EEI's contract is ready to go for physical trades of electricity, but the architects say it's likely too late to make a difference this summer.Will the return of summer again find power marketers glued to computer screens, watching for that killer price spike that in minutes could wipe out a year's worth of profits?
The fear is real. Suppliers who default can cause havoc if the underlying contract for physical energy delivery fails to spell out the financial liabilities. And in the past, that's been the case in U.S. power markets, says Chuck Shivery, president and chief executive officer at Constellation Power Source.
"Part of the reason we have contractual risk," he notes, "is because there is not standardization within the industry. Everything works well and [then] when there are problems, you get into significant disagreement about this term or that term."
Yet all that may change - and for the better - if the industry embraces the long-anticipated standardized contract for physical trades of electricity, which was introduced in New York city in April, at a conference sponsored by the Edison Electric Institute.
The contract, developed by EEI, the Alliance of Energy Suppliers, and the National Energy Marketers Association, defines a common set of terms for physical transactions for both utilities and marketers. EEI's work to create the contract was spurred by the finding that differences in legal terms have magnified financial problems for energy companies in times of market stress.
The new contract creates six precisely defined physical electricity products: 1) Non-firm energy, 2) Unit firm, 3) System firm, 4) Firm with liquidated damages, 5) Energy "into" a delivery point, and 6) Firm with no force majeure exception. Also, the contract is flexible enough to allow electronic agreements on trades, and many of the real-time credit provisions fit well in that online environment, say analysts.
In fact, EnronOnline, an Internet-based transaction system for trading energy-related products and other commodities with Enron, is working with Standard & Poor's to create a real-time credit system, according to an S&P executive. Enron executives hope such a system would prevent defaults from increasing as a result of the quick pace of online trading, he explained.
In addition, there are provisions that can be added within the contract allowing for further financial guarantees, collateral, or letters of credit in response to a standard counterpart's ratings downgrade. Of course, that option would apply to both companies in a bilateral agreement. (For more details, see "EEI's Master Contract: If You Draw It Up, Will They Trade?" , Jan. 1, 2000, p. 38.)
Overall, EEI and others believe that these new definitions (and other rights and duties specified in the contract) will make traders more confident. They hope to avoid the pitfalls of the summer of 1998, when price spikes and market defaults focused industry attention on credit concerns and risk management, and those of last year as well, when events drew attention to inconsistencies between tariffs and contracts.
"What obligations or liabilities do you have?" asked one speaker at the April meeting.
"If the power does not come, don't call HoustonStreet.Com," one executive cried. Because online trading systems do not take title to the power, he added, a standard contract is the only hope of seeking damages when a counterpart fails to deliver power.
But will utilities embrace the new contract?
Shivery recalls how difficult it was for energy traders to persuade utilities to sign on to new commercial contracts prior to electric deregulation. yet he is confident they will come around."The commercial aspect of the business from a contractual standpoint is not very consistent. It has to change."
And it will change, he says, because of people who are "as sophisticated as the largest power marketers and truly understand these deals."
The Fine Print: Who Won, Who Lost
Could you describe the various firm power products?
Katz: We have firm [power] with liquidated damages (LD), the most iron-clad product without almost any out. There is a firm product without LD. There is an "into" product, which has very limited outs involved. Beyond these, [there are products] that are really not firm. You have unit firm vs. system firm.
Who got what they wanted - the utilities or the marketers?
Katz: What the marketers wanted was very tight provisions, a very definite and final transaction-execution process where the deal is cut on the phone and a written confirm memorializes the deal. Once that process is finished, the deal becomes a binding obligation.
On the utility side, you have more concern about the physical things that utilities have to be worried about as sellers, which sort of created the desire to have more outs for performance based on transmission-related events. The utilities really drove the unit firm and system firm products. From a marketer's perspective, the "into" and the firm product with liquidated damages may be the product that they want to be trading 90 percent of the time.
How does the contract define ?
Katz: It is considered an unanticipated unforeseen event beyond the control of any party. It cannot be financially based; in other words, it cannot be based on the price of the product and the market. A transmission outage in and of itself, like a TLR [transmission loading relief] - it does not excuse performance in order to have the right to be excused from performance under the gold-plated definition. There has to be other facts and circumstances demonstrated. The level of event has to be where anyone would have been prevented, that there is no way that you would have been able to perform.
