Risk analysis and recommendations on EURELECTRIC's Power Choices study Credit and Counterparty Risk

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A EURELECTRIC paper

January 2012

The Union of the Electricity IndustryEURELECTRIC is the sector association representing the common interests of the electricity industry at pan-European level, plus its affiliates and associates on several other continents. In line with its mission, EURELECTRIC seeks to contribute to the competitiveness of the electricity industry, to provide effective representation for the industry in public affairs, and to promote the role of electricity both in the advancement of society and in helping provide solutions to the challenges of sustainable development. EURELECTRICs formal opinions, policy positions and reports are formulated in Working Groups, composed of experts from the electricity industry, supervised by five Committees. This structure of expertise ensures that EURELECTRICs published documents are based on high-quality input with up-to-date information.

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Risk analysis and recommendations on EURELECTRIC's Power Choices study Credit and Counterparty Risk
-------------------------------------------------------------------------------------------------Focus Group Enterprise Risk Management (TF 2050 Risk Management Guidelines) Vittorio DECCLESIIS (IT) Chair Peter AGH (SK), Jos ALLEN LIMA (PT), Fredrik ARNO (SE), Roberto BALZERANI (IT), Michael BROUSTIS (GR), Rui EUSTAQUIO (PT), Harald HAUER (AT), John HEALY (IE), Michael HERRMANN (DE), Walter HOLLENSTEIN (CH), Filip HONS (BE), Iigo IBARRONDO (ES), Murathan KARA (TR), Kari LAAKSONEN (FI), Gabor LAVICH (HU), Heikko MAE (EE), Ignacio MARTINEZ DEL BARRIO (ES), Rita MARTISIENE (LT), Francisco PEREZ THODEN (ES), Thomas POLZER (AT), Alistair SMITH (GB), Marcel STEINBACH (DE) Pierre SCHLOSSER (EURELECTRIC Secretariat), Charlotte RENAUD (EURELECTRIC Secretariat) Contact: Charlotte RENAUD, Policy Officer Management Committee E-mail to: crenaud@eurelectric.org

TABLE OF CONTENTS
FOREWORD ................................................................................................................................ 1 1. EXECUTIVE SUMMARY ................................................................................................................ 6 2. INTRODUCTION....................................................................................................................... 11 3. CLASSIFICATION AND DEFINITION OF CREDIT RISK .............................................................................. 13 3.1 Risk Value .......................................................................................................................................... 13 3.2. Sources of Risk ................................................................................................................................. 14 4. COUNTERPARTY RISK EVOLUTION DURING THE FINANCIAL CRISIS BY RISK SOURCE ........................................ 18 4.1. A helicopter view on credit risk management over the past decade ........................................... 18 4.2. Risk related to Commercial Counterparties ..................................................................................... 20 4.3. Risk related to Financial and Insurance Counterparties .................................................................. 20 4.4. Risk related to Procurement and Partnerships/projects .................................................................. 21 5. QUANTIFICATION EXERCISE ......................................................................................................... 22 5.1. Methodology .................................................................................................................................... 22 5.2 Assumptions ...................................................................................................................................... 22 5.3. Results .............................................................................................................................................. 23 5.4. Quantification of the impact of an increase in credit spreads in WACC .......................................... 24 6. MITIGATION OF COUNTERPARTY RISK FOR THE POWER SECTOR .............................................................. 26 6.1. Mitigation tools................................................................................................................................ 26 7. CONCLUSIONS AND RECOMMENDATIONS ........................................................................................ 28 ANNEX: METHODOLOGY USED TO QUANTIFY THE IMPACT OF AN INCREASE IN CREDIT SPREADS IN WACC ............... 33

Foreword
On 10 November 2009, EURELECTRIC presented its flagship roadmap entitled Power Choices Study: Pathways to Carbon Neutral Electricity in Europe by 2050. This followed a declaration earlier in the year signed by sixty-one European electricity company CEOs in which they expressed their commitment to achieve a carbon-neutral power supply by 2050. The purpose of the two scenarios developed by the study was to examine how this vision can become reality. The Baseline scenario assumes all existing energy policies are followed and could be referred to as a business as usual scenario. The Power Choices scenario however sets a 75% CO2 reduction target across the entire EU economy to be achieved domestically equivalent to some 80-90% when offsets are included, as in the official EU targets and aims for an optimal power generation portfolio based on an integrated energy market. The study shows the positive outcomes for economy, society and the environment which result from making the correct power choices on both the supply and demand side of the energy equation. Accordingly, EURELECTRIC calls on EU and national policymakers to take strong and immediate political action in order to create the framework for achieving a low-carbon future, at reasonable cost to the economy, without jeopardising energy supply security. To complement the identification of barriers that could jeopardise the fulfilment of the Power Choices scenario, EURELECTRICs Focus Group Enterprise Risk Management (FG ERM)has undertaken a risk analysis (including a quantitative assessment) on the results of the Power Choices scenario with a view to making appropriate policy recommendations. The purpose of this report is therefore to apply a risk analysis on EURELECTRICs Power Choices Study highlighting management issues that should be addressed in order to secure the financial viability of the required investments and reduce the cost burden for the power sector. Indeed, after more than a decade of liberalisation, risks with increasing complexity such as market, credit and liquidity risks are playing an increasing relevant role in the power sector. It must be noted that risks are inherent to every competitive business and volatility does usually represents a healthy indicator of demand-supply balance in a free market. At the same time, it must be also recognised that these risks represent a cost for power companies which in turn also impact investment decisions. The aim is clearly not to avoid or eliminate risks in the electricity markets but rather to spot and reduce distortive effects which could distort price signals. In particular, EURELECTRIC FG ERM members, while believing that most risk can be adequately managed by professional risk management, are of the view that it is important that risk related to market distortions are reduced. Reducing those regulatory risks and distortions can help in reducing overall system costs which, all other things being equal, would translate into potential savings for customers, and in supporting the financial viability of new investments in the current capital intensive phase. On this background, FG ERM members have identified five areas of interest for further investigation: Market volatility derived from oil and CO2 price Counterparty risk (volume risk & credit risk) Liquidity & capital cost risk Regulatory risk
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Technology risk

While the drafting of the overall report on Risk analysis and recommendations on EURELECTRICs Power Choices Study is still underway, the chapter on counterparty risk was finalised to be presented at the EURELECTRIC workshop Are European electricity companies evolving in a sound investment climate? Emerging risks in unfavourable times, which took place on 8 March 2011 in Brussels.

