Energy trading returns, healthier and wiser.
The recent announcement of a trading joint venture between TXU and Credit Suisse First Boston (CSFB) is the latest in a series of positive news items supporting the return of energy trading. Wall Street firms continue to expand into the energy-trading sector, with Citigroup as well as CSFB moving into an area already well represented by the likes of Morgan Stanley, Goldman Sachs, and UBS.
On June 7, reported on Constellation's continued success in this area. Then, on June 8, Entergy and Koch announced their intention to sell their successful trading business. Entergy's stock price subsequently fell.
Commenting on TXU's newly minted venture, company President and CEO John Wilder stated, "We've surveyed customers, and we think there are unmet needs for customer-oriented risk management. … We're looking to get back into speculative trading." Until recently, such a comment would have led to a plummeting stock price, but TXU's stock price did not fall.
As the overall market and, in particular, credit ratings begin to improve, will utilities and other energy players jump back into this market? Only if the return of trading adds real value to a company ().
What does trading mean today? Utilities have continued to trade. There is no difference fundamentally between the process and controls needed to hedge or optimize existing generation -efficient trade capture, risk evaluation, and compliance procedures-and those used in trading.
In both hedging and trading, these processes allow the business to improve its risk profile and protect future revenue streams. However, hedging is a very different strategy from a speculative trading that sets out to beat the market through superior market timing.
There are a number of different ways a trading floor can add value, including:
- Better market knowledge or position. If, through size, systems, or credit advantage you have a more comprehensive view of the market or ability to trade, you can retain some value in back-to-back deals.
- Correlation or basis trading. For instance, taking limited risk by using some other (lower-cost) product to hedge your position.
- Market timing. Deciding when to place a trade to close a long or short position. This includes spot market and forward market.
- Structured hedging. This involves taking a complex asset or contract, then mapping it to its tradable components and trading them in the liquid markets.
The first three approaches are based on the superiority of one trading shop over another through infrastructure or superior trading skills. For trading to return as a successful industry segment, it will require the demonstration of added value through structured trading, rather than simply trying to beat the market.
Structured trading is basic risk management. It encompasses the process that maps a complex primary asset into its market components. Each market component is then hedged separately. Hopefully, when all the individual components are added together with the principle asset, additional profit has been locked in or risk has been reduced.
Let's look at hedging a power station. Some generation assets are relatively easy to map. A reliable coal plant well "in the money" maps to peak and off-peak forward contracts. However, mid-merit and peaking generation is more difficult.
If we analyze a generation asset through a Monte Carlo simulation model (such as Global Energy Decision's EnerPrise software) to identify the potential cash flows from the asset under price uncertainty, we see a significant distribution of values.
Unfortunately, the distribution in today's market is highly skewed, with revenues under the expected price streams toward the lower end of valuations. In many cases, this means the plant is not expected to run under the base case, but there is some probability that prices will increase and the plant will earn significantly higher revenue. Another way of looking at this is to break the generation asset down into its tradable components of forward contracts and option contracts.
When the asset is deep in the money (likely to run), it can be hedged with a forward contract. The hedge can be placed once. This can be equated to the intrinsic value of the asset. When it is out of the money it can be hedged only by an option. This is the extrinsic value. Unfortunately, the extrinsic value for many generation assets is significant, and the relationship between the two values continually changes.
What about these same value components for a combined-cycle plant?
Intrinsic and Extrinsic Values Per Year
A significant portion of the value is extrinsic (see Figure 3). Because of the skewed distribution, without option hedging only the lower value likely will be captured. A trading floor allows you to go after the rest. Henwood/GED has evaluated all the individual combined-cycle plants in its and estimates that the extrinsic value of these assets is $17.6 billion.
So where is this value going?
In a perfect market, this value will be captured in the supply chain from generator to customer, resulting in higher profits, lower prices, or both. In an inefficient market it will be lost. Combined-cycle plant will not be able to sell this option, and the retail suppliers will source it from alternative higher-cost sources (by maintaining their own inefficient peaking fleet, for instance).
The current market mixes both of these situations. Capacity markets are one form of these option markets, but they are far from perfect hedging tools. Vertical integration is another, but again, there can be significant inefficiencies if you use only your own portfolio to capture this value. Significant regulatory issues also must be considered.
With so many new combined-cycle plants having little intrinsic value in the short run, this extrinsic value is probably the highest it has ever been in the history of the U.S. power market. So what has this got to do with trading?
