Ensuring the Flow of PowerNew regulations address credit in the wholesale electricity markets

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Federal Energy Regulatory Commission (FERC) Orders 741 and 741-A are rules to reform credit practices within the organized wholesale electricity markets and protect consumers from the adverse effects of a default in the market.

During the autumn of 2008, the crisis in the financial markets shook the United States profoundly. Along with other consequences, credit markets were disrupted, severely limiting the availability of capital. Companies participating in wholesale electricity markets were vulnerable to the effects of this liquidity crisis, and concern grew that a Regional Transmission Organization (RTO) or Independent System Operator (ISO) might not have access to the capital they needed. This could leave many utilities at risk, causing a potential disruption in the flow of power.

Recognizing the possibly serious consequences, the Federal Energy Regulatory Commission (FERC) took a closer look into the role of credit among RTOs, ISOs and market participants. The result is FERC Orders 741 and 741-A. The purpose of the rules is to strengthen credit practices among organized wholesale electricity

markets. Companies participating in wholesale electricity markets will need to demonstrate that they can meet the requirements in seven areas outlined by the new FERC rules. The majority of the legislation went into effect October 1, 2011, with the remainder effective January 2012.

RTOs, ISOs and market participants may implement the new FERC rules in various ways, but it is clear to all that changes are coming. For all participants in the organized wholesale electricity markets, Order No. 741 and Order No. 741-A will have an impact on multiple areas of the company (Figure 1). Processes, systems, tools and people will be affected. The work now for RTOs, ISOs and all participants in this market is to determine how to adjust the organization to strengthen risk management practices that support compliance. See Figure 2 for the mission of the Federal Energy Regulatory Commission.

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Figure 1: Summary of FERC Orders 741 and 741-A

Source: Federal Energy Regulatory Commission

Figure 2: The Mission of the Federal Energy Regulatory Commission

Source: Accenture

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Commission Determination

1. Shortening of Settlement Cycle

“In this Final Rule, the Commission adopts the NOPR proposal to direct each ISO and RTO to submit a compliance filing that includes tariff revisions to establish billing periods of no more than seven days and settlement periods of no more than seven days after issuance of bills.”

FERC Order No. 741 ¶32

ConsiderationsAre your current settlement policies, processes, systems and reporting set up to comply with a shortened settlement cycle?

Companies will need to consider the systems and business processes that support their settlement and resettlement activities. The breadth of change required to support the shortened settlement cycle should be understood and actions taken to identify—and efficiently close—any gap.

Settlement systems tend to be highly interconnected with many upstream and downstream systems. These include the front office system, market information system, credit management system, decision support system, invoicing system and general ledger system.

Technology enables the essentials of credit risk management – measuring and monitoring exposure, risk rating counterparties and scoring, for instance. But the biggest contribution it makes is allowing the company to know at any point in time what a counterparty owes or could potentially owe in the future.

Commission Determination

2. Use of Unsecured Credit

“The Commission grants rehearing on this issue. Specifically, the Commission is persuaded that an entity reconfiguring its corporate structure, to avoid the $50 million single-entity cap and to instead take advantage of the $100 million corporate family cap, raises a significant risk that is inconsistent with Order No. 741’s intent to lower risk ... The Commission therefore grants rehearing and finds that the limit on the use of unsecured credit should be no more than $50 million per entity, including the corporate family to which an entity belongs.”

FERC Order No. 741¶

ConsiderationsAre your business objectives affected by the $50 million limit on unsecured credit?

Are capital disbursements effected?

Is your current risk profile still effective?

In order to provide alerts for tracking limits are changes required to limit monitoring tools and/or internal credit risk reporting capabilities?

Do current credit risk management policies and procedures provide alerts when nearing limits?

Elimination of unsecured credit for transmission capacity contracts requires changes to tariffs, business processes and systems to manage and separate collateral. These contracts will need to be accurately priced and updated and this will result in periodic price updates and possible margin calls to ensure that the entire value on the contract is collateralized. This could lead to greater strain on market participants’ liquidity, and individual market participants will need to determine the maximum length and cost they are willing to assume on these contracts.

