Gas market investigations - a quick guide to enforcement

15 November 2012

Peter Willis

Reports in the UK press about investigations into alleged wholesale gas market manipulation have created a degree of confusion about the respective roles of the various regulators, and their enforcement powers.

As we explain below, the alleged conduct appears not to lie comfortably within any of the existing enforcement regimes - other than private enforcement via damages claims - although REMIT, for which regulators are due to be given enforcement powers next year, is designed to tackle precisely this kind of conduct.
 
The allegations are not entirely clear, but appear to involve traders submitting artificially low prices for wholesale gas products at the close of trading on particular days. It is not clear whether these prices reflect actual transactions deliberately entered into at a loss, or were deliberately reported incorrectly. It appears that the low prices then formed the basis for pricing either further physical contracts or perhaps more likely derivative contracts such as swaps where the party depressing the benchmark would benefit from a lower variable price.

It should be emphasised that this note is intended as a quick guide to the enforcement options, with a view to adding an understanding of the press reports. It is based on the facts as alleged, summarises complex areas of law and should not be taken as legal advice.
 
Competition law

In order to establish an infringement, a competition authority would need to establish either that businesses had colluded with each other to fix wholesale prices, or that a business with a dominant position in the wholesale gas market had imposed unfair prices. There do not appear to be any allegations of collusion in this case, and it is unlikely that any gas suppliers/traders are dominant in the diversified and liquid GB wholesale gas market. Competition law therefore does not appear to be an appropriate tool, on the basis of the information available from the press reports.

In the event that there were an investigation in this area, it could be conducted by EU or UK authorities. The European Commission would probably defer to UK authorities on the basis that the allegations relate primarily to UK markets. Ofgem, the energy regulator, has competition enforcement powers in the gas sector, concurrently with the OFT, and would be most likely to take the lead. The Financial Services Authority (FSA) has no competition powers in this area. Ofgem and the OFT have wide-ranging powers of investigation and can impose penalties of up to 10% of group turnover.
 
Market abuse - civil enforcement

The FSA has powers to investigate and impose civil penalties for infringement of the market abuse provisions contained in section 118 of the Financial Services and Markets Act 2000 (FSMA). These implement the EU Market Abuse Directive (MAD) 2003/6. The type of market abuse likely to be relevant here consists (simplifying a little) of effecting transactions which are likely to give a false or misleading impression as to the price of one or more qualifying investments traded on a prescribed market, or to secure an abnormal or artificial price of one or more qualifying investments traded on a prescribed market. Either the conduct must take place in the UK, or the investments must be traded on a UK prescribed market. Qualifying investments include commodity derivatives.

Merely manipulating prices of physical gas products (which are not qualifying investments), whether directly or by manipulating an index or benchmark price that forms the basis for further physical contracts, would therefore not be caught. Manipulating physical prices in order to influence the price of an energy derivative (a qualifying investment) would be caught only if the derivative were traded on a prescribed market, ie. a recognised investment exchange or regulated market such as ICE Futures Europe. It would not be caught if the derivative were traded OTC.

Some of the earlier reports that the FSA was investigating physical gas markets now appear to have been corrected, and the statement by Energy Minister Ed Davey on Tuesday made it clear that Ofgem is taking the lead on physical markets and the FSA on derivatives markets. However, some confusion remains: until the government gives Ofgem enforcement powers under REMIT (see below), Ofgem has no power to investigate alleged market abuse, whether in physical markets or in OTC derivatives. The FSA has the power to impose unlimited fines for those abuses falling within its competence, although in practice it sets its fines in accordance with its guidance. The largest penalty imposed to date is £17 million.
 
Market abuse - criminal enforcement

In addition to its civil enforcement powers, the FSA has the power to bring criminal prosecutions for market abuse under section 397 of the FSMA. The definition of the offence is a little different from that of the civil infringement. Section 397 provides that (summarising again) a person who knowingly or recklessly makes a misleading statement, or dishonestly conceals material facts, for the purpose of inducing another person to enter into an agreement for a relevant investment, commits an offence. As in the case of civil enforcement, relevant investments include commodity derivatives, but not physical energy products. Similarly it is an offence for a person to engage in any course of conduct which creates a false or misleading impression as to the price of a relevant investment (including a commodity derivative) if he does so for the purpose of creating that impression and of thereby inducing another person to acquire those investments. As in the case of the civil infringement, this applies only to commodity derivatives traded on prescribed markets. It would therefore not be an offence to manipulate prices of physical energy products alone. Ofgem would have no jurisdiction here.

There is an added complication for the FSA in the case of the criminal offence, which is that in the scenario alleged in the press reports, the counterparties would presumably already have entered into the derivative contracts and therefore could not be said to have been "induced" to enter into them by the misleading impression created by the artificially low physical prices. Conduct must take place in the UK, or must affect relevant investments traded on prescribed UK markets. There are various defences to a charge under this section. Penalties include imprisonment for up to 7 years and/or unlimited fines. It is important to note that there are proposals to amend section 397, in the wake of the Wheatley review into the LIBOR rate-fixing, which might remove the "inducement" requirement, but these proposals would not have retroactive effect.
 
The Regulation on Wholesale Energy Market Integrity and Transparency (REMIT)

REMIT was enacted in order to fill the enforcement gaps highlighted in this case. It prohibits insider trading and market manipulation in relation to physical and financial energy products. It excludes financial products traded on regulated markets, which remain covered by MAD. So in principle it is capable of covering the types of conduct alleged in the press reports. However, although market manipulation is already prohibited, Member States are not required to give regulators enforcement powers until June 2013. So Ofgem cannot yet enforce REMIT. One point overlooked by the press reports, however, is that because REMIT is a directly applicable EU Regulation, businesses and individuals who suffer loss as a result of an infringement of the prohibitions can already claim damages before the courts. Given the scale of some of the contracts allegedly affected, this is a distinct possibility.
 
In conclusion, there are a number of obstacles to enforcement by regulators in this area, and it is entirely possible that only private actions will result. Nevertheless, any investigation will be a major exercise - the Minister reported that the regulators were devoting "significant resources" to their investigations. Any response should therefore be handled carefully, with due attention paid to internal evidence-gathering and analysis.

Contact us

For more details or any inquiries, please contact:

Peter Willis
Partner
Tel: +44 (0)20 7415 6000
Email: peter.willis@twobirds.com


 

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