Trading and risk management is all about dealing with this type of uncertainty and complication. Instead of hedging once and going home, the hedged position should be re-evaluated each day. Every time the forward market or associated volatility changes, the components need to be separated out and the position re-hedged. To do this requires traders and systems.
The extrinsic asset value of $17.6 billion is more than enough to sustain a healthy trading industry. But can a sophisticated trading business really capture this value? The answer is yes-and no. No because there are few liquid option markets (if any), and it is certainly not a $17.6 billion market. Yes because some of the value can be captured through delta hedging in the forward markets (albeit less efficiently and with additional transaction costs), and yes because the market needs it.
Buyers see the same price distribution and fear the potential price spikes that drive the high-value events for generators. They need to buy the options as insurance to protect themselves from these low-probability, high-impact events. As long as we have power price volatility, there will be a need for these markets. In other words, there's more need now than ever for trading to exist.
So, will a healthy trading industry redevelop to fill this void? We believe so. Credit will recover, while improved analytical tools increasingly show the need for more sophisticated hedging. Also, appropriate governance and accounting treatment is now catching up with what was a completely new industry in the 1990s.
Will we return to the speculative trading seen in late 1990s? No. Trading floors are increasing their focus on reducing risk, and systems and people are getting better at identifying and pricing the risks. The CSFB/TXU joint venture, whether ultimately successful or not, is a step toward the reintroduction of a healthy power trading market, one that can bring benefits to both producers and customers.
Strategic Outsourcing for Utilities: Where to Draw the Line?
Business history is littered with both success and failure.
A utility could be damned if it does and damned if it doesn't outsource parts of its operations.
That's the lesson of many IT and manufacturing companies that have undertaken strategic outsourcing, a concept that has been around for decades, but only recently became a phenomenon in the utilities industry. While strategic outsourcing can lower a company's costs, the issue is always about where to draw the line.
Today, utilities are being offered a larger list of outsourcing alternatives, such as accounting, customer information service (CIS), energy trading, and human resources. But whether any of these alternatives are a core skill, and whether outsourcing could impact other core utility skills, or not at all, remains to be seen. What are the utility's core skills? Answering that question correctly is critical for utility managers, experts say.
For example, would TXU lose critical power or resource planning skills as a result of outsourcing in a 50/50 partnership of its energy trading and risk management activities to Credit Suisse First Boston? Did Entergy or Constellation lose critical risk management skills when they devolved their energy trading partnerships with Koch Energy Trading and Goldman Sachs, respectively? Furthermore, what did it cost the companies in competitiveness to replace the talent lost from the failed partnerships, and what was the replacement cost of personnel and systems?
According to Dartmouth Professor James Quinn, in an article published in McKinsey Quarterly in the mid-1990s, outsourcing all or even just a part of any activity will create opportunities but also new types of risks, including:
- Loss of critical skills or developing the wrong skills. Outsourcing a key skill may mean a company loses its capability to innovate independently from a vendor.
- Loss of cross-functional skills. The interactions among skilled people in different functional activities often develop unexpected new insights or solutions.
- Loss of control over a supplier. Real problems can occur when the supplier's priorities do not match the buyer's. Remedying the conflicts is critical. If there is not sufficient depth in the market, powerful suppliers can hold a company ransom. But Quinn says that specialized suppliers can often produce higher value-added at lower cost for the activity than almost any integrated company. That is why he recommends benchmarking suppliers against internal operations to determine the value proposition of outsourcing. Furthermore, Quinn says outsourcing can force many types of risks and unwanted management problems onto suppliers.
Michael A. Beltz, executive vice president at Alliance Data Systems (ADS) and president of utility services at the company, says that he believes outsourcing customer information systems may be the answer for utilities that have legacy software systems and under-performing assets. "Most utilities are caught in the dilemma of needing to improve the quality of customer service, but doing so without significant IT investment and a corresponding rate-case increase," Beltz says. Furthermore, according to an ADS report, business process outsourcing provides an "insurance policy" for CIS implementation cost overruns and system failures.
Echoing Quinn, Bill Mahoney, president and CEO at Excelergy, says the question to ask when thinking about outsourcing is whether the utility's CIOs and managers are good at managing the relationship with outsource providers. He notes that a utility can take billions of dollars in costs, in some cases, off the books and look more attractive to Wall Street. The cost of ownership of IT and other systems is cheaper, particularly when implementing later generations of IT, Mahoney says. Indded, let the outsourcing lines be drawn.
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Energy trading returns, healthier and wiser.