Credit Risk Management in the European Day-Ahead Power Markets
by Doron Ezickson, Andrea Kramer and Prajakt Samant
The once clear-cut distinction between spot power trading and futures trading is becoming increasingly blurred, as spot power markets exhibit futures-like risk profiles and spot power exchanges move towards futures-style clearing, settlement, and risk management systems.
As a result, we see a growing interest in spot powermarkets fromproprietary trading firms, particularly with respect to credit risk management in those markets. This article, in a sense, examines the similarities between spot power trading and future trading by highlighting the key factors that influence credit risk management policies for major European power exchanges. We focus on the day-ahead power market because of its importance for both dayahead and longer-term contracts.
APX Group
APX is the central counterparty for the Dutch day-ahead power market (Dutch DAM). Through APX Power UK, APX also provides spot and forward power market trading for the U.K. market. Before 2007, APX relied solely on individual member collateral to mitigate default risk. For the Dutch DAM, those requirements were previously equal to 28 days of gross member purchases. In the first quarter of 2007, however, APX made three key changes to its risk capital structure, creating a more capital-efficient structure while preserving market integrity and protecting APX as the central counterparty.
First, APX revised the individual member collateral requirements. Under the new regime, APX requires daily collateral for members trading in the Dutch DAM in an amount equal to either (1) the maximum of either the one-day average net purchasing activity of that member, plus seven times the daily volatility in that member’s net purchases, or (2) the oneday average net selling activity of that member, plus seven times the daily volatility in that member’s net sales. This is a value-at-risk margin tailored by APX to meet the specific risk attributes of its markets. These new collateral requirements provide a better correlation between collateral and risk than APX’s earlier requirements, covering approximately 97% of potential price and quantity risk exposures.
Second, to cover its remaining risk— without forcing each member to post significant additional collateral—APX implemented a €20 million clearing default fund, financed by member contributions. The mutual default fund is available to cover default-related losses by any APX member after the defaulting member’s collateral and default fund contribution have been exhausted. Third, to manage the credit risk that APX members now have to one another, APX enhanced its member credit risk management and credit surveillance processes. The changes to the risk capital structure have lead to a better coverage of risk and an overall reduction of total requirements of 50%. The changes to the risk capital structure were made for a number of reasons, including the exchange’s interest in enhanced capital efficiency, a desire to attract financial firms as new members, and growing competition in European power. APX is considering extending the new risk capital structure to some of its other markets but has not yet announced any official plans or timetable for doing so.
European Energy Exchange
European Energy Exchange is Germany’s main energy exchange. EEX spot power market trades are conducted as an auction with the central counterparty being European Commodities Clearing, a wholly-owned subsidiary of EEX established to provide clearing services for EEX and the European Energy Derivatives Exchange and for over-the-counter energy trades with EEX or Endex. EEX members must post initial margin, which takes into account close-out of anticipated new transactions on EEX’s next trading day. EEX members must also post current liquidating margin, which takes into account possible close-out losses or profits from the close-out of netted-out amounts receivable and liabilities. Under its risk assessment procedures, EEX can also demand intra-day margin if it deems additional margin appropriate.
A general clearing member in the EEX spot market contributes a minimum of €1 million, while a direct clearing member generally contributes €250,000. At the date of this writing, it is believed that the clearing fund holds about €40 million. The fund volume differential between EEX and APX may be attributable to the fact that ECC’s clearing conditions do not distinguish between the derivatives and spot markets. As a result, there is one common default fund with commingling of funds. In the event of a default, all funds in ECC’s clearing fund can be utilized irrespective of the market in which the default took place on.
If an EEX clearing member becomes insolvent, EEX first uses the defaulting member’s collateral and contributions to the clearing fund. If those collateral calls are insufficient to meet the defaulting member’s obligations, contributions by other members to the clearing fund are used to meet the shortfalls. As a result, mutual default liability potentially applies to all EEX clearing members. EEX does not provide a stated cap on the amount of collateral its clearing members must post, although German law requires such calls to be reasonable.
Energy Exchange Austria Energy Exchange Austria is an energy exchange mainly for the Austrian energy market, with its stated aim to provide access to the liberalized energy market for smaller utilities and municipal entities. EXAA is the central counterparty, guaranteeing the financial settlement of all energy deals in the Austrian day-ahead power market. EXAA serves as a neutral market organizer and risk manager for all of its trading participants, while also acting as clearing and settlement agent, on the Wiener Börse. EXAA is responsible for the financial clearing, settlement, and risk management of exchange transactions in the Wiener Börse’s spot and derivatives power markets.
