Commission Watch

IOUs, RTOs duke it out over standardization.
Fortnightly Magazine - September 2004

Commission Watch

IOUs, RTOs duke it out over standardization.

Have regional transmission operators (RTOs) and independent system operators (ISOs) asked for excessive levels of credit from customers, to the extent that the burdensome requirements foreclose full market participation by competitive entities? The Federal Energy Regulatory Commission (FERC) must face that difficult question as it investigates whether to institute a rulemaking on credit-related issues for service provided by ISOs, RTOs, and transmission providers.

Finding the right balance is critical. Higher-than-needed credit requirements imposed on market participants by RTOs/ISOs exacerbate the financial strain on those participants, reducing the amount of participation and liquidity in the market. Lower liquidity then reduces customer choices, transparency, and competitiveness of the market.

RTOs or ISOs currently act as settlement agents between buyers and sellers in electric market transactions. An RTO/ISO determines each customer's risk profile and collects collateral based on that profile to protect against losses from defaults. Bad debt, when it occurs, is spread across all remaining market participants.

FERC notes that transmission providers are entities that provide electric transmission service but are neither ISOs nor RTOs, and credit concerns facing transmission providers and ISOs/RTOs differ. Those differences warrant varying approaches to creditworthiness requirements for those entities ().

The problem not faced by RTOs/ISOs is vagueness. A perceived lack of transparency exists in creditworthiness requirements in the pro forma Open Access Transmission Tariffs (OATT) used by transmission providers. FERC notes that OATTs do not provide specific credit standards and processes but require only that transmission providers use "reasonable credit review procedures" and that such review must be "made in accordance with standard commercial practices."

Because OATT standards are not clear and are not used by RTOs, FERC is trying to determine whether it should consider a similar course for the electric industry as it has taken for the gas industry. In the , FERC contemplates standardizing creditworthiness provisions in the natural gas industry ( ], FERC Stats. & Regs., Notice of Proposed Regulations 32,573 [2004]). FERC believes standardized provisions in general can be beneficial by promoting consistent practices across markets and utilities, while providing customers with an objective and transparent creditworthiness evaluation.


But on the electric side, the standardization issue has pitted utility companies against RTOs. The main concern is over flexibility. At a recent technical conference held at FERC headquarters in Washington, D.C., some participants, especially those from utility companies, were uneasy with the concept of standardization. The RTO and ISO reps, however, appear much more comfortable with it.

At that conference, utility company representatives described their credit policies under the OATT and interactions with transmission customers. They touted the need to account for individual variations that affect credit and to take part in "fuzzy" analyses. Tommy Lee, senior director for credit at Duke Energy, stressed that "maintaining flexibility is an absolute necessity," allowing companies to handle all contingencies that arise.

He said that flexibility is crucial in credit evaluations because within the utility industry risks can vastly differ. He pointed to some of those differences, including varying state regulatory frameworks, reserve margins, fuel costs, transaction volumes, and credit-risk portfolios.

Dan Santee at Arizona Public Service agreed. He noted that while utility companies do make a quantitative analysis, they need to be free to make a qualitative analysis.

Thomas Foster, director of Investments, Regulatory Finance & Analysis at MidAmerican Energy Co., argued that real harm could come from a standardized FERC policy with no flexibility. If FERC sets up a policy that demands transparency and is cast in stone, then it could keep analysts from doing their jobs and taking into account the individual variations among companies that occur in the evolving marketplace, he said.

Robert Klein, group risk director at PacifiCorp, saw no reason to change the approach used under the OATT. He suggested posting credit-risk policies on OASIS Web sites, adding that universal standardization "is a bad solution to a problem that doesn't exist."

Disagreeing With Utilities

In comments filed in the proceeding, various RTOs/ISOs agreed that standardization is needed (Re Electric Creditworthiness Standards, Docket No. AD04-8-000). The New York ISO strongly supports FERC initiatives to develop creditworthiness standards for certain aspects of the electric industry, based on accepted business practices and trade credit principles. Rooting standards in the familiar framework will help ensure adequate collateral requirements to protect from defaults, the ISO says.

The Southwest Power Pool (SPP) RTO agrees, stating that although standardization generally is beneficial, FERC needs to recognize the need for credit and security differences among the RTO/ISO markets, as it has with other regional variations. SPP adds that generic standards need to be tailored to markets and products of varying stages of development and complexity.

Alan Yoho, California ISO financial systems analyst, also disagrees with the utilities. He says the ISO would like to see a credit policy that includes standardization of criteria for establishing creditworthiness, limits on amount of unsecured credit extended to credit- worthy entities, definitions of default events, enforcement mechanisms, timelines, billing and settlement, and default provider issues. He calls for shortening of the settlement period, which he calls "the most important step the FERC can take right now to minimize credit risks."

