8th Annual Gas & Power Institute September 10-11, 2009 ISDA and its Commodity Annexes: The New EEI or NAESB? Craig R. Enochs Craig R. Enochs cenochs@jw.com Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas 77010 (713) 752-4200 phone

Issues Are the ISDA Gas and Power Annexes becoming more widely-used than the NAESB and EEI? Why use the ISDA Gas and Power Annexes instead of the NAESB and EEI? What are the “gap risks” between the ISDA Gas and Power Annexes, the NAESB and the EEI?

Use of the ISDA Commodity Annexes: A Growing Trend ISDA originally intended for use with financial products Drafted by bankers and lawyers in New York and London to standardize derivative transactions In the last few years, the ISDA has gained popularity in the energy industry because of the publication of various commodity annexes Power Annex (2003), Gas Annex (2004), Emissions Allowance Annex (2006), Coal Annex (2007), Crude Oil Annex (2008)

ISDA Gas Annex and the NAESB Joint Effort: After NAESB published in 2002, ISDA and NAESB worked together in creating the Gas Annex Gas Annex published by ISDA in 2004 Similar Provisions: Gas Annex closely follows the NAESB’s provisions relating to the purchase and sale of physical gas Clauses (b) through (g), (h) and (i) of the Gas Annex are similar to Sections 3 through 8, 11 and 13 of the 2002 NAESB, respectively

ISDA Power Annex and the EEI Joint Effort: After EEI Master Agreement published in 2000, ISDA and EEI worked together in creating the Power Annex Power Annex published by ISDA in 2003 Similar Provisions: Power Annex closely follows the EEI’s provisions relating to the purchase and sale of physical power Clauses (b)-(c), (d)-(e), (f) and (g) of the Power Annex are similar to Articles 3-4, 6-7, 9 and Sections 10.3-10.4 of the EEI Master Agreement, respectively

Why Use the ISDA Instead of the NAESB or EEI? Trade various energy commodities under a single agreement by using the ISDA Annexes Net credit exposures across transactions and products Single agreement setoff rights in bankruptcy Payment netting across transactions and products

Why Use the ISDA Instead of the NAESB or EEI? (cont.) Streamlines negotiation and documentation process Once ISDA Master Agreement and Schedule are in place, fairly simple to added Gas and/or Power Annex.

Sources of Gap Risk in ISDA, NAESB and EEI Though similar to the NAESB and EEI, the Gas and Power Annexes (respectively) are not exclusive agreements Annexes form only part of entire ISDA agreement Contain only those provisions necessary to implement purchase/sale and delivery of gas and power E.g., delivery/receipt, scheduling, title, force majeure

Sources of Gap Risk in ISDA, NAESB and EEI (cont.) ISDA Master Agreement, Schedule and Credit Support Annex (as applicable) govern all transactions under Gas and Power Annexes Provisions not specifically related to physical commodities, but still applicable to gas and power transactions E.g., events of default, termination and settlement, credit provisions, notices, confirmation procedures

Sources of Gap Risk in ISDA, NAESB and EEI (cont.) Common reasons for gap risk across trading agreements: ISDA, NAESB and/or EEI with same counterparty at the same time E.g., ISDA for new transactions with Counterparty A, and NAESB/EEI for existing transactions with Counterparty A ISDA, NAESB and/or EEI with different counterparties at the same time E.g., ISDA for all transactions with Counterparty A, and NAESB/EEI for all transactions with Counterparty B. To mitigate gap risk, must be aware of differences across agreements.

Gap Risks in the NAESB, EEI and ISDA A. Confirmation Procedures B. Netting C. Notices D. Credit Obligations E. Events of Default & Termination Event F. Termination, Liquidation and Settlement G. Setoff

A. Confirmation Procedures 1. NAESB § 1.2: Procedure elected on Cover Sheet Oral Transaction Procedure Transaction is binding when parties orally agree upon terms Failure to send Transaction Confirmation does not affect performance obligations Written Transaction Procedure Parties must exchange non-conflicting Transaction Confirmation before parties legally obligated to perform

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

A. Confirmation Procedures 3. Gas and Power Annexes: ISDA Master § 9(e)(ii) Parties legally bound from the moment they agree on commercial terms Confirm transaction terms by sending written Confirmations No other specific terms or procedures in Master Agreement, Gas Annex or Power Annex

A. Confirmation Procedures 4. NAESB, EEI and ISDA: Risk Analysis Confirmation procedures should conform to risk in underlying transactions Short-term v. Long-term Risk of disagreement regarding future performance obligations Operational Risk in Confirming Transactions Seller confirms in NAESB and EEI, but ISDA does not specify Inconsistent Dispute Resolution Procedures NAESB v. EEI v. ISDA

B. Netting 1. NAESB § 7.7 All payments due and owing (or past due and owing) netted into single amount The party owing the greater amount shall make a single payment to the other party Not limited to amounts owed under a single transaction

