Grant Thornton - Financial Reform; How the Dodd-Frank Act Affects the Energy Industry

8/8/2019 Grant Thornton - Financial Reform; How the Dodd-Frank Act Affects the Energy Industry

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Financial reform: How theDodd-Frank Act affects the energyindustry

The recently enacted Dodd-Frank WallStreet Reform and Consumer ProtectionAct (the Act) is changing the landscapefor nancial services rms and nancialinstitutions, as well as several othereconomic sectors — including the energyindustry. The Act addresses four majorissues: transparency, risk management,accountability and structural oversight.However, these changes reach far beyond

hedge funds and investment banks.As the legislation creates newregulators, brings new entities underregulatory oversight and providesregulators with new rulemaking andenforcement powers, energy companieswill be confronted with new challenges.Compliance with regulations will requirechanges in a number of areas, from legalentity structures and internal controls totax planning and disclosures. Althoughmany of the specic rules have yet to be

dened by regulators such as the SECand the Commodity Futures TradingCommission (CFTC), this guide outlinesthe biggest issues energy companies willface under the Act and strategic actionsthey should consider now.

The legislation broadly denes a“swap” to include most types of OTCderivatives, including energy, emissionand commodity swaps that are subject toa carve-out for “security-based swaps”and “any sale of non-nancial commodityor security for deferred shipment ordelivery, so long as the transaction isintended to be physically settled.” Withthis in mind, the law appears to include

those physical contracts settled with apayment based on the price difference.

1. Energy derivativesTitle VII of the Act repeals priorregulatory exemptions for over-the-counter (OTC) derivatives, impactingenergy companies that use derivativesto provide risk management, enhanceprotability or take a position on marketmovements. At this time, many of thekey concepts and processes have yet to bedetermined by the CFTC; however, it is

clear that this legislation will signicantlyimpact the energy derivatives market.

A nancial reform resource



How the Dodd-Frank Act affects the energy industry

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2. Business entity categorization:Exempt versus non-exemptHow a company will be affected bythe Act is largely dependent on howits individual operations are denedand categorized: nancial entity, swapdealer, major swap participant or enduser. Company categorization will bedetermined by the type of businessenterprise, the types and amounts of swap transactions in which the companyengages, and the purpose for which theyare in operation.

At rst glance, many companies maybelieve that they are exempt, but thatmay not be the case. Accordingly, anorganization should conduct a carefulreview of its current hedging and tradingactivities to determine if, and to whatdegree, it will be affected. In addition,companies should assess all open contractsin order to identify any necessary changesto their portfolio and/or business strategyto ensure an alignment between theirongoing business strategy and how thelaw will classify them.

3. Clearing and tradingIf an energy company currently engagesin OTC contracts in fuel, power,emissions or other commodities and noexemptions apply, the company maybe required to clear swaps through aclearinghouse in the future.1 In addition,the new rules will require marginingassociated with clearing and trading,which may increase a company’scost to hedge, as well as its liquidityrequirements. Furthermore, if a companyis required to post margin, existingcredit provisions (e.g., credit limitsand guarantees) and netting of existingphysical contracts may no longer beavailable.

4. Counterparty statusEven if a company qualies as an end userand is exempt, its counterparties may beclassied as nancial entities, swap dealersor major swap participants, and thus willbe subject to increased costs associatedwith regulation, reporting and capitalcharges. It appears likely that the cost of

hedging will increase to cover these costs.Companies should also be mindful of thedemand that margining may place on theircounterparties’ liquidity.

Counterparties that are classied asnancial entities, swap dealers or majorswap participants may need to changetheir legal structure to comply with theAct. Companies should be aware of theprovisions of their non-exchange physicaland nancial contracts, which may relyon either the existing collateral value orcorporate guarantees, as values may shift.

5. Non-cleared swaps reportingAny publicly traded end user will needto now report all non-cleared swaps toa recording depositor. This will increasescrutiny of all companies’ recordkeepingand classication of contracts as swaps,supply agreements or other arrangements.

As more counterparties use theexchanges to avoid additional regulation,it may be harder and more expensive tond a counterparty to enter into tailoredtransactions that are currently used to

more closely mirror risk. However, theremay be new entrants to the market tocapitalize on this opportunity.

1 In order to integrate physical and nancial markets, NASDAQ OMX Commodity Clearing LLC (NOCC) provides “credit protection from transaction through the delivery and settlement” and its servicesfocus on OTC-traded power and natural gas contracts in the United States. Energy companies and related market participants should be aware of the implications of participating in this type ofclearing facility. http://www.necclear.com/index.cfm.

At rst glance, many companies may believe thatthey are exempt, but that may not be the case.




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6. Energy trading process andprocedure developmentCompanies that trade energy-basedcommodities will likely be required todevelop new processes and procedures inresponse to the Act, including changes inoverall corporate governance, as well asmore detailed processes for originations,monitoring positions, scheduling andsettlement.

7. Energy trading disclosurerequirementsThe Act requires companies to developdisclosures related to their energy tradingpositions and activities. Companies will needto ensure information systems and processescan meet the new disclosure requirements.

