Systemic risk in the energy sector—Is there need for financial regulation?

• We assess the need for regulating OTC energy commodity derivatives under EMIR.
• We present a methodology to model systemic risk in non-financial sectors.
• We analyse direct and indirect channels for contagion giving rise to systemic risk.
• Contagion risk from the energy towards the banking sector is not relatively high.
• New EU regulation for energy OTC trading not supported by analysis of systemic risk.

The credit crisis points at serious systemic risks in Over The Counter derivative trading. This has resulted in new financial regulation, covering both the financial sector and non-financial sectors. The actual extent to which non-financial companies trading on OTC markets contribute to systemic risk has hardly been the subject of research. This paper investigates the need for financial regulation in the energy sector, which shows a high use of OTC derivatives, by modeling systemic risk measured by the expected fraction of additional failing firms (EAF). Contagion risk within the energy sector and from the energy sector towards the banking sector is compared with that in other non-financial sectors. This paper adds to existing systemic risk literature by specifically looking at financial interdependence between a non-financial sector showing a high usage of OTC commodity derivatives and the banking sector, while contributing to the discussion on energy sector regulation with technical systemic risk analysis. Results indicate that contagion risk from the energy towards the banking sector is not relatively high compared to other non-financial sectors. Our results provide a first indication to question the need for generalized regulation of OTC derivative transactions, as recently introduced by the European Market Infrastructure Regulation (EMIR).