ELECTRICAL INDUSTRY RESTRUCTURING

Financial Derivatives in Ontario's New Electricity Marketplace

The Ontario electricity market opened on May 1, 2002. While it is possible to participate directly in the physical electricity market (which entails registration with Ontario's Independent Electricity Market Operator ("IMO")) many parties negotiate privately to enter into financial derivative contracts, such as swaps or contracts for differences that have the effect of reducing or eliminating price volatility for the parties. Derivatives arrangements are usually associated with the wholesale electricity markets. This article examines the forms of agreement that are commonly used by parties entering into financial arrangements to fix the price of wholesale electricity in the Ontario market.

Swaps

Swaps (or "contracts for differences") are individually negotiated transactions in which each counterparty to the swap agrees to exchange periodic cash flows based on differences over time in the state of one or more specified underlying reference price. In the case of swaps in the Ontario electricity market, the reference price is the IMO's Hourly Ontario Electricity Price. A swap agreement is conceptually the same as a series of forward contracts, the primary difference between the two products being that a swap features less credit risk because there are more frequent settlements of cash flows between the parties during the life of the agreement.

Hedging Electricity Prices

A hedger in the Ontario electricity market is a party, such as a wholesaler or retailer of electricity, who desires to reduce or eliminate risks associated with changes to the spot price of electricity in Ontario.

For example, a retailer will enter into a fixed price contract with a customer. The price risk associated with this contract can be off-loaded by entering into a wholesale swap arrangement with an electricity wholesaler that fixes the price that the retailer will pay for electricity. The retailer thus makes money only on the spread between the price the retail customer pays for a given quantity of electricity and the price it "pays" (or at least has fixed for itself) to the wholesaler. The actual mechanics of the wholesale relationship are different than those at the retail level; if the spot market price drops during a particular period with reference to a certain quantity of electricity, the retailer pays the wholesaler the difference between the fixed price and the floating price. If the spot market price rises, the wholesaler pays the retailer the difference.

However, often the quantities arranged in the wholesale market may not match those sold at the retail level. Thus, while price risk may be eliminated, a retailer may still be subject to volume risk for a particular quantity of electricity. Speculators, on the other hand, may take a position in the financial markets and make money by taking a view on whether electricity prices will rise or fall. In the process, speculators assume the risk that hedgers are trying to avoid.

Forms

Ontario wholesale electricity arrangements that are purely financial can be referred to as over-the-counter ("OTC") transactions. Many OTC derivative contracts that fix the price of electricity use the International Swaps and Derivatives Association ("ISDA") form of contract. Even where the ISDA form is not used, the concepts used in the ISDA form still appear in the contract. The ISDA contract consists of a master agreement, a schedule and a confirmation for the various transactions.

Changes to the master agreement, elected options, and additional provisions are all contained within the schedule to the master agreement. The current ISDA form is the 1992 Master Agreement. For Canadian purposes there are two master agreement forms; namely, the multicurrency-cross border and the local single currency form. While the local single currency form is somewhat simpler, the multicurrency-cross border version is generally used for Canadian transactions.

The ISDA master agreement features the following provisions; general conditions relating to the various transactions; withholding tax provision; provision for default interest; representations by both parties; specifications of the events of default and termination; calculation of damages; assignment provisions; currency provisions; allocation and expenses; governing law; notification addresses and miscellaneous interpretation provision.

Netting and Set-off

The master agreement provides that when, in respect of the same transaction and the same currency, both parties owe each other money, then the person owing the higher amount pays the other the difference. If the parties desire to net amounts in respect of more than one transaction, then they need to so specify in the schedule or in a specific confirmation.

Netting is distinguished from setting-off. Setting-off is generally contemplated in a default situation and is affected against amounts payable under other contracts. Such contracts may include only those between the two parties, or those between the two parties and any of their affiliates.

