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.
Market Liberalization
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.
Competitive
Trading
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.
Conclusions
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.
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