ANOTHER PERSPECTIVE

One way to manage risk efficiently in any market is through a contract that is standard—for both purchaser and seller—across regions. When you purchase a home, for example, one of the most important things you do before moving in is to sign a real estate contract defining the terms, conditions, and expectations you must fulfill to complete the purchase. The contract describes many of the specific obligations to which the purchase exposes you. Most residential real estate contracts are standard within a region, though they leave several blanks to fill in according to your particular situation—price, closing date, amount of earnest money deposit, and so on.

In energy markets, standard contracts embody good risk management and trading practices for lowering exposure and reducing liabilities—and a lack of common legal terms in electricity transaction documentation and differences in the contract/tariff infrastructure can become critical in times of market stress. But up until a few years ago, agreements on power purchases varied in important ways. After the first Midwest electricity price spikes, for example, traders discovered that although the contracts they used appeared similar, common terms were not defined consistently. For instance, treatment of oral transactions, confirmation processes, allocation of force majeure risk, and payment netting, among other critical elements, lacked the credit and legal controls needed to address the risks of a volatile electricity market.

In 1999, Edison Electric Institute (EEI)—along with the National Energy Marketers Association and a working group of legal experts, power marketers, traders, and public power representatives—began to put together a standardized master power contract for wholesale power. The contract, a model bilateral master agreement containing the essential terms governing purchases and sales of wholesale electricity, focuses traders on the transaction's negotiable "fill-in-the-blank" elements, e.g., price, quantity, location, and duration.

The group is working on a critical addendum to the contract—a master netting agreement, which should streamline risk management even more.

Easy Math
Netting can play a role in counter-party risk and exposure. In its basic form, netting out your obligations means that if someone defaults on his or her obligation to you, you are assured of receiving the obligation's net worth. Say energy trader A sells energy trader B $1,000 worth of energy, and trader B sells $1,500 worth to trader A. Via a netting agreement, trader A can simply secure the difference ($500) in case trader B defaults on its obligation. As a result, trader A can write down less money ($500 vs. $1,500) as a liability, thus reducing its exposure and requiring less collateral to run its business.

The EEI standard contract contains payment netting arrangements for electricity trades and has sought to define the arrangements consistently. But it gets more complicated. Energy traders also trade gas and weather and financial derivatives, among other things. Netting across multiple commodities raises its own set of legal and financial issues. Last fall, a group representing a cross-section of energy trading companies proposed to develop a master netting agreement that would enable such cross-commodity netting, even on deals entered into under different master contracts. Being able to net out electric trades with gas, weather, or other commodity trades adds to the flexibility a company can exercise and reduces its risk exposure.

To allow for input from interested parties, the proposed master netting agreement was on EEI's website this spring and summer. Considering the complex legal issues involved, it has been developed on a fast track, and a final version of the agreement will be completed by the end of the year. With it will be a detailed discussion of relevant legal issues for traders to consider before using it. EEI also plans to hold a series of educational workshops for contract users.

Standardization in Unstable Times
The master power contract and netting agreement give traders good tools to help master the risks of the market. Another advantage of the contract and netting agreement is that they are balanced: Both buyers and sellers can use it to better manage their credit and risk exposure.

Standardizing complicated issues from a legal point of view is critical in this unstable period in the energy trading sector. Energy traders have to be able to deal in a balanced way with commercial transactions in a competitive environment, or the market won't work. The master power contract and netting agreement help us get closer to a liquid, well-functioning wholesale power market.

© 2008 Edison Electric Institute