Power Market Glitch in '98 Had 'Silver Lining'
Something good did come out of the power market malfunctions of
last summer, according to Moody's Investors Service. In a report
released yesterday, Moody's said the experience has triggered a new
commitment to counterparty risk management by energy trading firms
that will enhance credit quality in the energy sector and inspire
greater confidence in the market.
"When June 1998's price spikes in the Midwest electric market
caused at least three trading firms to fail, the experience,
although painful, had a silver lining," said Moody's Emily
Eisenlohr, vice president and senior credit officer.
Because of the event, some companies have reassessed their
energy trading business and scaled back their operations to match
their risk appetite and willingness to commit capital. Others have
reaffirmed their commitment to the business, but are proceeding
more carefully by improving their auditing systems to squeeze out
rogue traders, bringing in "rocket scientists" to help quantify
their exposure, and retaining expert legal counsel that can
negotiate stronger contracts. Other new risk management techniques
include "margining," or the use of an escrow account to provide
collateral to protect against price movements.
Also among the new trends in the industry is more formal credit
support of trading operations by the parent company. In the past,
such parental support was rarely formally present, although often
assumed by investors and other counterparts in what analysts call
the "halo effect" that comes from association with a highly rated
or well regarded company, Moody's said. Power Company of America,
one of the marketers to default last year was, for example, a
limited partnership that included affiliates of Barr Devlin
Associates, a top investment banking and advisory firm; NIPSCO, a
major electric utility; and General Electric.
Trading firms can benefit from investment in a good contract
with clear, strong language that governs the relationship between
the trading parties. "Examples abound of only skimpy documentation
in the face of all kinds of legal challenges," Eisenlohr noted.
"Some firms have found they have tripped up on a very basic
step-getting the right signatures on the contract."
Other features of a good contract include specifications of the
commodity to be traded, delivery requirements, and billing and
payment terms, as well as language that addresses dispute
resolution, a deterioration in either parties' credit quality, and
obligations under certain force majeure events. However, more work
remains to be done, the rating agency concludes.
Moody's expects the stronger focus on risk management will
result in more public ratings in the industry as ratings are
recognized as a cost-effective way for companies to perform due
diligence on other parties with which they do business, while
preserving the confidentiality of the firm's trading strategies.
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