February 2006 Market Clearing in the Energy Industry 5-27 © Copyright 2006, CCRO. All rights reserved. Significant reductions in collateral requirements through daily settling in ISO/RTO administered markets would have a tremendous impact on freeing-up merchant generators cash flow and placing this portion of the working capital responsibility with the firms best positioned to finance that debt, which should be viewed positively by both the credit rating agencies and the capital markets, and would allow merchants to better access ISO/RTO markets for virtual transactions and FTR/CRRs. This would, in turn, increase market liquidity, and allow for more effective hedging of risks within ISO/RTO administered markets. Additionally, with accelerated market clearing, market participants would be able to reduce the cost of hedging fuel supply (e.g., natural gas) in forward markets such as the NYMEX or LCH (London Clearing House) by using the power revenues from accelerated payments to offset fuel supply and hedging obligations. Further, shortened cash conversion cycle reduces the probability that there will be a market default and the magnitude of any default that will need to be mutualized to the market, which improves the certainty that the generator will be repaid for energy services it is providing to the market. Providing greater certainty to the merchant generator that they will be repaid will reduce the cost for the merchant to participate in the market, which should translate to lower costs to the market, to the benefit of the market as a whole. 5.2.3. Impact of netting on collateral requirements Current as well as proposed clearing solutions provide the benefits of multilateral netting and centralized collateral management. While accelerated settlements account for a significant reduction in risk and related collateral requirements (as evidenced by the NEPOOL experience), comprehensive clearing solutions include both physical and financial products, and allow for the ability to net and set-off across commodities (i.e., gas and power), both of which are of significant benefit to the merchant sector. For example, as natural gas is the predominant fuel supply for much of the new generation that the merchant sector has brought on line since the 1980’s, ISO/RTO markets such as ERCOT are extremely sensitive to the cost of gas fired generation.19 For a natural gas-based generator, 90% of the marginal cost of power production is the price of natural gas. Market clearing solutions that include the ability to net and set-off against physical gas purchases will significantly and positively impact the cash flow of the merchant sector. Additionally, the ability to (i) set-off against all energy products within an ISO/RTO environment, (ii) set-off these ISO/RTO transactions against other bilateral transactions, and (iii) set-off across cash and forward markets, would significantly improve liquidity for those in the merchant sector. The benefits would be numerous: • The ability to net and set-off energy sales in ISO/RTO energy markets against virtual transaction or hedge congestion via FTR/CRRs in nodal markets 19 ERCOT survey from the Reliability and Operations Subcommittee Report to the Technical Advisory Committee, Dec 2, 2004. With 95% of the MW’s available to ERCOT responding, natural gas represents 82% of ERCOT units and 75% of its energy output.