February 2006 Market Clearing in the Energy Industry 5-28 © Copyright 2006, CCRO. All rights reserved. • The ability to use energy sales to satisfy margin requirements (i.e., initial, variation and maintenance) for exchange traded instruments, thereby potentially reducing collateral requirements • The ability to set-off across different ISO/RTO administered markets would reduce the cost of capital by allowing unutilized “positive” collateral (e.g., energy sales) from one ISO/RTO-administered market to be used to meet credit requirements in another ISO/RTO-administered market. Netting and set-off of power and natural gas will speed up cash conversion of the spark spread for merchant generators and reduce the variability of the merchant’s portfolio as the merchant is better able compete for longer dated transactions, and convert those longer dated transactions into spark spreads. The result of a merchant generator having the ability to better compete and hedge its gas supply for longer dated transactions, as well as reducing collateral costs of managing the gas hedge, will positively impact the view of the rating agencies on the liquidity and ability of the merchant to withstand stress events, as well as the merchant’s access to capital markets. 5.2.4. Issues associated with long-dated bilateral / structured transactions While market clearing holds out enormous promise for the merchant sector to reduce collateral costs, improve cash flow, improve the sector’s outlook in the eyes of the rating agencies and capital markets, long-dated and structured (i.e., non-standard) products present important concerns for discussion. A basic issue associated with long-term bilateral/structured contracts is the marking of contracts to market on a daily basis. The difficulty with this is that long-term bilateral/structured contracts typically involve the purchase and sale of illiquid energy product(s) that are often not fixed in volume (i.e., load shape) and are composed of a variety of energy and ancillary products for which there is no published forward price curves. Traditionally, clearinghouses clear transactions whose energy products are defined, volumes specified and terms framed by established effective and termination dates. Unless the parameters of the transaction’s terms are set, the volumes/blocks of contract quantity established and the type of energy product(s) clearly defined, clearing these types of transactions will remain difficult, if not impossible. While some of the risks associated with long dated and non-standard transactions can potentially be mitigated with off market transactions and using highly correlated products, there will be products that will not be able to be cleared at the present time through clearing solutions available in the market. Perhaps time, and an increase in the use of cleared products, will allow for more pricing liquidity, which in turn will allow for a greater number of longer-dated transactions to be undertaken. Also, perhaps the financial community will also develop new products to allow for derivatives of the underlying transactions to be entered into with financial intermediaries, and allow for the derivative product to be novated and transacted via one of the clearing solutions.