January 16, Managing Gap Risk Between the ISDA Power Annex, the EEI and the WSPP. Craig R. Enochs

Transcription

1 January 16, 2014 Managing Gap Risk Between the ISDA Power Annex, the EEI and the WSPP Craig R. Enochs 1

2 I. Document Overview Who drafted each form? Typical user Typical transaction 2

3 II. Analysis of Gap Risks 1. Confirmation Procedures 2. Credit Obligations 3. Events of Default 4. Force Majeure 5. Netting 6. Notices 7. Setoff 8. Termination, Liquidation and Settlement 3

4 EEI A. Who drafted it? 1. Edison Electric Institute published the EEI Master Sale and Purchase Agreement in EEI members comprise all U.S. investor-owned utilities and its associates include power marketers, independent power producers, and companies providing goods and services to the electric utility industry. 4

5 EEI B. Typical User 1. Electricity merchants 2. Utilities 3. U.S. entities 4. Not retail electricity customers 5

6 EEI C. Typical transaction 1. Wholesale purchase and sale of power 2. Power plant tolling agreement 3. Asset-based power purchase agreement 4. Power-related products a. Capacity b. Ancillary services c. Environmental attributes 5. Not retail electricity sales 6

7 ISDA Power Annex A. Who drafted it? 1. International Swaps and Derivatives Association in 2003 a. The Power Annex may be used with either the 1992 or 2002 ISDA form of Master Agreement 2. ISDA is made up of swaps industry participants with heavy participation from banks, insurance companies and hedge funds in the U.S. and U.K. 3. ISDA Master Agreement originally intended for use only with financial products 4. ISDA Master Agreement was drafted by bankers and lawyers in New York and London to standardize derivative transactions 7

8 ISDA Power Annex 5. The ISDA Power Annex was drafted as a joint effort between ISDA and the EEI a. After EEI Master Agreement published in 2000, ISDA and EEI worked together in creating the Power Annex 1) Power Annex published by ISDA in 2003 b. The substantive operative provisions of the Power Annex are verbatim to similar provisions in the EEI 1) Contains only those provisions necessary to implement purchase/sale of power a) E.g., delivery/receipt, title, force majeure 2) Clauses (b)-(c), (d)-(e), (f) and (g) of the Power Annex are almost identical to Articles 3-4, 6-7, 9 and Sections of the EEI Master Agreement, respectively c. Provisions in the ISDA Master Agreement relate only to nonphysical/operational matter such as Events of Default, early termination, credit, notices, confirmation procedures and miscellaneous boilerplate provisions 8

9 ISDA Power Annex 6. The Power Annex is not a stand-alone agreement a. Annex forms only part of entire ISDA agreement 1) Requires an ISDA Schedule 2) ISDA Master Agreement, Schedule and Credit Support Annex (as applicable) govern all transactions under the Power Annex 7. In the last few years, the ISDA has gained popularity in the energy industry because of the publication of various commodity annexes a. Power Annex (2003), Gas Annex (2004), Emissions Allowance Annex (2006), Coal Annex (2007 and 2009), Crude Oil Annex (2008 and 2010) 9

10 ISDA Power Annex B. Typical User 1. Bank 2. Power merchants 3. Global entities 4. Sophisticated parties 5. Parties transacting in both physical and financial power 6. Parties transacting in power and other physical and/or financial commodities 10

11 ISDA Power Annex C. Typical transaction 1. Wholesale purchase and sale of power 2. Power plant tolling agreements 3. Asset-based power purchase agreements 4. Power-related products a. Capacity b. Ancillary services c. Environmental attributes 5. Not retail electricity sales 11

12 WSPP A. Who drafted it? 1. The Western Systems Power Pool (WSPP) began in 1987 as an agreement among a group of utilities in the western states. 2. The WSPP agreement was a multi-state bulk power marketing experiment. a. Tested whether broader pricing flexibility for coordination and transmission services would promote increased efficiency, competition, and coordination. 3. Initial purpose was to allow sales of power for short-term transactions to take place with maximum flexibility and minimum regulatory filings and to test market efficiency and competition 4. WSPP is not executed or negotiated a. If a party joins WSPP then it is instantly enabled to enter into transactions with every other WSPP member utilizing the WSPP terms 12

