Denmark – a netting-friendly jurisdiction for physical energy trading
When the new Danish Capital Markets Act entered into force on 3 January 2018, it did not only implement various MiFID II provisions in Danish law, it also introduced an extended scope of the types of financial obligations which can be subject to close-out netting and financial collateral arrangements.
This important amendment facilitates that physical energy trading may now benefit from these important risk-mitigating measures, which are considered key components in the trading in derivatives by banks, investment firms and other derivatives traders.
Prior to 3 January 2018, the Danish close-out netting regime was based solely on the EU Collateral Directive, which provided a robust basis for allowing banks, investment firms and other derivative traders to agree with binding effect also for third parties that they had the right to terminate, also in case of bankruptcy of their Danish defaulting counterparty, and net all outstanding amounts under the master agreement into one single sum. In addition, it was possible to make use of the rules on financial collateral arrangements, which for example allow transfer of title as a security interest, provision of top-up collateral due to market movements, and the right to appropriate the posted financial collateral and take the value into account when calculating the termination net amount.
Physical energy trading has only to a limited degree fallen within the scope of these rules, which basically meant that positions between counterparties from a credit perspective had to be looked at on a gross basis, since the risk in a bankruptcy scenario was that a Danish bankruptcy trustee would affirm those contracts which had a positive market value (i.e. would be "in-the-money" for the now bankrupt Danish party) and disclaim those which had a negative market value (i.e. would be "out-of-the-money" for the now bankrupt Danish party), leaving the counterparty worse off than if the value of all positions could be netted out. Before 3 January 2018, this was the legal position also for transactions traded under a master agreement, such as the EFET General Agreement, which in many ways are similar in a default scenario to a derivatives master agreement, such as the ISDA Master Agreement.
"Claims originating from agreements on energy products"
As a Danish law invention, the scope of financial obligations has now been expanded for both financial and non-financial entities to also cover "claims originating from agreements on energy products". Defined in the Capital Markets Act, the term comprises claims originating from contracts and derivatives in the following products, irrespective of how they are traded, and irrespective of whether they may only be cash-settled due to a default or other termination event: Natural gas, electricity, coal, oil or biofuel or transportation thereof, and CO2 allowances and certificates for energy based on renewable energy (in Danish VE-beviser).
Accordingly, it is now possible for counterparties to be protected by the close-out netting and financial collateral arrangement rules when they set up their master agreements and collateral documents, such as a credit support annex, in respect of such energy-related claims with their Danish counterparties.
As far as we are informed, this is a fairly unique legal position within the European energy market, and it may even inspire other jurisdictions to reform their rules as well for the benefit of the European physical energy trading going forward.