HomeMy WebLinkAboutStaff Report 137-07City of Palo Alto
City Manager’s Report
TO:
FROM:
HONORABLE CITY COUNCIL
CITY MANAGER
8
DEPARTMENT: ADMINISTRATIVE
SERVICES
DATE:FEBRUARY 12, 2007 CMR: 137:07
SUBJECT:REQUEST TO ESTABLISH LETTER OF CREDIT FACILITIES TO
PROVIDE COLLATERAL ASSURANCE UNDER NEW ELECTRIC AND
GAS MASTER AGREEMENTS FROM FINANCE COMMITTEE
MEETING OF JANUARY 17, 2007
RECOMMENDATION
Staff recommends that the Council accept the Finance Committee’s recommendation to direct
staff to establish a credit facility with Wells Fargo Bank, the City’s current banking services
provider, for the sole purpose of providing credit assurance instruments for the natural gas and
electricity commodity supplies.
COMMITTEE REVIEW AND RECOMMENDATIONS
The amount of the facility recommended is $1.0 million for gas and $2.0 million for electricity.
The annual cost is $15,000 with a one-time set up fee of $10,000. All costs will be covered by
the respective utility funds. After discussion, the Committee to accept start~ s
recommendation.
PREPARED BY:
KARL VAN ORSDOL
Manager, Energy Risk Management
E~IILY HANSON
Assistant City Manager
ATTACHMENTS
Attachment 1" CMR 108:07
CMR:137:07 Page 1 of 1
ATTACHMENT 1
City of Palo Alto
City Manager’s Report
TO:HONORABLE CITY COUNCIL
ATTENTION:FINANCE COMMITTEE
FROM:CITY MANAGER DEPARTMENT: ADMINISTRATIVE
SERVICES
DATE:
SUBJECT:
JANUARY 17, 2007 CMR: 108:07
REQUEST TO ESTABLISH LETTER OF CREDIT FACILITIES
TO PROVIDE COLLATERAL ASSURANCE UNDER NEW
ELECTRIC AND GAS MASTER AGREEMENTS
RECOMMENDATION
Staff recommends that Council direct staff to establish a credit facility with Wells Fargo Bank,
the City’s current banking services provider, for the sole purpose of providing credit assurance .
instruments for the natural gas and electricity commodity supplies. The amount of the facility
recommended is $1.0 million for gas and $2.0 million for electricity. Costs associated with the
establishment of the facility will be covered by the respective utility funds.
BACKGROUND
The new master agreements for natural gas purchases are being presented to Council under
CMR:106:07. The CMR for electric purchases will be prepared shortly. These contracts differ
from the existing contracts in the manner to which collateral assurance terms are applied. In
previous agreements, the City was ndt required by the counterparties to post collateral assurance
if the City maintained a superior credit rating (BBB- or better) and if the Council maintained the
ability to set rates.
In the new contracts with five of the counterparties (BP, Coral, JPMorgan, Powerex, Conoco
Phillips), collateral assurance is a requirement of the City’s energy and gas contracts and applies
to both the City and the energy providing c0unterparties. Collateral assurance provides additional
forms of assurance to one party when the outstanding contracts constitute a large credit risk for
that party. The level of risk is based on the market value of the contracts and the credit condition
of the counterparty.
CMR:108:07 Page 1 of 4
DISCUSSION
Collateral assurance is a key term in energy purchase agreements. The assurance reduces the
risk to one party when its exposure to the counterparty is high, the counterparty’s credit rating
declines, or both conditions emerge. Collateral assurances can be issued either in the form of
cash or a Letter of Credit (issued via an independent third party financial institution), or some
other form of security.
Collateral assurance is provided when the risk exposure of a party exceeds the credit threshold
specified in the contract..The threshold is determined by the counterparty’s credit rating with the
threshold rising in $2.5 or $5 million increments for each "notch" increase in the credit rating
(Table 1). Once the exposure exceeds the credit threshold, the counterparty can request
collateral assurance in $250,000 increments.
