Mastering the Mastering Agreement


Special Series Part 5:  How to find "commercially reasonable" valuation in power contract terminations.

Fortnightly Magazine - May 2005

Contract termination should be easy. Consult the applicable master agreement, calculate the close-out amount, and send or receive a check. If only it were so. The well-publicized demise of key players in the energy industry has led to many counterparties failing to perform on their contractual obligations.

In the course of calculating settlement amounts, it has become apparent that many sections of the governing agreements, particularly those sections dealing with termination and settlement calculation, are maddeningly vague and unclear. Disputes and litigation have resulted, with many cases yet to be resolved.

Whereas the contractual language that defines an "event of default" is often clear (although even this seemingly straightforward topic can be subject to interpretation and dispute), the guidelines regarding the calculation of a "settlement amount" following an event of default often are not. The language within the majority of master agreements used in electricity trading remains murky and open to interpretation. Phrases such as "commercially reasonable valuation" or "settlement amount must be determined in good faith" are commonplace in electricity trading master agreements but are not clearly defined. In the absence of clear guidelines or standard industry practice, the settlement process often turns out to be litigious, protracted, and costly.

In this discussion, we investigate the guidance offered in the key electricity master agreements regarding the calculation of settlement amounts following an event of default and subsequent termination. We also illustrate what we perceive to be a "commercially reasonable" or "good faith" approach to determining settlement amounts.

Let's start by examining the three major contracts most common in power trading: the ISDA Master Agreement, the Western States Power Pool Agreement (WSPPA), and the Edison Electric Institute (EEI) Master Power Purchase and Sales Agreement (the EEI agreement).

Interpreting the ISDA Master Agreement

So what does all this contractual jargon mean from a financial perspective? Is there really any concrete guidance here to assist us in determining a commercially reasonable "close-out amount," or do we have to rely on our own interpretation of commercial reasonableness? As is usual with power contracts, the answer lies somewhere in the middle (see sidebar, “A Reference: Reading The Fine Print,” below).

First we are told to act in good faith and use commercially reasonable procedures, , behave in a fair, reasonable, truthful, and equitable manner. In fact, the Uniform Commercial Code (UCC) demands "honesty in fact and the observance of reasonable commercial standards of fair dealing." An assumption of good faith runs through all aspects of the ISDA as well as all other power contracts, from original execution, to the decision to terminate, to the determination of a fair and reasonable settlement amount. That should not be taken lightly; duplicitous or disingenuous behavior in negotiation, termination, and settlement is forbidden.

Second, the ISDA seems to provide for contract replacement over time if instantaneous replacement is deemed to be commercially unreasonable. When can this occur? In extremely illiquid and volatile markets (such as electricity) where bid/ask spreads are extremely wide, the ISDA could be interpreted as suggesting that replacing terminated transactions instantaneously is commercially unreasonable. By instantaneously replacing contracts, we mean replacing contracts to sell at the price somebody is instantaneously willing to buy (the bid price) or replacing contracts to buy at the price somebody is instantaneously willing to sell (the "offer" or "ask" price). It should be noted that the ISDA contract is vague here and does not specify exactly when a contract should be replaced.

Third, the ISDA master agreement suggests that the determining party should use quotations for replacement transactions from brokers or other third parties to calculate the close-out amount. What is a replacement transaction? Must it fit the exact term, volume, and other specifications of the original? And what price is applicable from the third parties? The bid, the offer, the mid point, or somewhere in between? Again, guidance appears to be fuzzy to nonexistent.

The ISDA master agreement further suggests that we can apply different valuation methods depending on the type, complexity, and size of the transactions. The use of different valuation methods for different types of transactions is logical and part of normal business practices. After all, different models and techniques were used in the original pricing of the instruments and should be used to determine their termination value as well.

What is interesting here is that different valuation methods can be applied depending on the size and type of the original transactions. Market liquidity is therefore a factor, albeit difficult to quantify. Valuing 25 MW at a liquid location is very different from valuing 1,000 MW at an illiquid location. Brokers generally transact in liquid locations and for standard contractual volumes (25 to 50 MW). Therefore, the first example could be valued directly from several broker quotes in a straightforward manner. The second example is more difficult as it would be extremely difficult to find a replacement in a short period of time. Further, in this case broker quotes would no longer be an appropriate or relevant vehicle for valuation since they are for much smaller volumes and most probably represent the opinions of a very small number of market participants. The ISDA is silent on how to proceed.