Background to EURELECTRICs Power Choices Study Power Choices: Pathways to Carbon-Neutral Electricity in Europe by 2050 is a EURELECTRIC study carried out in conjunction with Athens Technical University and VGB PowerTech. Following a declaration signed in March 2009 by the chief executives of power companies representing over 70% of total electricity production in the EU, who made a commitment to a carbon-neutral power sector by mid-century, the EURELECTRIC Power Choices study was set up to examine how this vision can become reality. It uses the PRIMES energy model developed and run by a team at Athens Technical University under Professor Pantelis Capros, which is also used by the European Commission for its energy scenario work, to examine scenarios to 2050. Power plant association VGB Powertech provided plant investment and generation input data for the modelling. The Two Scenarios The study develops two distinct scenarios for the EU-27 countries during the 1990-2050 period. The Baseline scenario assumes all existing energy policies are followed. This means inter alia that the current EU targets for reducing CO2 emissions are pursued beyond 2020, nuclear energy is phased out in those countries currently envisaging such a move, and electricity does not become a major transport fuel in the period to 2050. The Power Choices scenario sets a 75% CO2 reduction target across the entire EU economy to be achieved domestically equivalent to some 80-90% when offsets are included, as in the official EU targets and aims for an optimal power generation portfolio based on an integrated energy market. In this scenario, policymakers make climate action a priority and an international carbon market defines the price of CO 2, which applies uniformly to all economic sectors ensuring that all sectors internalise the cost of the greenhouse gases they emit. Energy efficiency also becomes a top priority and is pushed by specific policies and standards on the demand side, which results in lower overall energy demand. In contrast to the Baseline scenario, electricity becomes a major transport fuel as plug-in hybrid and electric cars are broadly rolled out. The Power Choices scenario sees electricity claim a greater share of total energy consumption, as the energy-efficiency drive squeezes out less efficient vectors. However total EU power generation reaches a level not much greater than under Baseline, rising by around 50% from some 3,100 TWh in 2005 to around 4,800 TWh in 2050. The optimal power generation portfolio developed under this scenario sees power production from renewable energy sources (RES) increase dramatically and becoming despite a phase-out of national subsidy schemes by 2030 the greatest single source of power at 40% of total EU generation. Among RES technologies, wind power takes the lead, with on-shore wind providing 35% of the RES contribution and off-shore wind 27%. Hydropower remains stable throughout the period, accounting for 23% of the RES total. Biomass-fired electricity also sees a substantial increase, although in relative terms its share of RES power slightly decreases, while solar power also enters the picture. Nuclear power reaches 28% of total net power generation in 2050. Electricity from solid fuels also
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increases from 2025, due to deployment of carbon capture and storage (CCS) technology, and reaches a share of 16%. Gas-fired power reaches its peak in 2040, followed by a slight decline as gas and carbon prices rise and CCS also becomes necessary for gas-fired plants. It stabilises at 750 TWh in 2050, representing 14% of total EU electricity. In this scenario, oil-fired plants have only a marginal role, with production progressively reducing over time and reaching 1% of total production in 2050. With this power mix, the electricity industry achieves a major reduction in CO2 emissions from 2025 to 2040. While policy action under Baseline reduces sector CO2 emissions by 66%, still leaving 750 Mt CO2 emitted in 2050, Power Choices sees CO2 emissions plummet by 90% versus the 2005 level, from 1,423 Mt to just 150 Mt in 2050. This means that, taking as an example a typical large-size lignite-fired plant of 1,250 MW capacity, with average emissions of 0.955 tonnes of CO2 per MWh electricity produced, and assuming an average base-load operation of 7,500 hours per year, the entire European power sector would emit in 2050 the equivalent 2009 emissions of roughly only one single power plant for every two EU member states. This brings the industry close to carbon-free electricity. To achieve credible carbonneutrality it is essential to calculate sector emissions accurately in a transparent manner, reduce emissions to the fullest extent feasible within the sector, then offset residual emissions through actions to reduce greenhouse gases elsewhere via technology transfer, afforestation, etc. such that net carbon emissions are equivalent to zero. The Power Choices scenario also shows primary energy consumption across the economy to 2050 falling 20% on Baseline. The major part of this reduction is accounted for by considerably lower demand in the transport and residential sectors, much of this trend being due to substitution by electricity of relatively inefficient uses of oil and gas in road transport and household heating. A significant role is also played by much improved building insulation, plus efficiency advances in existing electrical applications. The Power Choices scenario also delivers a major reduction in import dependency a reduction of 40% in net energy imports compared to Baseline. This reduction in primary energy demand translates into an even steeper decrease in final energy consumption, a saving of 30% on Baseline. The Power Choices scenario delivers a significant part of the reduction in final energy consumption through a shift towards electric applications. Finally, the Power Choices scenario sees overall energy cost in the economy decreasing from just under 10.5% in 2010 to just below 10% of GDP in 2050. Policy Recommendations The study shows the positive outcomes for economy, society and the environment which result from making the correct power choices on both the supply and demand side of the energy equation. Accordingly, EURELECTRIC calls on EU and national policymakers to take strong and immediate political action in order to create the framework for achieving a low-carbon future, at reasonable cost to the economy, without jeopardising energy supply security.

Policymakers must support the carbon market so as to deliver the EU CO2 cap at least cost, ensure that all sectors internalise the cost of their greenhouse gas emissions, and since the global challenge of climate change requires a global solution actively promote an international agreement on climate change. They must also enable the use by the market of all low-carbon technology options: renewable energy (RES), carbon capture and storage (CCS) technologies, new nuclear power plants, plus smart networks. If the necessary capacity is to be constructed, they must also encourage public acceptance of modern energy infrastructure and CO2-storage sites, and take action to streamline their licensing procedures. However, energy efficiency will be the major driver for the carbon-neutral Europe of tomorrow, the study indicates. Public authorities must therefore take a leading role in energy efficiency, adopting standards and incentives to help consumers choose energyefficient technologies in their domestic appliances, heating and cooling, and road transport.

1. Executive Summary
Chapter 2 of our Risk analysis and recommendations on the Power Choices study presents the European power industrys exposure to counterparty risks and the dynamics thereof during the financial crisis. The chapter uses an example to quantify the cost impact of various counterparty risks, thereby contributing to an understanding of how these risks can materialise. It closes with risk mitigations recommendations for the power and gas market designs which could help to reduce the risk premium. Counterparty risk exposure

In order to capture the growing complexity of credit risk, energy companies are moving from a pure credit risk concept to a broader counterparty risk definition which attempts to encompass all exposure to risk along the value chain that could jeopardise a companys liquidity balance. Energy companies global counterparty risk can usually be mapped on two main dimensions: the source of risk and the value exposed to the risk, as summarised in the figure above. Counterparty risk quantification

This chapter calculates a representative quantification example of counterparty risk exposure for a power company during the financial crisis. The example clearly illustrates how power companies during the financial crisis were heavily squeezed between reduced positive cash flow expectations on the one hand, due to the reduction of demand and of customers creditworthiness, and increased negative cash flows on the other, due to the rigidity of supply and financial contracts. The example assumes that a power company decided to hedge 10 TWh of CCGT gas fired production by selling forward the power for calendar year 2009 during the second and third quarters of 2008, while simultaneously hedging fuel costs through financial contracts on oil and $/ Foreign Exchange rate. Our calculations show that, for the 10 TWh of power sold forward, the power company registered on its books around 340 Mln of direct exposure to counterparty risk at the beginning of 2009 (including settlement exposure, replacement exposure, prepayment, financial over-hedging). More details on this quantification exercise can be found in section 2.5. Counterparty risk mitigation measures

Counterparty risk, like any other risk, represents a cost for the power sector. While risk is inherent to every competitive business, this should not mean that efforts to reduce overall systemic risk should not be pursued. On the contrary, we feel it is important to reduce as much as possible the unnecessary risk related to market design failure, regulatory framework, systemic asymmetries, etc. The following table summarises by risk source the various risk mitigation measures proposed in this chapter:

RISK PROFILE TRENDS

COMMERCIAL (energy sales, trading & supply)
Increase of settlement risk because demand reduction recently experienced is more than compensated by increasing % of volumes sold on EU free markets Increase of replacement risk because higher markets volatility translate in higher fair values of sales contracts Depressed creditworthiness of Industrial clients

