The Inevitable Electricity Credit Crisis
By Andrew Webb
Electricity is a new market flooded with firms with dubious credit. It’s no longer a question of whether a credit crisis will occur, but when.
Colossal volatility! Inexperienced traders! Unrated counterparties! Minuscule margins! Welcome to the U.S. electricity business, one of the last of the wide-open markets. In the past two or three years, the prospect of making untold riches in the soon-to-be-deregulated electricity trading business has inspired almost 400 new power marketing companies to set up trading desks. But like most new markets, expectations about the future have outpaced the preparations that could prevent the disasters that are inevitable in new trading arenas.
The Achilles’ heel of the U.S. electricity market is credit. The problem, to put it bluntly, is that many of the new trading subsidiaries don’t have two nickels to rub together. To make matters more confusing, some are subsidiaries of creditworthy parents, but don’t necessarily have an explicit parental guarantee. Under these circumstances, credit risk management is difficult, if not impossible: Credit managers have to check out the credit numbers, if they can find them, while making decisions about which corporate parents will pay up for the mistakes their kids make.
Before June’s extraordinary price spike (see story on page 21), cooler heads in the business were talking about the inevitability of a credit crisis. Although the events in June have yet to lead to any bankruptcies, a number of people in the industry now believe a full-blown credit crisis is just around the corner. “How can we not have a blow-up in a market in which daily prices can go from $60 to $300?” asks Michael Hiley, vice president of commodity advisory services at Merrill Lynch. “I don’t think that the electricity market has fully assessed the potential for counterparty risk. People are looking at it, but in my view not hard enough when you consider that it’s by far the most volatile market the energy industry has ever traded. At present, trading volumes are small in the context of volumes in the industry as a whole. But as these grow, the potential for a whole daisy chain of power marketers to collapse also grows.”
Thus far, a number of factors have conspired to prevent a serious credit blow-up in the market. Low trading volumes have helped keep a lid on things. Many of the trades being done these days, moreover, have involved shorter-term transactions with lower credits. But as the market develops volume and the average term on these deals increases, the risk of default will increase exponentially.
The two biggest questions on many minds are, Which marketer will blow up first, and who will it take with it? At present, the most likely candidates are the small, unrated power marketers. Although it’s possible that one of the largest utilities could walk away from a failing (and nonguaranteed) subsidiary, it’s more likely that a big utility would decide to take a write-off than lose credibility. “Utilities have a lot of cash flow. I think a meltdown there is unlikely,” says Peter Fusaro, an energy consultant at ABB Financial Services. “Some of them are already absorbing losses from their trading activities.”
|“At present, trading volumes are small. But as these grow, the potential for a whole daisy chain of power marketers to collapse also grows.”
vice president of commodity
Others, however, are less certain of the utilities’ impregnability. “Not all of the bigger utilities are developing credit policies and checks, so it is still quite possible that one of those could fail,” says Clare Broido, consultant in Deloitte & Touche’s Power Energy Group. “Obviously, if one of them were to collapse, the damage to the market as a whole would be much more dramatic.”
What makes the potential impact of a failure on the market far more serious is that transaction chains in the electricity market are long. Estimates vary, but some research has shown that as many as 50 separate contracts are involved in the electron path from the generating source to the end-user. The key issue is the sequence of these transactions. If the trail includes a large number of adjacent deals involving undercapitalized marketers, the domino effect could be severe.
On the brighter side, a certain amount of current market activity is believed to consist of “sleeve” trades. These arise when Company A wishes to do business with Company B, but is at or over its credit limit (or doesn’t have one). To get around the problem, Company A finds an acceptable counterparty for Company B (Company C) that is willing to assume an intermediate role and take a penny out of the trade in return. The expectation is that Company C is likely to be a more creditworthy entity and may thus provide a much-needed “credit trip switch” in the event of a failure elsewhere in the chain.
Despite advances in credit risk management techniques by some participants, the potential for a failure is increased by a well-entrenched “producer” mentality that views electricity as a product that needs to be sold—regardless of the creditworthiness of the purchaser. Utilities have not tended to devote much time to thinking about bankruptcies, because historically they haven’t been exposed to many. Relatively loose bilateral agreements have been the norm in the electricity market, rather than intensively vetted and monitored credit risk management controls. Although utilities may have individual credit limits with every counterparty, many in the business treat this as an accounting technicality.
This producer mentality also means that many marketers may have overlooked the way in which credit risk can also beget market risk. A trading operation that enters into a trade with a counterparty to deliver electricity in three months may not want to carry that exposure on its books, so it will enter an offsetting trade with another counterparty. If either counterparty collapses, the trading operation will have to buy or sell in the market to fulfill its obligations. And given the wild volatility these days, the price hit could be substantial. “While that’s been common knowledge in financial markets for years, it’s probably one of the more subtle issues that may not have occurred to some participants in this market,” says Emily Eisenlohr, vice president and senior analyst in the electric utilities group at Moody’s Investors Service.
