Counterparty evaluation: some challenges

Unfortunately, the standard assessment measures employed by credit rating services
such as Moody’s, Standard & Poor’s, Fitch Investors or Dunn & Bradstreet, while
useful, often provide insufficient detail when evaluating an energy trading businesses.
Rating agencies rarely address in detail the controls within the business and the
potential for major losses. Coupled with this is the lack of financial information on
subsidiary trading businesses. The result is that risk professionals who rely solely
on the rating agencies can miss potential problems or set an overly prudent
approach.19
Companies that want to quantify adequately the creditworthiness of a counterparty
will need to develop their own internal scoring methodologies to complement the
rating agencies and develop their own specialist ratings. The internal scoring system
should take account of qualitative as well as quantitative factors such as the
ownership and control of the entity, track record and diversification. This need for
an internal scoring system is reinforced by the fact that many trading organizations
are not rated by the agencies and that their financial strength can change very
rapidly. Second, as evidenced in the above Utility Y scenario, the significance of the
replacement cost of electricity becomes particularly important.
The legal issues around default can also be complex. In the US power market the
legal framework was initially created through ‘enabling’ agreements which have not
fully addressed the problem of credit risk appropriately. Failure to deliver may not
result in either default or damages. The enforceability of netting or set-off agreements
can also be problematical, as can the implementation of credit enhancement or
‘further assurances’ clauses that are intended to improve your position when a
counterparty’s creditworthiness is called into doubt.
One area that is still being clarified is whether electricity constitutes a good or a
commodity. As the market becomes more ‘commodity-like’ it moves more into line
with the protection given to commodities under the relevant bankruptcy codes and
allows the default process set out within ISDA documentation to be used. This
development in the legal framework surrounding electricity and gas contracts is one
that is likely to repeat itself throughout the world.
Thus, ensuring the master agreements reflect appropriate termination and netting
provisions is an important first step to mitigate credit exposure. Understanding
the interactions between utility tariffs, master agreements for different products,
guarantees and additional agreements (such as separate netting agreements) is an
essential but unfortunately major exercise, as is ensuring you understand the
corporate structure of the counterparty with whom you are dealing. With this
structure in place you can set an exposure limit for each counterparty.