POTENTIAL MITIGATIONS
Development of mitigation tools and risk management models for fair pricing of credit risk on sales Rebalancing supply and sale sides of Power Sector in term of markets and contractual structures (renegotiate/remove Take or Pay clauses and increase supply flexibility; increase role of gas spot markets; increase M/L term power contracting opportunities)

COUNTERPARTY RISK SOURCES

Strengthen soundness and creditworthiness of Financial Institutions by implementing new capital requirements (Basel III)

FINANCIAL INSTITUTIONS & INSURANCES

Increase of replacement risk because higher markets volatility translate in higher fair values of hedging and trading contracts
Depressed creditworthiness of Financial Institutions Risk of reduced availability of credit lines and funding capacity for supporting M/L term investments plan and short term liquidity absorbed by core business

Reform of financial OTC market with propter credit risk management. Non financial firms, such as Power Companies, using derivatives mainly for hedging should be granted an exemption from compulsory clearing and other far reaching requirements imposed to financial institutions by MIFID and CRD) thus avoiding cost increase. Standardisation of derivatives should be addressed with a specific set of rules for commodity markets Enhance energy market specific measures, as envisaged by EC concerning market disciple, transparency and supervision through REMIT. Improve credit risk pricing models

Depressed creditworthiness of Partners Risk increased only in case of critical strategic Partners Increase role of Export Credit and Multilateral Agencies Reduced Replacement risk due to increased competition linked to global economic downturn Room for Private/Public Partnership to guarantee part of counterparty risk reducing investment costs Country and sovereign risk increase might affect exposure when Governments are Partner in projects and/or supply chain

PROCUREMENT & PARTNERSHIPS

o Commercial counterparties Rebalancing the supply and sale sides of the power sector as regards markets and contractual structures would help to lower the exposure to counterparty and volume risk. To that effect, the following measures could be considered: renegotiating/removing take-or-pay clauses and increasing supply flexibility increasing the role of gas spot markets increasing the medium/long-term power contracting opportunities

o Financial counterparties Since recognizing credit risk mispricing and undervaluation as one of the most important causes of the financial crisis, both the European and the US governments have launched several political/legislative initiatives to strengthen the global financial system by means of higher capital and collateral requirements, standardisation of derivatives contracts and compulsory central counterparty clearing of current over the counter (OTC) transactions. Although the above actions would reduce the credit risk of the financial sector, they would result disproportionate for non-financial firms active in commodity trading (including power companies) which use financial markets mainly for hedging purposes and do not pose systemic risks. Indeed, this reform would in reality turn the credit risk on OTC contracts into a liquidity risk for power companies with higher hedging costs. Power companies would need to have adequately sized back-up cash credit lines in place in order to cover potentially extreme margin calls due to very volatile market movements. Moreover, some companies could give up hedging because of the higher costs, thereby actually increasing their price risk. Industrial players using derivatives for their hedging programmes, including power companies, should therefore be granted an exemption from mandatory clearing (and other far-reaching prudential requirements imposed on financial institutions by EU directives MiFID and CRD), thus avoiding cost increases. At the same time, standardisation of derivatives products should be addressed through a specific set of rules for commodities markets. In addition, the concern about the high additional costs of managing the credit risk of OTC contracts transferred onto regulated markets might signal that credit risk is currently undervalued and mispriced in energy transactions.

o Procurement and partnership counterparties Credit risk guarantee constitutes an interesting area of public private partnerships, as demonstrated by the recent US government $8.3bn loan guarantee scheme put in place for financing two new nuclear reactors in Georgia. Credit risk guarantee by the EU or Member states might be an effective tool for fostering longterm capital intensive investments and a useful alternative to direct public financing. Such a guarantee might be priced and remunerated in cash flows generated by the investments after payback time, thus resulting in potential cash inflows for the EU or Member states that could be redistributed to tax-payers. Involving governments in backing the credit risk of long-term infrastructure investments should also create an incentive for them to provide for long-term stability of the regulatory framework.

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2. Introduction
Energy companies face credit risk in most of their businesses, although these risks do not always appear on the radar of energy managers and analysts. Some examples might help to understand the real scope of credit risk: o Every time a company hedges market risk it in fact enters into a hedging contract that creates credit risk, legal risk and often liquidity risk. o Every sales contract carries credit risk; not only the settlement and payment risk, but also the replacement risk or so-called mark-to-market (MtM) risk. o Every utility that places purchasing orders, e.g. for new generators or windmills, creates credit risk as the success and profitability of a project depends on timely and correct delivery. Any delay will reduce the profit of an investment, and a default of a major supplier may endanger a project as a whole. o Every fuel contract securing supply for power plant might entail high counterparty risk, especially if it is structured on a long-term and fixed price basis. Certainly in the recent past, long-term coal supply contracts for power generation were a significant source of replacement risk due to the continuous increase of the coal price. o Every credit line opened to support operating business or development programmes generates a significant exposure to the lending financial institution. Should said financial institution experience a credit distress or a default, the borrower would face a severe liquidity squeeze. This squeeze could prove particularly severe in cases of deteriorated capital markets fundamentals, which is normally the case. o The treasury business is another substantial source of credit risk which energy companies are exposed to. As the crises during 2008/2009 have shown, there is not only the risk to be considered when investing cash, but also the financing of projects or back-up liquidity lines which are vital to a companys survival when the financial markets crash. Despite such a wide range of risk sources, conventional wisdom sees energy companies as being mainly exposed to delayed or defaulting payments from their final customers. This perception would constitute a fundamental underestimation of sector risk. Moreover, the cost of credit risk is likely to increase with the large investment volumes of the power sector. These are indeed huge: EURELECTRICs Power Choices Study predicts that total cumulative investment in power generation will amount to some 2 trillion euros (in 2005 prices) by 2050. During the 2000-2025 period, investments under the Power Choices Scenario total 855 bn euros. In the subsequent 25 years, from 2025 to 2050, the required investments are much higher, totalling 1.141 trillion euros.

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Figure 1: Power Generation Investments (billion euros) (Source: EURELECTRICs Power Choices Study)

Additionally as shown in Figure 22 below EURELECTRICs Power Choices Scenario anticipates a large share of investments in renewables energy sources and nuclear energy over the years to come. These generation technologies will involve high upfront fixed costs and CAPEX which in turn will need to be borrowed or raised on the financial markets. Creditworthiness of companies and this is where credit risk management will be extremely useful will determine the conditions at which energy companies will have access to the needed capital.

Figure 2: Power generation by fuel type (in net TWh) (Source: EURELECTRICs Power Choices Study) Against this background, the purpose of chapter two is to present the exposure to counterparty risks and the dynamics thereof which the European power industry has been facing during the financial crisis. The chapter uses an example to quantify the cost impact of various counterparty risks, thereby contributing to an understanding of how these risks can materialise. It closes with risk mitigation recommendations for power and gas market designs which could help to reduce the risk premium. Before entering into the analysis however, the next section will review and define the various analytical components, both in order to ensure a common understanding of the terminology and definitions involved, and to facilitate the reading for non-experts.

