February 2006 Market Clearing in the Energy Industry © Copyright 2006, CCRO. All rights reserved. 3 A successful physically cleared power market would allow for convergence with a growing financially cleared power market. As the physical and financial power markets become more efficient and liquid and, ultimately, with more active participants, clearing should lead to lower prices for energy consumers and more effective capital investment by producers. Coupled with cleared natural gas, cleared physical power would allow for a significant reduction in collateral requirements through the use of inter-commodity spread credits. However, significant challenges remain before the avenue to clearing is easily navigable for participants in the physical energy markets. One of the largest challenges still remains: delivery of physical product. The issue of physical delivery is much more pronounced in the power markets than in the physical gas markets, where NGX in Canada has been efficiently transacting physical gas for over a decade. While physical delivery remains a large issue, clearing vendors continue to innovate and propose models to address this challenge. Innovation in this area should be supported by the industry. Provider of Last Resort load obligations need resolution with respect to FERC and ISO/RTO application/oversight, and a much clearer understanding of the legal landscape is required. This is particularly true with respect to safe harbor status of netting, cross commodity netting, master netting agreements and the interpretation of specific Bankruptcy Code sections. As well, at the ISO/RTO level, issues such as the timeliness and quality of real-time energy data, and the related issue of metering and resettlements create additional risks that are not found in other industries that employ clearing. Likewise, auctions and similar products administered at the State level present additional challenges. Regulators, both state and Federal, should encourage the markets to continue experimentation with clearing model design and market products, including those related to the design and structure of load based auctions, requests for proposals, or bidding processes that may provide for more efficient/effective mitigation of credit risk and collateral exposures. It is clear that clearing within a very wide, very deep multilateral netting pool, and best practice risk management discipline, is in the interest of markets and participants as a whole. As this paper describes, efforts in the securities industry to improve clearing after the market crash in 1987 are cited as a success by the industry and regulators in restoring confidence in the securities markets. Likewise, in the energy industry, efforts by ISO-NE to move to weekly billing are widely seen as a success in substantially reducing credit risk to the market. Regulators should continue to support efforts by the industry to facilitate competition and innovation. However, if the evolution of energy market clearing follows the same trajectory as the evolution of financial market clearing, one can expect to see the marginal benefits of innovation decrease over time. At some point, the marginal benefit of widening and deepening the netting pool will come to dominate the marginal benefits of clearing service innovation. When this happens, consolidation of energy clearing solutions will begin.