This kind of insouciance is a luxury that cannot be afforded in electricity. Margins are wafer-thin and provide no effective cushion against credit losses. “When you look at the financial statements now being published by companies in this business, you may see a large revenue number, but the profits are negligible,” says Eisenlohr. “If you factor in the costs of staffing up, you have little leeway to play with.” Similarly, joint venture companies have been touted as marriages made in heaven, blending Wall Street trading and risk management expertise with the utilities’ knowledge of the electrical industry. But it’s unlikely that investment banks will be willing to squander their well-controlled balance sheets to buy market share in this low-margin business.
Given the primitive state of electricity credit management, what’s a power marketer to do? A number of participants in the power markets have developed credit procedures designed to make the best of current conditions. “Our credit-evaluation process has evolved continuously since our first contract with a power marketer some two years ago,” says David Wong, credit manager at Powerex, the power marketing subsidiary of BC Hydro. “The bar is continually being raised.”
The problem, says Wong, is not merely the limited capitalization of the counterparties but also the limited information available. “You try to get what you can,” he explains. “People are not, as yet, willing to provide much in the way of financial information. Although you are starting to see some power marketers giving it out, that’s the exception, not the rule.”
Apart from the more obvious items such as financial statements and trade references, the art in this sort of credit management lies in finding information in trade papers and other sources. If the information isn’t forthcoming, Powerex asks for credit enhancements. These can take a number of forms, including letters of credit and escrow agreements. In the case of a counterparty that is the subsidiary of a rated parent, a parental guarantee may be sought.
When assessing an unrated counterparty, the objective is to come up with an internal rating. The analysis will go far beyond the balance sheet and will cover the counterparty’s risk management techniques, the caliber and experience of its staff, its administrative controls, and its asset base. The last element will include considering such things as long-term contracts with other counterparties and any generating assets owned.
“We allocate capital among certain categories of counterparty,” says Wong. “Depending on the rating a counterparty achieves on our internal scoring system, it will be placed into one of those categories and the appropriate credit limit will be assigned to it. We are prepared to negotiate with counterparties that fall below the entry-level bar for extra information or provide guarantees that might help them above it.”
|“When you look at the financial statements now being published by companies in this business, you may see a large revenue number, but the profits are negligible.”
vice president and senior analyst,
electric utilities group,
Moody’s Investors Service
Trying to assess the potential volatility implicit in trades with a particular counterparty isn’t easy. Not only is there limited historical price data available for what has already proved to be an extremely volatile market, but historical data for credit defaults by unrated counterparties are effectively nonexistent. The obvious response is to refer to the gas market, but this is hardly an ideal proxy as the price volatility is considerably lower. Even if one arrives at a satisfactory solution here, there is still the question of how to apply it effectively. “You don’t know whether a counterparty has left open the other side of trades that it has done with you,” says Sally Stewart, product director at TransEnergy. “You need to assess how comfortable you are with the positions you have with it under those circumstances. If the counterparty is doing that kind of trade with you, how many other counterparties is it doing the trade with?”
|“Unsophisticated participants may not realize that they need a guarantee, or they may base their credit assessment on [the parent] alone.”
It’s one thing to look at a counterparty’s balance sheet and calculate how big a move it would take to wipe it out for a given position size. It’s quite another to assess how much of that same activity is taking place with other counterparties. In fact, trying to discover the nature and size of a counterparty’s daily trading activity is likely to result in data that are at best anecdotal. While a lot of that sort of information may get passed around from trader to trader, the traditional state of relations between risk managers and traders means that much of it will go no further than the trading desk.
Fathers and sons
One of the more abstruse headaches for credit managers to contend with is the “halo” effect, in which the unrated power marketing subsidiary of a well-rated name basks in its reflected glory, but little more. It’s unusual for the parent to provide explicit financial support, so counterparties negotiate for the guarantees that they require on an individual basis. “In many cases one counterparty will negotiate a parental guarantee, while others don’t,” says Ellen Lapson, an analyst at Fitch IBCA. “This can simply be because the marketer is limited in the number of guarantees that it can give—because it is charged for them by its parent. In other cases, however, unsophisticated participants may not realize that they need a guarantee, or they may base their credit assessment on the halo alone.”
“The halo effect is insufficient justification to provide credit in any size,” says Powerex’s Wong. “In order to determine the amount of real parental support, you must look at the balance sheet to see how much commitment the marketer has made to the success of the venture. You should theoretically find that information on a power marketer with a rated parent is more accessible than for one that is completely independent.”
The ultimate question, when push comes to shove, is, Which parent will stand by its subsidiary? One theory that seems to have an alarming number of adherents is that if the subsidiary shares the parent’s name, all will be well. Proponents of this theory point to LG&E Energy Corp. and CNG as proof positive. LG&E Energy stood by its subsidiary, LG&E Natural Canada Inc., at a cost of $17 million, when a major spike in Calgary spot gas prices left several players nursing substantial losses. When CNG decided that it wanted to close down its energy trading subsidiary (which also shared its name) and focus on retail operations, it did the decent thing and honored existing contracts. “Although a number of trading desks I talk to seem to believe this theory, I wouldn’t want to put serious money on it,” says Lapson.
