27 Apr 2017
Attention generators and retailers: How will the proposed Five Minute Settlement rule change impact on your electricity hedges?
By Dan Howard, Catherine Phillips
The proposed five minute settlement rule change may trigger processes or events under derivatives that alter the risk profiles of the parties to those transactions.
On 11 April 2017 the Australian Energy Market Commission (AEMC) released its Directions Paper on the proposed Five Minute Settlement rule change, with submissions due by 18 May 2017. We consider below how the proposed rule change may impact parties to electricity derivatives under the common terms of those financial instruments.
What is the proposed rule change?
In December 2015, Sun Metals Corporation Pty Ltd submitted a rule change request to the AEMC, proposing that the time interval for financial settlement in the wholesale electricity market be reduced from the current 30 minutes to five minutes. The purpose of this change is to better align financial settlement with the five minute timeframe for electricity dispatch.
The proposed rule change involves:
- compulsory five minute settlement for generators, scheduled loads and market interconnectors; and
- a choice of either a five or 30 minute settlement interval for retailers and large consumers.
The assessment of this rule change request is being undertaken in the context of a series of structural changes in Australia's energy market.
The AEMC Directions Paper
Given the significance and potential implications of the rule change request, stakeholders requested that the AEMC undertake an additional round of consultation before making a draft decision. The Directions Paper was released in response to this feedback, and sets out the AEMC's initial position on the rule change request.
Why is this important?
Electricity derivatives generally use the National Electricity Market (NEM) spot price for the applicable region as the reference price for that transaction. The NEM spot price is based on a half-hour trading interval, which is the average of the six dispatch prices for each five minute period during the preceding half hour.
If the physical electricity market adopts a five minute settlement and ceases to publish the 30 minute trading interval spot price as a result of this rule change, while the derivatives contracts continue to reference 30 minute price trading intervals, then the risks and benefits associated with the derivatives can be impacted.
These aspects of the potential rule change should be further considered by affected parties and where necessary, submissions made to AEMC to minimise impact to the existing derivative market.
Contractual implications of a five minute settlement
Financial instruments may be over-the-counter (OTC) or exchange traded. We highlight some common contractual events and processes that may be triggered by the implementation of a five-minute settlement below.
OTC transactions are often based on, or import the terms of, the International Swaps and Derivatives Association (ISDA) forms. Under the 2002 ISDA Master Agreement and the 2005 ISDA Commodity Definitions, the five minute settlement may constitute the following Market Disruption Events:
- Price Source Disruption: "failure of the price source to announce or publish the Specified Price (or the information necessary for determining the Specified Price) for the relevant Commodity Reference Price"; or
- Material Change in Formula: "the occurrence of a material change in the formula for or method for or the method of calculating the relevant Commodity Reference Price".
Triggering these change event provisions leads to various fallback options that apply to resolve the impact of the event, including negotiation, termination, or the selection of a fallback reference price (among other options that are specified to apply to the particular transaction).
Under other forms of instruments, the five minute rule change may trigger:
- a change in law; or
- a change in pricing formula or method.
Depending on the terms of the instrument, these events could lead to re-negotiation of pricing aspects of the instrument or even termination rights. In some cases the parties may simply accept that the five minute trading interval price be adopted instead of the 30 minute trading interval price or that the 30 minute price be calculated by reference to the published 5 minute intervals. However, parties will need to do careful analysis of these derivative contracts to determine whether the revised shorter trading interval pricing will deliver the same outcome for the contract.
What you need to do…
The nature of financial instruments for electricity transactions is to manage the exposure to risk as a result of the physical electricity market. Parties to financial instruments for electricity transactions need to consider how the adoption of a five minute settlement could affect their risk profiles under existing and future instruments.
We recommend that parties to financial instruments for electricity transactions:
- Keep yourself informed of further developments in the five minute settlement rule change.
- Consider how the proposed rule change could impact on your operations and existing contracts (including any potential contractual triggers and risk to business).
- Consider how best to cater for the possibility of the implementation of this rule change in your future transactions.
- Make a submission to the AEMC if the proposed rule change will have consequences on your operations or contracts. Submissions on the immediate and future costs and benefits of the five minute settlement are due by 18 May 2017.
What is next?
The AEMC will use the feedback to Directions Paper in the its draft decision on the rule change request. Stakeholders will be able to provide final comments on the draft decision.