Colin Cooper
Cap Gemini Ernst & Young, London, UK

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For energy and utility companies, the trading imperative – the requirement to trade, buy and sell energy products and manage risks in competitive markets – is becoming ever greater. As markets liberalize and continue to evolve, competition results in uncertainty and risk, which can only be effectively managed through the implementation of a successful trading and risk management strategy.

Figure 1. In the UK, power exchanges were created even before NETA was put in place
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The pace and impact of change will vary from market to market and over time. The recent introduction of the New Electricity Trading Arrangements, NETA, in England and Wales, will result in a rapid and fundamental change in the way power is traded. NETA will change for ever the world in which market participants exist. In order to be successful, or even survive, companies will need to implement a “world class” trading and risk management capability.

Whereas the introduction of NETA was a fundamental change, the power market in England and Wales will continue to evolve as a result of existing players and new entrants becoming more familiar with the opportunities and threats of operation within a true trading market. The response to NETA has to be more than the building of the interfaces necessary to schedule power.

A successful trading and risk management capability will enable a company to ensure the best price for energy, whether it is buying or selling or whether it is for fuel purchase, wholesale activities or retailing to customers. There are many other advantages that can be derived from a world-class trading and risk management capability, including lower cost of trading and hedging and increased effectiveness of hedging. Reduced inventory costs and increased value from arbitrage activities should also be obtainable. A reduction in risk capital, credit and counter-party risk, as well as lower overall portfolio risk and operational risk, can only be obtained from a global approach.

Many companies, while experienced in trading, do not have a truly global approach, which results in incomplete risk management and indeed exposure can be created rather than mitigated.

The challenge

Implementing a successful trading and risk management activity can be challenging. Markets in which the companies operate will continually change and evolve. Uncertainties are many and varied, and most significantly, margins will be at risk.

Difficulties of implementation are increased by a lack of alignment. Departments have different needs, stakes, expectations and understanding, and often a limited trading culture exists. Leveraging existing internal competencies and mobilising knowledge is difficult in an unaligned organization. Limited understanding of the issues associated with trading makes detailed definition of requirements difficult. Choosing a solution is complicated by the fact that there are too many packages with incomplete coverage. In order for a solution to be truly effective, systems must be fully internally and externally integrated.

As a result of sudden changes in the market, or procrastination or inertia, time may be limited once the decision has been made to proceed. The enormity of the challenge, and frequent lack of understanding, can make getting started difficult. The introduction of NETA was delayed but it is unwise to assume that the time to implement solutions can be extended in the future. In any case it is competitors that set the agenda post-NETA, not legislation, and they will not wait.

Market evolution

Trading and risk management will develop as markets evolve. The example here is for a power market but the principles apply to development of other energy markets, such as gas or oil. The England and Wales power market did not evolve this way and it may be that the inefficient market mechanism that was put in place is the direct cause of NETA.

The initial development in an evolutionary scenario often occurs as a result of the loss of customers by an incumbent monopolist. As soon as one customer is lost to a new supplier, the market changes. The incumbent is long and either has to reduce generation or sell excess power wholesale. The new entrant is short and has to buy wholesale or generate power to meet customer requirements. A secondary physical market will develop out of this supply and demand balancing activity. The requirement to balance is also driven by the transportation regimes and the penalties for imbalance can be very high.

The next step in the evolution of trading is the creation of exchanges, driven by the attraction of standardized contracts, avoidance of credit risk and business opportunities for creators of the exchanges. Exchanges can be created very early but unless the market is sufficiently mature, liquidity can be a problem. Germany, for example, has seen the creation of two exchanges but there is still a lack of liquidity in the market. In the UK, power exchanges were created even before the new electricity trading arrangements were put in place.

Exchanges are often based around spot trading at first, but as the market develops futures contracts are introduced. This is a significant step as it facilitates hedging and risk reduction. As trading activities develop, arbitrage opportunities will emerge across time, form or geography. Arbitrage is risk-free so anyone who has the ability to should take advantage of this activity. Companies often say they will not speculate. The problem is that they are, but they just don’t know it. A generator is by definition long and speculating unless the entire power production is sold and the price hedged. There is nothing wrong with speculation as long as it is knowing and controlled.

Trading will develop from a balancing necessity to a competitive, profit-driven activity.

Of course the pace of change of any market is not constant and evolution, as in nature, can be triggered by a single large event. The introduction of NETA can be considered in this way.

Risk exists in all phases but can only be effectively mitigated in a mature market. There are many market requirements, particularly connected with liquidity, which are needed before effective trading can be established. A mature market with sufficient liquidity to effectively mitigate risk will have: many willing buyers; many willing sellers; access to networks; access to storage; standard products for gas, power, oil and oil products, for example, futures, forwards, options and shapes; price discovery; price transparency; anonymity and market confidence. Not all markets have all these attributes yet.

Risk and reward

Competition and regulation are resulting in a fundamental restructuring of the traditional value chain – at the same time as e-business adds to the pressure for change – and distinct new roles have emerged. These include: asset owners operating in competitive markets, the producers and generators; asset owners in regulated markets; market operators, primarily TSOs (Transmission System Operators) and ISOs (Independent System Operators); traders and brokers; exchanges and retail service providers. Trading and risk management will be essential for success in each of the new roles.

The risk and reward profile of each role will be very different. Each role emphasises different key success factors but trading and risk management are of high importance to all players because of increasing uncertainty. The need to convert unmanageable uncertainly into manageable risk affects all players. Therefore, trading and risk management is emerging as a major business area for all the players in the market and as a major differentiator for success in competitive markets.