Companies with an integrated view of their exposure can be proactively placing hedges and demanding collateral. The company’s technology needs to always tie into its other critical solutions— such as Enterprise Resource Planning— to allow real-time updating of credit exposure. Credit reporting is a critical aspect of the technology and systems landscape. In today’s volatile environment, the front office may require flexible reporting solutions to capture inefficiencies in the market, while the middle office uses other reports to actively manage risk. And the back office may need an entirely different set of financial reports. Reporting that uses integrated data and systems allows the company to actively coordinate all those efforts and mitigate risk through informed, value-adding business decisions. Complex risk analytics are another area where technology can enable performance. The use of analytics can enhance the company’s capabilities around limit monitoring and integrating netting into its calculations.

Commission Determination

3. Elimination of Unsecured Credit for Financial Transmission Rights (FTR) Markets

“… the Commission directs each ISO and RTO to submit a compliance filing that includes tariff revisions to eliminate the use of unsecured credit in its FTR, or FTR-equivalent, markets…”

FERC Order No. 741 ¶75

ConsiderationsAre your current systems and business processes ready to support the new valuation models and collateral calls necessary to support FTR transactions?

Are there downstream system implications?

The following explores FERC rule changes and their potential impact on the business.

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Elimination of unsecured credit for transmission capacity contracts will likely involve changes to tariffs, business processes and systems to manage and separate collateral. These contracts will need to be accurately priced and updated. Periodic price updates and possible margin calls may be required to ensure that the entire value on the contract is collateralized.

A good, solid contract management process allows a company to structure agreements that provide credit protection when needed. If a company’s commercial agreements are in order, posting of collateral becomes a highly valuable credit management tool. But having current contract information and credit exposure data is critical to making use of such tools. Does your contract management system capture credit details in a way that gives you quick access to credit management provisions?

Commission Determination4. Ability to Offset Market Obligations

“While the Commission, in response to what it still considers to be a legitimate concern, originally proposed requiring ISOs and RTOs to establish themselves as the central counterparty to transactions with market participants, the Commission is open to considering other solutions to this concern. The Commission directs each ISO and RTO to submit a compliance filing that includes tariff revisions to include one of the following options:

i. Establish a central counterparty as discussed above.

ii. Require market participants to provide a security interest in their transactions in order to establish collateral requirements based on net exposure.

iii. Propose another alternative, which provides the same degree of protection as the two above-mentioned methods.

iv. Choose none of the three above alternatives, and instead establish credit requirements for market participants based on their gross obligations.”

FERC Order No. 741 ¶117

ConsiderationsCan the required system implementations and business process changes, necessary to offset market obligations, be completed in time to meet the new deadline?

Which markets are capable of fulfilling this requirement?

What will be the final solution? Security interest, establishing credit requirements or central counterparty? Each solution has its benefits and drawbacks. A security interest may be the easiest to implement for some, since similar wording already exists in some of the tariffs. However, will the security interest be in conflict with financing agreements or bond documents already in place? Determining such a conflict will require a review of all market participant legal documents to ensure that a security interest could be granted to the RTO and ISO. Market participants that cannot allow a security interest will have to post collateral based on their gross obligation. The definition of gross obligation will require interpretation at the RTO and ISO level.

The central counterparty approach may offer the greater potential benefit but it also comes at the highest cost and could result in significant changes to business procedures and technology. This approach would require the RTO and ISO to take brief ownership (“flash title”) of the power while it goes from destination to source—for energy sold by every supplier and purchased by every buyer. This has the potential for allowing transactions to be cleared on national exchanges. Companies may want to look at whether the netting of transactions is allowed across multiple RTOs and ISOs or with transactions in other types of markets (e.g., natural gas, crude).

Contracts offer differing ways to protect against counterparty default, such as netting agreements and the right to demand collateral from a counterparty. In leading practice organizations contracts are readily accessible, contain necessary credit details and are enforceable. And these organizations institute policies and practices that require the regular review of legal agreements to ensure that their credit rights are protected.

Commission Determination5. Minimum Criteria for Market Participation

“The Commission is persuaded that each ISO and RTO should include in its tariff language to specify minimum participation criteria to be eligible to participate in the organized wholesale electric market, such as requirements related to adequate capitalization and risk management controls. This will help protect the markets from risks posed by under-capitalized participants or those who do not have adequate risk management procedures in place. Minimum criteria for market participation could include the capability to engage in risk management or hedging or to out-source this capability with periodic compliance verification, to make sure that each market participant has adequate risk management capabilities and adequate capital to engage in trading with minimal risk, and related costs, to the market as a whole.”