13 WSPP B. Typical User 1. Utility 2. Power merchants 3. Located in western U.S. 4. Not: 1. Outside western U.S. 2. Global entities 3. Retail electricity customers 13

14 WSPP C. Typical transaction 1. Wholesale purchase and sale of power 2. Not: 1. Any products other than power 2. Structured agreements 3. Retail power sales 14

15 II. Types of Gap Risk A. Confirmation Procedures B. Credit Obligations C. Events of Default D. Force Majeure E. Netting F. Notices G. Setoff H. Termination, Liquidation and Settlement 15

16 A. Confirmation Procedures 1. Power Annex: ISDA Master 9(e)(ii) a. Parties legally bound from the moment they agree to commercial terms b. Confirm transaction terms by sending written Confirmations c. No other specific terms or procedures in Master Agreement or Power Annex 1) Parties often will add more detailed confirmation procedures in the Schedule 16

17 A. Confirmation Procedures 2. EEI 2.3 a. Parties evidence a transaction by exchanging a written Confirmation 1) Seller provides Confirmation to Buyer (or if Seller fails to provide, then Buyer may send) b. Failure to send or return an executed Confirmation does not invalidate the oral transaction agreed-upon by the parties 1) Similar to oral transaction procedure under WSPP 17

18 A. Confirmation Procedures 3. WSPP 32.1 a. Parties evidence a transaction by exchanging a written Confirmation 1) Seller provides Confirmation to Buyer (or if Seller fails to provide, then Buyer may send) b. For all transactions of one week or less an oral agreement is acceptable if the conversation is recorded 18

19 A. Confirmation Procedures 4. Risk Analysis a. Confirmation procedures should conform to risk in underlying transactions 1) Short-term v. Long-term a) Risk of disagreement regarding future performance obligations b. Operational risk in confirming transactions 1) Seller confirms in WSPP and EEI, but ISDA does not specify c. Inconsistent dispute resolution procedures 19

20 B. Credit Obligations 1. ISDA Power Annex a. No credit provisions in the Master Agreement or Power Annex b. Parties generally rely on threshold margining under the ISDA Credit Support Annex or may incorporate adequate assurances provisions for transactions with a short tenor or low exposure 20

21 B. Credit Obligations 2. EEI 8.1 and 8.2: Elected on Cover Sheet a. Credit Assurances (8.1(b) and 8.2(b)) 1) Can demand Performance Assurance upon reasonable grounds for believing that Party s creditworthiness or performance is unsatisfactory b. Collateral Threshold (8.1(c) and 8.2(c)) 1) Threshold margining c. Downgrade Event (8.1(d) and 8.2(d)) 1) Parties can demand Performance Assurance upon the occurrence of a Downgrade Event 2) Downgrade Event defined by the Parties on the Cover Sheet 21

22 B. Credit Obligations 3. WSPP 27 a. Either party can demand adequate assurance of performance if the other Party s (the Second Party s ) creditworthiness, financial responsibility or performance viability has been determined in the First Party s reasonably exercised discretion to be unsatisfactory under a variety of listed circumstances. 22

23 B. Credit Obligations b. Second Party may satisfy the request by providing any of the following within 3 Business Days of demand: 1) A Letter of Credit; 2) Cash prepayment; 3) Posting other acceptable collateral or security; 4) A Guaranty Agreement executed by a creditworthy entity; or 5) Some other mutually agreeable method. c. Only credit provision in WSPP 1) No threshold margining 23

24 B. Credit Obligations 4. Risk Analysis a. Inconsistent credit requirements across agreements could lead to varying rights to demand collateral and the amount and type of collateral received 1) E.g., adequate assurances under WSPP v. margining under ISDA) b. With respect to the ISDA, EEI and WSPP, the ISDA is the only agreement that permits the netting of exposures across products 24

