By Andrew Webb

The prairie fire that swept through last summer’s power markets has burned itself out, but the memory is still fresh. Although last June’s price spike caused a lot of participants to head for the sidelines, the conflagration served as a valuable object lesson in a new market that was losing its bearings.

Nowadays, market participants complain about sky-high volatility and the squeeze that has developed for the top-flight trading skills required to compete. But in this sober new environment, counterparty credit agreements actually mean something. Moreover, despite the lower liquidity, physical generating capacity is being bought and sold with ever-increasing frequency, with nukes being shifted as fast as Saturday afternoon bargains on a used car lot.

The big issues since last June have been credit, credit and credit. “People are now doing much more than they were in terms of counterparty risk management,” says Emily Eisenlohr, vice president and senior credit officer in the electric utilities group at Moody’s Investors Service. Eisenlohr identifies a number of areas in which participants are tightening up, including requiring some form of credit support from corporate parents, obtaining and analyzing financial information on counterparties, increasing credit analysis staffing, and enforcing credit limits. It isn’t just lip service—if the financials don’t stack up and support the credit profile, companies look for letter-of-creditor parental guarantees. Last year, by contrast, many market participants simply assumed that a power marketer that shares a name with a utility automatically has its parental guarantee. Peter Fusaro, president at Global Change Associates in New York, also notes an improving attitude. “People are doing gap analysis, looking for the loopholes in their credit risk management teams and systems,” he says.

The power industry is recovering from last summer’s brownout. Mature, sophisticated risk management may be just around the corner.

Others are less impressed with the progress. “We’ve seen two sorts of response from the power marketers since last year,” says David Shimko, a principal in the risk management advisory at Bankers Trust. “Those who weren’t affected by the losses now think they are invulnerable. And those who are revising their policies and procedures still rely on problematic collateral such as parental guarantees.” Shimko points out that parental guarantees often require actual nonperformance on the part of the subsidiary in order to collect on the guarantee. A substantial market move on the position, however, may precipitate a collateral request that the subsidiary refuses, which isn’t technically a performance failure but which nonetheless leaves a cash imbalance. In addition, collateral collection processes in the energy business are generally still weak—typically only once a month, compared with once a day at banks and other financial institutions.

While most utilities have paid less attention to credit issues than power marketers, they are nevertheless waking up to the idea fast. “Last year most utilities were pretty clueless; now they realize that they may be short power this summer and need to buy in the open market,” says Shimko. One incentive for them to get their credit departments up and running is that most forward contracts are for 90 days—counting backward from June, the time to be vetting and entering those highly volatile contracts is now.

“Some marketers are making presentations to the public power communities to convince them to hand over their power marketing responsibilities. The utilities’ bond holders will want some comfort level.” —Paul Messerschmidt ENERGY SECURITY ANALYSIS

Nevertheless, there is continuing pressure for higher levels of efficiency and professionalism in trading and credit risk management. All the major rating agencies are looking closely at how wholesale power transactions are handled now that they have started rating power marketing subsidiaries—another new development. While this process is still in its infancy, many participants are now looking for independent confirmation that they are doing business with the right sort of counterparties. “This is particularly important when you consider that some marketers are making presentations to the public power communities in an attempt to convince them to hand over their power marketing responsibilities,” says Paul Messerschmidt, manager of power markets services at Energy Security Analysis. “The utilities’ bond holders will want some comfort level—and a pukka rating will help address that.”

In this new credit-conscious era, documentation has become increasingly important, with industry committees being set up to thresh out the details. Master enabling agreements, such as the one developed by the Western Systems Power Pool (WSPP), are also being upgraded in the wake of last summer to include several credit-related clauses such as netting and closeouts.

New netting agreements would be a welcome way to minimize lengthy contractual disputes following a bankruptcy. Similarly, closeout clauses, which allow companies to terminate agreements with downgraded counterparties, might head off credit problems before they occur. Care, however, is still required. Not all clauses in such agreements are hard-coded (in other words, compulsory), so counterparties can opt out of these. Making sure that everybody is agreeing to the same clauses may seem overwhelmingly obvious, but it’s not unknown for power market participants to fail to get the agreement signed at all.

