In an effort to grease the gears of energy trading and sharply lower collateral requirements in this time of extreme credit scrutiny, the Committee of Chief Risk Officers (CCRO), which represents 32 major energy companies, has recommended a standardized agreement that will facilitate trading of energy contracts through clearinghouses and other multilateral trading platforms.

The “Clearing, Novation and Release Agreement” is designed to allow trading partners to adapt existing contracts to a universal format for clearinghouses, which assume the risk in energy trading transactions by stepping in and becoming the counterparty to each side of the transaction for a fee. The industry is rapidly moving toward greater use of clearinghouses, but in order to reap the true benefits of the clearinghouse function there have to be changes to the business framework in which bilateral and multilateral contracts are consummated.

The CCRO’s standard agreement is expected to enable new and historical energy and derivative contracts to be efficiently cleared through one or more of the emerging multilateral clearing platforms, such as EnergyClear, IntercontinentalExchange (ICE), New York Mercantile Exchange (Nymex) and Virtual Markets Assurances Corp.

“It doesn’t have any preference to any clearing solution, which is to say it is platform agnostic,” said CCRO Executive Director Mike Smith. “It will work just as well in clearing Nymex transactions as it will on ICE or EnergyClear or any other alternative that may present itself.”

Nicole Daggs, an attorney at Mirant who worked on the development of the agreement, said the “principal benefit of adapting new and existing contracts to the same format is trading partners will more easily be able to utilize the multilateral platforms’ ability to net out overlapping credit obligations. Multilateral clearing could result in significant reductions in collateral requirements.”

Smith said it could significantly improve market liquidity because companies are posting a tremendous amount of collateral right now. Collateral posting is nothing new but has become a near fatal thorn in the side of the trading industry recently because many trading companies have suffered repeated credit ratings downgrades.

With each new transaction with a given counterparty, an additional amount of collateral may have to be posted despite the potential for duplicative collateral requirements in complex trading relationships. With a netting agreement, however, those obligations are substantially reduced, particularly in the case of multilateral netting through a clearinghouse, explained Smith.

“If I owe you $10 and you owe me $9, and if we don’t have a netting agreement, I’m posting to you on a $10 obligation and you are posting to me on a $9 obligation. That is an inefficient usage of capital,” he said in an interview. “Companies are tying up a lot of dollars in posting against gross requirements. What the industry is moving toward is having companies on a bilateral basis put in netting agreements that would allow me to post $1 worth of obligation [in the previous scenario]. And what multilateral clearing does is allow us to step beyond bilateral netting…and get the netting benefit across numerous counterparties. If we are all posting our position at the end of the day against a clearinghouse, we will be posting collateral based on our net exposure to the clearinghouse.”

The CCRO’s standard agreement is designed to move the industry further down the road toward greater use of clearinghouses and universal use of multilateral netting agreements. The recommended novation agreement (“novate” means to “transfer associated credit risk” to a clearinghouse) is “standardized” in that it provides a consistent contractual framework that can be modified as required.

“This can save co-signers a significant amount of time and quickly bring the benefits of multilateral clearing to their companies, investors and customers they serve,” said Lisa J. Mellencamp, assistant general counsel of Duke Energy Trading and Marketing.

The novation agreement can be used to clear transactions across any platform, assisting the industry in restoring confidence in the merchant energy and trading sector.

Despite the potential benefits, however, some may question the willingness of industry companies to adopt the standard agreement. In the past, standardization has been a hard pill for the industry to swallow. But Smith believes this is much different. In fact, he said companies have been eagerly awaiting the release.

“We are optimistic that it will get widespread adoption,” he said, adding that the major clearinghouses have endorsed the agreement and support CCRO’s efforts.

“The first hopeful sign is that 32 odd companies and their lawyers came together reasonably quickly and with a fair degree of enthusiasm and understanding and got behind this and got it done… It’s not a particularly controversial agreement. Most of it is very process oriented, and there are not a lot of covenants and things that should require extensive negotiations. What’s more, it’s drafted to be as encompassing as possible. It reaches out to the traditional trading companies but also to governmental entities and the non-traditional financial players, hedge funds and investment companies and banks.

“We’re optimistic that we’ll see this agreement put in place pretty rapidly. We’ll begin finding out almost immediately. There’s been a lot of interest in seeing this.”

Smith said the “umbrella” agreement doesn’t obligate two parties to trade, or to clear transactions that they do trade. What it does is provide preset rules and answers to questions. “It will replace the labor intensive work most parties currently are doing manually,” he said.

The standard agreement is one of the “high-priority items” on the CCRO agenda, but CCRO also is working on determining a standard for capital adequacy for investment grade credit ratings and is expected to release early next month guidelines for companies submitting data to energy pricing publications and for the publications themselves (see Daily GPI, Dec. 6). Copies of the Clearing, Novation and Release Agreement and other information are available on the committee’s web site, www.ccro.org.

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