January 16, 2014

Managing Gap Risk Between the ISDA Power Annex, the EEI and the WSPP

Craig R. Enochs

1

I. Document Overview

• Who drafted each form?

• Typical user

• Typical transaction

2

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

EEI

A. Who drafted it? 1. Edison Electric Institute published the EEI Master Sale and Purchase

Agreement in 2000

2. 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

EEI

B. Typical User 1. Electricity merchants

2. Utilities

3. U.S. entities

4. Not retail electricity customers

5

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

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

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 10.3-10.4 of the EEI Master Agreement, respectively

c. Provisions in the ISDA Master Agreement relate only to non-physical/operational matter such as Events of Default, early termination, credit, notices, confirmation procedures and miscellaneous boilerplate provisions

8

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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. Email: effective on date delivered

44

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 email (2002)

45

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

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

F. Notices 4. Risk Analysis

a. Operational Risk 1) Various methods of notice permitted in trading contracts

a) Ex: ISDA contemplates electronic means, including email, 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

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 email (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

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

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

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

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

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

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

Conclusion

56

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 cenochs@reedsmithcom

Reed Smith LLP 1800 Main Street, Suite 1700

Houston, Texas 77002