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Duff & Phelps Credit Rating Co. has released a report advising that a properly structured plan for securitization of stranded utility investment should address third-party credit risk. That is, the plan should limit the extent to which bondholders are exposed to credit risk that may stem from actions taken by small energy marketing companies that are expected to act as middlemen in aggregating retail customers or services distributed by electric utilities.

According to the report, Stranded-Cost Securitization (em Potential Aggravation With Aggregators, securitization deals for stranded costs may lie exposed to credit risk because aggregators (largely small, start-up companies) may bill utility customers directly and handle receipts, and thus play a role in the revenue stream that supports bonds issued in a securitization.

Billing Cycle. For example, if an aggregator bills and receives payments not only for the electricity consumed, but for the utility's transmission and distribution services (including the transition charge earmarked for a securitization), the aggregator would temporarily possess funds due security holders. Absent any safeguards, investors would be exposed to the credit quality of the aggregator during the period that it held the funds.

Duff & Phelps sees the issue as especially problematic because the securitization transactions presently envisioned appear likely to be rated AAA. However, it is unlikely that any aggregators would be rated that high, or would be affiliated with institutions rated that high, says D&P. Also, the primary form of credit enhancement in these transactions will be the true-up mechanism. It is unclear how, or if, true-up mechanisms will consider and compensate for losses stemming from an aggregator's financial mismanagement or bankruptcy.

Credit Enhancements. Duff & Phelps believes that additional credit enhancement or high, over-collateralization levels might be required to offset potential fund-flow interruptions and shortfalls from possible financial difficulties suffered by aggregators.

Also, because aggregators are not yet market players, it will be difficult to mandate via commission orders and legal closing documents a list of safeguards that sufficiently addresses every possible aggregator-related risk that could arise.

Having the aggregator bill and collect from end-users directly and then remit proceeds related to transmission and distribution services and transition charges to the appropriate utilities is the most problematic cash-flow scenario for a securitization transaction, said Duff & Phelps. But the company appeared confident that methods existed to mitigate risk.

Commingling Period. For instance, many asset-backed deals require a maximum commingling period of two business days. Once a commingling period is set, it is easier to assess the maximum amount of cash that could be lost or blocked in a transaction, and to size credit enhancement accordingly. Also, periodic checks on creditworthiness of aggregators could be mandated, and days of commingling could be tightened if any deterioration is found. An additional safeguard is a bond or a collateral account put up by the aggregator and representing the maximum funds owed to the utility. Finally, says Duff & Phelps, a plan should be in place to transfer billing and collection responsibilities to an acceptable party, likely the utility, in case of an aggregator's financial difficulty or default.