Energy Asset Optimization

Since the latter half of 2002, the industry has been in a back-to-basics mode
of operation. The focus, once on unregulated businesses and acquisitions,
has returned to obtaining better utilization of the physical and human assets
in the regulated portions of the business.

This focus is not new. Energy and utility companies have been methodically
taking 3 to 5 percent of cost out of the business for the past decade. However,
the situation today is quite a bit different than it has been in the recent
past. Financial markets continue to apply pressure for double-digit earnings
growth, yet are punishing companies that either remain in unregulated businesses
or fail to focus on the core regulated business itself (which is a 2 to 3 percent
growth business).

As a result, access to capital is constrained. Couple this with increased customer
demands and enhanced regulatory scrutiny, particularly from an environmental
perspective, and the situation is tenuous.

If that were not bad enough, the market is different than it was a decade ago.
First, most of the infrastructure assets are nearing the end of their economic
and practical life. This will require large quantities of capital (more than
$100 billion in North America over the next decade) to either refurbish or
replace these assets.

Second, a large portion of the workforce will retire over the course of the
next three to eight years, taking with them large quantities of institutional
knowledge that hasn’t been captured or passed on to younger employees.

Third, a couple of disruptive technologies, namely nanotechnology and the hydrogen
economy (see Web link) are poised to change all aspects of the regulated electric,
gas, water, telecommunications, cable TV, and consumer goods purchase and repair.
This last point is mainly an early warning indicator to businesses because,
while one can debate the specific timing of when these technologies will change
the game, one cannot debate that it will be within the depreciation lifetime
of the new assets that companies are deploying today.

Couple these industry-specific findings with the horrible track record of most
CIOs and technology deployments over the past five to seven years and you have
the recipe for some interesting industry dynamics for the next three years
or so.

Given this dilemma, what is the head of the energy delivery business unit
to do?

The Asset Management Context

Deregulation, for all its warts and pains, did provide the industry with a
different way of viewing the business. This new view is from the perspectives
of the asset owner, the asset manager, and service providers who implement
various parts of the asset management program on behalf of the asset manager.

The asset owner:

  • Allocates capital (human and financial) to the asset manager(s). There
    may be one each for wires, pipes, generation, or exploration and production;
  • Financially manages a portfolio of assets; and
  • Establishes the risk adjusted rate of return that each asset manager must
    use in evaluating capital projects

Think of the asset owner as an investment banker.

The asset manager:

  • Establishes the programs, service level agreements (SLAs), key performance
    indicators (KPIs), and market clearing mechanisms necessary for the service
    providers to function efficiently and effectively; and
  • Optimizes the performance of the assets in accordance with the financial
    goals established by the asset owner.

Think of the asset manager as a program designer and administrator.

Service providers may or may not be from the same organization as the asset
manager, and they provide one or more of the services shown in Figure 1 on
behalf of the asset manager.

Carefully sorting one’s core from noncore competencies has been a buzz
phrase from consultants for the past decade or more. However, that is not the
direct focus of this model. This model emphasizes the need for each portion
of the business to realize that it provides products and services to other
portions of the business. Setting up each of these functions as businesses
within a business and establishing the market-clearing mechanism for these
products and services to be bought and sold is the key to making this model
work. This effort will develop a clear and comprehensive understanding of what
it costs to do these functions internally. Once these costs are understood
and the KPIs and SLAs are established, it is much easier to benchmark the sourcing
of these same products and services externally.
Innogy, the privatized name for the former British Energy non-nuclear assets,
is the best example of how to effect this transformation.

Work and Asset Management

It’s important to establish effective work and asset management programs.
They are where most of the gains in workload and effectiveness of the workforces
can be expected. Work and asset management phases, described below, can be
viewed as a pyramid (see Figure 2).

Many times, companies jump into implementation of applications or programs
without having the right leadership and foundation in place. Such endeavors
have very predictable results: projects that fail to deliver the touted economic
value. As a result, we offer the following advice to asset-intensive industries,
like energy and utilities, when looking at work and asset management program
and application changes.

Successful work and asset management program changes and implementations start
with a strategy grounded in the fundamentals of asset management and 100 percent
committed by the leadership of the organization. The kind of commitment we
want to see from leadership is best exemplified by the following analogy.

