Market liberalization was viewed by many as the start of a brave new world in the electricity market, transforming it from a public service asset into a commodity that could be traded in a similar vein to the capital markets. However the events of the past twelve months, starting with Enron's bankruptcy, have tended to strip some of the glamour from the concept of an energy market that could be traded akin to the financial markets.
Since the demise of Enron in December 2001, the energy trading business model has changed dramatically. The energy sector has clearly shifted away from the Enron-style pure speculative trading, to a more physical asset-based trading approach. Energy companies are now seeking to limit their exposure to volatile energy markets and trade to optimize the profitability of their generation and distribution assets.
This paper assesses the different approaches to trading, accounting and risk measurement in the new energy environment as a result of the impact of liberalization and the lessons learned post-Enron.
Since the failure of California's deregulated electricity market an element of doubt has been introduced into the values of market liberalization. In the US market this has led to the Federal Energy Regulatory Commission to propose its Standard Market Design (SMD) model, the twin objectives being to eliminate pancake rates among the regions and to evolve a regional planning process to ensure adequate investment and management of transmission.
It has become evident over the past year that the process of liberalization is changing. Markets move through life cycle phases and the current phase is consolidation, driven by the need for economies of scale. And as the process of liberalization has changed so have the opportunities that it originally presented. At the onset of liberalization, companies sought to minimize an opportunity loss by being among the first wave of new market entrants. Now those companies that entered the market face a different loss if they fail to tailor their business to the changing dynamics of liberalization.
In a competitive market there are two trading extremes - the trading-centric approach and the asset-based trading approach - and participants in a competitive market can be categorized by where they are positioned between these two extremes.
Trading - Centric Market
A highly trading-centric market participant will seek to operate in the energy markets similar to that of a bank in the capital markets. Within the constraint of risk capital limits, traders execute their strategies in order to maximize mark-to-market gains. If these organizations have physical energy operations such as production, own consumption, transportation or retail sales then wherever possible these are mapped to equivalent trading transactions and simply considered as part of the trading portfolio to be exploited by the traders. The primary profit driver for this type of market player is the performance of the trading operation and its ability to deliver strong and stable results.
Asset - Based Trading
In contrast, an asset-based trading participant will invest in assets, and/or retailing operations, and will seek to operate these assets as effectively as possible with an objective to deliver a strong, stable return on investment.
However the primary objectives of the of asset-based participants are to assist in extracting as much value out of the physical operations as possible, and to support dynamic and cost effective hedging of the market price and volume risks associated with the core physical operations.
In a competitive market participants tend to position themselves somewhere between the two extremes of trading-centric and asset-based trading, adopting the accounting and risk measurement procedures that best fit their trading position. The legacy of Enron, which favored the trading-centric approach, has been to shift the trading position away from a trading-centric and towards a more asset-based position. Energy companies are now seeking to limit their exposure to volatile energy markets and optimize the profitability of their generation and distribution assets. The danger is that the market is moving too quickly from one extreme to another when a more prudent business approach would be to strike a balance between these extremes.
To adapt successfully to the evolving liberalized market, companies need to have the correct energy trading and risk management systems in place. The problem pre-Enron was simply that many energy companies thought they could simply impose financial trading methodologies and IT systems onto energy businesses. The nature of energy assets is such that the systems applied to the financial markets are simply not sufficient to deal with the very particular qualities of the energy business. Energy companies need to acknowledge this fact and invest in energy asset focused risk management systems to ensure they remain competitive in today's changing market environment.