Minimizing Risk

FERC is exploring methods to reduce credit/default exposure in RTO/ISO markets. RTOs/ISOs typically are non-profit entities that administer the market on behalf of market participants. Therefore, market participants collectively extend credit to each individual market participant. So if one market participant defaults, the remaining participants must make up the shortfall. And while some RTO/ISO markets use insurance to minimize risks, such insurance can be expensive.

One suggestion for minimizing risk is to shorten the period of time for settlement.

At the technical conference, Patrick McCullar, president and CEO of Delaware Municipal Electric Corp., advocated accelerated settlements only for higher-risk companies.

In their filed comments in the docket, Louisville Gas & Electric Co. and Kentucky Utilities Co., while recognizing that shortening the settlement period would cut the amount of collateral needed, expressed concern that such actions directly would conflict with most bilateral arrangements with settlement terms of "net 20 days."

PJM asserted that shortening the settlement period would be the most difficult and expensive option to implement, because it would require rewriting some of the most complicated software an RTO/ISO uses. On the upside, the rewrite would require only a one-time effort, with little or no recurring cost. PJM offered to FERC its recent proposal to the PJM stakeholder Credit Working Group as a possible solution, which would allow for voluntary, shorter settlement periods for participants, thereby allowing them to take advantage of the resulting reduced collateral requirements.

ISO New England (ISO-NE) said improved credit protection could be achieved via more frequent billing cycles, faster procedures for clearing transactions, and more frequent payment protocols. It also advocated shorter settlement periods, noting that financial markets such as NYMEX and NASDAQ rely on a daily settlement process.

ISO-NE, which has investigated those financial markets as a way to manage risk, said clearinghouse models used in those financial markets would increase the likelihood suppliers would be paid and would therefore lessen the default payment risk for the energy spot market administered by RTOs/ISOs.

What Next?

Executives from credit-related industries offered suggestions to FERC on how to resolve the problems with credit issues facing RTOs/ISOs.

Moody's KMV, a subsidiary of Moody's Corp., does not believe credit requirements for the wholesale electric transmission services should be standardized, but it does see a need for more sophisticated credit practices. It calls for the following guidelines:

  • Forward-looking default probability models such as Expected Default Frequency should be used for credit-risk assessment of public and private companies, rather than agency ratings alone;
  • Default probabilities should be placed in a well understood framework and mapped to a universal scale for public and private firms, allowing them to be understood across the industry;
  • Market measures of risk should be used to address the dynamic nature of credit risk and provide early warnings of credit events; and
  • Creditworthiness of firms should be monitored daily.
  • Peter Axilrod, managing director of the Depository Trust and Clearing Corp. (DTTC), the world's largest clearing infrastructure organization for all domestic cash trading and settlement in the United States, including stocks and bonds, points out that DTCC in the past 30 years has increased the size and efficiency of U.S. securities markets by removing counterparty risk and guaranteeing settlement of all securities contracts.

    But where energy markets are constrained by credit requirements, it isn't so easy to merely implement the DTCC method. Unique questions remain. Who will be the provider of last resort? How do you guarantee physical delivery of energy? Because of those differences, Axilrod urges taking an interim step by reducing the amount of collateral participants need to put up to participate in the energy markets.

    John Flory, who worked for the now defunct California Power Exchange and currently serves as president of North American Credit and Clearing Corp., wants his company to become the clearinghouse for energy transactions under the supervision of the federal Commodity Futures Trading Commission. He thinks one central counter-party to all the trades would make it easier and more productive to deal with one clearinghouse and establish one line of credit rather than to set up many lines of credit and establish separate collateral with many trading counterparties.

    Flory's company wants to take over all the credit risk for the RTOs and ISOs, similar to that done by the DTTC. He promotes bridging the financial and physical markets to ensure that physical and financial reliability reinforce each other. He says the challenge is creating a credit-clearing solution that fits the physical market and bridges to the financial energy markets.

    He calls for netting across market transactions-that is, treating electricity not as a commodity but as an accounts receivable, for spot and forward power, gas, and financial transactions. He also advocates multi-level clearing and says that netting allows significant reduction in cash requirements by freeing up the cash available to trade further forward.

    Mary Duhig, director of Aon Trade Credit, which focuses on mitigating credit risks, recommends credit insurance as a solution to mitigating risk of bankruptcies and late payments. The policies can be structured to fit needs. Prices vary depending on coverage and deductibles, which are determined by the level of risk clients are comfortable carrying on their balance sheets. She points to an ISO that wanted zero deductible on its insurance policy covering cooperatives with $100 million in annual revenue; the price was $150,000. She calls this type of insurance "very cost-effective especially when compared to derivatives." But questioning by FERC staff showed that they believe there is some reluctance on the part of RTOs to buy such insurance because of its high cost.


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