While the creditworthiness status of many energy companies is on life support due to the economic downturn in the industry and rash of scandals, the industry’s interest in using clearinghouses to jump-start sluggish trading appears to be lukewarm at this stage, said industry and clearinghouse representatives last week. More important are finishing the standardized market process and the western markets proceeding, giving some stable guidelines as to how business can be conducted, some believe.

Edward Comer, vice president of the Edison Electric Institute (EEI), suggested the lack of response to clearinghouses was in part because companies “clearly are reassessing their business models right now.” Also, they are waiting to see how FERC’s Standard Market Design (SMD) initiative progresses and the shape and nature of the electric markets that develop.

Comer detailed work by EEI and other organizations to provide standardized contract forms and the continuing work toward master netting agreements across commodities and across margins. But he said the most important thing FERC could do was finish the SMD process, centralizing real-time dispatch on a regional basis and providing financial hedging for congestion. Another major stumbling block is the all-pervasive western market investigation which has taken on a life of its own. Also, he recommended support of bankruptcy law amendments in Congress that would eliminate loopholes which make protection of netting agreements “ambiguous at best.”

Comer’s testimony and that of other witnesses, at the joint conference on credit issues and “Clearing and other Solutions” by the Federal Energy Regulatory Commission and the Commodity Futures Trading Commission (CFTC) last Wednesday, supported the conclusion that clearing organizations are not a silver bullet that will instantly restore creditworthiness. Energy firms seemingly are turned off by the high collateral costs, liability risks, and potential for reduced profits often associated with participation in clearing organizations, witnesses said.

The industry’s tepid interest in clearing was apparent at a Houston meeting of the CEOs of 35 energy companies last week, said Dennis Earle, president of EnergyClear Corp. When asked for a show of hands as to how many believed clearing would help their company, only “five raised their hands and three of those represented clearinghouses.”

Nevertheless, the necessary characteristics to conduct clearing are present in the energy industry, according to John Davidson, managing director of Morgan Stanley. There is a “sufficient concentration of counterparties” in energy to carry out clearing, he said, adding that “certain parts of it [the industry] are rich for introducing clearing into the process.”

But Davidson said clearing was a marketplace decision. “Clearing is a choice a marketplace can make. I would not say that every single market that doesn’t have a clearing organization is by definition not necessarily a well-functioning market. I think that marketplaces decide what they need in terms of how to make sure that counterparty credit risk is adequately managed, and efficiency and effectiveness are gained,” he told the two commissions.

In addition to having the right market characteristics for clearing, Davidson believes the credit instability of the industry makes it a ripe candidate for clearing or a comparable credit solution. “I would suspect that the recent history of the energy market…has diminished the number of companies that are quite that self-confident” to go it alone when conducting trading transactions.

“I [believe] there are a larger number of people that are willing to do that [use clearing directly or through intermediaries] than there were, say, three years ago,” he noted. Clearing currently is required on regulated exchanges, such as the New York Mercantile Exchange (Nymex) and Chicago Board of Trade, but it is optional in the OTC markets.

With clearing, “the original contractual obligations that had been entered into and agreed by the two counterparties…are extinguished and are replaced with obligations by and to the central counterparty,” or clearinghouse, Davidson said. By participating in the process, a counterparty is protected from having to bear the sole financial responsibility in the event a trading partner defaults.

While it sounds good, the clearing process — which lowers counterparty risk, thus allowing credit-poor companies to trade again — may not be right for all companies. A company may believe its ability to make counterparty credit decisions is “materially better” than those of a clearinghouse or other market participants, and that it doesn’t need the protections offered by a clearing organization, according to Davidson.

A company also may not want to risk its capital by joining a clearing organization, which may require members to assume risk in the event of a default by another member. Likewise, companies may be dissuaded by the fact that their “opportunity for profit is diminished” in the clearing process, he said. On the plus side, however, clearing “minimizes the adverse impact” associated with price volatility.

