APRIL 22, 2021 Exchange Clearing of Financial Transmission Rights (EFTRs) NEPOOL Budget & Finance Subcommittee Meeting Cheryl Arnold DIRECTOR, FINANCE & ACCOUNTING ISO NEW ENGLAND Sylvie Jobes SENIOR MANAGER, RISK & STRATEGIC ANALYSIS NODAL EXCHANGE, LLC ISO-NE PUBLIC Contents of Presentation Page(s) • Project Objectives 3 • Introduction: Current Financial Transmission Rights (FTR) Mechanisms 4-7 • Overview of Design Concept 8-9 • Proposed Design 10-33 – Participating Entities – Background on Clearing House Model – Sequence for Exchanging FTR Awards to Futures Contracts – Billing, Collections and Settlement Process – Benefits of Proposed Design/Risk Management • Legal and Regulatory Considerations 34 • Tentative Project Schedule 35-36 ISO-NE PUBLIC 2 Project Objectives • Replace ISO-NE Financial Assurance requirements for holding Financial Transmission Rights (FTRs) with clearing of equivalent futures contracts by a CFTC jurisdictional exchange / clearing house – A clearing house is better positioned to handle valuation (margin) on an ongoing basis – Default risk is shifted from ISO-NE’s market participants to clearing house • Facilitate secondary market trading ISO-NE PUBLIC 3 Introduction: Current FTR Mechanisms (1) • An FTR is a financial instrument − acquired in an ISO-NE auction − that entitles the holder to receive compensation for congestion costs. It can be used to hedge the Day-Ahead LMP congestion component difference on a specific path between receipt and delivery points in the New England energy market. • Revenues from the FTR auction are paid to Auction Revenue Rights Holders (ARR Holders) • FTR billing/collection occurs monthly; FTR Holders are paid from Day-Ahead and Real-Time Congestion Revenues, based on whether the paths purchased result in a positive or negative “target allocation” ISO-NE PUBLIC 4 Introduction: Current FTR Mechanisms (2) • FTR Holders are not fully paid for their positions if there is a shortfall in congestion revenue in a given month; however, monthly shortfalls can be reduced at year-end if any excess congestion revenue is remaining. Year-end excess remaining after paying monthly shortfalls goes to net congestion payers. ISO-NE PUBLIC 5 Introduction: Current FTR Mechanisms (3) • Currently, the ISO protects the market from FTR defaults by: – Requiring market participants to complete an ISO-prescribed training course prior to participating in the FTR auction – Requiring Market Participants to provide financial assurance (FA) in the amount equal to the sum of the FTR Settlement Risk FA, Unsettled FTR FA and the Settlement FA • FTR Settlement Risk FA covers the risk to hold a FTR position from last evaluation to maturity. It is based on the latest 36 month historical average Day-Ahead LMP congestion component. This is updated monthly. • Unsettled FTR FA covers the change in value of a FTR position from its acquisition to the time when the last evaluation is made. The unsettled FTR FA captures Mark-to-Market value of existing FTR positions. • Settlement FA is the net settled but uninvoiced value of FTR positions in the delivery month for a Market Participant ISO-NE PUBLIC 6 Introduction: Current FTR Mechanisms (4) • If an FTR Holder defaults, and these measures are insufficient, default amounts are socialized to market participants per the Billing Policy ISO-NE PUBLIC 7 Overview of Design Concept (1) • ISO New England runs the FTR auction to create the initial positions • The FTRs are processed by Nodal Exchange and novated to Nodal Clear; i.e., converted from ISO-NE market path-based positions into Nodal Exchange/Nodal Clear defined source and sink-based contracts • Nodal Clear establishes and maintains initial and variation margins • Nodal Exchange operates the trading platform and provides price transparency ISO-NE PUBLIC 8 Overview of Design Concept (2) • The ISO is a counterparty to the cleared contracts. • The ISO collects congestion revenues and distributes Auction Revenue Rights (ARR) revenues • Collected congestion revenues will be used to fund ISO-NE variation margin and to pay ARR holders • Rather than directly pay FTR holders congestion revenues, ISO-NE will pay variation margin on the contracts to which it is counterparty • The ISO will establish a line of credit to manage cash flow mismatches arising from differences in the timing of congestion revenue collection/distribution and variation margin payments/receipts ISO-NE PUBLIC 9 Proposed Design: Participating Entities (1) • ISO-NE has developed the proposed design in collaboration with Nodal – However, the design is not exclusive, and another or additional exchange/clearing partner(s) are possible ISO-NE PUBLIC 10 Proposed Design: Participating Entities (2) • In the proposed design, ISO-NE (consistent with the