The challenges of Utility Y

Let us take the example of a Cinergy Power trade by Utility Y. Utility Y is very
prudent, they like to have a fully hedged position and severely limit purchases from
small players.
Initiated in November 1997 for July 1998. Y buys a 50 MW contract from a small
counterparty for $35/MWh at a total cost $560 000, and with annualized volatility
running around 20%. Given they are buying, they see no receivable exposure, no
mark to market exposure, and estimate the potential market exposure to be $112 000.
By February the price is $50/MWh and a mark to market value is $240 000.
Volatility is now 30%, so potential exposure (receivables plus mark to market plus
potential market exposure) is equal to $313 600. Although the counterparty is a
small player they are still well within Y’s ‘prudent’ limit of $1 million set for this
particular counterparty.
In June 1998 the market price has risen to $350/MWh (annualized volatility is
now over 1000%) and Y’s counterparty defaults by telling them they will not deliver
the power under the contract. The replacement power they need to buy to meet their
customer’s requirements cost $5.6 million, a net loss of over $5 million, five times
the limit they thought. This could have been a true story for anyone trading the US
power market industry in the summer of 1998.
Given such volatility in these markets and their early stages of development, it is
not surprising to see some casualties. This tends to occur during major market
movements and can provide additional impetus to the market movement that started
it. The defaults of Federal Energy and Power Company of America were both caused
by and caused the extreme volatility experienced in the Cinergy spot market (it
reached x000% on an annualized, historical basis).17
It is an important point to note that the biggest risk facing many companies at this
stage was the non-delivery of power rather than the non-payment of delivered power.
As such credit managers switched their attention away from the traditional accounts
receivable approach to focusing on counterparty mark to market and credit VaR
approaches. This reinforced the need to focus on the total exposure to a counterparty
default and the potential for domino effects within a particular sector. We will
set out below a number of ‘must-haves’ in assessing credit risk within the energy
sector within an overall credit process.
Credit breaks down into two distinct areas: the initial credit evaluation process
and the on-going monitoring of exposures. Credit evaluation includes the evaluation
of a particular counterparty, taking account of the market they are in (country and
sector) as well as the current financial strength and track record of the company.
Counterparty credit limits are then based on your own risk appetite and strategic
importance of that counter-party.18
Exposure monitoring includes the identification and measurement of exposures as
well as the operational reporting and control process. This should be done at a
counterparty and portfolio level.