EXAA members must post collateral to cover their actual and potential liabilities, and EXAA’s collateral demands must bear an accurate relation to the member’s obligations and risks profile. EXAA demands conditional and unconditional margin, with unconditional margin demanded of a member that has used more than 80% of its posted collateral.
EXAA uses an active risk assessment system to determine the risks of default and failure to meet financial obligations, including the requirement to post adequate collateral. EXAA’s internal risk assessment classification is determined by the Austrian Control Bank, under which each of its members is assigned a “Risk Class” based on due diligence on the member’s financial and credit support documents. If an EXAA member does not meet its obligations, all of its pledged collateral is used to meet its obligations. Unlike APX and EEX, however, EXAA does not have a mutual default fund.
Nord Pool Spot
Nord Pool Spot is the central counterparty for physical power contracts in the Scandinavian region, guaranteeing trade settlement and participant anonymity. It is owned by Nord Pool ASA and each of the four Nordic (Danish, Finnish, Norwegian and Swedish) transmission system operators. In the event of a Nord Pool Clearing participant default, NPS does not provide for loss sharing. As a result, where a member’s close-out trades, margin calls, and NPS’s own resources are insufficient to cover liabilities, non-defaulting NPC members have no liability beyond their respective open positions.
NPS members must post a minimum collateral amount before trading. Each clearing day, NPS issues a daily collateral call, representing the total purchase price for each member net trade amounts over the preceding seven days (including VAT). NPS can base its daily collateral call calculation on anticipated future net purchases for new entrants. Factors taken into account include publicly available information on trading patterns and testimonials as to the type of counterparties with which the new entrant expects to trade. Each NPS member has a minimum daily collateral amount of either NOK/SEK/DKK 100,000 or €12,500. Although NPC does not have a clearing default fund, NPC extended its risk capital in April 2004 to €120 million (NOK 985 million) from a prior level of €55 million through an insurance arrangement with Swiss Re. The Swiss Re agreement is a default insurance policy with a total insurance limit of €65 million, accumulated over a three-year period. The Swiss Re insures against losses above a certain threshold, up to a total limit of €65 million, if a counterparty fails to settle with NPC in an amount larger than the margin security that the counterparty has on deposit with NPC.
Powernext
Powernext offers standard hourly contracts, with physical delivery the day after trading. LCH.Clearnet SA guarantees the financial security of Powernext’s transactions by acting as the central counterparty for payment commitments. RTE, the French transmission system operator, covers delivery default for all market nominations made through Powernext. Powernext does not have a mutual default fund for its day-ahead market. Instead, it seeks to maintain market security through daily adjusted and additional margin calls.
Initial margin starts at €50,000 and is adjusted daily. The daily adjustment to initial margin is calculated by multiplying the member’s daily average of purchases over its previous five trading days by a multiplier of: 1.5 from Monday to Thursday, with a minimum deposit of €50,000; or l + n (where “n” is the number of nonbusiness days that follow the eve of the day being counted as 1) (that is, 3 for Friday) with a minimum deposit of (n + l) multiplied by €50,000 to take into account days where the settlement system is closed.
Powernext can rely on an “explicit participant factor clause” that, if incorporated in the clearing agreement between the member and LCH, allows Powernext to increase initial margin requirements. This clause is imposed if LCH’s Risk Committee views the potential member’s financial condition to be below its norms.
Powernext also demands additional margin if a member exceeds its risk exposure limit, which is the member’s maximum daily net financial position. A member’s maximum net financial position equals the sum of its purchases (including VAT) minus its initial margin. If this limit is breached after the daily auction has been validated, the member must deliver within one hour additional margin to cover the excess amount. Powernext does not provide for loss sharing among its members. As a result, Powernext members are only liable for their own open positions.
Conclusion
What should be clear from this cursory survey of several key European power exchanges is that their credit risk management practices are different and rely on a wide variety of credit risk management procedures and policies. Given local customs and laws in each jurisdiction, this divergence is expected. But as these markets work to attract trading volume and new market participants, there will be increasing tension for these exchanges to balance their internal governance, regulation, and safeguards with requirements to remain competitive with their peers. Understanding the key differences between and among these European exchanges is useful as these markets converge in some ways and diverge in others.
Doron Ezickson and Andrea Kramer are partners and Prajakt Samant is an associate in the international law firm of McDermott Will & Emery. Ezickson and Samant are residents in its London office, and Kramer is a resident in its Chicago office. Kramer heads the firm’s financial products, trading, and derivatives group. Ezickson and Kramer co-head the firm’s energy services group. The authors would like to acknowledge the invaluable assistance of Lucas Schmeddes of APX Group, Alton B. Harris of Ungaretti & Harris, and Christopher Culp, Jamie Hodges and Barbara T. Kavanagh of Risk Management Consulting Services.
