Single Energy Market: a new regulatory challenge?

EY’s Colm Devine, Head of Government Services, and Ian Venner, Head of Energy Services, discuss the new EU standards on market abuse and how they interact with Irish energy.

The all-island electricity market is currently facing significant change. The Single Energy Market (SEM) Committee recently published its final High Level Design (HLD) decision regarding the new Integrated Single Electricity Market (I-SEM) following a period of consultation with the wider Irish energy industry. The design of the new wholesale electricity market was driven by the need for the Irish electricity market to align with the European Union’s Third Energy Package, aimed at establishing integrated, internal electricity and gas markets in the union.

In the run-up to the final HLD decision, marked progress was made with the industry appearing to reach a general consensus on many of the key high-level design features for the future I-SEM model. However, as stakeholders now turn their attention to the detailed design phase, one key facet of the new market design in particular remains somewhat unclear – how will the new market structure be appropriately regulated to mitigate against market abuse and anti-competitive practices?

The new I-SEM model comes in the wake of a paradigm shift in European energy and financial market regulation generally. In the aftermath of the 2008 financial crisis, confidence in traded markets and the integrity of price formation was seen as paramount to the existence of a stable economic environment. In light of this, the European Commission embarked on an overhaul of the regulatory framework to more effectively police against market abuse.

This saw the development of two separate pieces of legislation; firstly a revised Market Abuse Directive (MAD II) and a supporting Regulation (MAR) applicable primarily to financial markets, and then the introduction of the Regulation on Energy Market Integrity and Transparency (REMIT), an equivalent piece of regulation specifically targeting European electricity and gas markets, tailored specifically to capture the complexity and nuances of physical flows within these markets.

New standards

REMIT primarily addresses physical EU energy market operations (including production, storage, consumption, transmission facilities, as well as derivatives traded over the physical market), an area which has until now been subject to relatively light touch regulation.

As a result, energy markets across the EU are now subject to broader disclosure and market conduct standards through the compulsory publication of inside information and detailed transaction reporting (the latter due to come into effect in 2015), and an explicit prohibition against market abuse. There is also the obligation for participants to monitor their own market activities and notify their national regulators of possible breaches of the regulation, as well as a shared obligation to notify the regulator if suspicious activity is observed in the market.

REMIT also saw the formation of the Agency for the Cooperation of Energy Regulators (ACER), the pan-European agency responsible for, amongst other things, collecting and analysing wholesale markets data to identify possible instances of market abuse. Suspected breaches will be notified by ACER to the respective national regulatory authorities (NRAs), who will be responsible for the investigation and enforcement of REMIT where appropriate.

Enforcement under REMIT must be “effective, dissuasive and proportionate” and therefore may include fines, criminal sanctions (including custodial sentences, already introduced in some jurisdictions) and corporate liability. But how will these measures be effectively applied in the case of I-SEM and how will they complement existing market monitoring mechanisms, and will any gaps remain between them?

The extent to which the SEM Committee will place reliance on REMIT and ACER (based primarily on ex-post market surveillance) to police against market abuse, and potentially the abuse of market power (cited as a concern in a number of consultation responses), under the new I-SEM market design is likely to become clearer during the detailed design phase.

This will, however, need to be considered in the context of the regulatory mechanisms already in place in the SEM market and the current role of the national regulators, including the Market Monitoring Unit (MMU) which is one part of the market power mitigation strategy for the SEM along with the directed contracts process and the Bidding Code of Practice.

Enforcement

Despite the introduction of REMIT (and its financial counterpart MAD II) providing a comprehensive trading regulatory framework at EU level, its effectiveness for local markets will depend heavily on the ability of the local NRAs to investigate and enforce instances of abuse, as enforcement remains the prerogative of local NRAs and not ACER. While ACER will eventually use its broad access to fundamental and transaction data to identify suspicious events or anomalies across European markets, it will ultimately fall to the relevant NRAs to conduct an investigation and to draw conclusions on whether to prosecute or impose penalties on the offending party.

Whilst this seems like a logical approach, it is fair to question whether the scale of the all-island market, along with its unique market design (even when taking the proposed I-SEM into account) will receive the appropriate level of scrutiny from ACER. The absolute scale of potential market abuse within the I-SEM may be relatively small in contrast to larger EU markets (which ACER is also tasked with monitoring) and the intricacies of the I-SEM would also more than likely require detailed knowledge of the I-SEM to reliably detect potential abuse cases.

It seems likely therefore that reliance alone on the market surveillance measures introduced by REMIT would not on its own be sufficient to address all of the concerns raised by market participants in response to the I-SEM design (a point broadly acknowledged by most stakeholders).

Another key consideration in respect to regulatory monitoring under the proposed I-SEM model is the extent to which financial instruments used in the market will be regulated (financial instruments typically fall under financial regulation and are therefore within the enforcement jurisdiction of the financial regulator). Whilst both REMIT and MAD II, taken together, will most likely ensure that no instruments used within the I-SEM will escape market abuse regulation, there is a need for the regulators to distinguish the scope of financial instruments from energy instruments to ensure, amongst other things, that enforcement boundaries remain clear to market players.

Conclusion

In summary, the proposed changes under the new I-SEM market design are a significant divergence from the existing energy trading arrangements under the SEM. While the regulatory framework to prevent market abuse currently employed for the SEM appears to be satisfactory for most market participants generally, the new I-SEM model introduces some uncertainty on the future policing of the Irish market – an issue which will no doubt be addressed in further during the detailed design phase.

Given the changes set forth by the HLD, it is important that the regulatory authorities consider what adaptions and enhancements are required to the existing monitoring and governance mechanisms, weighed next to the coverage provided at European level by REMIT and MAD II, and identify any potential gaps which may need to be addressed at local market level.

Furthermore, it is clear from the consultation responses to date that potential abuse of market power is a key concern for many market participants. While the trading regulatory framework may mitigate certain behaviours in this regard, these concerns should be looked at in greater depth during the detailed design phase of the I-SEM.

The authors can be contacted via email at cdevine@uk.ey.com and ian.venner@ie.ey.com respectively.