Volume 4 — Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 2 practices will evolve and further develop through our future investigations and through the efforts and experience of the companies adopting and implementing them. Note that the best practices herein are offered as a resource. Their use is voluntary, and no company has agreed to or is required to use them. In addition, they may be modified as appropriate by individual companies, and they do not relieve any company from the need to comply with their legal and professional requirements. For further information on the aims and the objectives of the CCRO (including appropriate use of best practices), please refer to Volume 1 of this set of white papers. The purpose of this document is to present a set of credit risk management best practices for the energy merchant industry. We define credit risk as the cumulative potential nonpayment and nonperformance of counterparties on contracts to buy or deliver energy products and derivatives thereof. Counterparty credit exposure is equal to the sum of all money due (billed or delivered and unbilled) plus the replacement cost of the contracts if positive (netted if appropriate). While these definitions are not unique to energy, the contract structures and credit risk arising from commodity price behaviors are decidedly unique. Energy merchant credit risk management is concerned partly with industrial trade credit (because of the physical commodity business) and also partly with derivative and mark-to-market (MTM) credit risk. This document covers the five key credit risk management functions: • Credit Allocation and Financial Risk Analysis – This section provides a set of best practices for setting credit policy, for establishing credit limits based on the quantitative and qualitative counterparty analysis, for creating a scoring system to rate portfolios and counterparties, and for assessing the cost of credit associated with a counterparty. • Contracts – This section provides a set of best practices related to contractual arrangements used by energy firms. It encompasses a brief description of the financial and physical master contracts as well as a set of credit provisions that energy companies can select to better manage and mitigate credit risk. • Measurement – This section provides a set of best practices for measuring the credit risk inherent in the energy business. The discussion extends into the exposure measurement process and credit value at risk (CVaR). • Monitoring – This section provides a set of best practices for monitoring an energy firm’s credit risks. The discussion concentrates on the monitoring of counterparty credit quality, credit exposures, contractual arrangements, margining, and exceptions. • Mitigation – This section provides a set of best practices for mitigating credit risk and focuses on two general approaches: reduction and transfer. The reduction methods include establishing credit limits, monitoring and collateralizing credit exposures, and using appropriate contractual arrangements (e.g., master netting agreements). The transfer methods concentrate on the transfer of credit risk to the financial markets through the use of financial guarantees, credit insurance, and credit derivatives. This section also covers the concept of clearing energy products, including a set of desired