Seven steps for evaluating how well the ISO manages credit standards for its members.
To date, the power industry has viewed independent system operators (ISOs) as tariff supported, non-profit organizations that pose little to no credit risk, but that assumption deserves a second look.
Especially, as these agencies grow in number and membership, and trade greater volumes of electricity, the credit standards applied for membership will become increasingly important.
The credit standards used should be of particular interest to large sellers of power, such as investor-owned utilities, that traditionally have significant receivables exposure. In this regard, the ability to effectively evaluate the standards applied, including the level of daily oversight, is of paramount importance. This point is further reinforced by the fact that public rating agencies such as Standard & Poor's, Moody's Investors Service, and Duff & Phelps do not yet evaluate the credit risk of the ISOs.
The physics of the U.S. transmission system suggests that a handful of ISOs, regional transmission organizations (RTOs), transcos or their equivalent eventually will represent a substantial portion of overall trade volume. At the same time, however, the legal structures and funding mechanisms of the ISOs insulate them from default. That makes it all the more important to scrutinize the credit strength of members that comprise an ISO. In fact, for credit purposes, an ISO functions essentially as a pass-through entity where the true risk is linked to the quality of membership. It is the members - the power generators and suppliers - that bear the financial risk for any losses incurred as a result of contract default.
Before assessing the relative strength of credit standards used by an ISO, it is first important to understand why ISOs have been legislated and put in place. In April 1996, the Federal Energy Regulatory Commission's Order 888 was enacted to foster greater utility-industry competition by mandating that all wholesale users of the U.S. transmission system have equal access to transmission facilities. One response to this order has been the creation and adoption of non-profit ISO structures that assume the daily operational responsibility for designated transmission control areas. Since Order 888, four regional ISOs have been put in operation and perform the daily clearing function. The PJM Interconnection on Jan. 1, 1998 became the first power pool to adopt an ISO structure, followed by California (April 1, 1998), New England (July 1, 1999), and New York (Nov. 18, 1999).
Responsibilities include providing independent, open, and fair access to regional transmission systems and efficient dispatch of generating resources, as well as reliable management and operation of the bulk power system. These regional ISOs play a critical role in setting credit standards and in determining the quality of trading counterparties.
[: Although there are other ISO's which are either in operation (e.g., ERCOT) or are in start-up phase (e.g., MidWest), only the four ISOs detailed in this article are empowered to perform daily settlement, impose credit filters which materially influence the credit quality of regional power pools.]
In assessing overall creditworthiness, there are seven distinct credit-risk drivers, which need to be evaluated. As one might expect, ISOs with credit standards that demonstrate weakness in some or all of these areas pose a higher credit risk than ISOs that show strength .
1. Membership Standards. Credit standards for membership in an ISO provide important insight into overall credit strength, because an ISO can only be as strong as its weakest member company. Although all four ISOs have similar legislative mandates, they vary in the credit standards applied for membership.
For example, on an unsecured basis, the California ISO will accept a company for membership only if it has a commercial paper rating of A1 or P1 as measured by Standard & Poor's and Moody's Investors Service respectively. The New York and New England ISOs, on the other hand, base new member acceptance on an unsecured debt rating, which is a longer-term credit measurement. The New York ISO will accept members on an unsecured basis, as long as they have a debt rating of at least BBB, while the New England ISO accepts members with a rating of BBB- or higher. The difference in credit measurements applied is further illustrated by PJM. Although this ISO is required to perform credit reviews in accordance with standard commercial practices, it is not required to base credit decisions on a minimum accepted rating benchmark.
Credit strength also is related directly to how comprehensive the credit standards and practices are and whether they are clearly defined and enforced. An appropriate check includes thoroughly assessing the tariff and comparing a current membership list, when available, to these credit standards. To be effectively implemented, credit standards need to be transparent and understood by ISO staff and participants alike. In addition, the level of detail requested in the credit application process can provide additional insight into overall credit practices.
2. Loss Allocation. In the event of contract default, the mechanism applied by the ISO for dollar loss allocation will determine the potential financial impact. The dollar amount of this exposure is linked closely to overall credit standards and whether collateral is posted and sufficient to cover amounts owed. The most liquid forms of collateral include cash and letters of credit. Given that these are also the more expensive forms of collateral, when required, most participants post less-liquid forms such as parent guarantees and surety bonds.