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3. Classification and Definition of Credit Risk

In order to capture the growing complexity of credit risk, energy companies are moving from a pure credit risk concept to a broader counterparty risk definition that tries to encapsulate all different exposures along the value chain which could jeopardise a companys liquidity balance. Global counterparty risk for energy companies is usually defined along two main dimensions: source of risk and value exposed, as summarized in Figure 23 below:

Probability of default

Figure 3: Counterparty Risk Definition (Source: EURELECTRIC)

3.1 Risk Value Exposure: Settlement and Replacement Risks Settlement risk is the risk that outstanding amounts, created for example by deliveries of electricity, are not paid. In general, all amounts due by a counterparty that are not paid, or not paid on time, create settlement risk. Another common example of settlement risk is any form of prepayment to a supplier. Replacement or mark- to-market (MtM) risk is the risk of loss incurred as a result of a counterpart default when an existing contract has to be replaced with another, less favourable, contract. For the power sector, a specific example is the risk of energy being contracted at a certain price level and then (in case of bankruptcy of the contract partner for example) being forced to resell or repurchase this energy in the market at a different price, leading to a financial loss. This is often the largest source of credit risk in the trading and sales areas of an energy company.

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Example: electricity is sold to a customer for a single day (24 hours) in one months time for at a price of 50. If market prices drop to 30 and the customer cannot (due to default for example) take this electricity in one months time, the company will have to sell this electricity back to the market at the new price of 30. It will have incurred a loss of 20 for every hour of that day, i.e. 24 * 20. More broadly, replacement risk is linked to any contract and obligation that has a positive value with respect to the current market conditions, since in case of counterparty default the contract/obligation would be replaced at market condition, thereby losing any economic advantage of the original contract/obligation. Examples of replacement risk are in the money fuel supply contracts for power plants and advantageous procurement contracts for power plant parts or maintenance. Counterparty Creditworthiness The counterparty creditworthiness is an assessment of the counterpartys ability to fulfil obligations according to contract terms. This is often measured through ratings which can be obtained from external sources (such as credit information providers or rating institutes) or internal models which generate a rating on the counterpart. Ratings, which are a measure of creditworthiness, can also be translated into probabilities of default. This enables a quantifiable approach to measuring the risk value, e.g. by multiplying the exposure with the probability of default to calculate the expected loss. The approach can be extended through more sophisticated modelling to measure unexpected losses and credit value at risk.

3.2. Sources of Risk Sources of credit risk can be categorised as follows: commercial, financial, insurances, procurement and partnerships/projects. Commercial Sales The sales business has two major segments: retail and business (sometimes also called wholesale) customers. In both cases the credit risk stems from identical sources, one being the invoice that needs to be paid on time (settlement risk) and the other being the contracted energy that needs to be taken by the customers (replacement risk, both volumetric and MTM risk). The first source is similar in nature for both components, even if the amounts differ between mass market small amounts for retail (credit risk is reduced through diversification) and small to very large amounts for the business sector (wholesale market). The second source of risk, the volume risk i.e. the variability of the amount of energy being taken differs by segment. Retail demand is closely correlated to weather while business demand is correlated to the economic cycle. The price risk (or MTM risk) is similar for both segments.

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Trading Trading credit risk is often driven not by a single transaction, but by large portfolios of trades. Market standard netting agreements and other tools such as clearing1 ensure effective management of trading credit risk, which is mostly divided into settlement and mark-to-market (MtM) risk. In contrast to sales, replacement risk in trading does not usually carry volumetric risk. MtM risk is often the larger component, especially for trading portfolios with a longer duration. The sophistication of the participants in the various traded markets varies from banks with dedicated risk management, legal resources and models to smaller participants with no segregation of duties and a lack of modelling and risk management skills. The latter are therefore often exposed to unexpected losses. Clearing houses (notably) can both be a source of credit risk and of credit risk mitigation. Actual delivery of the underlying commodity becomes less important as more liquid markets allow replacement to be achieved within minutes. As long as the counterparty satisfies the subsequent demand for damages (the replacement cost), non-delivery will often have no major impact for an active energy trader. Supply While there is no clear distinction between trading and sourcing counterparties on a day-to-day basis, it is market practice to regard some suppliers, especially of single commodities such as coal and/or gas (which offer longer term supply agreements), as sourcing counterparties. In contrast to trading, the actual delivery is often important and non-delivery can lead to a disruption of operations. Also, netting agreements may be of lesser importance as the counterparty tends to be on one side (i.e. always selling). In the gas markets, the sourcing counterparts tend to be large, well-established parties with satisfactory financials. This is not always a given on the coal sourcing side, making credit risk management more challenging and requiring some risk-taking as well as flexibility. Settlement risk is less of an issue as payments tend to flow one direction (to the supplier). The MtM risk tends to be calculated but can often not be influenced (as the sourcing is a direct requirement of the physical operation). Financial Financial counterparties play a growing role in the energy sector not only as lenders or liquidity management partners, but also as commercial partners in trading and risk management. Treasury business is therefore one of the major sources of credit risk, especially as far as cash risk companies are concerned. Often, however, the credit risk management skills applied and processes followed are less rigorous than the ones applied to trading exposures. Treasury credit risk falls into three main categories: 1. Trading-related, for commodities, foreign exchange and interest rate hedging. Very similar to the trading exposures described above. 2. Investment risk. Many companies invest surplus cash on a daily basis in various instruments such as deposits, money market funds, CPs and CDs as well as other instruments such as bonds and shares. Should an issuer of such instruments default, the credit loss to the energy company can be severe.

See also section 2.6 on mitigation for more details. 15

3. Funding risk. This risk is relatively new on the horizon of many treasurers, as it was a risk that materialised during the financial crisis and credit crunch in 2008 and 2009. Many companies rely on back-up facilities for their cash management planning. This is especially valid for energy companies, which are exposed to very volatile markets and often to large and sometimes unexpected margin calls for cleared business as well as bilateral margining (see section 2.6 on mitigation). For these companies, such back-up liquidity lines are of high importance. In case a bank that has underwritten such a limit (or part of such a limit) goes into default or cannot fulfil its obligation to lend money upon the agreed terms, it could result in a liquidity shortfall, with serious consequences for the energy company in question. During the credit crunch, such banks were not easily, if at all, replaceable. Insurances Credit risk related to insurance companies stems from two sources. First, fees are paid in advance and are lost in case of bankruptcy as the insurance cover needs to be replaced. Second, should an insurance company not be able to pay for an insured and covered loss, incurred for example in a fire or other major incident, the damage to the company can be substantial. Therefore, close monitoring of the insurance companies used is of high importance. Procurement General procurement carries the credit risk of non-delivery. Yet in contrast to trading and/or sourcing, mark-to-market risk tends not to be calculated as no price curves are available for most of the products procured. However, the loss of an advantageous transaction carries credit risk. Not only does a new contract need to be drawn up, possibly at a higher cost, but the new efforts and time spent represent an internal cost to the energy company. In many energy companies, these counterparts are not monitored or analysed. Partnerships/Projects Project credit risk can only de defined very generally as the risk that a venture and/or project is reduced in its profitability or net present value (NPV) through the default or delay of a contractual partner.Sources of project credit risk can be: Suppliers/Contractors: Delay or non-delivery of crucial supplies for a project (e.g. a turbine) can lead to very long delays (e.g. delivery of wind turbines). As a result, projects approved on the basis of a profitable net present value (NPV) can be negatively affected and even become loss making. Additionally, it may be the case that subsidies, which are an important factor for certain investment decisions, are linked to a fixed start of operations. Delays caused by the supplier/contractor can lead to a company losing subsidies and severe NPV reductions can be the result. Supply contracts can also be exposed to replacement risk in the same way as general procurement contracts. Warranties: Even after projects have been completed, suppliers and contractors often remain a credit risk to an energy company as warranties remain in place for several years. In case these are not backed up by cash or bank guarantees, this credit risk needs to be monitored and evaluated on an ongoing basis. In addition, concentration risk may occur especially as far as turbine or wind turbine suppliers are concerned.