25 C. Events of Default 1. Common Events of Default: ISDA 5(a), EEI 5.1 and WSPP 22.1 (unless otherwise noted) a. Failure to pay when due b. False or misleading representations c. Breach of Agreement (other than failure to pay) (NOT WSPP) d. Insolvency and bankruptcy-related events e. Breach of credit obligations (WSPP s adequate assurances provision) f. Merger without assumption (NOT WSPP) g. Cross Default (NOT WSPP) 25

26 C. Events of Default 2. Events of Default and Termination Events in ISDA not found in EEI or WSPP a. Default under Specified Transaction b. Illegality c. Force Majeure Event d. Tax Event and Tax Event Upon Merger e. Credit Event Upon Merger f. Additional Termination Event 26

27 C. Events of Default 3. Automatic Early Termination under ISDA a. How it works 1) Upon occurrence of certain bankruptcy events, an Early Termination Date is deemed to occur 2) Parties do not follow Early Termination Date notice procedures b. Not in EEI or WSPP c. May be useful in jurisdictions without U.S. Bankruptcy Code safe harbor provisions d. Between U.S. counterparties, often not elected 1) Avoids risk of termination without Non-Defaulting Party s knowledge 2) Allows for cure and/or negotiation of better terms 3) Avoids risk of unwanted Settlement Payments by Non-Defaulting Party 4) Not necessary due to safe harbor protections in U.S. 27

28 C. Events of Default 4. Events of Default in WSPP not found in ISDA or EEI a. Failure to Provide Good and Clear Title 28

29 C. Events of Default 5. Risk Analysis a. Events of Default mitigate credit and payment risks with respect to the Defaulting Party b. More ways to terminate under ISDA than under EEI or WSPP, but all may not be necessary for every transaction c. Risks of underlying transaction help determine which Events of Default make sense 1) Short-Term v. Long-Term 2) Index Price v. Fixed Price d. Automatic Early Termination: May be beneficial under certain circumstances 1) But may create operational and credit risk if elected in some, but not all, contracts with a counterparty 29

30 D. Force Majeure 1. ISDA Power Annex a. What Constitutes a Force Majeure Event: Clause (i)(iv) 1) The event must not be in the reasonable control of the claiming party; 2) The event must not be the result of negligence; and 3) The event could not have been avoided by the exercise of due diligence by the claiming party. b. Time to Cure: Claiming Party must exercise diligence to cure the event with all reasonable dispatch. Clause (b)(iii) 30

31 D. Force Majeure c. Exclusions: The following events, among others, do not constitute an event of force majeure (Clause (i)(iv)): 1) Loss of Buyer s markets; 2) Buyer s inability to use or resell the product 3) Loss or failure of Seller s supply; or 4) Seller s ability to sell the Product at a price greater than the contract price. d. Prompt Notice: The claiming party must provide notice of the event as soon as practicable. Clause (b)(iii) 31

32 D. Force Majeure e. Obligation to Pay Outstanding Payments: Claiming party remains obligated to pay for performance arising prior to the force majeure or occurring outside the definition of force majeure. Clause (b)(iii) f. Non-claiming Party: The non-claiming party is excused from its corresponding obligations for the duration of the force majeure event. Clause (b)(iii) g. Section 5(b)(ii) (Force Majeure) of the 2002 ISDA Master specifically does not apply to any Power Transaction under the Power Annex. (Clause (b)(iii)) 32

33 D. Force Majeure 2. EEI Master 1.23 and 3.3 a. What Constitutes a Force Majeure Event: 1) The event must not be in the reasonable control of the claiming party; 2) The event must not be the result of negligence; and 3) The event could not have been avoided by the exercise of due diligence by the claiming party. (1.23) b. Reasonable Time to Cure: Claiming Party must exercise diligence to cure the event within a reasonable time period. (3.3) 33

34 D. Force Majeure c. Exclusions: The following events, among others, do not constitute force majeure: 1) Buyer s inability to use or resell the energy commodity; 2) Seller s ability to obtain a higher price; 3) Anticipated events; 4) Loss of buyer s markets or the seller s supply; or 5) Curtailment of transmission unless transmission is firm. ( 1.23) 34

