On April 4, 2016, the CFTC, together with the SEC, issued proposed guidance clarifying that certain electric power capacity and natural gas peaking contracts are not swaps within the meaning of the Commodity Exchange Act (CEA).

In the final rules defining the term "swap," issued under Title VII of the Dodd-Frank Act, the CFTC and the SEC adopted an interpretation under which certain agreements entered into by commercial and non-profit entities are not considered swaps because they are commercial agreements undertaken in the ordinary course of business (see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance). Following this, the CFTC received public comments concerning certain types of contracts related to the electric power and natural gas markets, which the proposed guidance addresses.

Although the proposed guidance does not provide a precise definition covering these types of contracts, it provides the following two examples of the types of agreements that would not be considered swaps under the CEA.

Capacity contracts are found where state public utility commissions (PUCs) require load servicing entities and load servicing electric utilities (collectively Load Servicing Entities) within the state to purchase capacity or resource adequacy from suppliers to ensure grid management and on-demand deliverability of power to consumers. These Load Servicing Entities are then recognized by the relevant PUC and the Federal Energy Regulatory Commission as having purchased capacity immediately and having met their obligations whether or not the underlying electricity is actually delivered.

Commentators expressed concern that these types of contracts are not traditional hedging arrangements and would therefore be ineligible for clearing and other exemptions and exceptions under CFTC Dodd-Frank swaps rules were they to be considered swaps.

The proposed guidance clarifies that electric capacity power contracts are not swaps under the final definitional rules because the Load Servicing Entity does not purchase a right to profit from the change in an underlying commodity which it would then settle, but rather purchases "a supplier's capacity to produce, generate and deliver the underlying electricity, thereby ensuring its ability to supply electricity in compliance with a regulatory requirement."

Natural gas peaking supply contracts allow utilities that operate cogeneration facilities to purchase natural gas from other providers on certain days when local natural gas distribution companies (LDCs) restrict their natural gas transportation ability. These agreements are typically structured on a "take if delivered" basis which requires utilities to take natural gas from LDCs if they are supplied with it. However, regulatory commitments from local boards of public utilities require these agreements to permit the LDC to interrupt its service to a utility if certain conditions are met (such as during extreme cold weather).

It is because of these potential service limitations, which are determined by the LDC and not the utility, that "peaking" contracts are entered into to ensure that utilities have enough natural gas to operate even during such interruptions, by allowing them to purchase natural gas from another gas provider for an additional fee.

Commentators have noted that there is no ability for financial settlement under these contracts and natural gas supplied under peaking agreements cannot be resold. Furthermore, since utilities have no discretion over whether or not it will exercise its option to receive gas under these peaking contracts, they should not be treated as "swaps." Because of these features, the proposed guidance clarifies that natural gas peaking supply contracts are not swaps under the final definitional rules.

In lieu of a precise definition, the proposed guidance identifies a number of common characteristics of both electric capacity power contracts and natural gas peaking supply contracts that excludes them from the definition of "swap," including that these contracts:

Also in these contracts, the specific identity of a counterparty is important for reliability and supply concerns.

This clarification reduces the Dodd-Frank compliance obligations that might otherwise apply to power plant owners and operators.

It is worth noting that these contracts may still be considered forward contracts depending on the circumstances (see Practice Note, Derivatives: Commercial Uses and Legal Updates, Certain Forward Contracts with Embedded Volumetric Optionality (EVO) to Be Excluded from Dodd-Frank Swaps Rules and CFTC Clarifies Dodd-Frank Exemption for EVO Forward Contracts).

Public comment on the proposed guidance is due by May 9, 2016, a month after the Guidance was published in the Federal Register. Comments submitted by mail should be addressed to Christopher Kirkpatrick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW, Washington, DC 20581. Online submission can be made on the CFTC website or on the Federal eRulemaking Portal.