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Partners in Joint Ventures, Tolling Agreements, Power Purchase Agreements and Production Share Agreements: Default of a partner in a Joint Venture or in another form of agreement might trigger unexpected cash calls for the remaining partners or might result in the need to cover defaulting party obligations (CAPEX, OPEX, management, risks, damages etc.). If remaining partners are not able to meet defaulting party obligations the venture/agreement/project might be liquidated, resulting in emerging costs and/or loss of future proceedings. Activities in CDM (Cooperation Development Mechanisms) or Joint Implementation (JI) projects differ in their risk/return profiles and the structure of implied risks. Direct investments in CDM/JI projects as a project developer and owner often lead to a high capital lock-up. Emission Reduction Purchase Agreements (ERPA), with or without preliminary payment between the utility and the project owners, usually imply a lower discount on the secondary Certified Emission Reduction (CER) market price than a direct investment because of the risks remaining with the project owner. These risks are replaced by higher price and credit risk of the counterparty. Both acquiring activities (direct investment and ERPA) mostly imply delivery of an unsecured number of primary emission certificates. Often it is combined with technical, country, legal and CDM/JI development risks (e.g. registration, verification from the United Nations Framework Convention on Climate Change - UNFCCC). Common risk mitigation tools are unusual in the CDM/JI project market. Thus to ensure a suitable risk assessment and an appropriate steering of a primary certificate project portfolio and preliminary payments, a statistical analysis of CMD/JI market data (e.g. from UNFCCC) to evaluate a project specific failure/delivery rate is essential.

Other sources of project risk: In addition to the above-mentioned sources, projects can be beset by other types of credit-related project risk. There is no generally applicable definition of these risks; these need to be investigated individually for each project. In Germany, for example, companies lease salt caverns for gas storage. The leasing company has the licence to operate the caverns. Should it go bankrupt, the licence falls back to the federal state and will be freshly auctioned. The price of this licence and the risk of not obtaining it put the entire sum invested in the gas storage at risk.

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4. Counterparty Risk Evolution during the Financial Crisis by Risk Source

4.1. A helicopter view on credit risk management over the past decade The various changes experienced in the European energy industry over the last decade have had a major impact on the credit risk to which the industry is exposed. The development of a credit risk management culture within energy companies is maturing and will not happen overnight. Yet when credit risks are not properly managed, unexpected credit losses and under-pricing of counterparty risks can be the result. If this persists over a long period of time, it can lead to system risks for the entire sector. An increase in perceived riskiness would lead to lower ratings, resulting in more expensive financing and less debt-bearing capacity. The slow road towards credit risk management processes and culture

While most companies began managing their exposure to market risk fairly early with the onset of liberalisation in the energy markets, many were much slower to follow with the implementation of effective credit risk management. Early movers implemented professional credit risk management departments in the years before the Enron collapse, whereas some are following only now after the severe economic and banking crises of 2008 and 2009. The situation in 2010 shows that significant country risks exist in the euro area. Trading and sales activities of energy companies are exposed to a huge impact of credit risk on the bases of counterparties, country risk and liquidity risk (potential economic downturn and counterparties that withdraw from the market, especially from the financial industry). Liberalisation and increased competition naturally leads to a reduction of margins in most companies core business (generation and sales). Reduced margins should, in theory, lead to companies taking on less risk as their capacity to bear risk is reduced. Often, however, the opposite is the result. A case in point is the financial sector where reduced margins led to pressure for increased risk-taking to make up for the loss in profitability. As a result of liberalised markets, energy companies are exposed to market risk as well as credit or counterparty risk. With reduced margins, companies need to be able to make such risks transparent and to mitigate them, at least to some extent. The effects of the exposure to credit risk can have a far-reaching impact on energy companies. Major credit losses can lead to reduced creditworthiness and, if in place, lowered public ratings. This, in turn, can reduce profitability and/or lead to reduced liquidity due to higher margin requirements. Even without any experienced credit loss, companies with no effective credit risk management in place may (all other factors unchanged) be considered riskier by their peers and the rating agencies. This alone will lead to reduced debt capacity and will reduce the amount of investments a company is able to carry on its balance sheet. In addition, risky companies are more willing to take on high-risk customers and/or transactions, as risks are not made transparent within the company. Lastly, credit risk will not be adequately priced.

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The recent banking crisis has shown another deficiency in the approach of many companies towards credit risk management. Often, credit risk stemming from trading is well managed and monitored, but in the sales divisions that is the case to a much lesser extent. Many companies also do not consider the credit risk in project development (e.g. what happens to the net present value of an investment if a crucial supplier goes into default?) or carry out reviews on treasury counterparties. During 2008 the latter was at least remedied in many organisations, but the competitive pressure in the sales segment still leads to imbalances between companies with good credit risk management capabilities as the market standards are due to competition dictated by the companies with the least demands for credit risk protection. Without a minimum standard/a level playing field for credit mitigation in the industry, risk-based pricing is not possible. This will, in the long term, lead to a weakened profile for the industry as a whole and will in the end affect the amount of debt a company can carry on its balance sheet. Proper pricing of counterparty risk by energy companies is a challenge

One of the main consequences of the financial crisis for the energy sector has been the relevant increase of counterparty risk level. For all sources mentioned in paragraph 2.3.2, the financial crisis has led to decreasing creditworthiness and increasing default rates. Additionally, the industrial downturn experienced during the financial crisis caused a reduction of energy consumption, affecting energy companies not only in terms of credit risk on cash payments, but also in terms of volume risk on supply. Finally, a big increase of counterparty risk in the energy sector was created by the huge market volatility experienced during financial crisis. Most energy companies hedged market risk through physical and/or financial hedging that ultimately transformed market risk exposure into credit risk exposure towards the counterparties providing the hedging contracts. It is questionable whether energy companies actually have the possibility and/or the capability to fairly factor in such increased levels of risk into their business and, ultimately, into energy pricing. There is no doubt that financial institutions have immediately factored in the increased level of credit risk to lending costs, even though one of the most important causes of the financial crisis has been recognised as credit risk mispricing itself. By contrast, energy companies have not had the possibility and the ability to increase energy prices as a result of growing counterparty risk that would have added another pro-cyclic factor to the crisis. Instead, counterparty risk has been substantially internalised by the energy sector with serious consequences: a reduced risk weighted profitability of invested capital in the energy sector, increased levels of risk supported by risk capital of energy companies on balance sheet, a growing weakness of the energy sectors rating and creditworthiness, and increasing costs of financing new investments in energy projects. Risks that are heavily underestimated and mispriced for a long period of time might turn into systemic risks for the sector, which in turn might trigger sudden shocks to properly rebalance a fair risk profile.