Interpreting the WSPPA

Again the phrase "commercially reasonable" appears. Does the WSPPA provide any further guidance as to what is really meant by this term? Not really, but there is some guidance that merits further investigation and comment (see sidebar “A Reference: Reading The Fine Print,” below). First, the statement that gains or losses should be determined as though the terminated transactions had "not been terminated" is interesting. What does this mean? Does the term "not been terminated" imply that the settlement value should equal the transactions' mark-to-market value at the time of termination? In the normal course of business, companies engaging in electricity trading mark their books to market to determine their fair-market value. In the majority of instances, energy traders perform this by marking the book against the market "mid-market" price. Consequently, the WSPPA could be interpreted as suggesting that in calculating gains and losses the replacement contract could be valued using the "mid" price and not the bid or offer.

However, as in the ISDA contract, the definition of a replacement contract comes into play here. First, the reader is again left hanging as to whether a replacement contract must be for the exact specification, term, and volume, or may be a reasonable approximation. Second, the valuation of large, illiquid contracts is not specified. Yes, the mark-to-market at the time of termination may be indicative of value, but that was for contracts that were already executed and in the portfolio-not for a replacement contract. A daily mark-to-market is not the value at which the book could be liquidated and replaced; rather, it is the book's indicative value compared to standard-sized transactions valued at their mid-points. The contracts that must be replaced have additional costs associated with them, such as replacing the contracts at either the bid or the offer, rather than at mid-market plus possible brokerage charges.

If one looks at the definition of costs under the WSPPA, the determining party is permitted to recoup any transaction costs associated with replacement. Surely, one of the major transaction costs associated with replacing a contract (especially if one replaces it instantaneously to reduce market risk) is the difference between the value of the replacement contract and its mark-to-market price at the time of termination. This would be the difference between the bid and mid-market prices or offer and mid-market prices associated with contract replacement. Consequently, the WSPPA could be interpreted as sanctioning the crossing of the bid-ask spread; it's just that it may be defined as a transactional cost as opposed to a conventional gain or loss.

Interpreting the MPPSA

Unfortunately, the MPPSA also is lacking in guidance. Similar to the ISDA and to a lesser extent the WSPPA, the MPPSA does suggest that due to potential illiquidity of electricity markets it may be difficult to replace a contract instantaneously. However, it stops short of providing any real guidance as to how market illiquidity should be factored into the calculation of termination payments (see sidebar “A Reference: Reading The Fine Print,” below). Each of these master agreements has its own quirks and provides its own vague guidance as to what is meant by commercially reasonable.

All the agreements stop short of providing any real guidance regarding the commercially reasonable calculation of a close-out or settlement amount. Consequently, we need to look to industry standard practices to provide us with a definition regarding what "commercially reasonable" valuation really is.

Standard Practice and Commercially Reasonable Valuation

A commercially reasonable valuation must take into account the liquidity of the contracts in question. The three agreements that we have reviewed above do not address exactly how this should be done. They do address the concept of instantaneous recovery, however. This is important; in volatile markets such as power, the non-defaulting party must replace the contract as soon as possible or expose itself to market risk that results directly from the termination by the defaulting party.

The non-defaulting party may decide that the price is unfavorable to it at the time of termination and therefore not replace the transaction. However, this would mean that it would be liable for any subsequent price movements, favorable or unfavorable, and would possibly be in violation of the good-faith provision of the contract when calculating the termination value. Regardless, instantaneous recovery or replacement valve only is possible when the contracts in question are liquid and readily quoted by third parties. This leads to two possible valuation methodologies, one for liquid, standard products, and one for products that are not readily quoted by third parties. Let's examine each separately.