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

B. Netting 3. Gas and Power Annexes: ISDA Master § 2(c) Netting generally limited to amounts due (i) on the same date; (ii) in the same currency; and (iii) in respect of the same Transaction Often modified by the parties in the ISDA Schedule

B. Netting 4. Risk Analysis Inconsistent netting provisions across multiple agreements may create cash flow and operational risks Incorrect calculations on invoices Incorrect payments to counterparty Cross-Transactional Netting NAESB v. EEI v. ISDA

C. Notices 1. NAESB § 9.2 Methods: Fax, mutually-accepted electronic means, overnight courier, first class mail or hand delivery General Rule: deemed delivered when received on a Business Day If no proof of actual receipt, the following presumptions apply: Fax: deemed delivered when sending party receives fax machine’s confirmation of successful transmission. If after 5:00 p.m., deemed received the following Business Day Overnight Courier or Mail: deemed delivered on following Business Day after sent, or earlier if confirmed by receiving party First Class Mail: deemed delivered five (5) Business Days after mailing

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

C. Notices 3. Gas and Power Annexes: ISDA Master § 12(a) Writing/Hand Delivery: effective on date delivered Fax: effective on date received by responsible recipient in legible form Proof of receipt is on sending party and cannot be proven through fax confirmation Certified or Registered Mail: effective on date delivered (or delivery is attempted) Electronic Messaging System: effective on date received Email (2002 ISDA): effective on date delivered

C. Notices 3. Gas and Power Annexes: ISDA Master § 12(a) (cont.) 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 Notices relating to Events of Default or Termination Events may not be sent by electronic messaging system (1992/2002), fax (1992) or email (2002 ISDA).

C. Notices 4. Risk Analysis Operational Risk: Various methods of notice permitted in trading contracts Ex: ISDA contemplates electronic means, including email (2002 ISDA), but EEI does not contemplate electronic means unless otherwise elected by the parties Inconsistent notice provisions across trading agreements More likely that manner or method of notice may be insufficient

C. Notices 4. Risk Analysis (cont.) Credit and Payment Risk: Ineffective notice may create credit risk as to a defaulting counterparty: Ex: ISDA does not allow electronic means (1992/2002), fax (1992) or email (2002) notices with respect to Events of Default or Termination Events If notice is ineffective, Non-Defaulting Party cannot declare an Early Termination Date Parties should consider consistent notice provisions across trading contracts

D. Credit Obligations 1. NAESB § 10.1 Either party can demand Adequate Assurance of Performance if it has “reasonable grounds for insecurity” regarding other party’s performance “Reasonable grounds for insecurity” not defined in NAESB, except that it includes a “material change in creditworthiness” Only credit provision in NAESB apart from any CSA incorporated into the Contract

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

D. Credit Obligations 3. ISDA Gas and Power Annexes: 4. Risk Analysis: No credit provisions in the Master Agreement or Commodity Annexes Parties generally rely on threshold margining under the ISDA CSA 4. Risk Analysis: Inconsistent credit requirements across agreements (e.g., Adequate Assurances under NAESB v. margining under ISDA) Benefit of ISDA: netting of exposures across products to minimize collateral obligations

E. Events of Default & Termination Events 1. NAESB v. ISDA Gas Annex Common Events of Default: NAESB § 10.2; ISDA § 5(a) Failure to pay when due Breach of credit obligations Insolvency and bankruptcy-related events Events of Default in ISDA not found in NAESB: Breach of Agreement (other than failure to pay) Misrepresentations Default under Specified Transaction Similar to Transactional Cross Default election in 2006 NAESB Cross Default Similar to Indebtedness Cross Default election in 2006 NAESB Merger Without Assumption

E. Events of Default & Termination Events 1. NAESB v. ISDA Gas Annex (cont.) Termination Events in ISDA not found in NAESB: Illegality Force Majeure Event (2002) Tax Event and Tax Event Upon Merger Credit Event Upon Merger Additional Termination Event

E. Events of Default & Termination Events 2. EEI v. ISDA Power Annex Common Events of Default: EEI § 5.1 and ISDA § 5(a): Failure to pay when due False or misleading representations Breach of Agreement (other than failure to pay) Insolvency and bankruptcy-related events Breach of credit obligations Merger without assumption Cross Default

E. Events of Default & Termination Events 2. EEI v. ISDA Power Annex (cont.) Events of Default and Termination Events in ISDA not found in EEI: Default under Specified Transaction Illegality Force Majeure Event (2002 ISDA) Tax Event and Tax Event Upon Merger Credit Event Upon Merger Additional Termination Event

E. Events of Default & Termination Events 3. Automatic Early Termination under ISDA How it works: Upon occurrence of certain bankruptcy events, an Early Termination Date is deemed to occur Parties do not follow Early Termination Date notice procedures Not in standard NAESB or EEI May be useful in jurisdictions without U.S. Bankruptcy Code “safe harbor” provisions