One day on the farm, the chicken and the hog got into a discussion over who
was the most committed to the farmer and his wife’s breakfast meal each
day. The chicken started the debate by boasting how she laid these wonderful
and copious quantities of eggs for the farmer and his wife to enjoy each morning.
The hog, after listening for a few minutes, got rather disgusted with such
bravado, and said one simple statement of disgust: “at least you are
still alive to talk about it.”

What we are looking for from leadership when it comes to support for these
sorts of programmatic changes is hog commitment to breakfast.

Once the strategy and leadership commit-ment are respectively formulated and
secured, one can move into laying a firm and strong foundation on which to
build a robust and sustainable work and asset management program. The foundation
phase includes the following activities:

  • Implement standardized design throughout the business unit;
  • Implement configuration control wherein the as-built configuration is
    reflected in the critical design and operations documentation in a timely
    manner;
  • Identify all your physical assets;
  • Ascertain the health of your physical assets;
  • Resolve budget bucket behaviors that cost the business money – e.g.,
    picking up and redeploying a no-load transformer is an operations
    and maintenance expense whereas getting a new transformer out of the yard
    and installing it
    is a capital expense;
  • Prioritize and allocate capital budget based on improved engineering
    tools and techniques as opposed to the old new-load growth, refurbishment
    of worst
    performing feeders or circuits, and storm restoration bucket approach;
  • Do the right work for the right reasons – implement a robust reliability
    centered maintenance (RCM) program;
  • Invest in industrial engineering to measure direct activity;
  • Build effective work orders and job plans;
  • Build effective planning and scheduling processes that match the physical
    maintenance work to the physical assets in the field
    so as to reduce transport time, materials
    logistics, and set-up and tear-down time;
  • Utilize a comprehensive asset database to capture and store information
    about asset health and work history; and
  • Utilize your work and asset management system effectively.

As a result of laying this firm foundation for a work and asset manage-ment
program, one should expect to see a 20 to 30 percent reduction in maintenance
workload from implementing an RCM program and a 5 to 10 percent increase in
crew direct activity.

Once the foundation is laid, one can move into the continuous improvement phase.
In this phase you want to drive for efficiencies in the overall program. During
this phase, companies implement the following types of programs and processes:

  • Continue investment in industrial engineering to measure and report everything
    causing non-direct activity;
  • Invest in forensic skills to definitively identify causes of failures;
  • Implement post-work order completion reviews with craft as major participants;
  • Implement advanced kitting and staging of materials; and
  • Move to condition-based maintenance.

During this phase you can really drive crew-direct activity.

Today, crew direct activity, representing the actual hands-on time working
on an asset, ranges from 20 to 35 percent depending on the business unit. Generation,
transmission substation, compressor stations, and gas liquids processing facilities
are on the higher end of the range while line crews and pipeline crews are
at the lower end of the range. So for every eight hours worked, only 1.6 to
2.8 hours of that day are hands-on working.

Companies that have successfully implemented the continuous improvement programs
have seen the following productivity increases in direct activity:

  • Generation: 60 percent direct activity is top-quartile and best-in-class
    achieved by Tennessee Valley Authority in fossil. Hydro generation in a highly
    unionized
    environment was 75 percent direct activity;
  • Transmission Substation, Compressor Station, and Gas Processing
    Facility
    :
    55 percent direct activity is top-quartile; and
  • Field Crews: 45 percent direct activity is top-quartile.

Now that you have
been through the continuous improvement phase, you are ready to look to some
advanced technologies to drive process and human asset effectiveness
even further. We intentionally leave some of these technologies for consideration
in this phase, because moving to them prematurely will cause more frustration
and disappointment than good.

These advanced technologies include:

  • Trucks as rolling warehouses;
  • Mobile dispatch of crews based on skills and proximity to the work;
  • Just-in-time materials delivery; and
  • Exploitation of pervasive computing.

The additional crew productivity and process efficiencies delivered from the
deployment of these advanced technologies is unknown in the energy and utility
industry for a couple of reasons. First, we are unaware where anyone had done
most of these. Second, where companies have deployed mobile dispatch, there
have been some foundational issues that prevented the full realization of the
business benefits from this technology.

However, one only has to look to other industries such as Wal-Mart in retail
and the automotive industry to see the potential that these advanced technologies
have for our industry.