Who won the debate over the clause?
Katz: There has been a lot of interest in the fact that the EEI contract has a very tight definition. What has been changed in the latest release of the contracts is a new option that can be selected in a particular transaction to add a transmission contingency out as another feature of the trade. So [if] people are doing a delivery in an area where there might be a known transmission-related problem, they can hedge their obligation. They can add that. Of course, that will have some effect on the price. But it also, from a seller's perspective, gives additional comfort level. This was probably something that was pushed more from the people that were more concerned with the physical aspect of trading rather than the financial.
McMahon: The hope is that this contract will start to address the issue of these defaults and how you unwind transactions if and when those things happen. Secondly, [the contract] will bring in more and more participants because, as you know, the trend in utility deregulation and the mega-trends are [that] many distribution companies are divesting themselves of generation. So in order to meet their native load demand, they need to go out and basically purchase all their power in the spot market and the commodity market. These markets can go one of two ways. They can either develop into much more liquid, broader markets with broad participation, or they can go the other way.
Any mechanism for dispute resolution?
Katz: Still not specified, but I can tell you that there are parties in particular trading relationships that will do that on a bilateral basis.
What about changes in taxation?
Katz: Still undefined.
And the significance of bookouts, circles, and daisy chain transactions?
Katz: Still undefined.
Negotiating the Deal: The Confirmation Process
Can traders add their own contingencies? When do new provisions become binding?
Katz: With the confirmation process, there is an option in the contract for whether an unobjected-to confirmation becomes binding under the agreement. If the parties agree, you can have a contingency where if the confirmation contains new terms beyond the essential commercial terms like price, deliver point, whatever; for instance, an alternative dispute resolution provision can be added.
Who does this rule favor - utilities or marketers?
Katz: This was a tension between the marketers and the utilities. The marketers have built out their back-office and mid-office staff that are geared up to accommodate all this processing. They didn't have any problem with confirms going back and forth because they have the failsafe mechanisms established to scan anything that comes in and be able to object within the three-day window that is built into the default confirmation process in the contract.
The utilities, on the other hand, are just gearing up to build out their offices to handle the more dynamic processing of the transactions. So many of them desired to have this other option so that if for some reason this new confirm comes in with new terms and doesn't get caught, they are not necessarily on the hook for those additional terms.
My sense is that as the market evolves, you are going to see less reliance on that because I think everybody wants finality to get the deals done quicker. That is just the general trend in these transactions.
Complying with FERC Rules: What Utilities Need to Know
Will traders be required to file their contracts at the Federal Energy Regulatory Commission?
Katz: This is an activity that we were involved with in February. We arranged a briefing with FERC staff to discuss the documentation of transactions that would be executed under the master agreement. This is primarily a concern of the utilities because utilities, under current FERC policy, have a heavier reporting burden than the marketers do under their policies. This was a critical step in gaining utility acceptance of the contract because if there was going to be an overly burdensome process, [then] it would be difficult for the utilities to transition from their existing tariffs over to the type of tariff that would be compatible with using the EEI master. There would have been a lot of resistance to it being used by the utilities.
What developed in your meeting with the FERC?
Katz: The purpose of the meeting was to try and iron out those concerns. There were also concerns from all corners with termination [when] the counterpart has gone bankrupt, and FERC has definite rules on how you end a jurisdictional transaction. There are time periods involved. There is a lot of concern about two summers ago, with the Power Company of America bankruptcy. You had counterparts that wanted to stop their trading relationship with PCA, and FERC was saying there is a 60-day filing and notice period. Meanwhile, you are under contractual obligation to keep dealing with this party that you know probably won't be paying you. So there was a lot of concern about that.
How have you resolved that conflict?
Katz: The contract has real-time credit protections and protections in the case of a bankruptcy or other type of event [that] would obviously prevent the counterparty from performing its obligations with you. The remedy under the contract is you can just call a halt to every transaction that is on your book, and you calculate the termination amount and cash out and end your trading relationship. There was concern that FERC's requirements would somehow prevent those provisions from operating in the way that they were intended to operate, another very important protection. The meetings we have had with the FERC staff were very positive. On the documentation side, FERC has said that it will be very flexible with how the contract gets documented. They are going to require minimal documentation for what they call short-term transactions. Those are transactions that are for a year or less.