As a result, many parties would welcome standardization along the lines of an ISDA agreement. Many existing agreements say broadly the same thing, but differ in the nuances; they have also not been tested in court. “The power business could really use something like an ISDA agreement, which is automatically accepted by bankruptcy courts,” says David Wong, credit manager at Powerex, the power-marketing subsidiary of BC Hydro. Wong cites the certainty of being able to net exposure in the event of counterparty failure as one particular benefit.

Powerex found that its existing credit arrangements withstood the heat of battle well last summer, with the basic policy being continually developed and approved by the board of directors and the risk management committee of BC Hydro. Wong stresses the need to regard this as an ongoing process. “You have to refine [credit arrangements] continually. It’s not something that you can do once and then ignore,” he says.

Going sleeveless

The credit-sensitive nature of the marketplace has seen the almost total demise of one trading practice that attracted a lot of negative comment after June—sleeving. In the past, two counterparties without appropriate credit arrangements would trade through a third party willing to take the middle ground (and often substantial credit risk) in return for a small spread. “There’s a lot less noise in this market, with far fewer requests for sleeves,” says Kevin Fox, portfolio manager of power trading at Aquila Energy. “You used to get maybe half a dozen requests for these a day. Now it’s extremely rare because the people left trading have established credit with each other.” Furthermore, in these credit-conscious times, a request for a sleeve will probably set alarm bells ringing. “It’s not just that you wouldn’t want to get involved anyway because of the risks, but also because people are automatically wary of an organization requesting one,” says Eisenlohr.

New Power Products and Structures

The new lack of liquidity hasn’t exactly done wonders for financial product innovation in electricity. Two-hundred-and-fifty percent volatility has made even vanilla options brutally expensive to buy, and option sellers can’t be certain they’ll be able to hedge them cleanly enough. The result: activity is down dramatically over last year, and more complex structures are unlikely to find much favor. “There was a steady stream of interest in more complex mixed or exotic products through the first half of last year and even until as late as August,” says Savvysoft’s Rich Tanenbaum. But that’s now history—and the prognosis in the short term isn’t bright, given the problems people seem to be having in trading simply the basic product. A few innovative trades that put weather, emissions, generating fuel and electricity into one package have been done, but no more than a handful. Moreover, many see talk of weather and emission or other exotic products as an irrelevance. “I think the multi-package weather derivatives and emission talk only clouds the picture,” says Merrill Lynch’s Michael Hiley. “Utilities don’t necessarily combine those areas. People like to talk about the convenience of such packages, and they are a ‘nice to have,’ but in terms of liquidity and volume I don’t see them taking off.” The first RFPs (requests for proposal) that have recently emerged certainly bear this out, being almost exclusively for straight power or simple options. Exchange-traded electricity futures receive similar short shrift in some quarters. “There are a number of futures contracts being launched, but they’re all going to fail,” predicts Fusaro. “The latest announced launch of PJM [the Pennsylvania–New Jersey–Massachusetts contract] at both the Chicago Board of Trade and the New York Mercantile Exchange will do little more than split liquidity—as the already restricted liquidity on the existing western contracts shows. This will always be an over-the-counter market.” In other words, unless you are lucky enough to have your exposures mimic the exchange product exactly, it will be a case of little more than swapping credit for basis risk. Insurance products geared to the power industry aren’t setting the world on fire either. Last summer’s unexpected outages created some interest in an insurance product that kicks in when a utility’s generating unit breaks down. Protection like that could come in handy if prices are stratospheric and the utility has contracted to deliver at a lower fixed price. To date, however, the only entrant is CIGNA’s PowerBacker product, which will pay out the difference between the insured price and the replacement cost for power. (The product can be adapted for use with transmission or counterparty problems.) For those anxious about the downside and not too worried about participating in the upside, it looks like a win/win: no FASB 133 mark-to-market requirement, deductible premiums, no basis risk and no tax liability on payout. “You also don’t need to pay for the systems and people to keep track of financial instruments,” says Ed Zaccaria of CIGNA Power Products. Unlike most financial instruments, policies can also be written to cover small odd lots of megawatt hours and various eventualities. —A.W.

