A new coal agreement

The ISDA Coal Annex allows market participants to combine physical coal trades and coal derivatives under a single trading agreement. Lauren Teigland-Hunt says this development should improve liquidity in the global coal market

More than ever before, market participants are seeking to standardise and commoditise the trading of coal. Much of the desire for standardisation stems from the increased volatility in electricity prices brought about by deregulation of the electricity sector. This volatility has led to greater demand for short-term physical coal purchase and sale transactions as well as coal derivatives, as many market participants have realised that unhedged, longer-term physical contracts might expose them to unacceptable levels of market price risk. This shift in transaction demand has heightened the need for standardised coal trading documentation that will facilitate market liquidity and minimise negotiation costs.

With the publication of the ISDA Global Physical Coal Annex in April 2007, coal market participants can for the first time capture both physical coal trades and coal derivatives under a single, standardised trading agreement. This development is significant for several reasons: not only will it allow certain market participants to maximise their credit lines and efficiently collateralise their obligations in respect of coal trades, but it is also expected to facilitate market liquidity more generally by allowing firms to trade coal under a versatile and standardised trading agreement that is widely recognised and accepted by financial institutions and commodity trading companies around the world. The introduction of the ISDA Coal Annex along with other standardised documentation undertakings means that trading and price risk management practices in the coal industry should increasingly resemble those embraced in the markets for electricity and natural gas.

Historically, coal trading markets have faced certain significant impediments to liquidity, in part due to the fact that coal, by its very nature, is not "standardised" – neither in the way it is produced, nor in how it is used. For example, coal characteristics and quality can vary substantially by region and even by mine. In addition, coal consumers often have specific demands in terms of coal quality depending on the environmental requirements to which they are subject or the mechanical limitations of their processing plants and equipment.

In recent years the market responded to these challenges by developing agreed quality standards and specifications for the major coal products in various regions. Although the development of these product standards significantly advanced the prospects for a more liquid coal trading market, the lack of standardisation in other coal trading terms remained a serious obstacle to facilitating trading and liquidity in the coal markets.

Recent initiatives

In recognition of the need for more consistent trading terms, several initiatives have been undertaken in recent years to standardise trading documentation for physical coal and coal derivative transactions. The first attempts were made in 2000, when the US Coal Trading Association (CTA) developed the Master Coal Purchase and Sale Agreement for the trading of physical coal sourced in the US. That same year globalCOAL developed its Standard Coal Trading Agreement (SCoTA) for physical transactions in coal sourced at various points outside the US.

These initial industry-level documentation efforts helped to promote market acceptance of standardised trading terms for coal. However, many firms continued to trade physical coal using 'bespoke' agreements and other forms developed specifically for their own use. In addition many coal derivatives were being traded separately under documentation developed by the International Swaps and Derivatives Association (ISDA). As a result, collateral arrangements between coal market participants generally were not able to take account of offsetting physical and financial transaction exposures.

Furthermore, since inconsistent legal terms persisted across the various trading agreements, market participants trading coal often incurred greater legal and credit risk than necessary due to the fact that different trading agreements with the same counterparty would often have conflicting default and termination (or 'close-out') provisions. In addition, the time and energy necessary to negotiate these differing agreements necessarily led to increased transaction costs while diminishing the market's liquidity potential.

The ISDA Coal Annex

One of the key purposes of the ISDA Coal Annex initiative was to allow market participants to document physical coal trades along with coal derivatives and other physical and financial products under a single, standardised trading agreement. By putting multiple products under a single master agreement with the same counterparty, parties can achieve consistency of terms where uniformity is important, thereby reducing contractual risk. Specifically, parties can ensure consistent events of default, termination provisions and credit terms.

Utilising the ISDA Coal Annex as part of the ISDA Master Agreement also allows for the maximisation of credit lines, as a single credit line established with respect to the ISDA Master Agreement can cover multiple products and transactions. In this way the parties need only negotiate a single collateral annex (ISDA's Credit Support Annex) to cover multiple products, allowing for the offsetting of physical and financial transaction exposures and the possible reduction of collateral posting obligations overall.

