Credit risk management in the energy industry

This paper offers a practical insight into Credit Risk Management (CRM) in energy trading and enables the reader to understand, develop and apply adequate credit risk mitigating strategies in practice under special consideration of EFET Master Agreements and the related Credit Support Annex (CSA). Sensitized by the spectacular Enron default in 2001 and related losses, the energy industry started to consider credit risks in their daily business operations. On basis of Principal-Agent problems in credit relationships, this paper demonstrates the development of CRM with a focus on energy trading and introduces relevant figures such as Probability of Default, Recovery Rate, Loss Given Default as well as Expected and Unexpected Loss. The focus of this paper lies on potential means to either reduce or transfer credit risks to avoid losses from the default of counterparts. Such credit risk mitigating techniques comprise among others credit limits, PCGs, EFET Master Agreements, MAC-clauses and financial covenants, collateral management, credit derivatives and credit insurance. The prominent cases of TelDaFax and Noble Group Ltd. illustrate that such instruments are still needed today. Originating from the aformentioned instruments, applicable strategies to adequately address credit risks related to these two counterparts are developed to show how credit risks can be reduced effectively.