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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

some combination of all of the above. In this case, broker quotes are not applicable. Brokers transact in standard-sized pieces (25 to 50 MW) and standard locations. For that reason, they are not an appropriate vehicle to determine prices outside of their customary locations and volumes. For illiquid contracts, broker quotes simply give an indication as to where the market may be, but their opinions are speculative and generally unsupportable. Rather, for these types of complex transactions, a theoretical price must be modeled using visible and/or calculated model inputs.

When valuing illiquid contracts, it is important to calculate the replacement contract in line with the marking procedure followed in the normal course of business (after accounting for replacement costs and whether the bid or offer is applicable). For long-term transactions, price determination in the absence of identifiable and discoverable forward curves is obviously the issue. In this case, prices must be modeled to determine replacement cost. There are several techniques available here: external forecasts of long-term energy prices, basis spreads from more liquid locations, heat rates applied to natural gas prices, or the use of fundamental models. From the possible curves, theoretical prices can be determined by using a model with visible or calculated inputs. Obviously, as the number of possible curves multiply, so do the number of possible close-out values.

Adding to the possibilities is another valuation technique, the RFP, whereby results are used from previous RFPs for the product in question or for similar products. This is not as improbable as it seems; often complex products are solicited using an RFP process. In any case, several close-out values for the contract in question are obtained. If RFP results are available, applicable, and can be updated, these would represent the most accurate valuation, since they represent the value at which a party was willing and able to do the transaction in question.

None of the theoretical models are going to agree in value; such is the nature of the beast. At this point, this is a subjective exercise, with each value weighed for reasonableness, accuracy to observable data, and usage in the normal course of business. In the absence of more specific valuation guidelines in the governing agreement or in the specific contract, such contracts will most likely end up either in arbitration or litigation. Knowing that in advance is very helpful. In fact, the "litigation premium" can be discussed in the context of a "credit risk premium" and should be considered as part of the original transaction price for such instruments. In any case, thorough documentation concerning valuation during the life cycle of complex transactions can make such disputes much easier to defend.

There is still the issue of exact replacement, however. Some have made the argument that some of these contracts tied to a specific asset or circumstance are truly unique and are therefore irreplaceable. In our experience, however, this is rarely the case and is a disingenuous argument; almost all contracts can be replicated.

The vagaries of the master agreements can result in substantial differences in close-out values.