Is a proposed solution to energy-trading woes too little too late?
The Committee of Chief Risk Officers (CCRO) representing various utilities and merchant energy companies, recently released a set of detailed guidelines to improve the image and overall practices of energy trading, but the effort misses the mark.
First, these guidelines are voluntary not mandatory, with no teeth to ensure compliance, policing, or remedy for non-compliance. The proposal appears to be more of an attempt by the 31 participants to demonstrate they can regulate themselves and avoid oversight by a less than sympathetic third party. But as recent accounting scandals have shown, self-regulation without independent oversight does not work.
Secondly, the CCRO proposal does not address one of the primary gray areas that helped to fuel the recent industrywide meltdown. Mainly, how should energy companies account for off-balance-sheet transactions, including reporting and mark-to-market practices, especially in instances when there is no observable price and low to no liquidity?
The guidelines also fail to define and adequately address what the appropriate risk reserves should be against estimated transaction values. Such reserve "best practices" could set a standard for conservatism when taking reserves for anticipated and unforeseen risk, such as market and credit risk. This is an important area because many energy industry transactions are off-balance-sheet (e.g., long-dated (10- to 20-year) tolling agreements and operating leases).
Critical Issues
The CCRO proposal does not address how to mark-to-market long-dated transactions and how much of non-current and non-cash income should be booked as current profit. Should it be 25 percent? Fifty percent? Seventy-five percent? Or more? Enron thought it should be 100 to 150 percent. And if a market price is not available, how should models be applied when marking the overall trading book to market?
Also, which model(s) and types of standardized assumptions (e.g., price volatilities and correlations) should be used when applying pricing and risk measurement models? As learned with long-term capital management, models and assumptions can and will be precisely wrong.
Additionally, although certain members who crafted this proposal have previously admitted providing false pricing data for industrywide indexes, the current CCRO proposal does not address this clear industry weakness. This is a missed opportunity to swiftly address a serious issue that continues to undermine overall industry creditability.
Although industrywide reporting, standardization, and consistency is a good thing, the CCRO recommendations do very little to solve the industry's current woes. This proposal attempts to address longer-term issues while most major energy trading and merchant companies have lost large quantities of blood and are fighting for their lives. How will the guidelines resuscitate Dynegy, El Paso, NRG, NEG, Calpine, or Williams?
The Evolution of Energy Markets: A New Model Emerges
If the new CCRO proposal will not fix the current energy trading industry woes, what will? To answer this question, it is important to identify the main underlying trend in the industry.
The new energy-trading model, which is rapidly evolving, will not remotely resemble the wholesale model, which has been the norm over the previous six years. Unregulated wholesale energy trading the way Dynegy, 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 level have finally begun to show their teeth and impress upon the industry that such egregious behavior will not be tolerated. Only with such actions will industry credibility be restored and needed credit and liquidity return to the power and natural gas markets.
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