current tariff provisions) will continue, under FERC-approved tariff and subject to FERC jurisdiction, to run the FTR auction to create the initial FTR positions • FTRs will be exchanged for futures contracts via CFTC permitted execution method known as Exchange for Related Position (EFRP), which Nodal refers to as Exchange for FTR (EFTR) • ISO-NE will collaborate with two entities to facilitate FTR Clearing (EFTRs): Nodal Exchange, LLC and Nodal Clear, LLC (jointly, Nodal) – Nodal Clear, LLC is wholly owned by Nodal Exchange, LLC – Nodal Exchange, LLC is part of the EEX Group, which is in turn part of the Deutsche Börse Group ISO-NE PUBLIC 11 Proposed Design: Participating Entities (3) • Nodal Exchange – Current operations: • Nodal Exchange is a designated contract market (DCM) under CFTC jurisdiction, and currently offers futures and options contracts on power locations that settle to prices published by RTOs/ISOs, as well as natural gas and environmental products • Nodal Exchange provides multiple mechanisms for cleared trading of its futures contracts: (1) T7, a high-performance, low-latency trading platform supported by front-end trading applications including CQG, Trayport and TT, (2) Nodal LiveTrade, a screen interface to a central limit order book that enables bespoke trading of granular products and (3) Nodal BlockTrade, which permits negotiated transactions that are based on Nodal Exchange futures contracts to be cleared, including Exchange for Related Position (EFRP) transactions • Nodal Exchange prices every futures contract expiry twice per day. Volumes and open positions on each futures contract expiry are published daily. ISO-NE PUBLIC 12 Proposed Design: Participating Entities (4) • Nodal Exchange role in proposed design: – Provide the futures contracts for which FTRs will be exchanged – Authorize and process the exchange of Nodal Exchange futures contracts for related FTR positions, and price the futures contract expiries twice per day • Nodal Clear role in proposed design: – Provide trade risk limit verification services to assist ISO-NE in its administration of the FTR auction process – Clear (i.e., manage the cash flows and risk stemming from) the Nodal Exchange futures contracts that are created as a result of the EFTR submission of FTRs to Nodal Exchange ISO-NE PUBLIC 13 Proposed Design: Background on Clearing House Model (1) • When contracts are to be settled in the future, there is risk regarding the counterparty being able to meet payment obligations at that future time • To manage this risk, parties transact through a clearing house which is a derivatives clearing organization (DCO) under CFTC jurisdiction – A DCO overseen by the CFTC acts as the buyer to every seller and the seller to every buyer, taking no market position risks, only default risk; the DCO has a counterparty on both the buy and sell side – The clearing house has clearing members that guarantee the trades of participants, and the clearing house holds funds such as the initial margin and the guaranty fund to manage financial obligations in event of default ISO-NE PUBLIC 14 Proposed Design: Background on Clearing House Model (2) • There are two types of margin: – Initial margin: covers the potential price movements that could occur after a potential default and are determined to cover a set number of days to liquidate with a certain degree of confidence – Variation margin: is called at least daily and covers actual movements in the expected settlement price of the contract (mark to market). Variation margin is required to cover potential market exposure. ISO-NE PUBLIC 15 Proposed Design: Sequence for Exchanging FTR Awards for Futures Contracts (1) • Participants submit initial margin to Nodal prior to submitting orders to ISO-NE – Participants calculate requirement by submitting preliminary order slate to Nodal risk check tool • Once final order slates are submitted to and validated by ISO- NE, ISO-NE will send order slates to Nodal for margin review – Initial margin covers liquidation risk. For Nodal, it is structured to cover the portfolio loss, to a 99.7% certainty, assuming one to five days to liquidate the defaulting portfolio depending on contract composition. Margin requirements will include an additional buffer to account for potential price drift between bid submission and clearing. – If a participant has submitted insufficient initial margin, that participant’s bids will be rejected prior to running the auction – Nodal establishes and maintains initial and variation margin requirements in collaboration with its clearing members ISO-NE PUBLIC 16 Proposed Design: Sequence for Exchanging FTR Awards for Futures Contracts (2) • ISO-NE runs the FTR Auction – ISO-NE will make all external interfaces, load zones, unit nodes