Taxes

If a Canadian party enters into an ISDA master agreement with a foreign counterparty, the Canadian party may be faced with tax withholding obligations in respect of interest. Since derivative instruments are priced without consideration of taxes, the ISDA master agreement contains a mechanism by which the applicable party must gross-up its payments to put the counterparty in the same position as if there was no tax withheld.

Events of Default and Termination

Section 5 of the ISDA master agreement specifies certain default and termination events, while section 6 deals with the parties' rights and remedies in the event of early termination. Much of the schedule is dedicated to options and clarifications relating to these two sections, and the schedule can also be amended to customize these terms. Significant time and effort will likely be spent by each party ensuring that it is satisfied with the credit worthiness of the other party to the transaction. Credit risk may be sufficiently reduced through a parental guarantee or other credit support device.

The ISDA master agreement allows the parties to identify specific entities and transactions where a default will be deemed to be a default of the agreement as a whole. Such specified transactions or parties would likely be those with which the counterparty has dealt, or parties who have provided credit support. Events of default in the agreement include normal and expected events of default such as: the failure to pay or deliver when required pursuant to a transaction; any other breach of the agreement; a failure in a credit support document; a misrepresentation; a bankruptcy or other insolvency event; or a merger that obstructs any one of the merged party's obligations, including credit support obligations.

The parties can also choose to include a cross-default provision. The cross-default provision must be elected in the schedule to be effective. This provision merely specifies a cross-default as between the parties to the contract if any default occurs in respect of borrowed money, provided that the amount of the borrowed money is in excess of a threshold amount. The threshold amount is negotiated and then specified in the schedule as either a dollar amount, or a percentage of a party's equity.

In addition to "events of default", there are "termination events", which trigger different remedies. Termination events are essentially "no fault" events that include the following: illegality (i.e., where a law changes, rendering any transaction unlawful or preventing a credit supporter from performing its obligation); a tax event which results in a gross-up amount having to be paid or a new withholding tax to be withheld (as mentioned earlier in this article); and a tax event which arises upon the merger of either of the parties. In addition, if so elected by the parties to the agreement, a merger of a credit support provider can be treated by the other party as a termination event if the creditworthiness of the resulting entity is materially weakened by the merger. The parties are also free to specify additional termination events in the schedule.

Remedies

In the event that only one party is affected by a termination event, the unaffected party must calculate its resulting losses or gains on the basis of either (1) market quotes, if that method was elected and is feasible, or (2) the loss of bargain or cost to replace the unaffected transaction, adjusted for any amounts owing by one party to the other.

If the termination arose as the result of an event of default, the applicable remedy will depend on the elections of the party as set forth in the schedule to the master agreement. The parties can elect that the "first method" or the "second method" will apply and that either the "loss" method or the "market quotation" method will apply. The "loss" method requires the non-defaulting party to calculate its losses and costs (or gain, in the event of a negative loss) resulting from termination of the transactions which includes "any loss of bargain, cost of funding or, at the election of such party both without duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or re-establishing any hedge or elating trading position (or gain resulting from any of them)". The "market quotation" method requires the non-defaulting party to obtain a market quote for the terminated transaction if one is available, and to calculate the loss if a market quote is not available for the terminated transaction.

The "second method" requires the non-defaulting party to pay to the defaulting party any gain it might achieve as a result of the early termination, contrary to the "first method", which does not require such gain to be disgorged. Unless the parties specify otherwise, the "market quotation" and the "second method" apply by default. Any resulting amount payable by one party to the other is subject to any set-off that is specified in the schedule or otherwise permitted by law.

Confirmations

The master agreement provides that confirmation in respect of each transaction may be made orally, by fax, or by exchange of electronic messages on an electronic messaging system. Many parties amend this provision because enforcing or approving a transaction that has only been agreed to by a telephone call between the traders may be difficult for evidentiary reasons, particularly because of the Statute of Frauds which requires that an agreement over a term of one year be in writing.

