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Market Resurgence

Banks are reshaping the energy-trading landscape. When the dust settles, utility companies will face different strategic horizons.

Fortnightly Magazine - March 2006

intelligent contracts.”

Credit discipline is evident not just among financial firms. Market participants, including merchant-power companies and other energy suppliers, have endured significant scrutiny of their balance sheets and business plans in the last few years. Those that remain in the market are, by definition, standing on more solid financial footing.

“There has been a growing risk-management culture in the utility sector over the last few years,” says Jonathan Taylor, head of commodities sales for Barclays Capital in London. “Today people are thinking in terms of risk-management tools, not the frequent transactions coming out of a trading desk. They understand their risks better and are managing them appropriately.”

Such sophistication among market participants likely will increase along with greater depth in OTC markets and services. Cumbersome bilateral contracts increasingly are giving way to more standardized OTC contracts, reducing the transactional friction and credit barriers that have kept energy markets from maturing. Additionally, major trading exchanges—NYMEX and the ICE—are developing increasingly sophisticated electronic clearing services to facilitate OTC trading among counterparties. “Exchange clearing has created an easier entry into the market, and made it possible for financial institutions to provide services beyond just trading,” Jacobson says.

Banks are offering a growing variety of contracts, not only for energy supplies but also related products. For example, the notional value of weather-contract trades nearly doubled, from $4.6 billion to $8.4 billion, between fiscal years 2004 and 2005, according to the Weather Risk Management Association. Similarly, emissions credits have become increasingly active in the United States and on the world stage, and are expected to grow in importance as environmental compliance becomes more challenging.

“Mitigating greenhouse gases will drive technology shifts and disrupt the market,” Fusaro says. “It will affect the entire value chain, including emissions trading. The linkage between emissions and power prices is becoming tighter.”

Going to Market

A few utility holding companies still are strong energy-market makers themselves; specifically, the wholesale trading affiliates of Constellation, Entergy, and Sempra are perennial leaders in terms of trading volume. But for most utility companies, the prevailing “back-to-basics” business strategy deters them from contemplating more aggressive arbitrage strategies—at least for the time being.

“With respect to financial hedging going forward, management will need to determine the right risk-reward balance,” says Pete Sheffield, a Duke Energy spokesperson. “Duke’s post-merger marketing and trading focus will be similar to the current Cinergy platform—shorter in term with less collateral required.”

Duke Energy is emblematic of companies that brought an ambitious, integrated approach to energy marketing during the boom years, and have since adopted a back-to-basics business posture. Duke spun off the Duke Energy North America (DENA) trading book to Barclays Capital late last year, and in January 2006 LS Power agreed to acquire 6,200 MW of DENA’s generating capacity in the Western and Northeastern United States for about $1.5 billion.

Such transactions mark not only the final dissolution of the old energy-trading business model, but also the genesis of a new model that might change the strategic equation for U.S. utility companies. If the energy-trading markets remain robust, utility companies eventually