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4.2. Risk related to Commercial Counterparties Commercial counterparties have undoubtedly been a relevant source of credit risk for the energy sector during the financial crisis. The first obvious consequence of the economic crisis following the financial one was the settlement risk on sales, with energy companies turnovers affected by defaulting or delayed payments of bills, especially for core commercial segments of EU energy markets, i.e. large industrial consumers and small/medium enterprises. However, the most unexpected counterparty risk for a sector used to a continuous growth of demand was the collapse of physical consumption experienced on the sale side. In essence, the sale side of the energy sector was characterised by an unforeseen drop in consumption and an unhedgeable credit risk on payments. The actual peak of counterparty risk was due to replacement risk related to forward sales on OTC and final end-user markets. This can be partly explained by the structure of final sales, often based on annual fixed-price contracts, and partly because forward selling at a fixed price was energy companies main way of hedging against market volatility. Indeed, during the financial crisis, power companies accumulated a huge amount of replacement risk on forward sales that went deep in the money when the power price collapsed. Only one part of this huge risk was evident: the part related to future sales on the regulated market, since credit risk is regulated cash managed through the margining mechanism. Instead, replacement risk on deeply-in-the-money forward sales on OTC markets and to final customers was substantially internalised on the guarantees structures and balance sheets of power companies. The risk profile of the power sector was furthermore increased by the asymmetry of volume risk between the supply side and the sale side: o On the supply side (e.g. gas for generation), markets are characterised by a much more rigid structure with a lesser role of spot markets, a medium/long-term contractual horizon and heavy take-or-pay clauses. o The power market structure on the sale side, by contrast, is characterised by liquid spot and forward markets, a medium-term contractual horizon of normally 1-2 years and the absence of volume risk protection clauses such as take-or-pay clauses. Therefore power companies ended up being squeezed between flexible consumption and rigid supply, bearing volume risk both on the sale side (lower consumption) and on the supply side (gas take-or-pay clauses).

4.3. Risk related to Financial and Insurance Counterparties The distress of the financial sector during the crisis has had heavy effects on the counterparty risk profile of power companies. The most obvious were the settlement risk on the premium paid to insurances, as AIG and other international insurances were defaulting, and the settlement plus replacement risks on hedging and trading contracts negotiated with financial institutions playing an active role in most regulated and OTC commodity markets. Some of the most important investment banks that were defaulting or about to default were involved in commodity markets.
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Moreover, it is normal practice for a power company hedging physical power output with forward/future sales to simultaneously hedge fuel costs (i.e. oil, coal and US dollar exposure) and CO2 by means of financial contracts structured mainly via OTC with banks. Being forward on sales deep in the money meant that financial hedging contracts were deep out of the money, with payments due by power companies to banks. Also in this case, the counterparty risk suffered by power companies on the sale side (as industrial customers reduced their consumption) was not offset by a proportional reduction of financial contracts physical underlying as financial contracts are structured on fixed volumes, thus transferring volume risk onto power companies. Ultimately power companies were obliged to pay hedging negative cash flows also on the amount not consumed by their final customers. In other words, given the overall amount of demand reduction, they paid negative cash flows for hedging their costs without receiving the positive cash flow on forward sales. However, the main problem was on the liquidity side, as merchant banks struggled to support committed lines and were reluctant to open new credit facilities, exacerbating a liquidity concern in the energy sector. Such concerns were justified by the cash shortfall stemming from credit and volume risk on the sale side, in the very period in which most energy companies were right in the middle of investment plans for new infrastructures and/or acquisitions. Liquidity concern, in turn, was a basic driver for the power sectors deteriorated rating ratios and creditworthiness.

4.4. Risk related to Procurement and Partnerships/projects Energy companies exposed to such risk were mainly those relying on a strategic partner that was not easily replaceable. However, one might assert that in general, replacement risk related to procurement was reduced during the financial crisis because of the economic downturn. On the other hand, several suppliers were in financial distress because investments stopped, thus increasing the probability of default. Severe demand reduction for machineries, materials and services released the stress put on the supply side of the markets, as was the case, for example, for solar panels or oil rigs, which were in strong demand before the crisis. By contrast, counterparty risk related to partnerships/joint ventures/agreements increased due to the liquidity shortage. This pushed many companies to delay their CAPEX programmes, in some cases affecting their partners capabilities to actually carry out the initiatives.

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5. Quantification exercise
5.1. Methodology This section provides a representative quantification example of a power companys exposure to counterparty risk. The calculations assume that a power company decided to hedge 10 TWh of CCGT gas fired production by selling forward the power for calendar year 2009 during the second and third quarters of 2008 while simultaneously hedging fuel costs through financial contracts on oil and the dollar-euro foreign exchange (FX) rate. The situation is summarised in the figure below.

5.2 Assumptions

GAS 2 Bcm of Gas Consumption

OIL

$/

8 Mln bbl of Brent Oil and 650 Mln $ of financial contracts for heding fuel costs

Figure 4 Using EEX Cal 2009 market data, the power sold forward for 2009 during the period of Mar-Aug 2008 would have been priced at an average of 72.7 /MWh. Using Brent oil and dollar-euro FX rate market data for the same period, the financial hedging would have been structured on an average of 121.8 $/bbl for Brent oil and 1.47 for the dollar-euro FX rate.

EEX Price Cal. 09 Volumes Sold Forward Volumes Sold Forward

10 9

100
90.2 83.3 79.0 72.5 64.5 66.6 78.3 68.3 57.2 56.3

MWh )) MWh // ((

90 80 70 60 50 40

TWh TWh

) ((

8 7 6 5 4 3 2 1 0
61.5 61.5 63.1

10 TWh of Power Sold Forward on Calendar 2009 @ 72,7 /MWh on avg.

30 20 10 0

Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08 Oct 08 Nov 08 Dec 08 FWD @ 31/12/08

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Figure 5: Counterparty Risk exposure on 10 TWh hedged by selling forward physical power and hedging gas cost with financial derivatives on Brent and $/ FX 5.3. Results

Settlement Exposure: 180 Mln Replacement Exposure: 120 Mln

Take-or-Pay Exposure: 22 Mln Over-hedging Exposure: 18 Mln

For the 10 TWh of power sold forward in terms of counterparty risk direct exposure at the beginning of 2009 the power company registers on its books: around 180 Mln of settlement exposure related to an average of 3 out of 12 months of supply at 72.7 /MWh (volumes supplied but not paid by customer before being able to cut supply) around 120 Mln of replacement exposure related to the positive market value of the remaining 9 months of supply sold at an average price of 72.7 and revaluated at 56.3 /MWh on the 31 December 2008 forward curve for calendar year 2009.

The overall level of risk is increased not only in terms of growing exposure due to market volatility but also by reduced creditworthiness of industrial customers and therefore an increase in expected loss. On top of such exposure on the sale side, the downturn in demand decreases actual consumption and turnover for the power company during 2009 without the possibility of proportionally reducing gas supply volumes and financially hedging physical underlying contracts. The power company therefore experiences an exposure on the gas supply side related to the takeor-pay clause and an exposure to the financial sector related to financial hedging on oil and $/ FX. Assuming that the 10 TWh sold forward to industrial customers were affected by the average 2009 on 2008 reduction of German industrial demand (around 5.5%), the power company would see a reduction of 0.55 TWh on power delivery and would be exposed to: a negative cash out of around 20-25 Mln related to prepayment of around 100 Mln Scm of take-or-pay gas, assuming an average 2009 gas price of 21.56 c/Smc and that the power company had already used the flexibility of the supply gas contract; a negative cash out of around 18 Mln related to financial over-hedging on Brent oil and $/ FX for the 0.55 TWh equivalent of demand reduction, considering that Brent oil and $/ settlement prices were respectively on average 78.2 $/bbl and 1.42 vs. 121.8 $/bbl and 1.47 of hedged levels.

In a nutshell, power companies during the financial crisis were heavily squeezed between reduced positive cash flows expectations, due to the reduction of demand and reduced customer creditworthiness, and increased negative cash flows, due to the rigidity of supply and financial contracts.