Parties may also provide that a confirmation supplied by one side may become binding if the other side takes no action within a certain period of time. Or, the preference may be that the transaction lapses if the confirmation is not responded to.

Locational Marginal Pricing

For the first 18 months after May 1, 2002, the Hourly Ontario Electricity Price or HOEP will be a uniform market-clearing price within Ontario calculated on a congestion-free basis. Settlements for generators and consumers will be based on metered energy. During this initial 18-month period, the IMO will collect and publish locational pricing data to determine the extent of congestion in the Ontario market and will recommend whether to move to some form of congestion pricing after this initial period. This change could result in locational marginal pricing, in which individual market clearing prices would be established for various locations in Ontario. Because wholesale electricity arrangements generally refer to the HOEP as the reference price, they must account for the possibility that HOEP will be replaced by differential pricing at different locations in Ontario.

Credit Support

The ISDA Credit Support Annex is a standard form document that provides for credit support between parties to the ISDA master agreement. The Annex provides for the levels at which calls may be made for specified security. Such security may not be required so long as, for example, the contracting party or its "credit support provider" (usually a corporate parent) has a specified credit rating. The credit support provider may be bound to support the credit of the contracting party by guarantee.

The Annex provides that failure to post the agreed to collateral will constitute an event of default. The Annex also sets out certain rights and remedies with regard to posted security and contains representations and warranties relating to the security.

Just as the master agreement is a form to which changes can be made in a schedule, the Annex is a form containing 12 sections, referred to as "paragraphs". Changes to and customization of the Annex can be made in "Paragraph 13", which is a separate document in which parties can fill in blanks and alter wording. The parties can specify, for example, acceptable types of security, e.g. cash, letter of credit, etc., valuation and timing issues, conditions precedent and other specific items.

Ontario personal property security law imposes certain non-waivable obligations on a secured party with respect to collateral in its possession. These provisions may conflict with certain contractual provisions in the Annex that allow the secured party to deal with the collateral freely. Specific provisions should be added in the case of an Ontario secured party to deal with this issue.

Choice of Law and Choice of Forum

Where the wholesaler and the retailer are both Ontario corporations, they will naturally choose Ontario law to govern their contracts and will choose Ontario as the forum in which to litigate their disputes.

However, where the wholesaler is, for example, a Delaware corporation operating in Michigan, and its guarantor is located in New York, the situation is less clear cut. The parties may have to negotiate which law will apply and where any disputes may be tried. Furthermore, the law or forum chosen for the contracting parties may be different from those applicable to the guarantees.

Market Disruption Events and Disruption Fallbacks

Standard ISDA Definitions (including the 2000 ISDA Definitions, the 1993 ISDA Commodity Derivatives Defini-tions, and their respective supplements) may be used to provide for alternative approaches in the event that the HOEP or other agreed to reference price is unavailable. These include postponement until a reference price is once again available, prices offered by alternative internationally recognized dealers, or a negotiated fallback price. Parties may choose one or a combination of these alternatives. However, in the context of the Ontario electricity market, parties may also wish to make reference to the IMO-determined administrative pricing provisions contained in the IMO's market rules.

Conclusion

Financial derivatives in the form of the ISDA master agreement and associated documents are somewhat complex to practitioners not familiar with them. However, they provide a standardized yet flexible instrument for wholesale counterparties to allocate risks associated with the price of electricity in the Ontario market.

Although many of these provisions are still the subject of intense negotiation, it is expected that, as the market matures, they will become more standardized and the costs, time and effort necessary to negotiate these types of transactions will be reduced.

Ron W. Clark is a lawyer in the corporate/commercial and energy practice areas of Power Budd LLP in association with CMS Cameron McKenna in Toronto, Canada.

Ron advises numerous electric utilities, retailers, corporations and municipalities, domestically and internationally, on corporate and regulatory issues relating to the electricity industry. ET