of operational efficiencies gained through successful software solutions. Fuzun has lead the IT division of Shell Trading for many years and one of her core competencies is namely her extensive experience to navigate the business objectives and corporate strategy to lead the creation and execution of the corresponding technical strategy for the company.

Maria Popova will address the topic of REMIT compliance. Over the past seven years she has been involved in regulatory and energy policy consulting around Europe and has contributed in various capacities to the work of the European Federation of Energy Traders (EFET). Her current position as EFET’s Manager for Market Supervision puts her at the forefront of regulatory change discussions and makes her the perfect person to give us a summary of company’s obligations under REMIT.

Snezhina Mileva is a Senior Business Consultant at ROITI and has built upon her extensive experience in energy advisory to present how she sees the most appropriate approach to tackling the compliance puzzle of REMIT. Snezhina has developed advisory services and consulted clients on how to meet compliance requirements under the Energy Efficiency Directive and Non-financial Reporting Directive.

Who should attend?

This event is designed for anyone wondering how energy software could give your company a competitive advantage. In a market driven by regulatory changes and vulnerable to price volatility of the underlying commodity, energy wholesalers, energy retailers and big energy consumers need to think strategically about software. This is what we want to show you at this event. So, whether you are a procurement specialist at an energy intensive company or dealing with software solutions or business development at an energy company, this event is for you.