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Power Market Glitch in '98 Had 'Silver Lining'

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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