Unfortunately, determining the close-out value of standard products is not as simple as it first appears. Although prices should be readily available from a number of sources (brokers, publications, other traders), power does not trade evenly across all maturities. Significant price gaps can and do occur even in the shorter maturities; off-peak price is poorly quoted across the board. Usually, acquiring quotes from several sources and eliminating the high and low quotes is usually enough to establish market prices. But again, the issue of which prices to use comes up-bid, offer, or mid-market. Consider the following example:

A counterparty has committed an event of default and we have subsequently terminated the agreement. Under the terminated contract, we had agreed to purchase 50 MW of peak power in the New England Power Pool region for August 2005 at $50.00/MWh. To instantaneously replace a purchase agreement, we would repurchase at the price that somebody was instantaneously willing to sell, or the ask price. Various third-party sources indicate that the offer for the August 2005 contract is $61.00/MWh, the bid is $57.00/MWh, and the midpoint is $59.00/MWh.

Assuming 23 peak days and 16 peak hours in August and a discount factor of 0.99, we can calculate two preliminary close-out amounts as below:

As is apparent, the difference in approach can account for substantial differences in close-out amounts. Which is more correct? In this case the bid is, because it represents the price that third parties believe are available for the instantaneous replacement of the contract. In this case, using the bid is synonymous with instantaneous replacement. It is important to note here that the mid-market price used to mark contracts to market in the normal course of business is indicative of the replacement value but not at all the same. The resulting mark-to-market is not an indication of where the book could be liquidated or replaced; rather, it is an indication of its value in comparison to transaction prices for standard amounts. For that reason, mark-to-market is not an appropriate method to determine the close-out amount.

Determining the replacement value of illiquid contracts is less straightforward. Such contracts usually are not actively traded, involve a complex derivative, and extremely large, long-term, and unique to a particular situation (e.g., tolling agreements on a particular asset), or some combination of all of the above. In this case, broker quotes are not applicable. Brokers transact in standard-sized pieces (25 to 50 MW) and standard locations. For that reason, they are not an appropriate vehicle to determine prices outside of their customary locations and volumes. For illiquid contracts, broker quotes simply give an indication as to where the market may be, but their opinions are speculative and generally unsupportable. Rather, for these types of complex transactions, a theoretical price must be modeled using visible and/or calculated model inputs.

When valuing illiquid contracts, it is important to calculate the replacement contract in line with the marking procedure followed in the normal course of business (after accounting for replacement costs and whether the bid or offer is applicable). For long-term transactions, price determination in the absence of identifiable and discoverable forward curves is obviously the issue. In this case, prices must be modeled to determine replacement cost. There are several techniques available here: external forecasts of long-term energy prices, basis spreads from more liquid locations, heat rates applied to natural gas prices, or the use of fundamental models. From the possible curves, theoretical prices can be determined by using a model with visible or calculated inputs. Obviously, as the number of possible curves multiply, so do the number of possible close-out values.

Adding to the possibilities is another valuation technique, the RFP, whereby results are used from previous RFPs for the product in question or for similar products. This is not as improbable as it seems; often complex products are solicited using an RFP process. In any case, several close-out values for the contract in question are obtained. If RFP results are available, applicable, and can be updated, these would represent the most accurate valuation, since they represent the value at which a party was willing and able to do the transaction in question.

None of the theoretical models are going to agree in value; such is the nature of the beast. At this point, this is a subjective exercise, with each value weighed for reasonableness, accuracy to observable data, and usage in the normal course of business. In the absence of more specific valuation guidelines in the governing agreement or in the specific contract, such contracts will most likely end up either in arbitration or litigation. Knowing that in advance is very helpful. In fact, the "litigation premium" can be discussed in the context of a "credit risk premium" and should be considered as part of the original transaction price for such instruments. In any case, thorough documentation concerning valuation during the life cycle of complex transactions can make such disputes much easier to defend.

There is still the issue of exact replacement, however. Some have made the argument that some of these contracts tied to a specific asset or circumstance are truly unique and are therefore irreplaceable. In our experience, however, this is rarely the case and is a disingenuous argument; almost all contracts can be replicated.

