February 2006 Market Clearing in the Energy Industry 5-32 © Copyright 2006, CCRO. All rights reserved. the cause of the disparity in credit arrangements is due to disparities in credit standing, then no “solution” is required. Directionally, the situation is as it should be: riskier borrowers post more collateral than less risky borrowers. That being said, there are opportunities to refine ISO credit policies so as to achieve a finer resolution of credit standing. One such solution would be to separate the quantity of collateral required to cover market-driven credit risk from the quantity of collateral required to cover credit default risk. This would have the effect of improving trading economics for highly rated trading organizations while requiring all market participants to pay for the credit extended to them by the ISO. The second issue that trading organizations cite is inefficiency in the way settlements occur. They point out that the timing of day-ahead bidding, publication of day-ahead prices for the next day, and the settlement of physical and financial obligations in the real-time market provide information that risk managers at ISO/RTOs can use to margin positions more efficiently that is done currently. For example, there exists a period of time after day-ahead prices are published but before positions are settled. Some trading organizations have argued that preliminary settlements can start immediately following the publication of day-ahead prices. This would have the effect of reducing the amount of collateral a trading organization must commit to the market collateral that could be redeployed for other purposes in that market or elsewhere. It has been argued that final settlement could occur as it does now, during the real-time market with positive and negative settlement adjustments being made to “top up” differences between the price used to execute the preliminary settlement and the final settlement price. ISO/RTOs maintain, though, that there are “blind spots” in the settlement processes that make the algorithm suggested infeasible. 5.4.2. Issues and Solutions for the Forward Markets Two factors drive credit exposure, particularly in the forward markets: price volatility and duration. Both these factors, when combined with the limited credit capacity that is intrinsic to the balance sheets of many energy companies, have severely curtailed the development of robust forward energy markets: markets with liquidity, price transparency, a complete set of hedge products and low transaction costs. The current complement of market clearing solutions and the nascent spot market clearing solutions provide a partial solution to the problem. The solution is only partial due to the impediments imposed by coverage and cost. Some solutions cover only the most liquid bases, most of them in natural gas. The price volatility of power, and the resulting volatility in credit exposure, has prevented the vendors from offering clearing of many power products. Other solutions limit themselves to products for which there are well-populated forward price and volatility curves. The cost of clearing of the current solutions can be high relative to alternatives. One source of this cost is the two- tier clearinghouse model, which creates both clearinghouse fees and banking fees from the FCM. Another source of cost is the average pricing that clearinghouses employ: clearinghouse members are homogenous with respect to their credit standing and, so, pay the same price for membership. This transfers the task of securing full payment for credit extended to the FCMs, which may not charge the market rate for credit.