A guide to Credit Riskfor major energy users

What is Credit Risk?This guide is designed to help you understand more about Credit Risk; what it is, how it iscalculated and the level of Credit Risk your business is exposed to. In addition, it gives you anawareness of how npower can work with your business to mitigate your level of risk.

Credit Risk is essentially assessing the risk that you will not be able to meet your contractual paymentobligations.

It is calculated from a combination of two factors:

1) Underlying Exposure and;

2) Counterparty Risk, where Underlying Exposure is an amount in £’s and Counterparty Risk is derivedfrom an assessment of a company’s financial strength.

1) Underlying ExposureTwo elements of Underlying Exposure exist, Settlement Exposure and Credit Equivalent Exposure(also known as Potential Future Exposure). Settlement Exposure is based on energy delivered but notyet paid for, whilst Credit Equivalent Exposure is a statistical measure for valuing the potential cost tonpower for selling back undelivered volume to the market.

When assessing Underlying Exposure we look at:

• Payment Record • Wholesale Market Prices• Payment Terms • Market Volatility• Credit Insurance • Deal Duration

2) Counterparty RiskCounterparty Risk is typically based on a financial assessment of statutory accounts, althoughmanagement accounts can also be taken into consideration. Companies are encouraged to provide asmuch financial information as possible at point of tender and maintain dialogue throughout thecontract duration.

When assessing Counterparty Risk we look at:

• Statutory Accounts • Share Price Performance• Management Accounts • Industry and Economic Trends• External Credit Ratings/Scores • Material Adverse Change (MAC)• Press Releases

npower assesses the Credit Risk for all potential new customers and continually monitors the CreditRisk of all existing customer’s working with them, to understand their credit profiles and the impact ofany change in financial standing (Material Adverse Change) throughout the lifecycle of the contract.

Underlying Exposure explainedUnderlying Exposure is made up of:

1) Settlement Exposure;

2)Mark to Market Exposure and;

3) Credit Equivalent Exposure (CEE).

An explanation of these factors are as follows.

1) Settlement exposure

What is Settlement Exposure?

• Settlement Exposure is the value of energy delivered but not yet paid for.

How is it calculated?

• The exposure level is based on the price at which energy has been purchased. The calculationrelates to the period over which we have delivered energy, which has not yet been paid for.

Peak ExposureExposure £

Time

Termination

Normal Exposure

Disconnection

Defau

lt

Debt Chase

M1 M2 M3 M4 M5

3 months bills

Missedpayment30+3+14

Commencedisconnection

process

6 weeks

Missedpayment

An example of underlying Settlement Risk

2) Mark to Market ExposureWhat is Mark to Market Exposure?

• Mark to Market Exposure is the difference between the purchase price and the current value of the energy.

How is it calculated?

• We multiply this price difference by the volume of energy purchased but not yet delivered.

3) Credit Equivalent Exposure (CEE)

This is also known as Potential Future Exposure (PFE)

What is Credit Equivalent Exposure?

• Whereas Mark to Market exposure is a measure of current risk, CEE is a measure of potentialfuture risk when taking into consideration market volatilities.

How is it calculated?

• Volatilities are used to ‘shock’ current forward prices to produce forecast forward prices in orderto derive a potential Mark to Market exposure.

• Our CEE calculations quantify credit risk by evaluating existing positions, both open and closed,against the possible market prices in the future during the lifetime of the transactions.

• CEE can be used to simulate a range potential future Mark to Market values based on a desiredconfidence level

CEE Inputs:

The variables applied to customer specific transactions are as follows:

• Volume

• Contract Dates

• Current Market Prices

• Historic Market Volatilities

• Desired confidence Level

Y days

Price /MW

h

Current market price £60.00/MW: 95% con�dent that in 20 days it will be no more

than £80.00 and no less than £50.00/MW

X con�dencelevel

• The initial Mark to Market value of the forward contract is zero at the point of deal execution andthere is no credit exposure at the start

• As time progresses, the forward contract has a Mark to Market value, credit exposure exists based onprice confidence levels

• As the transaction moves into delivery the CEE eventually reduces until the point of final delivery andpayment when Mark to Market returns once again to zero

0

50

100

150

200

250

300

350

400

04-Mar-09

11-Mar-09

18-Mar-09

25-Mar-09

01-Apr-09

08-Apr-09

15-Apr-09

22-Apr-09

29-Apr-09

06-May-09

13-May-09

20-May-09

27-May-09

Valuation Date

Expo

sure

£

An example of Market to Market exposure

An example of Credit Equivalent Exposure (CEE)

2) Counterparty RiskWhat is Counterparty Risk Measurement?

Counterparty Risk is an evaluation of your credit risk based on evaluation of the credit position ofyour business. We undertake our own financial assessment of your company and also obtain creditratings from a number of sources and build a profile of your business’s credit strength. To achievethis we use the following sources:

Credit reference agencies These are companies such as Experian, Dun and Bradstreet and Graydon who provide credit scoringfor individual businesses.

Credit rating agencies Ratings can be assigned to short-term and long-term debt obligations as well as securities, loans,preferred stock and insurance companies. If available, suppliers may use external ratings issued bycompanies such as Standard and Poor’s (S&P) and Moody’s to obtain an assessment on yourcompany’s credit strength. If these aren’t available, then an alternative such as Moody’s KMVRiskCalc can be used. This is a quantitative method that takes key financial data from statutoryaccounts in order to derive a credit rating. By combining financial statement and equity market-based information, an expected Probability of Default can be calculated.