Conclusion

The generation and regulated wires and pipes portions of the business are
under more pressure than ever to drive better utilization of physical
and human assets.
Laying the right foundation and building continuous improvement on top
of that foundation is critical. Following this approach can help answer
the call and
effectively respond to the pressures being brought on by the asset owner
in response to a variety of external market forces.

Driving the Enterprise

Enterprise performance management (EPM) is a slippery term that is difficult
to define. It has a few aliases, such as corporate performance management (CPM)
and business performance management (BPM),
but what is it?

Simply put, EPM is a strategic approach to improving business performance.
Gartner Inc., a research and analyst firm that prefers
to call it CPM, defines it as “an umbrella term that describes the methodologies,
metrics, processes, and systems used to monitor
and manage the business performance of an enterprise. CPM is an important concept:
It represents the strategic deployment of business intelligence solutions.”

But why is EPM important to energy and utility organizations?
First, increasing volatility and competitiveness in the industry means that
energy and utility executives are adapting their corporate plans more frequently;
they constantly shift their strategies to meet market, regulatory, and environmental
pressures. Making rapid changes to corporate strategy is one thing but getting
a large organization behind these changes is another. In this shifting environment,
EPM processes and tools can ensure that operational activities are rapidly
brought
in line to support new strategies. This is achieved through effective translation
of strategies into operational targets and metrics followed by timely reporting
of operational performance against key strategies.

EPM also plays a key role in achieving profitability in this industry. As commodity
businesses, energy and utility companies must focus on asset optimization and
operational costs and risks in order to control profit margins. EPM can provide
visibility into supply chain and inventory levels for just-in-time management
and to minimize costs.

Performance management is also vital to those energy and utility companies
that are expanding into nontraditional markets. When shaping their products
and services to new and existing customers these organizations must differentiate
themselves by adding customer value and achieving service excellence. This
requires effective tracking of customer behavior and service issues and the
monitoring of service delivery. EPM has three fundamental ingredients:

Three Key Factors

  • Metrics: Up-to-the-minute snapshots of your key performance indicators
    (KPIs) in a personalized, Web-based dashboard or scorecard to enable fast,
    proactive decisions and organizational agility.
  • Business Intelligence (BI):
    Enterprise software designed to track, understand, and manage information.
    BI enables decision-makers to manage by exception, stay informed with
    alerts, and drill into data to examine the root cause of business conditions.
  • Methodology: A systematic and sustainable means of tracking, measuring,
    and improving business performance, applied top-down throughout the enterprise.

Metrics

Simplicity is fundamental to EPM. It begins with the most basic questions:
How is our organization doing today? Is everything running according
to plan? If not, how do we get back on track? EPM can intelligently sort
the most
important
metrics and indicators from the vast amount of data in your organization
to provide focus, insight,
and answers that translate to fast action.

To answer these questions and benefit from EPM, you need a Web-enabled dashboard
or scorecard to present highly visual, easily understood metrics and KPIs.
EPM dashboards are configured to zero
in on the metrics that matter most to an executive or manager. Problem
areas are red-flagged for the user’s immediate attention. The dashboard
serves as a real-time barometer and benchmark platform of business conditions
and
helps put the decision-maker in control. Dashboards and scorecards are
the first step in making proactive and predictive business management
a reality.

Business Intelligence

Metrics and key performance indicators are critical, but sometimes don’t
provide enough information. A manager will often want to know more about the
business dynamics behind those data points: Why are sales up? What’s
our fastest growing service or product? Why are inventory costs rising?

To answer those questions, the EPM dashboard lets you drill through to
underlying data for analysis, comparisons, and answers. Today’s
BI tools make it simple for non-technical users to run queries and generate
reports that
are
easily shared with colleagues. You can explore details of who, what,
when, where, why, and how for the insights you need
to fine-tune processes for maximum performance. The devil is in
the details, and BI provides a surefire means of flushing him out.

Critical to any EPM solution is an integrated, enterprise-wide view of
data drawn from various sources – finance, sales, supply chain, and more – that
would otherwise have to be cherry-picked by hand. Concealed from the
user is a powerful back-end data access and integration platform that
taps into
those
disparate systems.

Methodology

EPM typically applies a systematic methodology across management and
business processes. The objective of the methodology is to monitor, measure,
and
improve performance in a structured environment that is common across
all business
units.

