You've got the power
Unprecedented price movements can underline the need for corporates to implement comprehensive credit risk management systems. Leslie McNew, Gary Lavey and Taehyun Kim explain the building blocks of credit risk management in a power utility
At the end of June 1998, an unusual series of events occurred. First, an intense heatwave struck the US midwest and southern states. Next came a number of nuclear unit shutdowns, utility closures, forced or storm-related outages, and transmission constraints. Typical June energy prices would have been between $37 and $39 per megawatt (MW). However, this rare combination of events produced huge spikes in demand, forcing real-time prices as high as $7,000/MW. The hardest hit area was the Cinergy Hub in the central US.
These circumstances produced a fault line between those utilities and power marketers with strong credit risk management systems and those yet to establish them. A default domino occurred. First down was Federal Energy Sales, of Rocky River, Ohio, with $984,000 of power to the City of Springfield, Illinois. The Federal default caused the City utility to default on $1.3 million-worth of energy to Peco Energy Co, El Paso Energy Corp, LG&E Energy Corp, and Southern Company.
Soon after the City of Springfield defaulted, rumours began to circulate of potential defaults from other industry players, including Power Company of America. Shortly afterwards, New Energy Ventures, ConAgra Energy Services and Southern Company terminated contracts with Power Company of America.
The events of last June were a classic market contagion for which few players were adequately prepared. But nevertheless, this credit default domino was not surprising.
Opportunities for utilities to lay off risk are restricted, with less than 10 futures contracts for the newly developing power market traded on US exchanges, and limited liquidity in listed electricity options. A lack of attention to credit discipline by utilities and power marketers added fuel to the fire.
Ameren Energy is one of the few utilities to have developed a robust credit risk management strategy, enabling it to avoid the fate suffered by so many others last June.
Ameren implemented its risk management policy in 1998, establishing a two-pronged approach to managing credit risk: by counterparty and by portfolio.
It has two separate sections dedicated to the analysis and control of credit risk. The credit risk management team fits within the independent risk control office (IRCO), reporting to the risk management steering committee.
Counterparty risk
The IRCO defined that
the risk of a particular counterparty default is
determined by the size of the exposure, the maturity of
the exposure, the probability of default and the
systematic or concentration risk of the counterparty.
Thus Ameren developed a way of allowing traders to
analyse quickly the available credit exposure to each
counterparty. Every evening, a consolidated credit
position report is issued, for both power and natural gas
transactions, which produces the available credit by
counterparty. No transactions that would exceed a
counterparty’s credit limit can be executed.
The following four factors must be considered in order to establish the amount of credit available:
- Current exposure = Replacement exposure + settlement exposure
Replacement exposure, or mark-to-market exposure, is the estimated cost of replacing the unsettled position with another counterparty, should the original counterparty default. Settlement or delivery exposure (accounts receivable) is the amount due to Ameren after it has fulfilled its obligations (or the required portion thereof).
- Potential exposure = Potential incremental replacement exposure + Potential incremental settlement exposure (value-at-risk)
Potential incremental replacement exposure represents potential exposures at some period in the future, based on the applicable holding period and confidence interval, using the assumed price distribution of the underlying commodity. Potential incremental settlement exposure is the potential incremental credit exposure from accounts receivable for settlements from transactions that will occur in the near-term.
- Statistical probability of default by the counterparty.
- Recovery rate: the amount of the defaulted position that is likely to be recovered.
The practice of netting is a complex credit issue, that can affect credit exposure to a counterparty. The energy marketing industry involves large volumes of low margin transactions. During the peak seasons of energy use, summer and winter, the sheer volume of transactions can result in millions of dollars of sales and purchases between the same counterparties. Rather than trading wire transfers, counterparties simply net the payments. So if counterparty A owes counterparty B $102 million, and B owes A $104 million, B makes only one payment to A of $2 million. This reduces both the need for cashflow and the outstanding credit exposure.
Although the netting of payments is a common practice in energy marketing, the structure governing the netting process varies widely, and netting is often carried out quite informally. Many of the underlying contracts for netted transactions have no formal language allowing for the set-off of payments. In addition, the netted transactions may be governed by different contracts, for example, a sale to a utility could use a standard contract such as the Western Systems Power Pool Agreement, while a purchase from the same counterparty could come under the utility’s market-based rate tariff. Netting could subject a company to preference issues if a counterparty files for bankruptcy. In other words, you might think you are netted when you are not.
The inclusion of the netting process in contracts would protect counterparties against such a risk. If the contracts are already in place, a formal netting agreement can provide protection for the future, as long as there is nothing in the underlying contract to preclude it from being tied to such a separate agreement. All transactions governed by the netting agreement should be clearly defined, and any exclusions considered. Effective dates, transaction periods, settlement dates, payment methods, invoice verification procedures, dispute resolution and termination procedures and dates must all be specified in the agreement. The company’s potential netting risk can be calculated according to a credit exposure report (see box).
Portfolio risk
The second part of
Ameren’s credit risk management method entails
quantifying the credit exposure within the entire
portfolio. The IRCO developed a credit VAR model to
assess better the company’s potential credit risk in
financial terms. The model is designed to calculate the
size of a potential credit loss, given a confidence level
on a portfolio basis. It uses rating agency Standard
& Poor’s mean default rates, default rate
standard deviations, counterparty exposure, credit
ratings and sector analysis as inputs.
The model’s objectives are to measure the unexpected and expected portfolio credit loss, determine the economic capital reserve to support the credit risk of the portfolio and highlight the assets that contribute the most risk within the portfolio.