Table 1. Example Credit Collateral Thresholds
Credit Rating of City or Counterparty
AA- or Above
A- to A+
BBB+
BBB
BBB- or below
Threshold (Millions)
$20.0
$15.0
$10.0
$5.0
$0
For example, if the City has a contract with a counterparty rated at BBB, and the value of those
contracts initially increases above the $5 million level, the City is able to request collateral
assurance of $250,000 from the counterparty. If the value of the contract (the "mark to market"
value) increases above $5.25 million, the City can request additional payments of credit
assurance of $250,000 with each $250,000 increase in the mark to market value. If the value of
the contracts declines, the City !s obligated to return the collateral assurance within 5 days of the
reduced valuation.
In each agreement, the amount of collateral the City is required to post is symmetrical to the
City’s rights to request collateral from the counterparties at a given credit rating. That is, for
each credit rating, the City’s ability to request credit is equal to the counterparty’s ability to
request credit in the reverse situation.
The probability of the City requesting collateral is significantly higher than the probability of the
City having to post collateral. This asymmetry in liketiness of outcome is the result of energy
market behavior and the City’s purchasing strategy.
a) Market behavior. Energy prices can show greater upswings in price than downswings.
Prices for electricity, for example, currently at approximately $65 per MWh can
quickly spike to $200 per MWh (as observed last summer) but can never drop below
$0. The City’s right to request collateral will be based on a high positive mark to
market value of the outstanding contracts. The counterparty’s right to request
CMR: 108:07 Page 2 of 4
collateral from the City requires a high negative MTM, a situation that can only occur
when prices drop.
Purchasin~ Strategy. While the City purchases energy commodities from
counterparties who offer the lowest price, a key component of its risk management
strategy is diversification of suppliers. Therefore, the City actively manages its risk
of possible credit exposure resulting from a large position with one counterparty.
Under the City’s laddering program, the City has committed to approximately $35 million in
forward purchases for gas and $25 million for electricity. Exposures to any one company for gas
and electric purchases are not combined. To trigger a collateral call, the City would have to
purchase essentially all forward gas or electricity positions from one counterparty (a violation of
risk management protocol), experience an unprecedented drop in prices of 75%, and suffer a four
notch rating decline. While such a succession of events is possible, it would require market
dislocations as broad and deep as those occurring during the energy crisis in 2001. In such a
turbulent environment, the LOC facility would provide assurance tothe counterparty without the
City issuing cash.
Conversely, the City can request collateral assurance when prices increase. Historically, the City
has been in the position on at least one occasion when it was prepared to request collateral
assurance from a counterparty. In October and November of 2005, shortly after Hurricane
Katrina, escalating energy prices exposed the City to a credit risk of $29.5 million with one
counterparty, Coral Energy. Had the mark to market value of the contracts risen to $30.0
million, the City would have requested collateral assurance from Coral.
The use of an LOC is recommended over the use of cash for several reasons.
Issuing cash exposes the City to additional financial risk. A steep decline in prices is
required for a collateral request to the City and would likely impact negatively the credit
ratings of energy counterparties. Such a loss in credit quality of a counterparty at the time
that the City was being requested to post collateral would expose the City to risks of not
being able to readily retrieve the collateral in the event that the counterparty defaults or
enters bankruptcy proceedings.
2.The issuing of collateral assurance must occur within 5 business days of a request.
Transferring cash in such a short period o.ftime could be problematic.
o Under the terms of the contract, a posted LOC assurance cannot be "called" (i°e., cashed)
unless the other party defaults in receiving or supplying the energy purchased. Thus, the City
would not be required to actually transfer funds when collateral is requested unless it defaults
or~ the contract.
However, that if an LOC is called and the bank of record transfers the funds to the counterparty,
the City will be required to repay the bank "immediately."
CMR:108:07 Page 3 of 4
RESOURCE IMPACT
The costs associated with opening a Letter of Credit Facility are in the order of 50 basis points
ione half of one percent) per year for the maximum dollar value of the facility plus initial legal
fees. With the recommended initial $3 million facility, the total costs would~be approximately
$17,500 for the first year and $15,000 for each subsequent year.
If the facility is used, an additional cost of approximately 50 basis points is also levied against
the City. These costs will be paid by the gas and electricity enterprise on an amaual basis.
PREPARED BY:
KARL G. VAN ORSDOL
Energy Risk Manager
DEPARTMENT APPROVAL:
CARL
Services
CITY MANAGER APPROVAL:
HARRISON
Assistant City Manager
CMR: 108:07 Page 4 of 4