seven essentials to a successful credit risk management program

Rene’ Schreiber Dumstorf

What happens if one of your counterparties fails to meet its obligations with your utility?

Maybe it’s non—payment. Maybe a major player files bankruptcy. Maybe a utility has an emergency outage and they don’t deliver the energy you were expecting.

Any one of these events can have a serious impact to your organization. And while a certain amount of good faith is required to succeed in energy trading, there are seven essential steps any market participant should take to manage its credit risk exposure.

The Energy Authority (TEA) is a non—profit energy marketing and trading organization owned by six public power entities. That means TEA’s tolerance for credit risk and its operating performance metrics may be different from those of investor—owned utilities or energy marketers. But, TEA exists to extract the maximum value from the wholesale markets on each member’s and customer’s energy portfolio while ensuring that overall credit risk exposure remains within acceptable parameters. To that end, TEA has developed a credit risk management methodology based on the following seven essentials.

1. credit policy

The first and foremost requirement is a credit policy that formalizes the process. The credit policy is used to set credit limits as well as to identify, measure, manage and report on credit risk exposures. Most often, the credit policy is defined in a company’s risk management policy. Your credit policy should reflect your company’s risk appetite and should describe maximum credit limits, establish the credit value at risk (CVaR) limit, identify the individuals authorized to approve credit limits and exceptions, define how credit exposure is to be calculated, and outline the process for handling violations and exceptions to policy.

2. counterparty evaluation

Secondly, every organization should have a method for evaluating its counterparties and setting their credit limits. This is usually a credit scoring model. Most energy companies today utilize models that incorporate quantitative factors–like financial statement analysis–and qualitative factors.

Industry experts highly recommend that a company use different scoring models for different types of trading counterparties: consumer—owned utilities, investor—owned utilities and energy marketers. The use of different scoring models helps compensate for differences in both the qualitative and quantitative factors inherent in each sector’s business profile, debt structures and operating strategy.

The credit review will most likely result in some counterparties not qualifying for unsecured credit. In this case, you’ll want to secure credit support through parent guaranties, bank letters of credit or cash. It may be necessary to have a collateral tracking system to ensure the credit support renewals occur as expected. It is recommended that you review the guarantor company or letter of credit issuer for creditworthiness in the same manner as your utility evaluates counterparties.

3. continuous monitoring

Hand—in—hand with evaluating your counterparties is monitoring them regularly– after the initial credit reviews are complete and the credit limits are set. It’s a good idea to monitor market intelligence daily using sources such as Bloomberg, CreditRisk Monitor, rating agency reports, Megawatt Daily, the Power Marketing Association’s Web site, industry contacts and more. At TEA, we set review triggers whereby certain news and events will prompt us to immediately re—assess a counterparty for a possible adjustment to their credit limit. At a minimum, we perform a credit reassessment of each counterparty annually.

4. measuring current credit exposure

Once credit limits are set, the trading activity with a counterparty must be measured and monitored against that counterparty’s limit. Certainly, an automated process is the preferred way to go. At TEA, we have established an automated, real—time credit exposure report. Available credit is updated as soon as a trade is entered into our trade capture system or settlement payments are received.

As mentioned previously, the credit risk policy should explain how credit exposure will be calculated for your organization. The calculation should include billed and unbilled receivables, forward physical exposures, and forward financial exposures.

A common approach for including forward physical exposures is to use notional value for forward sales or parts of forward sales within 60 days and mark to market (MTM) beyond. Forward exposure typically includes the incremental replacement costs (IRC) of the part of the purchase that has not been delivered. Forward financials include swaps, options and other derivatives whose exposure is calculated via replacement cost or market value.

This is a fairly simplistic view of the calculations, which could also be affected by netting, exposure to the counterparty for different commodities and parent/subsidiary relationships. The credit report must be delivered to or accessible by energy trading and marketing personnel so they can monitor credit availability for potential future deals. No trader should enter into a transaction that would put a counterparty over its credit limit. Therefore, you must have a clear plan of action as counterparties approach their credit limits.

5. peak potential exposure/credit exposure at risk

The fifth credit essential relates to the forward positions addressed in the previous paragraph. A good credit report should mark your forward positions to market using that day’s market price. This gives you a snapshot of existing exposure if your counterparty were to default today.

However, it’s not prudent to believe that for the life of say, a one year deal, that today’s market price will be the constant for the duration of the deal because market values will change over time. Thus, you need to consider “What is my potential exposure if the counterparty defaults in the future?” This analysis is typically called peak potential exposure or credit exposure at risk (CER), and involves statistical modeling using probability analysis or simulations and a company’s forward market and volatility curves. TEA’s CER model, based on option valuation principles, gives us with 95 percent confidence the maximum, or worst case, potential exposure.

There are various schools of thought on how to incorporate the potential exposure results into your credit analysis. One is to add the potential exposure to the current exposure and apply both against the credit limit. Another school of thought is to have separate potential credit limits and tools for mitigating potential exposure as the potential limits are approached.

6. credit value at risk (CVaR)

Your company must know, within some confidence interval, how much credit loss you could have at any given time with the current portfolio of trades. TEA’s CVaR model uses the potential credit exposure described above and applies default probabilities implied with a counterparty’s credit rating, projected recovery rates, and counterparty correlations. It derives a worst case credit loss amount within a 95 percent confidence interval. The risk policy should address the maximum CVaR limit for a company’s risk appetite.

7. credit support (yours)

The final essential toward a successful credit risk management program is your utility’s preparedness to provide credit support when the inevitable collateral call comes from your counterparty.

For example, if your utility is an IOU and qualified for a significant unsecured credit limit, there is still the possibility that one of your counterparties may make a margin call or your utility may get called for performance assurance if a material adverse change occurs, such as a rating agency downgrade. If you are a public power entity, the unsecured credit lines you may qualify for may be smaller than most IOUs’ lines. That means market changes in a forward position could cause a counterparty to call you to cover their MTM exposure from the position that put you over your credit limit. If you are a power marketer, who may not have audited, stand—alone financial statements and/or a rating from a rating agency, you will likely have to post credit support up—front before trading begins just to secure your credit line.

Whatever the situation, your company must either be aligned with a creditworthy guarantor who is willing to provide a guaranty on your behalf, or you should establish a letter of credit facility with a well—rated bank. Another option is to have cash set aside for margining, prepayments, early settlements and more. The bottom line is, as a player in energy trading, it’s essential that you prepare for large and sudden liquidity demands in the form of collateral calls; otherwise you risk contributing to an event of default.

Implementing these seven strategies will go a long way to helping your utility manage its credit risk in the current energy trading market. However, it’s important to note that the move toward Standard Market Design creates very different credit risks for those markets which, in turn, require different credit essentials for succeeding in them. But we’ll save that topic for another article.

Dumstorf is the chief credit officer for The Energy Authority. She can be reached via e—mail at rdumstorf@teainc.org or by calling 904—356—3900 ext. 3036.

The Energy Authority is a non—profit energy marketing organization formed for public power by public power. The company provides comprehensive resource management and optimization services to publicly—owned utilities. This includes trading and marketing physical power and natural gas, energy risk assessment and management services, credit risk management, contract management, credit advisor services, MISO settlement services and more. For details, visit www.teainc.org or call 800/423—4800 ext. 1317.

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