“It seems to me that clearing processes [have] sort of a classical moral hazard question…especially in the energy field where entities of lesser credit may want to rush in,” said CFTC Commissioner Walter Lukken. “For somebody of lesser credit it’s a good deal to come into that system because they’re passing off that risk to other folks. But somebody with a higher rating, they may actually lose in that transaction. They may be taking on more risk…than they’re getting in return,” he noted.

“I think that the existing clearing structures do not impose unnecessary moral hazard to the extent that participation in the clearing process is voluntary,” responded Davidson. “But fundamentally it’s up to the design of the clearing organization to make sure that moral hazard is minimized.”

Importantly, clearing organizations should extend their guaranty protections only to their members, he said. “If I can gain those benefits, but I don’t have to observe the discipline that the clearing member has to observe, and I don’t have my capital on the line, that clearly would be a case of moral hazard,” Davidson told federal regulators.

Clearinghouses generally have strict guidelines and standards to protect against “moral hazard.” They have standards for company admission and continued participation in the group; a collateral requirement for participants — it may be equal to the maximum movement in product price on a single day; clearinghouses may be at risk for their contingent financial resources (capital and retained earnings) in the event members’ collateral deposits are not sufficient to cover a member’s default; a clearinghouse guaranty protection generally extends to clearing members only, but there are some exceptions; clearing members may be required to participate in what is called “risk mutualization,” a joint sharing of financial risk if a member defaults, or the risk may be “syndicated” out to banks or insurance companies; and they agree on a single source for prices.

Avoiding default is the “No. 1 mission” of any clearinghouse and its members, although all are prepared to deal with this possibility, Davidson said. If a clearing party defaults, a clearinghouse must step in and meet the member’s financial obligation. If it doesn’t, “it might as well cease to exist as a clearing organization,” he noted.

A clearing organization has the right to liquidate a defaulting customer’s positions, Davidson said, and it can carry this out “fairly quickly” — in one day.

He advised that before joining a clearinghouse energy companies should become familiar with the financial and credit conditions of a clearing organization and its existing members, whose names generally are available on the Internet. A clearing organization is only as good as its knowledge of the books and records of its members, according to Davidson.

He said specific things to look for were:

Clearinghouse representatives were especially candid in their remarks before the commissions. “I don’t think we have made it clear to organizations [energy companies] as a whole what specific benefit they’re going to get relative to the cost,” said Charles McElhenie of Guaranteed Clearing Corp. “To get the energy industry to accept a clearing proposition it has to have value, and we’re all trying to figure out what that value is.”

“They [energy] have their own market and it operates very well. The lights stay on,” EnergyClear’s Earle said, in opposing attempts by financial clearinghouses to force different standards on the industry.

Neal Wolkoff, COO of Nymex, also objected to mandatory clearing, saying it “could raise costs and add unwanted risks into the system.” He suggested it was more important to push development of the underlying cash and derivatives market, and that part of the reluctance of companies to sign on with clearing organizations was due to the fact that there are three clearing companies currently competing for business. That splits liquidity and companies may be “sitting on the fence, waiting to see which is used.”

The IntercontinentalExchange has expended tremendous time and effort, but has had a problem getting companies to focus on the clearing solution, said ICE’s David Goone. So many branches of a company must be involved and it’s difficult to get people in the companies to push the clearing solution with other departments in their own company.

Others at the conference pointed out it will be difficult to conform different commodities and unique contracts with special provisions representing practical requirements of business into master agreements. It also was suggested that many companies currently have positioned themselves to limit trading — keeping transactions below negotiated levels so they don’t have to post collateral. If they go to multi-lateral agreements, they will have to post collateral starting at zero and they’re not willing to pay the high margins required by the clearing companies.

Robert Stibolt, representing Tractebel North America and the Committee of Chief Risk Officers, and Craig Goodman, president of the National Energy Marketers Association, both stressed the need for more transparency in price discovery. But Goodman also reiterated the pleas of others for FERC to make the critical calls on SMD.

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