February 2006 Market Clearing in the Energy Industry 5-26 © Copyright 2006, CCRO. All rights reserved. unsecured credit. In the bilateral and capital markets, unsecured credit also has become very limited for the merchant sector. Given the poor credit quality of the merchant generation sector in general, many merchants must limit the extent of their trading activities or the products they offer in the market due to cash flow considerations. In ISO/RTO administered markets, as these markets have or are in varying stages of establishing nodal markets, merchants may be limited in their participation in virtual markets or FTR/CRR markets to the detriment of price discovery and overall market liquidity. In bilateral markets, longer dated (term) transactions, especially fixed priced transactions, participation has become less common, especially for many merchants, as counterparties may be unwilling to accept any mark-to-market exposure from transactions with sub-investment grade entities. These credit problems lead to significant cash flow being tied-up by merchant generators to secure obligations which, in turn, reduce many merchant generators’ ability to transact in the marketplace, to the overall detriment of market liquidity. In ISO/RTO administered markets, where settlement cycles can be as long as 90 days, merchants and other generators are faced with effectively financing as much as three months’ worth of the natural gas used to generate the power that is sold in those markets. As well, given that merchants often lack unsecured credit from their gas suppliers, this natural gas must be procured via margining, or prepayment, all of which ties up cash. 5.2.2. Impact of shortened payment cycles Settlements for bilateral transactions traditionally happen on the 20th of the month following flow for physical power, and on the 25th of the month following physical flow for natural gas. In ISO/RTO administered markets, settlement cycles vary and range from an initial invoice settling mid-month after physical flow, to 90 days after physical flow. In July 2004, ISO-NE implemented weekly billing, reducing its settlement cycle from mid-month following physical flow to 13 days. At the time the NEPOOL stakeholders were examining weekly billing, ISO-NE “project[ed] that the overall amount of financial assurance required in the Pool would be reduced from approximately $176,791,000 to $58,128,000 (i.e., 67%). ISO-NE data subsequent to the implementation of weekly billing indicates that Total Amount Due and Owing (“TADO”) has been reduced nearly 65%17, with similar reductions in collateral that market participants are required to post. These reductions in risk and collateral requirements are significant for merchants, as well as others. Moreover, market clearing solutions that provide for daily settlement, among other services, could theoretically reduce market risk above 90%18. 17 Memorandum to NEPOOL Participant Committee re: Amendment to Billing Policy and Financial Assurance Policies to Implement Weekly Billing, Paul Beval and Scott Myers, NEPOOL Counsel, February 12th, 2004, and comments from ISO-NE staff to the NEPOOL Budget and Finance Subcommittee confirming the reduction in TADO from implementing Weekly Billing. 18 Theoretically, a clearing solution should remove risk beyond 90% through rapid settlement and margining practices that are based on 95%-99% confidence interval and other layers of protection.