Trading activities will depend on a company’s business scope. Each company has a distinct set of characteristics: the role or roles it plays, its portfolio, markets, competitive position, information technology and culture. Therefore a unique trading and risk management solution is required.

There are many issues to address before carrying out effective trading and risk management: strategy, organization, processes, systems, culture and capabilities. All areas must be addressed, starting with strategy.

The strategic foundation

Even if the trading activity is limited to balancing supply and demand, a trading strategy is essential. There are many issues to address when considering trading activities for supply and demand requirements, including the portfolio of long term and short term contracts, the company’s own production and generation and the potential for demand-side management. The ability to accurately forecast supply, demand and price will be critical to success. The identification of transportation requirements and scheduling and the effectiveness of physical balancing and the use of balancing markets will also determine a company’s success.

Trading impacts on all a company’s businesses and an effective business model is essential to ensure an effective global organization, which apportions risk and reward throughout the value chain and captures the synergies inherent in the company.

Hedging, arbitrage and speculation will be primarily determined by the risk policy. Hedging strategies are normally determined by risk policy and cash flow requirements. Arbitrage is often limited by the markets in which a company operates and the ability to identify and capture opportunities as well as the risk policy. Speculation opportunities will be similarly limited, but also by the appetite for risk and the availability of risk capital.

Without a well-developed trading strategy, many essential benefits will not emerge. Many of the benefits associated with the strategy development address essential cultural issues. The strategic foundation will also create a way forward for risk instruction, design process implementation and integration.

Solution design

Effective design of the trading organization needs to address many important issues, including organizational alignment, business process definition, organizational design, system design and the appropriate package selection.

Designing systems and bespoke developments to meet detailed requirements and selecting the appropriate package are a key area. It is often difficult for individual companies to acquire the depth of knowledge and skills necessary, after all how often does a company design its trading and risk management system?

In order to create the understanding of requirements, knowledge and experience gained through strategy, design, package selection and implementation projects have to be incorporated. The understanding of packages available and on-going relationships with leading package vendors is essential to understand their offerings and capabilities. It is also important to use a proven method for matching functional requirements and package capabilities. These activities are very difficult for a company to do well on their own, particularly if they are trying to set up a trading system for the first, or even the second, time.

Requirements will depend upon the trading and risk management system development that has already taken place. There is an increasing requirement for fully integrated global solutions. Some companies may even require the replacement of fully integrated systems, where the build or operation has proved unsuccessful.

There are many benefits to be gained from effective design and selection including incorporation of new competencies, inclusion of all relevant functions within the trading organization, recognition of “routine” and “non-routine” activities, maximization of operational efficiency, the capture and dissemination of knowledge, the definition of roles, skills and objectives, appreciation of formal and informal networks and interfaces, delegation of decision-making to the lowest practical level and organizational alignment and mobilization.

Delivering success

The successful implementation of a trading and risk management solution requires integration of internal and external environments, and is dependent on three primary key success factors – successful delivery, rapid implementation and an effective solution.

Successful delivery will depend on project management and quality assurance, understanding of interfacing systems, packages, standard interfaces and trading knowledge. Integration experience and technical expertise will also be essential.

Rapid implementation will be enabled by having an early working system where the trading and risk management software is installed before integration and scenario testing is used to quickly validate the functional fit and identify any gaps.

Energy and utility companies can implement an effective solution through the use of a package, bespoke modules made-to-fit and interfaces and testing for business readiness, as well as process and organizational alignment.

Essential skills

Figure 2. Departments have different needs, stakes, expectations and understanding
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People play an essential part when establishing an effective trading activity. Gaps will exist in the new organization in terms of skills, knowledge, capabilities and culture, which can be met by a combination of recruitment, education, partnering and outsourcing.

There will be skill gaps resulting from lack of experience of trading, knowledge gaps from a lack of understanding of trading and gaps in the company capabilities. The culture gap will need to be addressed, from engineering to commercial and volume to financial risk, among others. The gaps could be in terms of quality or quantity and can be filled by a combination of some or all of a number of sources.

Internal recruitment might be possible, for example recruitment of traders from oil trading organization to trade gas, or recruitment from other countries if a company has an international set-up. External recruitment might occur from financial institutions, commodity or energy companies, competitors or other countries where trading has occurred. Education of existing resources and new ones recruited will play a major part.

Partnering could fill some of these gaps, although this may be a short-term solution. Outsourcing is also an alternative but a company is unlikely to outsource its trading or risk management activities. Any issues with culture can be addressed by alignment through strategic and system design stages and incentivization in terms of reward, recognition, KPIs (key performance indicators), objectives and performance targets.

Strong foundations

There are many key stages in the development of a successful trading activity. It is essential to build a strategic foundation. This is a stage often completely or partially ignored by companies.

Figure 3. Companies require a unique risk management solution
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It is crucial to design a total solution including processes, organization and systems, where the system is used in its widest sense and not just information technology systems. Don’t just buy a package. Evaluate and select the most appropriate system, remembering that no package will exactly meet all your requirements, and build the system ensuring that the solution is technically integrated as well as integrated with the internal and external environments.

Energy and utility companies should also include the increasingly important areas of retail integration and demand forecasting, and address the issues of culture and capabilities, which is not just a matter of recruitment. Finally, you need to consider all these activities – they are all critical to success.