There is less agreement about the development of another practice that was signally absent last year—namely, pricing for credit. Before last June, everyone paid the same price, from the smallest outfit operating out of a back-bedroom to the largest utility. Although the back-bedroom operations may have disappeared, Eisenlohr says pricing policies haven’t changed. “From what I can gather, people are doing much more in terms of counterparty risk management, but still aren’t pricing for credit risk,” she says. Others take a different view. “I think people now have a much stronger picture of counterparty credit assessment, and based on this, they are adjusting the pricing or seeking additional credit support where necessary,” says Shannon Burchett, former president of Ameren. Burchett also sees pricing for credit as likely to increase as the normal credit mechanisms that have evolved in other markets take hold in the power market.

“There’s a lot less noise in this market, with far fewer requests for sleves. Now it’s extremely rare because the people left trading have established credit with each other.” —Kevin Fox AQUILA ENERGY

Ellen Lapson, an analyst at Fitch IBCA, sees another important angle on the counterparty issue apart from credit status. “You are no longer a credible trader unless you have some physical delivery abilities—be it owned or controlled in some other way,” she says. Lapson believes that predictions that power would develop into a mainstream financial market haven’t yet materialized. In fact, she says it has become more physical in nature because of an increasing sensitivity to the risks of a failure in physical delivery.

Lapson notes the flurry of deals being done by integrated utilities to sell off generating capacity in their home markets, with more divestitures expected this year and in 2000. Some use the proceeds to purchase generating capacity in other areas in order to broaden their reach or replace the income stream they will lose because of utility restructuring. In some cases, utilities have been able to sell capacity for more than its book value; in other cases, the shortfall (called “stranded costs”) will be recovered from consumers. That, in turn, will put the restructured utilities in good financial condition. This capacity is being snapped up by firms that are solely marketers (such as Dynegy), independent generation companies (such as AES and Sithe), as well as other utilities. Lapson feels that marketers are making the acquisitions to satisfy a need for delivery credibility and to increase trading volume and expectations for better incremental returns. Marketers are also entering into marketing agreements with the new purchasers of generation capacity to guarantee supply access.

Model gaps

Modeling both credit and market risk for power remains problematic in some respects. While the vendor systems available are perceived by the marketplace to have improved substantially since last year, there are still gaps. Some nimble newcomers with an energy rather than financial background, however, have been making the running by getting functionality to the power market quickly.

“You are no longer a credible trader unless you have some physical delivery abilities—be it owned or controlled in some other way.” —Ellen Lapson FITCH IBCA

For example, Nucleus Corp., founded in 1996, got the year off to a good start by announcing the sale of its Energy Trading System to four utilities, including Florida Power & Light Co. and Western Resources. In an interesting step designed to boost its credibility in a marketplace typically wary of start-ups, Nucleus escrowed its original source code for the Energy Trading System, so that in the event of the company failing, clients can gain access to it.

A particular problem for vendors and players accustomed to financial markets is getting a handle on the sheer volatility in the power market. “I think the banking industry is just starting to address the existence of what is, effectively, another curve at the end of the credit distribution tail,” says Powerex’s Wong. “It’s as if there’s another flip in the outliers there.” As a result, Wong believes subjecting portfolios to severe stress-testing is the most viable approach in an environment where multiple-standard-deviation events are likely to be the rule rather than the exception. In his view, this approach also fits in well with any netting arrangements that may evolve. “As you stress your portfolio, you’ll know what kind of counterparties you’d want to deal with to lay off any particular exposures,” he says.

Coming together

The new credit awareness in the power market has precipitated a sharp bout of consolidation. Apart from more rigorous procedures, participants have been paring their lists of counterparties. “We have one client that had 100 counterparties in early June last year and has now trimmed that to 24,” says Ed Zaccaria, senior vice president of CIGNA Power Products. If the goal of deregulation was to increase competition and open up markets, it has clearly failed. The prognosis is that price volatility will remain a feature of power—at least until someone figures out a way of storing the stuff. Another spike in the market could spur another shakeout.

As the amount of power being moved from the regulated arena to the unregulated arena grows, it looks as if those that stay the course will be those with the determination—and the deepest pockets. The market already appears to be consolidating around those who have multimillion dollar bankrolls to invest in systems and top talent. And these days, investments in top talent include not only trading but also counterparty risk management and audit and back-office operations.

