Opening Statement of Commissioner Brian D. Quintenz before the CFTC Energy and Environmental Markets Advisory Committee

November 7, 2019

Thank you Commissioner Berkovitz for convening today’s meeting of the Energy and Environmental Markets Advisory Committee (EEMAC).  Sadly, I am not able to participate in person due to a prior commitment, but I am looking forward to watching all the panels later via webcast.

The Committee has a packed agenda before it today, exploring issues that are timely and pertinent to the intersection of the derivatives markets with environmental and energy developments.  Historically, exchange-traded and over-the-counter derivatives products have enabled producers, merchants, and users of energy and environmental products to manage and hedge their commercial risks.  Today, the derivatives markets continue to be on the cutting edge of risk management by offering an ever-expanding suite of products designed to assist firms hedge risks related to climate, government-mandated emissions reduction targets, or fuel prices, including renewable fuels.

As I have noted previously, I believe the robust energy derivatives markets in the United States have played a pivotal role in supporting our nation’s energy independence as well as our country’s unheralded reduction in carbon emissions.  This fall, the U.S. Environmental Protection Agency (EPA) released its latest Greenhouse Gas Reporting Program data which found that reported U.S. greenhouse gas emissions have declined roughly 10 percent since 2011.[1]  In 2018, greenhouse gas emissions were 13 percent below 2005 levels – the biggest reduction compared to 2005 among all the G-20 countries.[2]  A significant part of this decline in emissions has come from an unlikely source: the shale oil boom.  Let me explain.

The energy revolution in the United States over the last 10 years provided by shale oil extraction has not only resulted in an 80% increase in oil production, but also a 50% increase in natural gas production. That huge new supply of natural gas has led to a 50% increase in the amount of electricity produced from natural gas which, in turn, has led to a 2.3 billion metric ton reduction in carbon emissions.[3]

None of that progress – the benefits to national security secured from energy independence or the climate benefit from carbon emissions reductions – would have been possible without the explorers, innovators, and entrepreneurs behind the shale oil revolution, which, in my opinion, would not have been possible without having the world’s deepest and most liquid energy derivatives and hedging markets to offset the risk of those exploratory efforts.

In 2010, when the shale boom was just beginning, commodity price risk management in the futures markets enabled entrepreneurs to secure financing from banks, deploy capital effectively, and minimize cash flow fluctuations attributable to commodity price swings.  The ability to largely insulate their firms from volatile price movements in the oil and natural gas markets enabled these entrepreneurs to access credit and continue to innovate and expand, resulting in the shale oil revolution. 

There is an important lesson to be gleaned here:  the vibrancy and liquidity of the American futures and swaps markets have already played an important part in the reduction of carbon emissions related to electricity generation by serving as effective hedging venues that supported private sector ingenuity, discovery, and production of cleaner energy resources.

Unfortunately, the status of those markets, particularly related to energy derivatives, is under significant threat. 

I have noted repeatedly my concerns that the Prudential Regulators’ proposal to implement the standardized approach for counterparty credit risk (SA-CCR) methodology for purposes of calculating risk-weighted assets under the agencies’ capital rule could have a profoundly negative impact on the derivatives markets and energy end-users specifically.[4]

In 2014, the Basel Committee published a formula for SA-CCR calculations - without any supporting data or analysis - that penalized derivatives contracts through exaggerated risk weightings, particularly with respect to cleared futures and swaps.  The Prudential Regulators’ Proposal goes even further by cherry-picking the Basel Committee’s highest “supervisory factor” from the various commodity asset classes and applying it to every energy-related derivative –including exchange-traded, margined, and cleared WTI and natural gas futures, as well as energy swaps.  The result is enormously punitive treatment of oil and gas derivatives transactions on bank balance sheets that, according to some commenters, would increase a bank’s exposure calculations under SA-CCR with an end-user counterparty by up to 460%.[5]

Increased exposure calculations will result in higher capital charges to the bank, which, in turn, will either be passed on to the end-user in the form of higher transaction pricing or will simply cause the bank to withdraw from the market.  As I have stated previously, I believe the Proposal should revisit the supervisory factors for all types of commodities to ensure they are appropriately calibrated to the actual risks of the underlying commodity and the maturity of the derivatives contract.  Failure to do so may do irreparable damage to the energy markets, inhibiting or preventing altogether the next revolution in energy production.

Similarly, I remain concerned that the proposal does not recognize non-cash collateral arrangements.  Alternative collateral arrangements are frequently used by banks in commodity derivatives transactions with end-users to create “right way” risk and can be effective means of managing the credit risk of certain derivatives transactions.  Allowing for the appropriate degree of recognition of these risk-reducing arrangements would increase the risk-sensitivity of SA-CCR and mitigate any increased transaction costs passed on to commercial end-users.

In closing, I would like to reiterate my thanks to all of today’s panelists and the EEMAC membership for their participation, as well as Commissioner Berkovitz for organizing this meeting.