Standard and Poor’s Rating Service (S&P) on Thursday warned in a report titled “Risky Business: Selling Retail Electricity in the U.S.” that many retail marketers are in the same boat as wholesalers with significant market risk because of volatile prices and switching customers, operational challenges such as mass billing and collections, and weak credit.

The ratings agency generally views marketing and trading companies as having a “below average” business position, that is, 7, 8, or 9 on a scale of 1 to 10, where 10 is the weakest, or highest risk, business profile.

The experience in the Texas retail market reflects these risks, S&P said. “The state, which addressed most of the potential market and credit issues in the legislation that created retail electric competition starting in 2002, has one independent marketer in bankruptcy and another affiliated marketer that will experience a significant loss in 2003,” said S&P credit analyst Judith Waite.

Both companies, bankrupt Texas Commercial Energy and First Choice Power, a subsidiary of TNP Enterprises Inc., were hurt by the February 2003 gas price spike. Their experiences make it clear that retail electricity marketers can, and usually do, share many of the same risks of marketing and trading companies, said S&P.

First Choice started out in 2000 buying fixed-rate electricity in blocks to match the fairly predictable load of its retail customers. But when the price of gas changed from the contracted level, it created a collateral requirement, and First Choice had limited credit capacity. “As an alternative way to cap gas price exposure [First Choice] bought gas-purchase options. Unfortunately, the options seller was a shell company created by a former First Choice employee, a fact discovered almost immediately because of a reported transfer of funds,” S&P explained.

“A revised payment approval process is now in place. However, before another options counterparty was approved, a few large competitive customer contracts were renewed with [historical and much lower] fuel costs. By the time gas price options were purchased, First Choice was stuck with a loss on the renewed contracts. So in its first year, the company faced two of the major risks associated with retail electric marketing: lack of the credit capacity needed for fixed-price contracts, and a weakness in internal credit and risk controls.”

S&P said that Texas Commercial’s bankruptcy parallels in certain respects the bankruptcy of Pacific Gas & Electric Co. in California. Texas Commercial sold fixed-priced power to customers but bought its power on the volatile spot market. It cited the high volatility of electricity prices in the Electric Reliability Council of Texas as the reason for its bankruptcy. Texas Commercial alleged that companies selling power in the market may have engaged in improper activities. Texas regulators are still investigating the matter.

“Texas Commercial’s president points out that barriers to competition in Texas are still very high and the lack of access to bank credit to provide collateral on fixed-price purchased power contracts is one key reason,” S&P said.

According to Centrica, the largest retail marketer in North America, “it’s good to have an ‘A’ credit rating.” In Texas, Centrica buys huge blocks of power to serve retail customers and buys gas swaps to fix the fuel price, but it doesn’t have to post collateral because of its high credit rating. Because it has customers in all four Texas electricity zones, it also has access to a broad range of electricity pricing information.

For much of its load, however, Centrica has a two-year contract with the generation portfolio that originally served its customers, specifically the customers of AEP Texas Central Co. (formerly Central Power & Light) and AEP Texas North Co. (formerly West Texas Utility Co.). The rates of those customers are still fixed at regulated tariff minus 6%, giving Centrica a fairly good margin on a significant portion of its electricity revenue in Texas.

All the retail marketers in Texas have had to deal with the risk associated with nonpaying customers. It has evolved due to regulatory changes to the market rules. Although retail marketers now have to sue the nonpaying customers to get paid, they also can disconnect those customers, whereas in the past that option was reserved only for the provider of last resort in the marketplace.

The challenges experienced by retail marketers in the first few years of retail electric competition “highlight the importance…of a strong financial profile — or the backing of an entity with a strong financial profile; a strong risk monitoring and risk mitigation program; and the ability to attract and maintain a large and diversified portfolio of high quality retail customers,” the report concluded.

For more information, contact Judith Waite at (212) 438-7677.

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