8 th Annual Gas & Power Institute September 10-11, 2009 ISDA and its Commodity Annexes: The New EEI or NAESB? Craig

1. 8th Annual Gas & Power InstituteSeptember 10-11, 2009ISDA 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

2. 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?

3. 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)

4. 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

5. 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

6. 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

7. 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.

8. 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

9. 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

10. 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.

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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).

24. 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

25. 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

26. 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

27. 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

28. D. Credit Obligations 3. ISDA Gas and Power Annexes: • 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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)

39. 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

40. 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

41. 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 byDefaulting 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

42. 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

43. 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 Conclusion