8. Government payment disclosurerequirementsThe Act requires disclosure of paymentsto governments for activities relatedto the exploration and developmentof oil and gas, including payments foracquisition rights, royalties and other

production-based revenues. Companiesshould prepare to invest in informationsystems to meet the new requirements.

9. Trading exchange requirements andreportingThis legislation will likely spur thecreation of new trading exchanges. Inorder to take advantage of opportunitiescreated by these exchanges, energycompanies will need to have the properprocesses in place. Company systems willneed to interface with the exchange, andIT infrastructure, controls and reportingprocesses may require testing, evaluationand updating. In addition, processes fortrading capture, reporting and marginmanagement may need to be modied.

10. Trading activity controlsFor many companies, controls overtrading activities were considered andaddressed during the Sarbanes-OxleyAct (SOX) era and have simply becomea part of the routine, particularly whenit comes to nancial hedges, mark-to-market methods and counterparty creditevaluation techniques by marketing ornancial managers. However, existingcontrols may need to be altered or new

ones may need to be created to addresscompliance with both SOX and the Act.

11. Tax liabilitiesChanges in commodities and securitiestrading practices and reportingrequirements as established by theAct may have a signicant impacton energy companies’ state tax liabilitiesas they switch from nancial to physicalsettlement to avoid being treated as aswap dealer. Accordingly, companiesneed to assess the tax treatment of theirtrading and marketing activities and makeany necessary adjustments in strategy.

Looking aheadEnergy companies must make it theirpriority to stay ahead of the curve asregulators dene the specic rules underthe Act. Companies can prepare now byaddressing these four key areas:

1. Strategy and business model2. Regulatory requirements, reporting,

process and controls3. Liquidity4. Risk management

The following table outlines implicationsof the Act for energy companies, thebusiness areas that will be affected andactions that should be considered.

Areas affected

Energy derivatives

Business entity categorization:

exempt versus non-exempt

Clearing and trading

Counterparty status

Non-cleared swaps reporting

Potential implications

Strategy/business model; risk management

Strategy/business model; regulatory requirements

reporting, process and controls; liquidity

Liquidity; risk management

Liquidity; risk management

Regulatory requirements, reporting, process and controls

Potential actions

Companies must decide which markets they should use to meettheir objectives while controlling their exposure to new reportingand liquidity requirements. They should evaluate whether to shiftto physical contracts with “imbedded” risk management terms andunderstand the tax implications of such a move.

Companies should review hedging and trading activities to

determine if and to what degree they will be impacted. Companiesshould also assess all open contracts to determine necessarychanges to their portfolio of contracts and/or their businessstrategy for proper classication.

Companies need to address marketing and nancial managementresources and consider the trade-offs of risk management benetsversus liquidity maintenance for the core business.

Credit management policies and resources may have to be revisedto consider increased analytics on counterparties.

Disclosures will have to be developed for all publicly traded,exempt entities.




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Areas affected

Energy trading process and

procedure development

Energy trading disclosurerequirements

Government payment disclosurerequirements

Trading exchange requirements,controls and reporting

Trading activity controls

Trading tax liabilities

Potential implications






Liquidity

Potential actions

Companies must address the impact on hedging and trading

operations.

Additional disclosures will have to be developed for nancialstatements to meet evolving standards.

Additional disclosures will have to be developed for nancialstatements to meet evolving standards. Companies will need toensure systems can meet these disclosure requirements.

As new exchanges emerge, company systems and processes willneed to be modied to efciently interact with new exchanges.

Companies must address the impact on hedging and tradingoperations.

Companies should review existing tax treatment of their trading andmarketing activities and make any necessary adjustments in strategy.

Loretta CrossManaging PartnerCorporate Advisory & Restructuring ServicesT 832.476.3630E [email protected]

Michael BennettPartnerBusiness Advisory ServicesT 832.476.3770E [email protected]

John LaBordePartnerState and Local Tax ServicesT 832.476.3605E [email protected]

Contact informationFor more information about how the Dodd-Frank Wall Street Reform and Consumer Protection Act will affect yourrm, to learn about emerging issues and to discuss your needs with a professional in our Energy practice,visit www.GrantThornton.com/nancialreform or contact one of our energy practice leaders below:

This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at theparticular facts and circumstances of any person. Persons interested in the subject of this document should contactGrant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts andcircumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or taxstructure of any matter addressed. To the extent this document may be considered written tax advice, in accordance with applicableprofessional regulations, unless expressly stated otherwise, any written advice contained in, forwarded with, or attached to thisdocument is not intended or written by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code.

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Brandon SearPartnerAudit ServicesT 832.476.5048E [email protected]

Vernon JonesDirectorCorporate Advisory & Restructuring ServicesT 832.476.3760E [email protected]

Edward HillExecutive DirectorBusiness Advisory ServicesT 832.476.3710E [email protected]

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Grant Thornton - Financial Reform; How the Dodd-Frank Act Affects the Energy Industry