Lifting the Lid off Pandora’s Box: Managing Risk in an Online Economy

Erin Norris – Enermetrix
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With every click, energy e-market participants lift the proverbial lid off of “Pandora’s Box”, filled with the unknowns in an open market system – a vast digital marketplace filled with anonymous counterparties and unrated players. All too often, many of the costly errors in e-trading and risk management are derived from credit defaults, delayed payments and risk exposure from unsecured counterparties, unknown third-party marketers and non-guaranteed subsidiaries. And deregulation itself has ushered in several new retail market credit challenges: extension of credit to new retail energy buyers, a vastly increased number of potential counterparties and an amplified complexity in back-office requirements.

Today, energy companies are quick to analyze commodity pricing down to the nth pricing component (basis, index, swing, etc.), but rarely consider distributing credit on a per-unit of energy basis. In truth, sound credit allocation should not be a decision, but a price determined on a per-unit fee based on the party’s credit rating.

A per-unit fee based on a counterparty’s credit scoring will usher in the future for credit risk, where everything is for sale…for a price. Let’s now look at how to assess this fee, some differences in risk between energy commodities and buyer and seller risk, how credit risk has changed, and what lies ahead for the future of credit risk in Internet commerce.

No Pain, No Gain

Since the unforgettable and pricey summer power price spikes of 1998, the U.S. energy market has been left reeling under the weight of a national credit crisis. And with that painful lesson, credit risk has – with sufficient reason – leapt to the forefront of boardroom discussions, shareholder meetings, and energy risk and trading conferences.

The electricity market, in particular, seems to harbor a particularly high propensity to credit risk disasters for some of the following reasons:

  • With daisy chains of up to 50 contracts for a single power transaction, the probability of a default among so many counterparties exponentially multiplies;
  • New power marketing entrants can foster unrated, unknown or undisclosed credit rankings;
  • The immature power market continues to suffer from traders and credit risk managers who are inexperienced in handling power’s sky-high volatility and,
  • Poor liquidity and low margins only serve to exacerbate the market’s trading and risk problems.

One key distinction in the retail side of these markets is that the credit risk that a buyer takes on is different than what a seller enters into with each transaction. The risks that a seller takes on include non-payment for delivered commodity, late payment for delivered commodity as well as inability to accept future deliveries under a contract (in cases of mark-to-market accounting only). In contrast, a buyer only takes on the risk that the market rises and the supplier does not deliver under the contract. As a whole, the seller takes the lion’s share of the credit risk in retail transactions.

Petting A Strange Dog

When you haphazardly allot credit to an unknown counterparty, it can be a lot like petting a strange dog – you’re never quite sure if you’ll wind up with the friendly wag of a tail or a nasty bite. But by taking the “guesswork” out of credit assessment and apportionment, you’ll enjoy a near fail-safe system at your fingertips.

Potential outcomes of a credit evaluation can vary as widely as the range of counterparties, from denial of credit to specified credit terms, and credit limits to discount rates (determined to apply against transactions where mark-to-market applies). Criteria that is generally considered in credit scoring can be business background, years in business, number of employees, public records (suits, liens, judgments, bankruptcy filings), payment performance, parent company rating (if business is a subsidiary), industry comparison, financial condition, legal structure, financing arrangements and more.

Credit scoring software should allow for customer-customized scoring credit limit algorithm rules, risk management objectives, business goals and report production.

The Wave of the E-Future: Real-Time Credit Scoring

While the Internet has forever changed the way trading is transacted, it has also accelerated the pace and introduced new risk management challenges. In gas and electricity e-marketplaces, energy suppliers are able to form an online link to sell to retail buyers through electronic markets like Enermetrix.

The good news is that there are already systems in place that can automate and streamline the on-line process of credit risk management and trading. Enermetrix 4Sure is an on-line credit risk system that allows suppliers to evaluate credit risk of buyers and offers a credit enhancement product (that suppliers can purchase to mitigate the risk of payment default due to bankruptcy). Based on a proprietary scoring system from Dun & Bradstreet, Enermetrix 4Sure puts the credit decision back where it should be – in the hands of the suppliers.

Credible credit analysis can be obtained through credit scoring companies like Dun & Bradstreet Credit Express, a software application that helps users to speed credit limit approval process, minimize up-front risk with new accounts, and proactively manage exposure to higher risk by quickly assessing and identifying the appropriate credit limit.

“With the largest database of commercial business information, Dun & Bradstreet provides the risk information needed to distribute credit on a per-unit of energy basis. Using D&B interface software, Enermetrix 4Sure is able to access online credit risk information that allows suppliers to evaluate the credit risk of buyers. Working together, Enermetrix and D&B have implemented a state-of-the-art real-time interface based on the latest Internet technologies to provide multi-tiered decisoning capabilities. D&B’s extensive company information database and internal credit decisioning capabilities provide a foundation for Enermetrix 4Sure to uniquely customize credit risk decisions for the energy marketplace,” said Frank Oswald, assistant vice president, Dun & Bradstreet.

Digital trading communities that are interfaced with real-time credit risk systems, like Enermetrix, can:

  • Offer significant time savings by dispensing with protracted credit checks;
  • Allow traders to view credit information simultaneously with digital exchange screen (available through Enermetrix);
  • Present a fast, low-cost Web-enabled alternative to costly trading services and high-dollar credit checks;
  • Enable market players with less-than-attractive credit ratings to participate – while at the same time safeguarding the counterparty;
  • Assure buyer/seller that a transaction is “completed” (and not merely somewhere in the process of credit verification, etc.) the instant it is electronically accepted. This is crucial in a fast-moving market that changes in seconds;
  • Allows the technology to automatically reject buyers that don’t meet credit requirements;
  • Automate and streamline credit scoring, risk and trading activities into a single seamless, all-electronic, end-to-end and real-time transaction chain; and
  • Offer an online credit enhancement fee based upon credit scoring, such as Enermetrix’s 4Sure’s optional fee (on average a fraction of a cent per dollar). These enhancement fees are usually offered via a third-party underwriter for protection in the event of a counterparty’s bankruptcy.

Due to a number of factors – the increasing use of digital markets, late payments and defaults, utility mega-mergers/acquisitions and deregulation – electric utilities today must continue to widen their knowledge and sophistication concerning real-time credit risk evaluation and exposure.

Clearly, there’s no turning back. As the traditional means of evaluating companies and making credit decisions are neither scaleable nor automated, companies today need to look for ways to automate their credit policies and focus on the cost of trade credit. So start to say “yes” to more counterparties, but reflect your cost of doing business with them in their price.

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