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Mastering the Mastering Agreement

Special Series Part 5:  How to find "commercially reasonable" valuation in power contract terminations.

Fortnightly Magazine - May 2005

unreasonable. When can this occur? In extremely illiquid and volatile markets (such as electricity) where bid/ask spreads are extremely wide, the ISDA could be interpreted as suggesting that replacing terminated transactions instantaneously is commercially unreasonable. By instantaneously replacing contracts, we mean replacing contracts to sell at the price somebody is instantaneously willing to buy (the bid price) or replacing contracts to buy at the price somebody is instantaneously willing to sell (the "offer" or "ask" price). It should be noted that the ISDA contract is vague here and does not specify exactly when a contract should be replaced.

Third, the ISDA master agreement suggests that the determining party should use quotations for replacement transactions from brokers or other third parties to calculate the close-out amount. What is a replacement transaction? Must it fit the exact term, volume, and other specifications of the original? And what price is applicable from the third parties? The bid, the offer, the mid point, or somewhere in between? Again, guidance appears to be fuzzy to nonexistent.

The ISDA master agreement further suggests that we can apply different valuation methods depending on the type, complexity, and size of the transactions. The use of different valuation methods for different types of transactions is logical and part of normal business practices. After all, different models and techniques were used in the original pricing of the instruments and should be used to determine their termination value as well.

What is interesting here is that different valuation methods can be applied depending on the size and type of the original transactions. Market liquidity is therefore a factor, albeit difficult to quantify. Valuing 25 MW at a liquid location is very different from valuing 1,000 MW at an illiquid location. Brokers generally transact in liquid locations and for standard contractual volumes (25 to 50 MW). Therefore, the first example could be valued directly from several broker quotes in a straightforward manner. The second example is more difficult as it would be extremely difficult to find a replacement in a short period of time. Further, in this case broker quotes would no longer be an appropriate or relevant vehicle for valuation since they are for much smaller volumes and most probably represent the opinions of a very small number of market participants. The ISDA is silent on how to proceed.

Interpreting the WSPPA

Again the phrase "commercially reasonable" appears. Does the WSPPA provide any further guidance as to what is really meant by this term? Not really, but there is some guidance that merits further investigation and comment ( see sidebar “A Reference: Reading The Fine Print,” below ). First, the statement that gains or losses should be determined as though the terminated transactions had "not been terminated" is interesting. What does this mean? Does the term "not been terminated" imply that the settlement value should equal the transactions' mark-to-market value at the time of termination? In the normal course of business, companies engaging in electricity trading mark their books to market to determine their fair-market value. In the majority of instances, energy traders