E. Events of Default & Termination Events 3. Automatic Early Termination under ISDA (cont.) Between U.S. counterparties, often not elected: Avoids risk of termination without Non-Defaulting Party’s knowledge Allows for cure and/or negotiation of better terms Avoids risk of unwanted Settlement Payments by Non-Defaulting Party

E. Events of Default & Termination Events 4. Risk Analysis Events of Default mitigate credit and payment risks with respect to the Defaulting Party More ways to terminate under ISDA than under NAESB or EEI, but all may not be necessary for every transaction Risks of underlying transaction help determine which Events of Default make sense (short term v. long-term; index v. fixed price) Automatic Early Termination: May be beneficial under certain circumstances May create operational and credit risk if elected in some but not all contracts with a counterparty

F. Termination, Liquidation & Settlement 1. NAESB v. ISDA Gas Annex NAESB § 10.3.1 Non-Defaulting Party determines: Amount owed by each party for Gas delivered and received on or before the Termination Date All other applicable charges related to such deliveries and receipts for which payment has not yet been made If “Additional Termination Damages” apply: Liquidation and acceleration of Terminated Transactions at Market Value If Market Value greater than Contract Value, difference due to Buyer If Market Value less than Contract Value, difference due to Seller Default two-way payment

F. Termination, Liquidation & Settlement 1. NAESB v. ISDA Gas Annex (cont.) ISDA § 6(e): Market Quotation and Loss Market Quotation: Value of Terminated Transactions based on quotations from Reference-Market Makers plus any Unpaid Amounts owed to Non-Defaulting Party; minus Unpaid Amounts owed to the Defaulting Party Loss: Non-Defaulting Party’s total losses and costs resulting from early termination and liquidation, including loss of bargain, costs of funding, and costs of terminating, liquidating or reestablishing any hedge ISDA § 6(e): First and Second Method One-way v. two-way payment

F. Termination, Liquidation & Settlement 2. EEI v. ISDA Power Annex EEI: § 5.2: Non-Defaulting Party calculates Settlement Amount for each Terminated Transaction in a “commercially reasonable manner” § 5.3: Settlement Amounts netted into Termination Payment, payable either to or from the Non-Defaulting Party Default two-way payment unless changed by parties ISDA: § 6(e): Market Quotation or Loss, as elected by parties ISDA § 6(e): First or Second Method, as elected by the parties (one-way or two-way payment)

F. Termination, Liquidation & Settlement 3. NAESB, EEI and ISDA: Risk Analysis Inherent operational risks in various calculation methods: NAESB method and Market Quotation are substantively similar, while EEI requires calculation in a “commercially reasonable manner” Use of market quotes may not accurately reflect actual or anticipated value of transactions Subjective nature of Loss calculation Inconsistent Payment Risks to Defaulting Party: NAESB and EEI are two-way payment Potential exposure if one-way payment elected in ISDA

G. Setoff 1. NAESB v. ISDA Gas Annex NAESB § 10.3.2: Election on Cover Sheet Other Agreement Setoffs Apply: 2002 NAESB: Bilateral 2006 NAESB: Bilateral or Triangular, as elected by the parties Other Agreement Setoffs Do Not Apply Setoff limited to amounts owed under the NAESB. ISDA Gas Annex: 2002 ISDA § 6(f): Setoff provision Setoff amounts owed between the parties arising under ISDA or any other agreement No cross-Affiliate setoff Identical to bilateral setoff in 2002 NAESB

G. Setoff 2. EEI v. ISDA Power Annex EEI § 5.6: Setoff options elected on Cover Sheet Option A: Non-Defaulting Party sets off obligations owed by Defaulting Party to Non-Defaulting Party under any agreements between the Parties 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 ISDA Power Annex: 2002 ISDA: Setoff provision in § 6(f) Setoff amounts owed between the parties arising under ISDA or any other agreement No cross-Affiliate setoff

G. Setoff 3. Risk Analysis: Risks Mitigated by Setoff Commercial Risks: Immediately extinguishes payment obligations Reduces involvement in bankruptcy proceedings Credit Risks: Amounts owed by Defaulting Party are immediately setoff Cash Flow Risk: No waiting for payments from Defaulting Party Enterprise-wide risks among Affiliates: Manages risk of having to pay Termination Payments across trading contracts and Affiliates

Conclusion ISDA is becoming more widely-used in energy commodity industry Differences exist between ISDA Gas Annex, Power Annex, NAESB and EEI May be difficult to make all agreements consistent Important to prioritize issues and determine scope of transactions when deciding whether to use ISDA Commodity Annexes and/or the NAESB and EEI Research paper Gap risk summaries located at Appendices 1 and 2 Craig R. Enochs cenochs@jw.com Jackson Walker L.L.P. 1401 McKinney, Suite 1900 Houston, Texas 77010 (713) 752-4200 phone