February 2006 Market Clearing in the Energy Industry © Copyright 2006, CCRO. All rights reserved. 2 (CBOT). In the physical energy markets, NordPool in Scandinavia and the Natural Gas Exchange (NGX) in Canada illustrate clearing solutions that have been successful in clearing physical energy products. In the United States a number of vendors, discussed herein, offer creative clearing services to an increasing number of market participants. 1.3. Benefits and Challenges The most commonly cited benefits of market clearing for the energy markets relate to capital efficiency and risk reduction, both systemically and for individual market participants. The concentration of transactions with a single central counterparty provides for the netting of positions and leads to the calculation of a single initial margin for a market participant within a clearing platform. As well as the use of initial margin, clearing solutions employ variation margin with short cycles for posting liquid collateral for out of the money accounts, most often daily. Daily cash settlement via variation margin allows the clearing entity to substantially reduce the amount of initial margin a customer is required to post. As such, the effects of the combination of netting and accelerated cash settlements may be significantly less than the amount of collateral required for the same position if the transactions are spread only among bilateral counterparties. Challenges identified include the fact that the benefits of clearing are not distributed evenly across participants. For example, while clearing may have a material positive impact on some participants’ cost of capital, other participants that presently do not have to collateralize many transactions may be required, if they employed a clearing solution, to post liquid collateral, thereby raising their cost of capital. Other challenges include those associated with delivery of physical power, Provider of Last Resort (POLR) complications, loss mutualization from a systemic event, and bankruptcy considerations, though in the later instance the new bankruptcy code that became effective in October 2005 provides greater clarity and certainty for certain clearing related issues. In this regard, it is critical for potential participants to measure accurately and completely the costs associated with non-cleared transactions, including the cost of capital, the value of transferring credit risk to a clearinghouse, and the impact of improved market efficiency to market liquidity and prices. Often, exposures that are unfunded involve costs that are less obvious than settling marks, but just as real. Cost comparability must also take into consideration the benefits of netting, which is far less available in non-cleared transactions. 1.4. Summary Market clearing has been the standard of many financial markets, such as the domestic futures industry, and has been shown to be a successful model, providing confidence to market participants that obligations will be met, and ultimately supporting efficient markets. In energy markets, market clearing has been successfully employed via many financial energy products, including the Henry Hub natural gas contract, and many gas basis and oil contracts. In fact, post Enron and since the launch of NYMEX’s Clearport platform and the LCH Clearnet Cleared products, both the number of offered products and the volumes transacted has increased significantly each year. But clearing of physical products has lagged.