[BETA] Fortnightly

Solving the electricity credit malaise.

"TCE, a [qualified scheduling entity] QSE in the ERCOT region, filed for bankruptcy protection in March 2003 … the outstanding principal amount owed to market participants at Jan. 1, 2005 is $13,692,188.37. … ERCOT intends to begin the process of uplifting to QSEs representing LSEs the principal amount remaining on TCE's payment obligation to ERCOT. … On Jan. 18, 2005, ERCOT will send invoices totaling $2.5 million to QSEs representing LSEs. … After this initial invoice, ERCOT will continue to uplift $2.5 million per month until it uplifts all remaining outstanding principal." ¹

Such was the news that greeted ERCOT participants the morning of Jan. 18. This situation is not unique, with many electricity spot markets ² around the world experiencing similar defaults in recent years-often in the millions of dollars.

In most electricity spot markets, the spot-market operator (SMO) ³ serves as the central counter-party to all trading, with any defaults socialized to the pool of all participants. Because participants do not have any knowledge of other parties' spot exposures and no way to manage these risks bilaterally, potential losses are both unpredictable and unhedgeable. As a result, participants are totally dependent upon the credit practices adopted by the SMO.

These credit practices, however, remain rudimentary in many spot markets. In the United States, most markets continue to operate on a monthly billing cycle, resulting in exposures of up to 60 days' settlement. Little collateral secures these exposures, with unsecured credit dispensed liberally. The likelihood of participant default-and the potential loss arising from such an event-is significant.

A better solution is required. Spot-market clearing provides the answer, using the sophisticated clearinghouse infrastructure that futures markets have evolved over many years, and extending it to the domain of spot electricity. Under this model the clearinghouse replaces the spot-market operator as the counter-party to all trades, and, more importantly, acts as guarantor, assuming all risk of counter-party default.

The Problem With the

Most electricity spot markets transact via a multi-lateral auction, in which the supply offers of all sellers and demand bids of all buyers are matched in aggregate. Because it is not possible to uniquely associate a single buyer with a single seller, this trading mechanism necessitates the use of a "central counter-party," which acts as the buyer to all sellers, and seller to all buyers. In most spot markets this role is performed by the SMO.

In the event of a default, the central counter-party is expected to ensure financial performance of all obligations of the defaulting party. In practice, however, the SMO does not have the balance sheet to carry this risk itself. As a result, most markets' rules call for any default amounts, in excess of the collateral being held, to be socialized to the remaining participants according to a pre-determined formula, often unique to that market. Because participants do not have insight into each other's spot-market exposures, these socialized amounts are both unpredictable and unhedgeable.

This would all be moot if the magnitude and probability of default were both sufficiently small that they