Several factors are encouraging consolidation. An increasingly competitive market inevitably puts pressure on costs. In this environment, inefficient smaller players who have not reached critical mass may be pushed to the sidelines. Another factor is strategic alignments, in which a merger or acquisition plugs gaps in a particular company’s coverage. These are especially attractive in situations in which contiguous service territories give companies an opportunity to buy a new market channel, such as in the convergence of gas and electricity. The biggest driver of consolidation, however, would be a change in the federal regulations governing public utility holding companies. “The repeal of PUHCA [the Public Utilities Holding Company Act], or at least a revision to it, would dramatically facilitate the merger-and-acquisition process,” says Ameren’s Burchett.

Despite the presence of a few investment banks, the demand for greater sophistication and skills hasn’t yet attracted a flood of Wall Street top guns to the power market. Much of the new talent, in fact, is coming from the natural gas and petroleum industries. “We’re also seeing power guys sliding into trading—which is a tougher transition,” says Michael Hiley, vice president of commodity advisory services at Merrill Lynch. Hiley argues that experience in natural gas trading would help prepare a future power trader, because the gas market also evolved from a monopoly environment and is affected by similar factors, such as weather and production problems. On the other hand, the change in mindset required by someone who used to run a grid and now has to manage price risk from an economic rather than a “gotta turn the lights on” perspective is much more demanding.

To some commentators, no matter where they come from, there still aren’t enough good electricity traders. “The bottom line is that there is a shortage of talent in this industry,” says Fusaro. “It’s a unique commodity. Gas traders have all been handed their hats, oil traders have found it tough, and the former foreign exchange traders dislocated by the euro who have come to the energy market don’t have a clue.” On the risk management side, many newcomers have been arriving from the banking industry in general rather than from Wall Street. From the industry perspective, this is probably not a bad thing, since those from a general banking background will probably have more experience in dealing with a wider range of credits than someone from Wall Street.

Irrational markets

Despite the relatively muted influx from financial markets into power, there are certain anomalies in the market that some attribute to the instincts of those with a financial, rather than an energy, background. “A heat wave that pushes spot prices up doesn’t necessarily imply global warming and so shouldn’t logically affect forwards one year out,” says Rich Tanenbaum, a partner at derivatives software vendor Savvysoft. Nevertheless, Tanenbaum points out, a spike in spot prices often illogically pushes forwards up as well. His hypothesis is that former currency and interest rate traders in the power market, steeped in the tradition of “spot up—forward up,” are unable to resist the knee-jerk reaction and are in turn joined by those who know better but who don’t want to miss the boat.

Aquila’s Fox has a different explanation for this phenomenon. “I think it’s a change of perception based on observations in the market that is causing this effect—‘If I undervalued this month, maybe I did the same with others?’ is probably more the psychology,” he says.

Electricity has also become a tougher market to trade in recent months. As people realize that electricity is a much riskier proposition than they originally assumed, they are much less inclined to trade for the sake of posting high-volume figures for ranking purposes. That, combined with a reduction in the number of participants, has lead to a liquidity squeeze.

As a result, dealing spreads have opened up. Last February, it was possible to trade the summer CINergy for a bid/ask spread of around a dollar. This February it could be anything up to $10, which amounts to quite a haircut on a standard package of around 33,000 megawatt hours. At the same time, this doesn’t do the value-at-risk numbers a lot of good, although summer months trading at 250 percent volatility don’t help much either. “I think this has put a lot of people off trading the summer months,” says Aquila’s Fox. “It chews up a lot of VAR and is therefore capital-intensive, which in turn has made the liquidity even thinner.”

This has played havoc with dealing spreads. The thin markets have made hedging difficult or impossible since huge gaps often open up between bids. Placing a stop loss in this environment is treacherous, which in turn widens spreads even further.

Instability of all kinds in the rapidly maturing power market is not likely to disappear soon. Unlike gold, power can’t be warehoused to provide a cushion during periods of production shortage. As a result, unexpected shortages are certain to keep volatility and prices on the move this summer—and some way into the next century.

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