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Solving the electricity credit malaise.
guarantee is only as good as the organization providing it, and the market must be confident that the counter-party won't itself fail-the California Power Exchange providing a salutary example. As stated more eloquently by Mark Twain in Pudd'n'head Wilson, "The wise man saith, 'Put all your eggs in the one basket and-watch that basket!'"
Protections and Safeguards
Clearinghouses preserve their financial integrity through a system of rigorous processes and robust guarantees. Spot-market clearing uses these same safeguards, modified as appropriate to fit the unique characteristics of electricity spot markets.
All positions held at the clearinghouse must be secured by collateral-specifically liquid redeemable instruments such as cash, treasury instruments and letters of credit-in accordance with the risk they present. Unsecured credit is not accepted, be it based on balance sheet, parent guarantee or IOU. 7
Credit risk is determined based upon a probabilistic assessment of potential credit exposure. This is the total exposure which a participant might incur by the time a default is detected and resolved, calculated to a given statistical likelihood. Due to the inherent volatility of electricity spot markets the calculation of potential exposure, as with futures markets, must be performed on a daily basis. The method of calculation, however, differs significantly between these two types of markets.
In futures markets, potential exposure is usually based upon the worst one-day move, within the chosen statistical bounds ( e.g., 99 percent), this being the exposure that can be incurred between when risk is assessed and when the position can be liquidated in the event of default. In electricity spot markets there usually is no position to liquidate, as the power has been, or is being, consumed by the time a default can be detected. Instead, potential exposure is determined based upon the (statistically determined) settlement liability that might be incurred between assessment and detection-or resolution. 8
The authors have undertaken significant work with NYMEX to identify methods for calculating and managing spot-market exposures, not just for real-time and day-ahead electricity, but the broad range of charges and payments associated with most electricity spot markets ( e.g., ancillary services, capacity, etc.).
One of the more attractive features of the clearinghouse collateralization model is the ability to perform portfolio margining. Many organizations are active in multiple electricity spot markets and the futures market, often with collateral assessed and posted separately for each. Consolidating all of these positions at the same clearinghouse allows credit exposure, and hence collateral, to be determined on a portfolio basis, with the potential to generate significant offsets between positions with correlated risk. Potential markets against which collateral offsets can be provided include:
- Positions in other electricity spot markets;
- Electricity future;
- Contracts for major fuel sources, such as natural gas, coal and fuel oil; and
- Other commodities with a significant linkage to electricity, such as weather and emissions credits.
To effectively provide these benefits, however, the clearinghouse must have a material standing in the markets in question. This makes the provision of collateral offsets between spot and forward markets a far more realistic proposition for organizations