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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

perform this by marking the book against the market "mid-market" price. Consequently, the WSPPA could be interpreted as suggesting that in calculating gains and losses the replacement contract could be valued using the "mid" price and not the bid or offer.

However, as in the ISDA contract, the definition of a replacement contract comes into play here. First, the reader is again left hanging as to whether a replacement contract must be for the exact specification, term, and volume, or may be a reasonable approximation. Second, the valuation of large, illiquid contracts is not specified. Yes, the mark-to-market at the time of termination may be indicative of value, but that was for contracts that were already executed and in the portfolio-not for a replacement contract. A daily mark-to-market is not the value at which the book could be liquidated and replaced; rather, it is the book's indicative value compared to standard-sized transactions valued at their mid-points. The contracts that must be replaced have additional costs associated with them, such as replacing the contracts at either the bid or the offer, rather than at mid-market plus possible brokerage charges.

If one looks at the definition of costs under the WSPPA, the determining party is permitted to recoup any transaction costs associated with replacement. Surely, one of the major transaction costs associated with replacing a contract (especially if one replaces it instantaneously to reduce market risk) is the difference between the value of the replacement contract and its mark-to-market price at the time of termination. This would be the difference between the bid and mid-market prices or offer and mid-market prices associated with contract replacement. Consequently, the WSPPA could be interpreted as sanctioning the crossing of the bid-ask spread; it's just that it may be defined as a transactional cost as opposed to a conventional gain or loss.

Interpreting the MPPSA

Unfortunately, the MPPSA also is lacking in guidance. Similar to the ISDA and to a lesser extent the WSPPA, the MPPSA does suggest that due to potential illiquidity of electricity markets it may be difficult to replace a contract instantaneously. However, it stops short of providing any real guidance as to how market illiquidity should be factored into the calculation of termination payments ( see sidebar “A Reference: Reading The Fine Print,” below ). Each of these master agreements has its own quirks and provides its own vague guidance as to what is meant by commercially reasonable.

All the agreements stop short of providing any real guidance regarding the commercially reasonable calculation of a close-out or settlement amount. Consequently, we need to look to industry standard practices to provide us with a definition regarding what "commercially reasonable" valuation really is.

Standard Practice and Commercially Reasonable Valuation

A commercially reasonable valuation must take into account the liquidity of the contracts in question. The three agreements that we have reviewed above do not address exactly how this should be done. They do address the concept of instantaneous recovery, however. This is important; in volatile markets such as power, the non-defaulting party must replace the contract