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5.4. Quantification of the impact of an increase in credit spreads in WACC In this quantification exercise we analyse the impact of the increase of credit risk on a companys cost of capital along the lines of the methodology used for the first part on market volatility risk. The focus is on the risk of a potential deterioration of power companies credit merit and the perception by markets and rating agencies (we are, so to say, looking from outside in, and not from the inside out). Most of the companies in the sector maintain the objective of not dropping below a rating of A. At the end of this section we quantify how much the capital costs for new CAPEX (based on the Power Choices study) increase when the rating of power companies decreases from A to BBB. We analyse the impact taking into account the difference in credit spreads of A and BBB ratings, both for a long-term period (January 2002 to June 2010) and a stress period (December 2008 the month with the highest credit spreads for corporations during the financial crisis). Yields 10Y Jan2002-Jun20102 (%)
10 9 8 7 6 5 4 3 2 1 0

01/02/2002

01/08/2002

01/02/2003

01/08/2003

01/02/2004

01/08/2004

01/02/2005

01/08/2005

01/02/2006

01/08/2006

01/02/2007

01/08/2007

01/02/2008

01/08/2008

01/02/2009

01/08/2009

Bund 10Y BFV Rat A

BFV Rat AA+ / AA BFV Rat BBB

Figure 6

BFV : Bloomberg Fair Values 24

01/02/2010

Credit Spreads 10Y Jan2002-Jun2010 (%)

6 5 4 3 2 1 0

01/01/2002

01/07/2002

01/01/2003

01/07/2003

01/01/2004

01/07/2004

01/01/2005

01/07/2005

01/01/2006

01/07/2006

01/01/2007

01/07/2007

01/01/2008

01/07/2008

01/01/2009

01/07/2009

BFV Rat AA+ / AA BFV Rat BBB

BFV Rat A

Figure 7

Credit Spreads 10Y scenarios for analysis Average values for spreads used in our model:
Spreads Avg Jan2002-Jun2010 Avg Dec2008 AA+/AA 0.5% 1.5% A 0.9% 2.7% BBB 1.6% 5.4%

For the average Jan2002-Jun2010 credit spreads, a change of rating from A to BBB implies an increase in credit spread of 0.7%, increasing the WACC as follows: 50%*(1-30%)*0.7% = 0.2%. If we analyse changes in WACC due to increases in credit spreads during the most agitated days of the financial crisis, then retaining a rating of A would imply an increase in WACC of 50%*(130%)*1.8% = 0.6%. The move from a stable-day rating of A to a rating of BBB in times of financial crisis would imply an increase in WACC of 50 %*(1-30%)*4.5% = 1.6. For the first case increase in WACC of 0.2% we have:
M

2005
(1) Annual Capital Costs for new CAPEX (2000-2050) (2) Impact of +0.2% in WACC (2)/(1)

2010
27,878 452
1.6%

2015
50,677 819
1.6%

2020
72,208 1,161
1.6%

2025
84,907 1,384
1.6%

2030
102,820 1,703
1.7%

01/01/2010
2035
113,630 1,907
1.7%

2040
129,661 2,198
1.7%

2045
137,872 2,323
1.7%

2050
143,626 2,424
1.7%

12,687 209
1.7%

As a result, an increase of 0.2% in WACC (applied only to new investments) will result in the increase of around 2.4bn in annual capital costs (+2.4bn +1.7% * 144bn ), in 2050.

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6. Mitigation of Counterparty Risk for the Power Sector

6.1. Mitigation tools Energy companies have a wide basket of mitigation tools at their disposal, although some of them can only be applied to: o a certain type of business (e.g. clearing to trading activities) o a certain type of customer (e.g. bilateral margining can only be entered into with a sophisticated contract partner that understands the implications of such agreements) o a certain jurisdiction (e.g. physical netting remains problematic in some countries within Europe) Netting agreements One of the most efficient tools to reduce credit risk, especially in energy trading, is the so-called close-out netting. Netting is applied to mutual claims which are then accelerated in the event of default. Claims include settlements and mark-to-market amounts of both the defaulting and the non-defaulting party, which are offset against each other, thereby reducing credit risk. For closeout netting to apply, parties will usually have to enter into netting agreements (for example EFET and ISDA agreements). Close-out netting is currently not allowed in all jurisdictions, making active trading combined with effective credit risk management difficult. Cross commodity netting To achieve maximum netting effectiveness, two counterparties may agree on a contract which enables netting across all commodity positions (if the jurisdiction allows this). For example, positions that are in-the-money in gas trading can be offset by positions in power trading that are out-of-the-money. Bilateral margining Another tool used to mitigate trading-related credit risk mainly is bilateral margining, whereby counterparties agree on thresholds for credit exposure. Should credit exposure rise above the agreed thresholds, then cash or other collateral is exchanged on a daily basis to reduce the credit risk back to the agreed threshold level. In doing so, credit risk is exchanged for liquidity risk. Clearing Very similar to bilateral margining, this method also sees an exchange of credit risk for liquidity risk. All transactions are entered with a central counterparty, the clearing house, which collects initial and variation margining to cover the credit risk on the transactions entered into. Collaterals Collaterals can be used to transfer credit risk to another, more creditworthy, counterparty. Examples include parent company guarantees, bank guarantees and letters of credit. Other forms of collaterals can also be used, including for example mortgages and deposits.

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Payment terms Often used in sourcing and sales, payment terms can be used to reduce the settlement risk of a transaction. Long-term payment terms substantially increase the settlement risk of a transaction while pre-payments reduce this risk to zero. Contractual clauses o Rating trigger: Collateral or termination of underlying transactions can be demanded in case a counterpartys rating falls below a pre-agreed level. Very useful for credit protection, rating triggers can also be used against an entity in case of financial difficulties resulting in a possible downgrade. Companies using rating triggers should monitor these carefully and be well aware of the negative impact such rating triggers can have. o Financial covenants can be agreed, as in bank loan agreements, for both trading and sales contracts. Covenants can be difficult to be agreed upon, cumbersome to check and often have a long delay as the covenant receiving party has to wait until the publication of the annual report in order to see if the financial health of its contract partner is still in line with the agreed minimum standards at the inception of the transaction. o Ownership clauses: Counterparties may take comfort in having a specific owner as a contract partner. Clauses can be added to the contract which allow forsaking for collateral or even early termination of a transaction should the ownership (for example state-owned companies) change. Other risk mitigation tools o Insurance companies offer various policies to protect from credit risk. Often these insurance contracts cover a limited time period (one year) and cover settlement risk more easily than MtM risk. o Credit default swaps: a credit default swap (CDS) is a swap designed to transfer the credit exposure of fixed income products between parties. It is the most widely used credit derivative and consists of an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a payment by the seller contingent upon a credit event happening in the reference entity.

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7. Conclusions and Recommendations

This chapter on counterparty risk has depicted the current credit risk dynamics from the point of view of energy company risk managers as well as breaking down the concept of counterparty risk with a view to enabling European risk managers to speak the same language. Two factors have driven this study: the financial crisis on the one hand and the large investments needs of the European electricity industry on the other, which a EURELECTRIC study has quantified as 2 trillion euros by 2050. Counterparty risk, as any other risk, represents a cost for the power sector. While risk is inherent to every competitive business, this should not mean that efforts to reduce overall systemic risk should not be pursued. On the contrary, we feel it is important to reduce as much as possible the unnecessary risk related to market design failure, the regulatory framework, systemic asymmetries, etc. The table below summarises by risk source the various risk mitigation measures proposed in this paper.