35 D. Force Majeure d. Prompt Notice: The claiming party must provide prompt notice of the event. ( 3.3) e. Obligation to Pay Outstanding Payments: Claiming party remains obligated to pay for performance arising prior to the force majeure or occurring outside the definition of force majeure. ( 3.3) f. Non-claiming Party: The non-claiming party is excused from its corresponding obligations for the duration of the force majeure event. ( 3.3) 35

36 D. Force Majeure 3. WSPP Agreement 10 a. What Constitutes an Uncontrollable Forces Event: 1) The event must not be in the reasonable control of the claiming party; 2) The event must not be the result of negligence; and 3) The event could not have been avoided by the exercise of due diligence by the claiming party. b. Reasonable Time to Cure: Claiming Party must exercise diligence to cure the event within a reasonable time period. If the event is not cured within a reasonable period, it ceases to be an Uncontrollable Forces Event. 36

37 D. Force Majeure c. Exclusions: The following events, among others, do not constitute an Uncontrollable Forces Event : 1) Buyer s inability to use or resell the energy commodity; 2) Increase in seller s cost to obtain the energy commodity; or 3) Under certain circumstances, for designated and not designated transmission path disruptions. 37

38 D. Force Majeure d. Prompt Notice: The claiming party must provide prompt notice of the event. e. Obligation to Pay Outstanding Payments: Claiming party remains obligated to pay for performance arising prior to the force majeure or occurring outside the definition of force majeure. f. Non-claiming Party: The non-claiming party is excused from its corresponding obligations for the duration of the force majeure event. 38

39 D. Force Majeure 4. Risk Analysis a. Inconsistent force majeure definitions across trading agreements 1) More likely to be surprised by a force majeure claim b. Differences are subtle but do exist c. Parties should consider consistent force majeure provisions across trading contracts d. Scrutinize any termination right that may be incorporated into the ISDA, EEI or WSPP as a result of a long-term force majeure 39

40 E. Netting 1. Power Annex: ISDA Master 2(c) a. Netting generally limited to amounts due (i) on the same date; (ii) in the same currency; and (iii) in respect of the same Transaction b. Often modified by the parties in the ISDA Schedule 40

41 E. Netting 2. EEI 6.4 a. All payments owed by each party in a monthly billing period are netted into single amount b. The party owing the greater amount makes a single payment to the other party c. Netting applies across all transactions 41

42 E. Netting 3. WSPP 28.1 and 28.2 a. Permits netting of payments b. Netting Agreement is attached as an exhibit to the Agreement c. Must include the netting of all payments received by the parties in the same calendar month 1) Not clear whether all payments received should be interpreted to include amounts related to damages, interest and payment of credits 42

43 E. Netting 4. Risk Analysis a. Inconsistent netting provisions across multiple agreements may create cash flow and operational risks 1) Incorrect calculations on invoices 2) Incorrect payments to counterparty b. Cross-Transactional Netting 43

44 F. Notices 1. Power Annex: ISDA Master 12(a) a. Writing/Hand Delivery: effective on date delivered b. Fax: effective on date received by responsible recipient in legible form 1) Proof of receipt is on sending party and cannot be proven through fax confirmation c. Certified or Registered Mail: effective on date delivered (or delivery is attempted) d. Electronic Messaging System: effective on date received e. effective on date delivered 44

45 F. Notices f. If notice (i) not delivered on Local Business Day, or (ii) is delivered after close of business, notice deemed delivered on following Local Business Day g. Notices relating to Events of Default or Termination Events may not be sent by electronic messaging system (1992 and 2002), fax (1992), or (2002) 45

46 F. Notices 2. EEI 10.7 a. Fax or Hand Delivery 1) If received during business hours on a Business Day, notice deemed effective at the close of business on such day 2) If received after business hours, deemed effective at close of business on following Business Day b. Overnight Courier or U.S. Mail 1) Deemed effective on the following Business Day after sent 46

47 F. Notices 3. WSPP 12.1 and 10 a. Methods: in person, sent by registered or certified mail, prepaid telegram, fax, or overnight delivery (with record of receipt) or as mutually agreed by the parties in the confirmation b. Uncontrollable Forces: notice may be delivered orally and must be promptly followed by written notice 47

