Its reliance on a company’s capital adequacy to determine credit ratings may work for most, but Standard & Poor’s plans to “refine” its analysis methods for energy marketers and traders because of the “recent developments” within the industry. S&P, which began covering the energy trading sector in 1997, noted that the continued price volatility for both power and natural gas markets, the “bilateral and unregulated nature” of the sector and a “lack of adequate trading infrastructure” all played a part in its decision to revamp its methods.

S&P, explaining what it puts into its ratings, said a qualitative review is conducted of a company’s strategy, process, infrastructure and environment, which includes meeting with management, conducting site visits, reviewing a detailed questionnaire and then benchmarking the results against peer firms. A second quantitative analysis includes assessing capital adequacy and liquidity. However, S&P noted that it would refine its methods to “address the evolution” in energy marketing and trading.

“More so now than ever before, energy trading and marketing is a highly confidence-sensitive operation — confidence in credit, management, and disclosure, among other areas, is a critical requirement for counter-parties, creditors, and investors,” said S&P. “It is still a nascent industry, one that has seen its largest player, Enron Corp., file for bankruptcy protection. Moreover, energy trading and marketing companies are often susceptible to contingent liquidity needs if their ratings fall below investment grade. The need to post more than $500 million in collateral following a credit downgrade below investment grade is more the norm than an exception with the larger players.”

S&P’s credit rating changes specifically for energy marketing and trading will focus on three areas:

In addition, S&P also will be looking for “additional disclosure from energy trading and marketing firms.”

The credit ratings agency plans to augment its assessment of market risk “beyond the calculation of an energy-trading firm’s value at risk (VaR),” which it called one of the most challenging components to accurately measure. It plans to continue to review each firm’s VaR, particularly for “short-term horizons” and to evaluate a company’s methods. However, it also will begin to request and review “market position reports and conduct stress and scenario analyses on market portfolios to enhance the analysis of market risk.”

S&P said, “Because the industry’s bigger players transact most of their merchant trading with each other for most of the shorter-term deals, there is some comfort gained that the variables used to transact and price deals do not vary too widely. Importantly, these firms must clear and settle transactions with each other nearly every day, which should limit the effect of many inconsistencies and discrepancies in market assumptions. To that end…S&P will analyze and evaluate an individual firm’s approach to calculating VaR, and adjust the value as necessary.”

Also getting a more intense look will be a company’s market portfolio to identify “geographic, counterparty, and commodity concentrations, as well as tenor and basis risks.” It will ask for summary position reports that will be evaluated along with a review of the risk-control procedures pertaining to volume limits by counter-party, region, commodity, and tenor.

S&P noted that energy companies “rely on each other for performance; when one party fails to perform, it could lead to the failure of another party not being able to perform-the so-called ‘house-of-cards’ or ‘daisy-chain’ effect. Each party in the chain may be a significant counter-party to others, which could compound the credit risk throughout the industry.”

The appropriate amount of risk capital, it said, “should incorporate some measure of these embedded risks. Moreover, it is expected that energy trading and marketing firms that desire higher credit ratings should carry higher multiples of this credit risk.” Because of these credit risks, S&P also is considering a revision that would eventually result in higher-risk capital amounts for an investment-grade rating. It also is interested in receiving market comments on what the revisions would mean to the industry players.

Noting that “few companies engage exclusively in energy trading and marketing,” S&P said its “stand-alone rating of a trading and marketing company can be influenced by the corporate credit rating of its parent. If the trading and marketing operation is seen as a fundamental part of the greater business, deeply entrenched within, and key to selling the output of a generating arm, then Standard & Poor’s can attribute some parental support to the trading company. It is possible for the ratings to be equalized, although for that to occur the trading company would have to be integral and essentially inseparable.”

©Copyright 2002 Intelligence Press Inc. Allrights reserved. The preceding news report may not be republishedor redistributed, in whole or in part, in any form, without priorwritten consent of Intelligence Press, Inc.