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What Does "Hedge or Mitigate Commercial Risk" Mean? How Will Energy Producers and Consumers Prove They are "Commercial End Users" Under the Dodd-Frank Act?
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act" or the "Act") attempts to sort through the energy trading and hedging market to protect "commercial end users" from new regulatory burdens intended for trading firms and financial institutions. The objective is to separate the large number of companies that use hedges like insurance to manage fluctuating prices on the one hand, from the small number of sophisticated energy traders and financial institutions, who would bear the brunt of the new regulation, on the other. An important criteria used by the statute and proposed regulations is whether hedges act to "hedge or mitigate commercial risk". The statute and proposed rules have a number of tests and reporting requirements to determine whether hedges "hedge or mitigate commercial risk", which rely on legal, accounting and financial concepts.
This paper examines these concepts, and in particular, studies the applicability of hedge accounting standards to the analysis. Using hedge accounting is not the only way to prove compliance with the "hedge or mitigate commercial risk" standard, but it may be the most objective standard to apply. The other standards are more subjective and need more substance to offer a viable alternative. But this analysis should not be conducted in a vacuum and consideration should be given to how potential "commercial end users" currently account for hedges. A study of the public filings of selected segments of energy producers and consumers shows that currently many of these companies do not account for hedges in a way that would enable them to qualify as "commercial end users". The paper discusses alternative methods of proving "hedge or mitigate commercial risk", and factors to consider for the process. Finally the paper discusses areas for the future development of the regulations.
Excerpted from a white paper co-authored with Johnny Molina of Ernst & Young on February 24, 2012. To read the full paper, click on the PDF linked below.
PDF - Hedge_or_Mitigate_Commercial_Risk.pdf