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The unclear language governing termination rights is subject to interpretation and extraordinary financial risk.
become more pervasive whereby, ironically, adequate assurance—conventionally a tool to guarantee performance—has been used as a tool to ensure non-performance. Consider the following example:
Example 2: Adequate assurance as a tool of termination
a) First party is downgraded to sub-investment grade by the rating agencies;
b) First party looks to monetize in-the-money positions to enhance cashflow;
c) Second party is downgraded to sub-investment grade by the rating agencies;
d) First party requests adequate assurances to ensure performance of contract;
e) Second party offers assurances deemed sufficient to ensure performance; and
f) First party deems all offers of adequate assurance unacceptable and terminates the contract and demands settlement amount.
The above example is similar to example 1, with one important exception: There no longer are two willing parties to the contract. This is the key difference between adequate assurances being used to ensure performance and being used to ensure non-performance.
The first party now appears to have an internal and ulterior motive for contract termination; the party needs to improve its credit rating.
This has been widespread in the energy trading industry in the past few years, with companies triggering terminations either to accelerate cashflows from in-the-money positions or in some instances using it as a vehicle to expeditiously exit the business altogether (and signal to the rating agencies they have shelved their devilish trading businesses). Surely, however, these motives are not commercially reasonable or in good faith. Why should the financial viability of the first party be a motive for requesting and then not accepting adequate assurance? Is adequate assurance not a tool to ensure financial performance of the second party?
To ensure commercial reasonableness and good faith, it is imperative that at all times the financial health of the first party be kept totally independent of decisions involving the request and acceptance of adequate assurance. That is not to say, however, that if the first party has itself experienced a previous credit event it has relinquished its right to demand future adequate assurances from the second party. It is commonplace, especially in physical transactions, for a contractual relationship to continue with sub-investment grade counterparties if it ensures surety of supply and business continuation. The first party should not be held hostage to a second party default simply due to the fact it has its own credit issues. Again, the financial health of the first party should be independent of the request and acceptance of adequate assurance from the second party.
Adequate assurance is an invaluable credit protection method if well defined and used in a commercially reasonable manner. However, the absence of clear definitions coupled with the widespread desire for early termination in a credit-constrained power industry has created perverse incentives, whereby requests for adequate assurance increasingly have been used as a means to guarantee non-performance. This is contrary to standard market practice. The sole purpose of adequate assurance is to encourage performance and maximize the probability that a contract runs to expiration.
Assurances when offered must be reviewed in depth and not dismissed out of hand. Both parties must exercise