The ISDA Coal Annex was developed by a working group comprised of ISDA members active in the coal markets in consultation with members of CTA, globalCOAL and the Edison Electric Institute (which produced a coal annex to its EEI Master Power Purchase and Sale Agreement in 2007). By working with other organisations that were developing and updating coal trading documentation simultaneously, the ISDA working group sought to ensure consistency with physical delivery terms generally embraced by the coal industry and minimise 'documentation basis risk' for parties that may choose or otherwise need to trade coal under different master agreements.

The ISDA working group also decided early in its deliberations to make the ISDA Coal Annex global in nature, so that market participants could transact in physical coal from different parts of the world under the same document, as described more fully below. This decision was made in an effort to reduce the number of documents that market participants need to negotiate overall.

Using the Annex

Consistent with the approach adopted by ISDA in its annexes for other physical commodity transactions (such as its electric power and natural gas annexes), the ISDA Coal Annex takes the form of an annex to the ISDA Master Agreement. As a result, when a party enters into physical coal transactions under the ISDA Coal Annex, the ISDA Master Agreement itself serves as the base document providing many of the standard terms appropriate to the establishment of a bilateral, over-the-counter trading relationship, such as general representations and covenants, events of default and close-out provisions, as well as collateral terms if applicable (via ISDA's Credit Support Annex).

By attaching the ISDA Coal Annex to the agreement, the parties to the ISDA Master Agreement effectively incorporate the provisions necessary for the physical delivery of coal into all physical coal transactions executed under the agreement. Like other ISDA documents, the ISDA Coal Annex is designed so that parties may amend and add to the document as they see fit to meet their specific needs. In addition, parties can always agree to override or amend provisions of the ISDA Coal Annex with respect to specific transactions as they deem necessary.

The ISDA Coal Annex is comprised of the following three distinct components:

•The main body of the ISDA Coal Annex contains general terms that are applicable to all physical coal transactions governed by the ISDA Coal Annex (such as general delivery obligations, force majeure provisions, limitations on liability and payment and transaction netting). The base document also includes various elections that the parties to an ISDA Coal Annex must make, including elections with respect to the netting of payments and force majeure 'make-up'.

•Appendix 1 to the ISDA Coal Annex contains terms relevant to transactions involving coal sourced within the US and are based on provisions from CTA's Master Coal Purchase and Sale Agreement. Covered products include the major coal products sourced from Central Appalachia and the Powder River Basin in the US.

•Appendix 2 to the ISDA Coal Annex contains terms for transactions involving coal sourced outside the US by incorporating by reference the relevant terms from globalCOAL's SCoTA, including globalCOAL's Relevant Standard Specifications (RSS) setting out terms, conditions and quality standards for different coal products. Products covered include those for which RSS have been published, including the key standardised coal products sourced from Australia, South Africa, Indonesia and Colombia.

Key advantages

The ISDA Coal Annex offers several key advantages to market participants that are actively trading in the coal markets. First, the ISDA Master Agreement governs the entire trading relationship between two parties for particular products and includes the key credit, legal and operational terms that apply, all of which can be tailored to the parties' specific needs.

Second, the ISDA Coal Annex allows market participants to enter into physical coal transactions, other physical commodity transactions and financial derivatives under a single master agreement – enabling a party to net these transactions under the established close-out netting provisions of the ISDA Master Agreement in the event of a default by its counterparty. This approach eliminates the inefficiencies inherent in trading under multiple master agreements and avoids unjustified inconsistencies among the master agreements.

Third, and perhaps most importantly from a credit and collateral perspective, trading related physical and financial transactions under one master agreement can potentially reduce a party's collateral posting obligations and maximise a party's trading lines with a counterparty. These advantages combined with market recognition of the ISDA Master Agreement should help to facilitate physical and financial coal transactions and thereby lead to greater coal market liquidity in the long run.

Lauren Teigland-Hunt is managing partner at Teigland-Hunt LLP. Email: [e-mail]