Although tariff language varies, all four ISOs can pass credit-related shortfalls on to participants. The standard approach is to allocate losses on a dollar-weighted basis to participants that were net sellers during the time period in which a loss occurred.
3. Demographics. Given that credit-related losses are allocated among members, ISO demographics including the number, composition and diversity of participant industries will assist in determining the level of shared exposure. In general, for a given fixed-dollar amount of loss, the higher the number of ISO participants, the smaller the loss assumed by any one participant. Moreover, participant mix and regional economic diversity will influence whether a credit event is isolated or part of a systemic event.
For example, a good member cross-section might include a mix of utilities, municipalities, cooperatives, energy majors, power marketers, as well as regional and national energy companies. This regional cross-section with a broad economic base, in turn, would reduce the likelihood of a correlated credit event. The number of participants for California, New York, New England, and PJM is approximately 70, 80, 145, and 160, respectively. The largest portion of net sellers in all four regions are investor-owned utilities. Such useful demographic information is available and updated frequently on the ISO Web sites.
4. Operational Experience. Do not discount the importance of the number of months or years an ISO has been in operation; it is a good measure of its ability to perform, work out problems and maintain credit controls. As a case in point, while the California ISO's initial 1998 launch date was delayed approximately three months, over the last year, this entity has continued to demonstrate strength in its credit controls and ability to modify changes when deemed appropriate. The historical default level of ISO participants also is a good measure of credit standards and overall control practices. Although the four ISOs have not experienced participant-related defaults, it is important for them to stand ready should any such events occur.
The scope and frequency of internal audits conducted is another strong indication of the overall control environment. For example, an ISO's successful completion of the rigorous SAS 70 audit ("Statement on Auditing Standards No. 70") indicates that appropriate controls are in place. PJM recently completed its SAS 70. The document is accessible on the Web and well worth reading.
5. Staff Turnover. Management strength and the level of overall turnover can provide insight into an ISO's ability to maintain focus and meet specific mandate requirements. In this regard, the experience level and backgrounds of senior management and the person(s) responsible for credit management are important. Excessive turnover at the top and at critical functional areas, such as credit, could be an early warning that appropriate leadership and credit focus is not being maintained. Although this information is not freely posted on ISO Web sites, it usually can be obtained through inquiries and by comparing notes with other market participants.
6. Regional Price Volatility. The level of power price volatility associated with a given ISO region can significantly influence the inherent price risk borne by all participants. For example, the volatility of spot power in California historically has been substantially less than the volatility experienced in New England. During summer months, spot volatility in New England can be three times as high as that experienced during the same period in California. In assessing the credit standards applied by the ISO, it is important to understand price risk and how the ISO is managing this exposure. In calculating volatility, it is useful to apply a three-month rolling average. To a greater extent, price risk is managed through higher minimum credit requirements, as well as through collateral requirements imposed on weaker members. Given the close correlation between price risk and credit risk, ISOs located in regions with higher power-price volatility need to have higher credit standards than those located in regions with lower volatility. The highest regional spot volatilities experienced to date, in descending order, have been in New England, New York, PJM, and California.
7. ISO Billing Cycles. Lastly, the length of billing cycle extended by the ISO to its members is an extension of credit and provides insight into the potential for credit risk. That is especially the case given that power prices in certain regions of the country can spike over short periods of time and result in sizable accounts receivable positions. From a credit perspective, ISOs in regions with the highest price volatility should have the shortest billing cycles. Billing cycles at the ISOs range from a high of approximately 80 days (California) to a low of approximately 45 days (New York). New England and PJM fall in the middle, with average billing cycles of approximately 50 and 60 days, respectively. As mentioned, California historically has experienced the lowest price volatility while New England has experienced the highest.
As the number and membership of regional ISOs continue to expand and the volume traded through these entities increases, the focus on credit standards applied will be increasingly important.
Although the number and diversity of ISO participants will surely reduce the potential dollar exposure, there is no substitute for strong credit practices.
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