Gatekeeper of Risk: The ISO's Forgotten Function?
to be evaluated. As one might expect, ISOs with credit standards that demonstrate weakness in some or all of these areas pose a higher credit risk than ISOs that show strength .
1. Membership Standards. Credit standards for membership in an ISO provide important insight into overall credit strength, because an ISO can only be as strong as its weakest member company. Although all four ISOs have similar legislative mandates, they vary in the credit standards applied for membership.
For example, on an unsecured basis, the California ISO will accept a company for membership only if it has a commercial paper rating of A1 or P1 as measured by Standard & Poor's and Moody's Investors Service respectively. The New York and New England ISOs, on the other hand, base new member acceptance on an unsecured debt rating, which is a longer-term credit measurement. The New York ISO will accept members on an unsecured basis, as long as they have a debt rating of at least BBB, while the New England ISO accepts members with a rating of BBB- or higher. The difference in credit measurements applied is further illustrated by PJM. Although this ISO is required to perform credit reviews in accordance with standard commercial practices, it is not required to base credit decisions on a minimum accepted rating benchmark.
Credit strength also is related directly to how comprehensive the credit standards and practices are and whether they are clearly defined and enforced. An appropriate check includes thoroughly assessing the tariff and comparing a current membership list, when available, to these credit standards. To be effectively implemented, credit standards need to be transparent and understood by ISO staff and participants alike. In addition, the level of detail requested in the credit application process can provide additional insight into overall credit practices.
2. Loss Allocation. In the event of contract default, the mechanism applied by the ISO for dollar loss allocation will determine the potential financial impact. The dollar amount of this exposure is linked closely to overall credit standards and whether collateral is posted and sufficient to cover amounts owed. The most liquid forms of collateral include cash and letters of credit. Given that these are also the more expensive forms of collateral, when required, most participants post less-liquid forms such as parent guarantees and surety bonds.
Although tariff language varies, all four ISOs can pass credit-related shortfalls on to participants. The standard approach is to allocate losses on a dollar-weighted basis to participants that were net sellers during the time period in which a loss occurred.
3. Demographics. Given that credit-related losses are allocated among members, ISO demographics including the number, composition and diversity of participant industries will assist in determining the level of shared exposure. In general, for a given fixed-dollar amount of loss, the higher the number of ISO participants, the smaller the loss assumed by any one participant. Moreover, participant mix and regional economic diversity will influence whether a credit event is isolated or part of a systemic event.
For example, a good member cross-section might include a