Something good did come out of the power market malfunctions oflast summer, according to Moody’s Investors Service. In a reportreleased yesterday, Moody’s said the experience has triggered a newcommitment to counterparty risk management by energy trading firmsthat will enhance credit quality in the energy sector and inspiregreater confidence in the market.

“When June 1998’s price spikes in the Midwest electric marketcaused at least three trading firms to fail, the experience,although painful, had a silver lining,” said Moody’s EmilyEisenlohr, vice president and senior credit officer.

Because of the event, some companies have reassessed theirenergy trading business and scaled back their operations to matchtheir risk appetite and willingness to commit capital. Others havereaffirmed their commitment to the business, but are proceedingmore carefully by improving their auditing systems to squeeze outrogue traders, bringing in “rocket scientists” to help quantifytheir exposure, and retaining expert legal counsel that cannegotiate stronger contracts. Other new risk management techniquesinclude “margining,” or the use of an escrow account to providecollateral to protect against price movements.

Also among the new trends in the industry is more formal creditsupport of trading operations by the parent company. In the past,such parental support was rarely formally present, although oftenassumed by investors and other counterparts in what analysts callthe “halo effect” that comes from association with a highly ratedor well regarded company, Moody’s said. Power Company of America,one of the marketers to default last year was, for example, alimited partnership that included affiliates of Barr DevlinAssociates, a top investment banking and advisory firm; NIPSCO, amajor electric utility; and General Electric.

Trading firms can benefit from investment in a good contractwith clear, strong language that governs the relationship betweenthe trading parties. “Examples abound of only skimpy documentationin the face of all kinds of legal challenges,” Eisenlohr noted.”Some firms have found they have tripped up on a very basicstep-getting the right signatures on the contract.”

Other features of a good contract include specifications of thecommodity to be traded, delivery requirements, and billing andpayment terms, as well as language that addresses disputeresolution, a deterioration in either parties’ credit quality, andobligations under certain force majeure events. However, more workremains to be done, the rating agency concludes.

Moody’s expects the stronger focus on risk management willresult in more public ratings in the industry as ratings arerecognized as a cost-effective way for companies to perform duediligence on other parties with which they do business, whilepreserving the confidentiality of the firm’s trading strategies.

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