The Fourth Wave


Are banks better at trading power than utilities?

Fortnightly Magazine - October 1 2002

Bank of America's recent request to FERC to be allowed to trade power was yet one more reminder that a whole new class of companies are quietly positioning themselves to dominate what's left of the energy trading space after the departure of traders like Enron and Aquila.

As a result, many energy executives are wondering whether these newcomers will bring greater liquidity, transparency, and discipline to a market that has lacked all three in the last year. Some even quietly hope that the banks might restore a level of credibility and prestige that has been lost amid disclosures of sham trading and market manipulation.

One energy trader describes the current state of energy markets: "There have been significant market impacts. People are behaving differently. There is a lack of liquidity at many locations now. There is declining participation and fewer creditworthy counterparts. But I don't think our process has changed."

The head of energy trading at a Wall Street investment bank I spoke to on a recent trip explained the new phenomenon as a natural evolution of the market:

"You first had the small and large independents-the federated types like a 'Spark Energy' and Enron. Then you had utility affiliates like Cinergy, Aquila, and Duke. Then you had the merchant independents… and now we have Wall Street-the fourth wave."

Furthermore, he believes that neither energy companies nor utilities were ever well-suited to be trading in the first place.

"I won't say that there wasn't any talent out there… [But] I think it is problematic for a business to be engaged in managing the risk of developing, the risk of operating, and price risk at the same time. There are different skill sets involved. I think you are starting to talk about a conglomerate. Conglomerates are a little bit out of style."

In reality, he says, the utilities never had the balance sheets and credit strength to be trading. "It is high time people wrote about this stuff. It is preposterous how the industry was offering credit. Why was everybody shocked that Enron went down? It wasn't a great credit rating."

Furthermore, the banker believes that the conglomerate approach has led many utilities to lose sight of their true business, operating and managing power plants. In fact, it is this confusion over what business utilities were truly in that was reflected in the bizarre descriptions they would sometimes offer about their energy trading activity. Some companies have said in the past that they "trade around the assets" or "optimize the power plants" to describe their business.

"I'm not sure I know what that means," says the seasoned energy veteran, explaining that the industry has done a poor job of defining energy trading. "Trading around the assets doesn't convey immediately what they are doing. I'll never really know what that means."

"That is what you would expect from an organization that has an identity crisis. If you got three or four businesses in the same organization and you ask them what their business is, they are going to have trouble answering.

"If you are going to use the term optimization. you are going to have to define the mathematical function that you are trying to either maximize or minimize. That is what optimization means. I think what they are saying is that they have the size, scale, and magnitude and wherewithal to deal with a lot of the [deal] customization in-house."

He bet that if I walked around the bank's sprawling trading floor, I would get a consistent answer as to what service or function the bank provides on the energy trading side. The general answer, he says, will be "We are in the business of providing price risk management services."

Indeed, that is typically the answer I get when I do ask.

Just what purpose does the energy trading function serve?

After energy companies were caught using energy trading as a means to boost revenues by booking unrealizable gains on questionable deals and round-trip trading, that's a reasonable question to ask. Investors and those outside the industry go further, and ask: Was it all a mirage?

The banker provides me with a back-to-basics explanation of one of the services he offers. "Do you know whether the Peach Bottom power plant is going to be available tomorrow? Let's say it is now May and it's going to be July-is it going to be ready?"

He asks, can I come to you and get a guarantee from you that power prices will not be above $30? "I'm a general public utility and I serve retail customers, and if power prices go up my earnings get squeezed terribly," he says. "Remember, I don't have a power plant, I sold my power plants and I don't have any backup power plant.

If Peach Bottom gives a guarantee, here is the problem for Peach Bottom.

"What happens if Peach Bottom goes down and it is not producing power? So it is not getting paid. Power prices go to $100. What does it owe? It owes the difference between $100 and $30 on the guarantee. It has this big cash flow out the door and no money coming in the door."

What the bank is going to do, he explains, is to make the guarantee to the retailer and stand in the middle, taking the risk. "We are taking a hedged risk. You can't make money without taking a risk. You are not providing a service to anybody unless you are taking the problem away. That is the problem that we take away," he says.

"The operator takes the problem of operating the plant away-such as the compliance risk with the Nuclear Regulatory Commission. The PJM operator takes away the hassle of operating the [grid] system. Everybody is doing their piece in this whole thing and this network of contracts arbitrates it. In my mind it is not any different than what you see in other businesses," he concludes.

Another wall street energy trader concurs that energy markets are really more financial than physical.

"The only real argument," he explains, "is that they are somehow avoiding some sort of physical or environmental risk. Maybe some tax issues. Whatever the legal implications are to having title instantaneously from original producer to the ultimate consumer with a whole bunch of financial players in the middle that collapse out instantaneously. I don't think it is physical."

In fact, our trader goes so far as to offer a mathematical proof.

"If you are in a physical business," he explains, "you have contract load and contract price." [And he adds that excess load-actual load above contract load-above contract volumes will settle at the spot price.] "That is basically the pay out. That is what you are going to be paid at the end of the month."

Here is that equation:
LC x PC + (LA - LC) x PS

And that equation can also be expressed this way:
LC x (PC - PS) + LA x PS

The banker continues: "So, you deliver that [contract load], and if your public needs more [excess load], you are going to be paid the spot price for the excess. If you deliver too little, then that is a negative number and that means you are going to buy in the difference that you owe there from the spot market. If I take the [contract] terms, that is a swap. These things are mathematically indistinguishable. The physical market and the financial market-the economics are entirely the same."

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