FERC Order No. 741 ¶131

ConsiderationsAre the appropriate risk management strategy, process, organization, and tools in place for compliance purposes? (see Figure 3)

Are ISOs/RTOs helping to clarify and define the minimum criteria for risk management?

FERC Order No. 741 is changing the way that RTOs and ISOs on-board and monitor market participants. FERC is looking to ensure that once a market participant is approved, the participant’s ability to mitigate or bear the risks of doing business in the wholesale energy markets is continually monitored. FERC has suggested that a review of each market participant’s risk policies and procedures is necessary to evaluate their ability to transact in this market. Risk management capabilities may include establishing minimal risk criteria, performing risk assessments of all market participants on a periodic basis, and maintaining clearly defined and auditable risk management governance, policies and procedures.

Figure 3: Accenture Approach to Enterprise Risk Management

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Source: Accenture

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FERC is also addressing adequate capitalization requirements for each market participant.

Risk rating models must align credit limits with the level of credit exposure required to enable an entity’s business objectives and at the same time be consistent with the entity’s credit strategy and risk tolerance. The best internal risk rating models take into account both qualitative and quantitative data. Qualitative input assigns a value to considerations like the strength of the management team, the robustness of the business strategies, the ability of counterparties to manage their own risk and thus their liquidity, and the ability to meet payment obligations.

Commission Determination

6. Use of Material Adverse Change

“We adopt the NOPR proposal to require ISOs and RTOs to specify in their tariffs the conditions under which they will request additional collateral due to a material adverse change. However, we are persuaded by commenters that this list should not be exhaustive and the tariff provisions should allow the ISOs and RTOs to use their discretion to request additional collateral in response to unusual or unforeseen circumstances. We are also persuaded that a market participant should receive a written explanation explaining the invocation of the material adverse change clause.”

FERC Order No. 741 ¶147

“In addition, material adverse change clauses need to be sufficiently forward-looking to allow market administrators to request additional collateral before a crisis starts. The Commission is concerned that any attempt to acquire additional collateral during or after a crisis has begun would either fail or destabilize the party asked to provide additional credit.”

FERC Order No. 741 ¶137

ConsiderationsWill your current people resources, systems and processes support the requirement for an enforceable forward-looking Material Adverse Change (MAC) clause?

How will each ISO/RTO define a MAC and how will this affect your enterprise?

The ability to request additional collateral is vital to the long-term viability of all the RTOs and ISOs. FERC has suggested that requesting additional collateral after the start of a crisis could destabilize the market participant and possibly the market as a whole; hence the shift in focus from reactive measures to predictive measures. Even if the company’s list of conditions that would invoke the material adverse change clause is not all-inclusive, FERC has suggested that it remain open-ended to support additional events that may arise.

One way RTOs and ISOs can monitor counterparty solvency is to develop predictive measures to highlight potential changes to counterparty’s solvency. This requires changes to their tariffs, business processes and systems.

Advanced credit risk metrics can give practitioners more insight into what their maximum expected credit loss could be given a predetermined time and stated confidence level; however, it is vital to stress test against real-world examples or hypothetical scenarios. Robust stress testing can help bring the company’s expertise, technology and planning together to prevent outcomes that may be critically damaging to the organization.

Commission Determination7. Grace Period to “Cure” Collateral Posting

“The Commission adopts the NOPR proposal to require each ISO and RTO to include in the credit provisions of its tariff language to limit the time period allowed to post additional collateral. In addition, we require each ISO and RTO to allow no more than two days to “cure” a collateral call.”

FERC Order No. 741 ¶160

ConsiderationsAre your infrastructure and people in place to support a two day grace period for “curing” collateral calls?

The systems of the RTOs, ISOs and market participants will need to be modified to ensure the timely transfer of funds after a collateral call in order to support FERC Order No. 741.

Ensuring the rights to collateral and obtaining collateral quickly can greatly minimize credit risk. On a daily basis, credit risk management needs to be able to quickly calculate margin amounts, both receivable and payable. It must be able to accurately and quickly process these payments and receivables. With the current market volatility, those amounts can add up to significant sums and seriously affect the balance sheet and liquidity.

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Do you have a clearly articulated credit risk management strategy?The following are ten important elements that go into best practice credit risk governance.