The model is also required to calculate the amount of capital necessary for a credit capital reserve, to define more precisely the size of the portfolio credit risk, to determine if and when the use of credit derivatives is necessary and to run stress testing and scenario analysis on Ameren’s credit risk at a portfolio level.
Other benefits of analysing portfolio credit risk involve diversification and concentration of risk.
Using this approach to risk management, the IRCO can examine the benefits of diversification that arise when a large number of individual risks are fully captured. The credit risk management by counterparty approach does not allow for diversification of risk and may therefore overstate Ameren’s credit risk. The IRCO can also manage the company’s concentration resulting from groups of counterparties that are affected by background factors, such as business cycles, which may cause the incidence of defaults to be correlated even though there is no causal link.
| Calculating current credit exposure | ||||||||||
| The credit exposure report (see main
feature) calculates exposure on a gross basis
(see chart). Taking into account the four factors
which make up available credit by counterparty,
and the potential risk of netting (see above), a
company may use this reporting approach to help
the trading floor to monitor, manage and control
credit risk by counterparty. Credit limit: This is approved by the IRCO. The counterparty credit analysis is primarily ratings-driven, with support from the analysis of financial statements. For counterparties with a credit rating assigned by rating agencies Moody’s Investors Service and Standard & Poor’s, the IRCO first reviews these ratings, and the lower of the two determines the maximum allowable credit limit. The counterparty’s audited financial statements and business profile is bound by a conservative percentage of its tangible net worth and the maximum allowable credit limit, established by its public debt ratings. If the counterparty is relying on the rating of a parent company, the review is performed on the parent. For a counterparty without public debt ratings, a thorough analysis of the company’s audited financial statements and business profile forms the basis of an internal rating recommendation, which is used for further credit limit analysis. Accounts receivable (A/R): Prior month A/R is the gross receivable for the counterparty for the previous month’s activity, based on the notional value of all sales transactions with a delivery period in the prior month. Current month A/R is the potential settlement exposure for the counterparty, based upon the notional value of sales transactions delivered and/or scheduled to deliver in the current month. Mark-to-market: Sales mark-to-market is the net mark-to-market value on all forward sales to the counterparty with delivery periods beyond the current month. If the sales mark-to-market value is a negative amount, only the amount which offsets the previous and current month’s A/R will be considered in the calculation for the available credit. Purchase mark-to-market (liquidation value) is the sum of all positive mark-to-market values on all forward purchases from the counterparty with delivery periods beyond the current month. Value-at-risk (VAR – potential exposure) The diversified VAR is calculated according to the counterparty’s forward activity. Price change DP, is calculated based on a daily volatility s and forward price. As we assume price return to be normally distributed, an exponential equation can be used to calculate a price change at a certain confidence interval and liquidation period. C denotes the confidence interval, approximately 1.645 standard deviations for 95% confidence level, and L is the liquidation period. Long positions use a negative sign, and short positions a positive sign in the exponential equation to estimate a potential price move. Daily volatility is adjusted to different risk horizons by multiplying a square root of time factor: Once we calculate a price change, undiversified VAR per bucket is calculated using second-degree Taylor expansion (Delta and Gamma approximation). Finally, diversified VAR of a portfolio is: V denotes the vector of values for undiversified VAR in each bucket and C is the correlation matrix. Available credit = Credit limit – previous month A/R – current month A/R – MtM sales – MtM purchases – VAR per counterparty. There may, however, be instances when extreme circumstances override set counterparty credit limits. Summer 1998 is an example. The IRCO has a provision in its risk management policy regarding periods of high volume and/or extreme price volatility. Such circumstances may cause a significant percentage of the company’s counterparties to exceed their credit limits. From a business point of view, it is simply not practical to cease trading with a critical portion of counterparties during these periods, thus significantly limiting hedging options and liquidity. Defining a period of extreme price volatility and/or high volume requires consensus at the highest level. During such a period, credit limit overrides are implemented, based on percentage increases which are computed by stress variables, subject to maximum dollar override limits. Not all counterparties receive override provisions and if a counterparty exceeds the override limit, no further trading can occur unless satisfactory credit enhancements (ie, a letter of credit) are secured.
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| Which model to choose? | ||||||||||
The IRCO analysed the methodologies
of two leading credit models – Credit Suisse
Financial Products’ CreditRisk+ and JP
Morgan’s CreditMetrics – and chose a
modified version of CreditRisk+, for four main
reasons:
Ameren based its model on concepts employed by CreditRisk+ without modifying the computational methodology, as its assumptions are legitimate for Ameren’s credit risk management. Instead, the IRCO refined the model to meet Ameren’s needs more closely and to allow the company to perform various analyses on the portfolio. These refinements give Ameren greater flexibility when stress testing its portfolio exposure and counterparty credit limits, while allowing the corporation insights into its exposure, and lowering credit risk.
Figure 1 shows the output of the model using sample data. Ameren has used a 99% confidence level for economic capital at risk in order to capture a significant portion of the tail of the credit default loss distribution. The model calculated that, at a 99% confidence level, Ameren would need $3,314,990 (see below) as an economic cushion to insure against the corporation’s unexpected credit losses. The actual level of credit losses suffered in any one year may be greater than this amount, but this number is treated as a credit value-at-risk, and added to the market VAR which is calculated each day. The 99% confidence level was chosen for a capital cushion amount as it represents a value greater than Ameren’s average credit exposure. |
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This article originally appeared in the April 1999 Credit Risk supplement to Risk magazine, published by |
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| Leslie McNew is vice-president of risk management, Gary Lavey is director of credit risk management and Taehyun Kim is risk manager at Ameren Energy | |