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The CCRO Proposal: Missing the Industry Trend

Is a proposed solution to energy-trading woes too little too late?
Fortnightly Magazine - January 15 2003

Williams, and Enron knew it has ended. These companies faltered not just because of mismanagement, aggressive accounting, and in some cases old fashion fraud, but they failed because their basic business model was flawed.

They forgot to add value to the product produced-a basic business tenant. If you think about it, an electron or gas molecule is a homogenous product. Under this old model, energy traders would buy a finished good, flip it a number of times, adding no economic value, and call it a viable and sustainable business.

Going forward, the new energy-trading model will consist of only a handful of financially strong, creditworthy energy companies and will revolve around primary generators and end users. Until recently, it was estimated that 75 to 80 percent of power and natural gas volumes were traded by top-10 players such as Dynegy, El Paso, PG&E, Reliant, Mirant, Aquila, and Williams. Given the weak financial positions that these companies now are in and the announcement by many of them to significantly scale back and even exit the energy trading business, those companies that survive will no longer be the main industry driver for price discovery and liquidity.

In addition, given the disclosure of round-trip trading and recent false pricing index data practices, it is hard to imagine that end users will again become comfortable with wholesale traders and rely on them for either pricing or actual purchases. In this regard, the generators and end users will directly negotiate bilateral agreements, and wholesale traders-functioning as middlemen-will be less relevant.

Surprisingly, the new energy model I am speaking about is not new at all. It reflects how energy procurement and sales were performed prior to the deregulation experiment. The outcome of this "new" model is peppered with both positives and negatives. Pricing will be less transparent, as generators to end users transact in one-off, over-the-counter type deals. Price discovery and determination will be done the old-fashioned way-by RFP, auction, telephone, Internet survey, guess-timation and the use of internal forecasting models.

It is in this new market environment that end users, such as utilities, will operate in meeting their near-term and long-term load demands. The role of wholesale energy traders will revolve around the hourly, same day, or next day market, and utilities or other end users might need help in matching demand that could stem from weather, system events, or planned or unplanned outages.

Change Is Constant

What the recent CCRO guidelines have failed to take into account is that the energy-trading model has irreversibly changed. The rules of the game now need to be clearly defined, police appointed, participation and compliance made mandatory, and severe penalties imposed for non-compliance. Current weaknesses in energy trading and risk management controls will not be effectively fixed until governmental agencies step up and provide vigilant oversight and enforcement.

The recent Justice Department indictment of a mid-level El Paso energy trader for providing false pricing data and the strong endorsement of this action by FERC could be a key step in the right direction. At a minimum, regulators at the federal