1. Credit limits based on the organization’s risk tolerance and business objectives

2. Counterparty risk rating and scoring process

3. Frequent risk rating reviews

4. Tools to manage credit risk and authority to use those tools

5. Methods to resolve internal credit disagreements

6. Definition of how contracts must address credit

7. Methods to monitor and report credit utilization and limit breaches

8. Minimum credit standards and limits for all types of exposures

9. Consequences and/or actions if a limit violation occurs

10. Establishment of a credit reserve

Source: Accenture

Counterparty exposure is a major risk. Managing it takes attention to these six credit risk management practice areas – and mastery of them. 1. Credit Risk governance

2. Risk rating of counterparties

3. Managing contracts and legal documents

4. Measuring and reporting credit exposure across the enterprise

5. Technology and systems

6. Managing credit exposure

Source: Accenture

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Given the lead time needed to implement some of the potential changes required by this regulation, utility companies could benefit by assessing their organizational model and business objectives sooner rather than later. One key objective is to determine where the new regulations impose constraints on current operations. Additional analysis may reveal areas where new regulation may provide opportunities for improved risk-adjusted strategic decisions.

Organizations which institute enhanced or leading industry risk management practices will have less difficulty transitioning to the new regime.

Accenture believes clients should tackle these reforms holistically by developing a master plan and making one set of business, technology and data changes across the enterprise. Companies that do this will have the critical insight and the competitive platform they need to stay one step ahead of the new financial landscape.

How companies should respond

Accenture can assist as you prepare your company’s response to the changes that come with regulatory reform. We can work with you to transform risk management into a value-enhancing capability and competitive differentiator to:

• Align business strategy and risk capabilities to evaluate market options and drive profitable growth;

• Embed risk management capabilities across the organization and support a risk conscious culture;

• Adapt to industry and geographic regulations in a holistic manner while focusing on the business impacts and outcomes;

• Provide the capabilities to collect, model and analyze business information for better risk-based decision making.

Accenture Risk Management works with clients to create and implement integrated risk management capabilities designed to gain higher economic returns and increased stakeholder confidence.

Working with you, we can help design and execute a transformation program to support your FERC ruling 741 plans. That includes assessing the status of your current systems and business processes against the FERC requirements and using that information to identify gaps and provide practical recommendations.

Amid complexity and change, the demands for better business performance are unrelenting. At Accenture our purpose is to help you align risk and reward to fuel that growth—and meet the challenge of change with skill and confidence.

Accenture can help

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References:Federal Energy Regulatory Commission (2010). Credit Reforms in Organized Wholesale Electric Markets. Washington, DC

About the AuthorsShelley Hurley

Shelley is executive director – Risk Management, Houston and Global Resources. Based in Austin, Texas, Shelley has more than 30 years of global, industry and consultancy experience in the energy, resources and metal sectors as a trader, managing director and NYMEX seat holder. Her previous roles as Chief Risk Officer and founder of the Committee of Chief Risk Officers in the resources sector and extensive experience in risk management, credit risk management, operational risk management, trading and performance management enable her to help executives from multinationals across the energy and resource sectors become high-performance businesses.

Christopher Murphy

Chris is senior manager – Risk Management, based in Austin, Texas. For more than 18 years he has led market, credit and enterprise risk management initiatives at major private and public companies, guiding global and national agriculture, energy, and commodity firms on their journey to becoming high-performance businesses.

Graham Lucas

Graham is senior manager – Risk Management, based in Los Angeles, California. For more than ten years, he has led and consulted on projects across oil, power, agriculture, and capital markets industries. Graham has experience in process design, financial and management reporting, and systems implementation.

About Accenture Management ConsultingAccenture is a leading provider of management consulting services worldwide. Drawing on the extensive experience of its 16,000 management consultants globally, Accenture Management Consulting works with companies and governments to achieve high performance by combining broad and deep industry knowledge with functional capabilities to provide services in Strategy, Analytics, Customer Relationship Management, Finance and Enterprise Performance, Operations, Risk Management, Sustainability, and Talent and Organization.

About Accenture Risk ManagementAccenture Risk Management consulting services work with clients to create and implement integrated risk management capabilities designed to gain higher economic returns, improve shareholder value and increase stakeholder confidence.

About AccentureAccenture is a global management consulting, technology services and outsourcing company, with more than 244,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the world’s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$25.5 billion for the fiscal year ended Aug. 31, 2011. Its home page is www.accenture.com.

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