Credit ratings are expressed in letters. Company’s achieving AAA ratings are the strongest financialentities, whilst CCC are the weakest. Those company’s with a S&P rating of BBB- (Moody’s Baa3) orabove are typically called investment grade, whilst those companies below this rating are known assub-investment grade. The below table shows possible credit ratings:

npower’s Credit Risk Mitigation ToolsWe have credit mitigation tools that work in isolation or can be combined to suit different businessrequirements. They can be used to align the credit risk taken against limits set.

Credit Risk mitigators are detailed below under the appropriate risk:

Settlement Exposure Mitigators

• Insurance by a third party provider (trade credit insurer)

• Security deposit – can be the form of cash, Letter of Credit (LoC) or Bank Guarantee (BG)

• Parent Company Guarantee (PCG)

• Advanced Payment Product

• Full Margin Agreement

• Increased payment frequency

• Margin agreement

CEE Mitigators

The following can help mitigate your potential Mark to Market exposure

• Advance Purchasing Restriction (APR)

• Credit Default Swaps (CDS)

• Parent Company Guarantee (PCG)

• Letter of Credit (LoC)

• Bank Guarantee (BG)

Contact usIf you wish to learn more about npower’s credit tools available or areconcerned about credit, please contact your Business DevelopmentManager or email

optimisation.desk.team@npower.com

Rating Definition Moody’s S&P

Best Quality Aaa AAA

High QualityAa1 AA+Aa2 AAAa3 AA-

Upper Medium GradeA1 A+A2 AA3 A-

Medium GradeBaa1 BBB+Baa2 BBBBaa3 BBB-

Speculative Ba BB

Highly Speculative B B

High Default RiskCaa CCCCa CC C

Default D D

Printed on recycled materials.

npower is a registered trademark and a trading name of Npower Limited (registered in England and Wales No. 3782443) and Npower Commercial GasLimited (registered in England and Wales No. 3768856) and associated companies. Registered Office: Windmill Hill Business Park, Whitehill Way,Swindon, SN5 6PB.npm7044/10.10

Advanced Purchasing Restriction (APR)

A clause that can be applied to Flexible Purchasing Contracts. The counterreply can only purchase up to anagreed number of months or days in advance. For example, up to a maximum of 9-months purchases inadvance of delivery. The tool allows npower to manage the size of its forward credit exposure.

Bank Guarantee (BG)Is a legally binding document, enforceable in Court, where a Bank will honour the debt of another company, up to an agreed limit, and usually within an agreed period of time.

Credit Default Swaps(CDS)

A bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of a third-party entity. Under a Credit Default Swap agreement, a buyer pays a periodic fee to a seller inexchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay)happening in the entity. Credit Default Swaps resemble an insurance policy, as they can be used by debtowners to hedge against credit events.

Credit EquivalentExposure (CEE)

The CEE (also know as ‘Potential Future Exposure’ or PFE) value is a prudent estimate of the current mark tomarket and the potential increase in value of the contract over its remaining lifetime; this value is derivedby using current market prices and "shocking" by historic market volatility.

Desired Confidence Level The applied probability within methodology to predict the likelihood of an events occurrence.

Dun & Bradstreet (D&B) Credit scoring agency - similar to Experian & Graydon.

Experian Credit scoring agency - similar to D&B & Graydon.

Graydon Credit scoring agency - similar to D&B & Experian.

Financial CovenantsA clause within a contract related to financial conditions, where certain balance sheet items or ratios mustnot fall below an agreed level.

Full Margining Agreement

An agreement is signed up to by both parties, where a threshold is initially set for both the MtM and SEexposure, based on the credit risk appetite. If the value of the threshold is breached, then the customer isrequired to post cash in tranches and in accordance with the terms set out in the margining agreement.Once the exposure reduces below each tranche, the cash is returned to the customer until the cash heldreaches £0. This can be reciprocal, i.e. it can be agreed that npower posts cash with the customer.

KMV Risk CalcMoody's online tool, designed to give an equivalent external rating to non-externally rated companies. Themethodology uses key financial ratios to derive a credit rating and associated probability of default.

Letter of Credit (LoC)Is a legally binding document, issued by a financial institution, like a Bank, where the financial institutionmakes a payment by an agreed date if certain conditions are met.

Margin Agreement

An agreement is signed up to by both parties, where a threshold is initially, based on the credit riskappetite. If the value of the threshold is breached, then the customer is required to post cash in tranchesand in accordance with the terms set out in the Margin Agreement. Once the exposure reduces below eachtranche, the cash is returned to the customer until the cash held reaches £0. This can be reciprocal, i.e. itcan be agreed that npower posts cash with the customer.

Mark to Market Exposure(MtM)

Replacement cost i.e. the cost to sell back to the market on a default event. The MtM value might bepositive or negative depending price at which the volume was hedged and current market rates.

Material Adverse Change(MAC)

A contractual clause within all contracts, that npower can invoke, should there be a material decline in thecredit status of the customer.

Moody’sOne of the big 3 agencies undertaking financial research into large corporate entities. These ratings arewidely used in financial markets to indicate the probability of a rated company honouring its debts.

Standard & Poor’s (S&P)One of the big 3 agencies undertaking financial research into large corporate entities. These ratings arewidely used in financial markets to indicate the probability of a rated company honouring its debts.

Parent CompanyGuarantee (PCG)

A legally binding document, enforceable in Court, where the Guarantor will pay npower if the counterparty defaults.

Potential Future Exposure(PFE)

Also know an CEE.

Open position Volume that has not yet been purchased.

Closed position Volume that has been purchased.

Quick Guide/Glossary