Figure 1. The New Electricity Trading Arrangements will have many knock-on effects for the players in the UK market
The UK electricity market is preparing for its biggest upheaval for over ten years – the introduction of the new electricity trading arrangements. Logica, part of the consortium responsible for implementing the new trading system, explains what changes market players should expect.
The rate of growth of energy markets across the world in the last few years has been rapid to the extent that the value of the energy traded is now predicted to outstrip that of any other commodity in the relatively near future. The changing nature and structure of gas and power energy markets worldwide is giving rise to a number of business issues that need to be addressed by energy companies wishing to participate in those markets.
Figure 2. Companies must manage risks such as operational risk, credit risk, legal risk, liquidity risk and so on
Some of those key issues will need to be addressed by companies participating in the UK electricity market as it gears up for its biggest change since the creation of the Pool in 1990. The ways and means by which an energy company might change in order to meet the challenges are numerous – many will find themselves drawing on experience from markets in other countries.
As essential background to a survey of approaches to energy trading, there are some key issues facing companies who intend to continue trading energy as the wholesale energy market in the UK moves to a more commodity-style market with the introduction of the new electricity trading arrangements (NETA).
Figure 3. Fluctuations in electricity prices over a 24 hour period. Physical energy markets – especially electricity – are notoriously volatile
Increasing risk – the case for becoming a trading-based organization: Physical energy markets are notoriously volatile. In the USA, where exchange-based markets exist for both gas and power, price volatility in gas commonly exceeds 50 per cent, and in electricity can exceed 200 per cent.
Companies which have been trading in the England and Wales Pool since 1990 have a relatively long experience of the unpredictable nature of spot market pricing and the need to manage the associated cash-flow issues. The latter have typically been managed using Contracts for Differences and similar instruments, which to a large extent eliminate the price risk presented by Pool trading. However, the new trading arrangements which are currently being introduced for England and Wales should prompt challenges to all current assumptions and certainties about what the trading activity entails and how to manage it.
Figure 4. The new electricity trading arrangements are to be implemented in October this year
Optimization of profits across energy production and supply assets: In a competitive energy market, energy companies can choose to continue running their supply and production (e.g. generation) businesses as separate profit centres within the group. However, this position fails to exploit the advantage of having positions on both “sides” of the market.
It clearly makes sense to try to balance production and supply portfolios with a view to managing a variety of different risks including price, volume and counter-party risks. However, management of the organization then becomes more complex and has less accountability.
Balancing the physical network through the market mechanism: Heavy financial penalties can be incurred in some liberalized markets by producers and consumers of energy if they diverge from agreed levels of production or consumption. It has been forecast that average cash-out prices in the NETA Balancing Mechanism will be twice/half power exchange closing prices.
The need to predict consumer demand accurately and to meet contracted production targets in each trading interval becomes vital to the profitability of the supply organization. For the generator, the ability to forecast plant capacity ahead of gate closure becomes equally vital. The non portfolio generators here are particularly exposed.
The balancing exposure risk can sometimes be managed through the introduction of special contract types or conditions, such as interruptible contracts. With these, the end user is given a financial incentive to allow the supplier some control of the volume of energy taken at various times under the contract. However, great care needs to be taken in the use of such instruments. Experience in the UK electricity market has shown that customers who have entered happily into interruptible contracts are often extremely indignant when their supplies are actually interrupted!
Accurate pricing of contracts is vital to success in any market. The energy market is no exception, yet, unlike mature commodity markets, price discovery is often a challenge. There is currently considerable concern over the development of price reporters for the NETA markets. For the balancing mechanism in particular, it will take a period of stable market operation before prices can be accurately forecast, though it must be acknowledged that the impact of this on the pricing of energy contracts should not be severe as the balancing mechanism is not intended to act as a residual trading mechanism. However, the need to establish a price reporter in the forwards markets (i.e. up to and including the power exchange), to replace the role currently taken by Pool Purchase Price, will be paramount.
The ability to accurately forecast prices in each market is vital if an organization is to compete effectively, and is likely to become even more so if the introduction of NETA drives down wholesale energy prices, and 25 per cent has been predicted. In order to forecast accurately, the organization must understand and be able to analyse (and if necessary manipulate, through various techniques) the underlying market price drivers in each market in which they trade.