There’s certainly contradictory evidence. For example, NIPSCO Industries walked away from the $18 million wreckage of recently acquired trading subsidiary N(NIPSCO)esi Energy Marketing Canada, which was demolished in the same Calgary price spike that hit LG&E. In general, the solution to sidestepping these losses involves trying to assess the strategic importance of the power marketing subsidiary in the parent’s overall strategy.
This sort of conundrum is seen by some as requiring a specific type of expertise. “We are helping a lot of clients to deal with just that halo effect,” says Scott Gauch, senior manager in the energy group at Deloitte & Touche. “The need to understand these issues means that participants are looking for the types of credit officer that have come from banks and are experienced in some of the intangible elements of deciding an appropriate credit rating for an unrated counterparty.”
Another of the “nontangible elements” to which Gauch refers is the quality of traders that the counterparty employs. A problem peculiar to the electricity market is the uneven distribution of trading talent. The obvious danger is that one loose cannon on a trading desk could effectively jack up the default risk of a counterparty. While companies with previous interests in gas or other energy markets have been able to devote existing expertise to electricity trading, others have been less fortunate. Some, in fact, have opened their checkbooks and recruited heavily from Wall Street or competitors. “There are a lot of people trading now who don’t know how to measure how well they are trading,” says Deloitte & Touche’s Broido. “You would hope that it would at least be the complicated transactions that would trip people up, but a lot of people don’t know how to value the simple contracts.”
Gauch recommends a two-stage credit-vetting process that considers the quality of a counterparty’s senior management and frontline personnel. “Once you have performed a quantitative analysis of a counterparty, by looking at such things as financial stability and parental obligation, it is helpful to consider myriad qualitative issues,” he says. One approach is to create a formula-based (black and white) internal rating hierarchy with credit categories ranging from “1” (best credit) to “10” (worst credit), and allow for qualitative adjustments (pluses or minuses) to account for such things as management effectiveness and trading expertise.
Another curio in the electricity market is that participants are not pricing for risk. By and large, an A credit pays the same price as an unrated one. As a result, margins are thin for everyone—even those that should be paying a premium. Many expect that this form of bargain pricing will change as activity picks up. “I think you’ll see credit pricing soon, certainly within a year or two,” predicts Wong.
Given the nature of the credit issues that the electricity markets are facing, one obvious solution would appear to lie in the exchange-traded markets, with margin requirements and central counterparties. In contrast to gas, which has substantial concentration points, the electricity market is far more fragmented in terms of delivery and specification. It may be a potentially bigger market, but there is considerable basis risk inherent in trying to hedge over-the-counter trades in an exchange market with imperfect correlation. As a result, although the new CBOT contracts are written against two huge suppliers (the Tennessee Valley Authority and Commonwealth Edison), because the exchange saw their hubs as being “significant,” they will still have limited application for hedging delivery obligations. In addition, hub activity levels are notorious for their volatility, being dramatically influenced by a particular combination of circumstances. It is believed that at least one hub index has been shelved for suddenly drying up after having shown dramatic activity for the previous six months. The range of exchange contracts that would be needed to cover every hedging eventuality would be colossal.
Anybody with a penchant for prognostication needs only to take a quick look at the gas market, where a major consolidation is likely as credit quality begins to determine who survives. Credit pricing, combined with narrow margins, is likely to encourage the development of a two-tier market, with the stronger and weaker credits trading among themselves. “The larger trading shops are getting to the stage where, for example, they won’t transact with anyone below A-,” says TransEnergy’s Stewart. “We believe that a common (high) entry-level credit standard will apply to this market.” This credit sensitivity may sharpen even more as deregulation proceeds and commercial and industrial users enter the market.
Another solution on the horizon is the construction of special derivative products corporations with their own dedicated credit facilities. “We have researched that question,” says Fitch IBCA’s Lapson. “Because the market has been much less sensitive to credit than we would have predicted, there hasn’t been a basis for an energy DPC. However, if we had a credit event that caused a round of jitters and made people more sensitive, we think that there is a possibility that DPCs would appear.”
Others, however, are more skeptical. “I think that their return is some way off,” says Wong. “The market isn’t yet ready—but it could be a competitive advantage for a company to go that route.” Structuring a DPC involves analyzing the value-at-risk of the specific transactions put into the DPC, in the same fashion as calculating the VAR of existing power marketer’s positions. While it is possible to set the multiple of capital times VAR for a certain number of days to reach a certain rating level, one again runs into the question of whether it is feasible to calculate VAR in the electricity market with a sufficient degree of confidence. The current lack of transparency and liquidity makes this a dubious proposition, although it should improve as volumes pick up. By the same token, this should encourage the adoption of concepts such as RiskMetrics and CreditMetrics for more general application.
The nascent electricity markets present credit managers with one of the last great untamed landscapes. If you’re an experienced credit manager on Wall Street looking for a change of scenery, start packing your bags. Your local power marketer needs you—now.
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