Will the contract conform to utility tariffs? Is that important? Why is that important?
Katz: The reason that is important is that under FERC law the terms of the tariff, to the extent that they conflict with the terms of a contract, will trump. Therefore it is very important that the tariff be consistent with the terms of any service agreements or contracts that people operate under.
So on the utility side, the staff was very receptive to using streamlined documentation. The contract for transaction of a year or less does not have to be on file. That is a critical point because under the FERC ruling in the PCA case, you don't even have a problem with terminations under their 60-day notice requirements for documents that don't have to be documented. It doesn't, so you really are not burdened.
On the other hand, there are the more burdensome aspects from the utility standpoint, and the way [FERC has] changed their policy is that utilities must continue to document their long-term transaction for longer than [the] year they want the contract. They want the confirmation letter that documents that particular trade on file at the FERC. In the course of this meeting, we reached an understanding that they are going to be accommodating with respect to terminations under the long-term agreements.
now under appeal in federal court in
In that case the FERC ruled that when a utility has authority to sell electricity at wholesale at market-based rates, and has an "umbrella" tariff on file that allows it to sign individual deals without filing a deal-specific tariff, then if a supplier defaults, and the utility decides to cancel the deal, it need not file any formal document other than a simple notice in the . PCA has appealed, arguing that the new FERC rule conflicts with FERC precedent set in the 1996 Portland General case . Commissioner Massey also has doubts, and favors a formal filing requirement, since he believes that the FERC might want to take a look at a contract cancellation, since, in his view, a contract to supply "firm" energy is not entirely "discretionary."
Final briefs in the PCA appeal are due Nov. 17, and the court has set oral argument for January 2001.]
What about the FERC's plan for RTOs - the regional transmission organizations?
Katz: There are a number of ways that it could affect the contract. I am not so sure that the bilateral market is going to go away just because there is centrally dispatched power in the Northeast. There still can be active trading between two counterparts. Even if the source of the power comes out of the pool, power can change hands in multiple daisy chains. So it can be used in multiple-party daisy chains. Where it is going to have an impact will come really in the application in some of the obligations. That is a detail that is not defined in the contract. There are obligations to arrange for transmission. To the extent that there are new rules for that created in the RTOs, that will have an impact on the underlying obligation to arrange for transmission in the contract. That does not change the obligation in the contract.
What is possible is that there may be new products emerging in these markets based on how the RTO's geographic scope and how the pools develop that we have not anticipated yet. Our group intends to keep working to review the contract, its relevance in the market, and on a going-forward basis, make any needed enhancements.
Looking Forward: The Contract Début Will the contract make a difference this summer?
Katz: I have a feeling, given where the contract is, that this summer's market will probably not realize the full effect of what the contract can do. The contract was really finalized on March 3, and deals that are being cut for the summer really started in February for the forwards contract transactions. Since the agreement was really final in March, it is going to take awhile before those transactions are covered by the contract. The summer will be too soon for there to be an effect.
If not, how will you measure success?
Katz: I don't know of anybody that can guarantee no defaults. One measure of success might be a reduction beyond what I understand to be a very small number to begin with in disputed transactions; 99.5 percent of transactions in the wholesale market clear without any controversy whatsoever. To that extent, it is the 0.5 percent that gets the headlines. To the extent that [the contract] reduces disputes, I would say that is a measure [of success].
The other [measure] would be to see entities that haven't been playing in the wholesale market in an active trading situation start entering the market. That is one area where I know there is a lot of interest in using the contract because there are some of the more traditional utility potential entrants into active wholesale trading that like the protections afforded by the contract. I think you will probably see new names coming up over the course of the year. That will be another measure of success. You will have more liquidity because there will be more people playing in the market.
McMahon: Right now the bulk of the transactions [is] physical and the derivatives side [is] some fraction of the physical. Hopefully, this contract and other initiatives will help the market get more like other mature commodity markets where physical market is one thing and the derivative market is some multiple of the physical market, which would also help to address the volatility issue.
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