The vagaries of the master agreements can result in substantial differences in close-out values. It is clear that counterparties will differ widely in their view of "commercially reasonable valuation" with current levels of guidance. This is not beneficial to the market; markets thrive in an environment of legal certainty and well-defined standardized contracts. Termination should be a contractual right, not a litigious and confusing chore. As things now stand, the latter reigns.


A Reference: Reading the Fine Print

The murky legal language in the most heavily used power trading contracts is the source of many contentious legal battles among utilities. 

I. The ISDA Master Agreement

The International Swaps and Derivatives Association Inc. (ISDA) Master Agreement governs the trading of financially settled contracts in the electricity trading industry. Section 6e of the 2002 ISDA Master Agreement provides guidance regarding the calculations of settlement amounts following an event of default and subsequent termination. Specifically, the “close-out amount” definition in Section 14 of the 2002 ISDA Master Agreement is particularly relevant (italics not in original):

• “Any Close-out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result. … Each Close-out Amount will be determined as of the Early Termination Date or, if that would not be commercially reasonable, as of the date or dates following the Early Termination Date as would be commercially reasonable.

This definition suggests the following data should be taken into account:

(a) Quotations (either firm of indicative) for replacement transactions supplied by one or more third parties (end-users, information vendors, or brokers);

(b) Information consisting of relevant market data; and

(c) Information as above but from internal sources—used in regular business.

Finally, the close-out amount definition states that commercially reasonable procedures used in determining a close-out amount may include the following:

“Application of different valuation methods to Terminated Transactions or groups of Terminated Transactions depending on the type, complexity, size of number of the Terminated Transactions or group of Terminated Transactions.”


The Western Systems Power Pool Agreement (WSPPA) governs the trading of physically settled power contracts in the Western United States. Section 22 of the WSPPA provides guidance regarding the calculations of settlement amounts following an event of default and subsequent termination. Specifically, Section 22.3 (a) of the Feb. 1, 2005, WSPP agreement states:

• “The Gains and Losses shall be determined by comparing the value of the remaining term, transaction quantities, and transaction prices under each Terminated Transaction had it not been terminated to the equivalent quantities and relevant market prices for the remaining term either quoted by a bona-fide third-party offer or which are reasonably expected to be available in the market under a replacement contract for each Terminated Transaction.”

Section 22.3 (c) goes on to state:

• “The Non-Defaulting Party shall set off or aggregate, as appropriate, the Gains and Losses (as calculated in Section 22.3 (a)) and Costs and notify the Defaulting Party.”

Section 22.3 (g) defines the above stated gains, losses and costs as follows:

• “‘Gains’ means the economic benefit (exclusive of Costs), if any, resulting from the termination of the Terminated transactions, determined in a commercially reasonable manner as calculated in accordance with section 22.3;

• “‘Losses’ means the economic loss (exclusive of Costs), if any, resulting from the termination of the Terminated Transactions, determined in a commercially reasonable manner as calculated in accordance with section 22.3;

• “‘Costs’ means brokerage fees, commissions and other similar transaction costs and expenses reasonably incurred in terminating any specifically related arrangements which replace a Terminated Transaction, transmission and ancillary service costs associated with Terminated Transactions, and reasonable attorneys’ fees, if any, incurred in connection with the Non-Defaulting Party enforcing its rights with regard to the Terminated Transactions. The Non-Defaulting Party shall use reasonable efforts to mitigate or eliminate these costs.”

III. The EEI Agreement

The Master Power Purchase and Sales Agreement (MPPSA), developed by the Edison Electric Institute in association with the National Energy Marketers Association, is often used to govern forward transactions of wholesale electricity. Section 5.2 of the MPPSA provides guidance regarding the calculations of settlement amounts following an event of default and subsequent termination. Section 5.2 of the April 2000 EEI MPPSA states:

“The Non-Defaulting Party shall calculate, in a commercially reasonable manner, a Settlement Amount for each such Terminated Transaction as of the Early Termination Date (or, to the extent that in the reasonable opinion of the Non-Defaulting Party certain of such Terminated Transactions are commercially impracticable to liquidate and terminate or may not be liquidated and terminated under applicable law on the Early Termination Date, as soon thereafter as is reasonably practicable).”— J.H. and B.F.