Measuring and managing
In addition to the issues of price and volume risk, organizations must actively manage other risks such as operational risk, credit risk, legal risk, regulatory risk, liquidity risk and so on, as well as further subdivisions in each class. Some classes of risk are measurable, and generally accepted techniques and models exist, while others are more an issue for the organization to address in its structure and processes. Whatever the case, an organization trading in the energy market must be aware of the risks it is taking and have both strategies and processes to manage those risks as well as system support to measure quantifiable risks.
The NETA process is in itself a classical example of regulatory risk since it is entirely due to the intervention of the industry
To take one example, credit risk has hitherto been managed primarily by the Pool, in that each Pool member was required to deposit sufficient monies in a dedicated bank account to cover its anticipated payments to the Pool. In a market based primarily on bilateral trades, however, no such
Interaction of markets
In energy markets, perhaps more so than in other commodity markets, what takes place in the financial markets is very closely coupled with the operation of the underlying physical markets. Environmental and industrial drivers and rules for running the physical market all affect the pricing of contracts in the financial market.
For example, in the Nordic market, snow fall affects the price of seasonal contracts, and the contracts themselves are structured in the long term on a seasonal basis partially in response to this strong seasonal effect on the price of the underlying physical commodity.
In the current UK electricity Pool, the effect of capacity payments (as defined by the physical market rules) drives volatility and leads to increased seasonal variation in the spot price (which of course has been one of the criticisms of the Pool).
Physical energy companies i.e. those requiring physical delivery of underlying energy commodities, need to consider these factors when designing their trading strategies and building their hedging portfolios. For instance, being fully hedged in terms of absolute volume can still lead (and has led) to basis risk exposure between hubs or indeed to defaulting on physical delivery at constrained locations. These physical features of a market should be taken into account when forecasting physical energy needs.
Hedging allows for the price to be fixed for some or all of the forecast volume in advance of actual delivery, thus locking in revenues and profits derived from physical assets in the way that pre-NETA generators have been doing for the last ten years. Portfolios can then be built out of various instruments with different cash and energy flow attributes including forwards, futures and swaps.
In a mature market, such instruments will be available in standard forms but in an emerging market they have to be negotiated individually on an over the counter (OTC) basis. As the market develops further, other derivatives become available, including those with physical options such as swing or interruptible contracts, as well as more esoteric types such as weather derivatives. Combinations of all these contract types are increasingly being engineered into other products and structured deals by energy merchants and speculators enabling large end users to manage risk in an increasingly varied number of ways.
As delivery time approaches, knowledge of actual physical volumes increases. This gives rise to opportunities to trade in the ability to control these volumes (i.e. flexibility), in order to exploit profit opportunities created by the time value of market price and volume volatility. Those traders who can measure their physical volume positions in the short term and act on the information stand to make substantial profits, as well as further limiting their down-side liabilities.
Given that they have the necessary real-time or semi real-time view of the actual physical flows, traders will trade the operational flexibility market using the physical options at their disposal. Own generation, which can be viewed as a physical option, may be ramped up or down, customers interrupted and in the money optional contracts exercised.
To allow traders to exploit both physical and financial options within an energy portfolio, they must be provided with information about the available contracts and options, as well as the current physical position. They must also be able to swiftly evaluate in financial terms the wisdom of exercising one option over another. Traders in the short term operational flexibility markets require the freedom to liquidate the portfolio in the most efficient manner ensuring maximum cash-flows given precise knowledge of the physical energy flows taking place as they work.
The changed environment in which the UK energy market participants find themselves have, without exception, caused them all to re-evaluate their core business strategies and implement new business processes and supporting IT systems. Some of the key IT questions that have been addressed include:
- To what extent are the key business process areas within the Energy Trading groups supported by core competence, and for which business process areas is external support required?
- Where external support is required, are there opportunities to set up a ‘win-win’ relationship with a service provider such as Logica, in which the service provider’s reward depends on the success of the Energy Trading business?
- Where will IT be a differentiator for the energy trading business, and where will it be a commodity? Where it is a commodity, are there opportunities for reducing cost by procuring a shared service?
- How long does it take to procure IT services to support an operation like energy trading? When are the benefits of change required, and therefore when does the procurement process need to start and what is the process from there on?
The New Electricity Trading Arrangements, Volume 2, document published by Ofgem in July last year forecast IT costs to become NETA-ready for the existing market participants to be something less than £1.5 million (a2.5 million) each. While many market participants have taken the opportunity to enhance their processes and systems and invested somewhat in excess of this figure the time to gauge the effectiveness of those investments and the accuracy of those estimates is Spring 2001.