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RISK PROFILE TRENDS

COMMERCIAL (energy sales, trading & supply)
Increase of settlement risk because demand reduction recently experienced is more than compensated by increasing % of volumes sold on EU free markets Increase of replacement risk because higher markets volatility translate in higher fair values of sales contracts Depressed creditworthiness of Industrial clients

POTENTIAL MITIGATIONS
Development of mitigation tools and risk management models for fair pricing of credit risk on sales Rebalancing supply and sale sides of Power Sector in term of markets and contractual structures (renegotiate/remove Take or Pay clauses and increase supply flexibility; increase role of gas spot markets; increase M/L term power contracting opportunities)

COUNTERPARTY RISK SOURCES

Strengthen soundness and creditworthiness of Financial Institutions by implementing new capital requirements (Basel III)

FINANCIAL INSTITUTIONS & INSURANCES

Increase of replacement risk because higher markets volatility translate in higher fair values of hedging and trading contracts
Depressed creditworthiness of Financial Institutions Risk of reduced availability of credit lines and funding capacity for supporting M/L term investments plan and short term liquidity absorbed by core business

Reform of financial OTC market with propter credit risk management. Non financial firms, such as Power Companies, using derivatives mainly for hedging should be granted an exemption from compulsory clearing and other far reaching requirements imposed to financial institutions by MIFID and CRD) thus avoiding cost increase. Standardisation of derivatives should be addressed with a specific set of rules for commodity markets Enhance energy market specific measures, as envisaged by EC concerning market disciple, transparency and supervision through REMIT. Improve credit risk pricing models

Depressed creditworthiness of Partners Risk increased only in case of critical strategic Partners Increase role of Export Credit and Multilateral Agencies Reduced Replacement risk due to increased competition linked to global economic downturn Room for Private/Public Partnership to guarantee part of counterparty risk reducing investment costs Country and sovereign risk increase might affect exposure when Governments are Partner in projects and/or supply chain

PROCUREMENT & PARTNERSHIPS

Figure 8: Risk mitigation measures proposed classified by risk source

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o Commercial counterparties The power sector is currently affected by an evident asymmetry between the sale side and the supply side resulting from the different competitive structures between the power market and fuel markets (gas, oil and coal). Compared to fuel markets, the power market is characterised by the strong role of EU spot markets and by contracts that are based on a short-term horizon, renewed annually, fairly standardised and have flexible off-take and prices, thus transferring most of the volume risk onto sellers. By contrast, fuel markets, in particular the gas market, are characterised by a still developing role of spot markets and a contractual structure based on a medium-long term horizon, long-lasting negotiations of customised contracts and rigid off-take clauses and pricing formulas, thus transferring most of the volume risk onto buyers. Rebalancing the supply and sale sides of the power sector as regards markets and contractual structures would help to lower counterparty and volume risk exposure. To that effect, the following measures could be considered: renegotiate/remove take-or-pay clauses and increase supply flexibility increase the role of gas spot markets increase the medium/long-term power contracting opportunities o Financial counterparties Since recognizing credit risk mispricing (undervaluation) as one of the most important causes of the financial crisis, both the European and the US governments have launched several political/legislative initiatives to strengthen the global financial system by introducing higher capital requirements the so-called Basel III capital requirements. The European Union (EU) has notably increased the power of EU supervisory institutions (creating new financial authorities) and has enhanced market discipline and transparency alongside broader initiatives such as the over-the-counter (OTC) market reform, the Markets in Financial Instruments Directive (MiFID) and the Market Abuse Directive (MAD). Although the above actions would reduce the credit risk of the financial sector, they are currently opposed by industrial players using financial markets for their hedging programmes, including power companies. This is especially the case for OTC market reform, which aims to shift financial trading as much as possible from OTC to regulated markets, where credit risk is properly and transparently priced and managed by central counterparty clearing based on a margining mechanism. This reform would transform the credit risk on OTC contracts into a liquidity risk for power companies, resulting in higher hedging costs and the need for an adequately sized back-up cash credit line to cover potentially extreme margin calls due to very volatile market movements.

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Industrial players using derivatives for their hedging programmes, including power companies, should therefore be granted an exemption from compulsory clearing, thus avoiding cost increases. In addition, the standardisation of derivatives products should be addressed through a specific set of rules for commodities markets. At the same time, the concern about the high additional costs of managing the credit risk of OTC contracts transferred onto regulated markets might signal that credit risk is currently undervalued and mispriced in energy transactions. Other pitfalls which regulators should avoid when pursuing financial sector reform are the additional bureaucratic burden, the duplication of information and the multiplication of ICT systems and protocols foreseen in the reforms. Lastly, there is a global concern about possible restrictions of the financial sectors funding capacity: higher capitalisation standards might ultimately result in a more difficult access to credit loans for the power sector, currently involved in a very capitalintensive phase. o Procurement and partnership counterparties Finally, as far as procurement and partnership counterparties are concerned, there is scope for an increasing role for those actors able to guarantee part of a projects credit risk in order to reduce financing cost. This is certainly the case for Export Credit and Multilateral Agencies, which normally also insure against country and sovereign risk. However, credit risk guarantee constitutes another interesting area of public-private partnerships, as demonstrated by the recent US government $8.3bn loan guarantee scheme put in place to finance two new nuclear reactors in Georgia. The loan guarantees were authorised by the Energy Policy Act of 2005. If the reactors are built and operated profitably, the borrowers will repay the banks and pay a fee to the federal government, in exchange for the guarantee that the federal government will repay the banks if the borrowers default. This case is a clear example of the US government using its creditworthiness to reduce the financing costs and ultimately the energy price for final customers. In addition, the US government receives remuneration for the service, which might be passed on to taxpayers by further reducing the final power price or reinvesting in infrastructures. The main conclusion of this chapter is that increased awareness in the power sector about credit risk would result in a prudent management of such risks, which could eventually lead to lower a lower risk premium paid by the power sector and by customers. Our quantification exercise shows that a simulated WACC increase of 0.2% in (applied to new investments only) due to additional credit risk will result in an increase in annual capital costs of around 2.4bn (+2.4bn +1.7% * 144bn) in 2050. Specifically, more prudent credit risk management would result in correct pricing and transparency of credit risk as well lower risk of unexpected credit losses. We hence recommend that the sector proactively pursues:

31

 A rebalancing of the risk between the sales and supply side through restructuring of contracts to lower the credit risk exposure, An active role in recommending financial regulations which increase transparency and effectively mitigate systemic risks at a reasonable cost, Encouraging potential guarantors of large projects such as export credit agencies or other public or private partnerships in order to reduce investment costs. Policymakers should play an active role in this regard and encourage the use of the potential credit risk mitigation tools listed above.

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ANNEX: Methodology used to quantify the impact of an increase in credit spreads in WACC

WACC = D/(D+E)*(1-Tc)*Cost_Debt + E/(D+E)*Cost_Equity Cost_Debt = Rf + Credit_Spread

Assuming that only Credit Spread changes, than change in WACC will be:

WACC = D/(D+E)*(1-Tc)*Credit_Spread
In our example:

WACC = 50%*(1-30%)*Credit_Spread

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Union of the Electricity Industry - EURELECTRIC aisbl Boulevard de lImpratrice, 66 - bte 2 B - 1000 Brussels Belgium Tel: + 32 2 515 10 00 Fax: + 32 2 515 10 10 VAT: BE 0462 679 112 www.eurelectric.org