48 F. Notices 4. Risk Analysis a. Operational Risk 1) Various methods of notice permitted in trading contracts a) Ex: ISDA contemplates electronic means, including , but EEI and WSPP do not contemplate electronic means unless otherwise elected by the parties 2) Inconsistent notice provisions across trading agreements a) More likely that manner or method of notice may be insufficient b) Especially important for demands for collateral or notices of default or termination 48

49 F. Notices b. Credit and Payment Risk: 1) Ineffective notice may create credit risk as to a defaulting counterparty: a) Ex: ISDA does not allow notices by fax or electronic messaging (1992 form) or electronic messaging or (2002 form) with respect to Events of Default or Termination Events b) If notice is ineffective, Non-Defaulting Party cannot declare an Early Termination Date 2) Parties should consider consistent notice provisions across trading contracts 49

50 G. Setoff 1. ISDA Power Annex v. EEI v. WSPP a. ISDA Power Annex 1) Setoff provision in 6(f) of the 2002 Master Agreement a) Setoff amounts owed between the parties arising under ISDA or any other agreement b) No cross-affiliate setoff c) Must be added to a Schedule to the 1992 Master Agreement 50

51 G. Setoff b. EEI 5.6: Setoff options elected on Cover Sheet 1) Option A: Non-Defaulting Party sets off obligations owed by Defaulting Party to Non- Defaulting Party under any agreements between the Parties 2) Options B: Non-Defaulting Party sets off obligations owed by Defaulting Party (or its Affiliates) to the Non-Defaulting Party (or its Affiliates) under any agreements between the Parties and/or their Affiliates c. WSPP 22.3: Allows for setoff but does not give parties the option to setoff with other contracts outside of the WSPP 51

52 G. Setoff 2. Risk Analysis: Risks Mitigated by setoff a. Commercial Risks 1) Immediately extinguishes payment obligations 2) Reduces involvement in bankruptcy proceedings b. Credit Risks 1) Amounts owed by Defaulting Party are immediately setoff c. Cash Flow Risk 1) No waiting for payments from Defaulting Party d. Enterprise-wide risks among Affiliates 1) Manages risk of having to pay Termination Payments across trading contracts and Affiliates 52

53 H. Termination, Liquidation & Settlement 1. ISDA Power Annex v. EEI v. WSPP a. ISDA: 6(e) 1) 1992 form a) Market Quotation or Loss, as elected by parties b) First or Second Method, as elected by the parties (one-way or two-way payment) 2) 2002 form a) Close-out Amount b) Always two-way payment 53

54 H. Termination, Liquidation & Settlement b. EEI 1) 5.2: Non-Defaulting Party calculates Settlement Amount for each Terminated Transaction in a commercially reasonable manner 2) 5.3: Settlement Amounts netted into Termination Payment, payable either to or from the Non-Defaulting Party a) Default two-way payment unless changed by parties c. WSPP 1) 22.3: Non-Defaulting Party calculates termination amount for each terminated transaction in a commercially reasonable manner by taking into account various third party sources 2) 22.3: Two-way payment 54

55 H. Termination, Liquidation & Settlement 2. Risk Analysis a. Inherent operational risks in various calculation methods 1) EEI and WSPP require calculation in a commercially reasonable manner while ISDA uses Market Quotation or Loss (1992) or Close-out Amount (2002) 2) Use of market quotes may not accurately reflect actual or anticipated value of transactions 3) Subjective nature of Loss calculation b. Inconsistent Payment Risks to Defaulting Party: 1) EEI and WSPP are two-way payment 2) Potential exposure if one-way payment elected in ISDA 55

56 Conclusion ISDA is becoming more widely-used in energy commodity industry Differences exist between ISDA Power Annex, EEI and WSPP May be difficult to make all agreements consistent Important to prioritize issues and determine scope of transactions when deciding which agreement to use This will likely involve discussion across Legal, Credit and Front Office personnel Craig R. Enochs Reed Smith LLP 1800 Main Street, Suite 1700 Houston, Texas