A methodology gives management a collaborative, top-down framework by
which to align planning and execution, strategy and tactics, and business
unit
and enterprise objectives. Common methodologies include six sigma, balanced
scorecard,
activity-based costing, total quality management, and economic value-add.
The methodology used to decide how to track and measure performance can
help an
organization determine which metrics are most important and define how
these metrics should be measured. The use of standard definitions promotes
consistency
and an improved decision-making process throughout an organization.

Process Drives Performance

Before the days of sonar, GPS, and mobile phones, traveling by
sea was a risky business. Transoceanic voyages could take several months
and were often plagued by freak storms and weak currents. For a ship
to arrive
at its destination on time and with few casualties, it was imperative
that those on board follow an established process. Before setting sail,
sailors
would chart a course based on the stars. During the journey, the course
would be checked regularly and adjusted as needed. And each crew member,
from the
captain to
the cabin boy, played a key role and understood what his day-to-day responsibilities
were.

Today, organizations are run using a similar process. The captains of
the industry, the board of directors, the executive team, and managers
at all
levels plan
a course and set goals. Those goals and objectives – central-region
target of 15 percent sales increase over the prior year, line efficiency
of 85 percent,
97 percent on-time delivery, 2 percent improvement in customer satisfaction – spread
throughout the entire organization and cascade down to individual employees
in each department. Every employee has goals and targets that drive his
or her daily activity. And the organizational course is re-evaluated
on a regular
basis and adjusted as needed.

EPM brings this process to life and closes the performance loop between
the high-level strategies and daily execution.

Monitor Metrics

You can’t manage what you can’t measure. In order to achieve
a
goal, you need to measure daily activity in support of goals and track
progress toward results. In order to improve performance, you need
to focus on key metrics to ensure accountability and consistency.
EPM allows managers to drive a process that connects metrics to
goals to people. With scorecards and dashboards, each employee
and department can view the metrics that are important to them
and manage to individual targets (i.e., sales by region, cost of sales,
margin, etc.). Those targets can then be rolled up across functional
areas, departments, and business lines to provide high-level views of
your organization’s
performance.

Dashboards provide a consistent way to track actual activity and results
with benchmarks and thresholds to measure against. They also provide
a quick way
for each person to see how they are doing so they can improve performance,
speed, and effectiveness.

Analyze

Where there is smoke, there is fire. Getting a heads-up alert that something
is off track is often the difference between a minor disruption and a
major problem. However, it is also critical to not
only know that something is happening, but also to understand why.
A successful EPM approach involves more than monitoring metrics; it also
requires deeper analytic capability to perform root-cause analysis down
to the detail
level. This allows executives, managers, and owners to receive alerts
in time to take action (e.g., sales in Europe are 10 percent below target).

At the same time, their teams can start to dig into the details
to gain insight into the business drivers, causes, and long-term implications
(e.g., economic changes, salesperson performance, product and service
mix, promotional effectiveness). EPM gives employees at all levels and
roles
the analytic capability they need
to help them better understand the impact that various alerts have on
business, and to allow them to act quickly to correct potential problems
before they
happen.

Decide

Connecting goals to metrics to people in order to monitor day-to-day
activity results in business transparency and smart decisions at all
levels. All
employees will be armed with the information they need to drive activity
and actions
in support of high-level goals (e.g., launch
a marketing campaign to support central region; focus on products
A, B, and F). Daily execution can be tied back to top-line objectives
to ensure alignment across the organization.

At the same time, new decisions can be made that drive incremental change
to steer the organizational ship back on course. Most importantly, everyone
can
keep track of how they are doing. Closing this loop with an EPM strategy
means your entire organization can make informed decisions, drive immediate
action,
and stay focused on what is most important.

Proactive. Predictive. Precise.

EPM solutions put you in the driver’s seat, with the ability to be:

  • Proactive: Speed is the critical factor. EPM solutions are easily configured
    to alert you to problems in mission-critical areas as they happen.
    You find out immediately. It’s red-flagged on top of your EPM scorecard.
  • Predictive: Knowing what’s up and what’s down in business
    requires you to examine all of the elements: EPM enables managers to easily
    collate,
    analyze, and drill into historical and external data to ascertain
    optimum pricing, spending, delivery, and service. Those insights are essential
    to predicting
    conditions and adapting accordingly.
  • Precise: The margin for error has diminished. Precise execution requires
    precise data – quality information that is consistent across the enterprise.
    More than ever, one accurate, integrated view is a prerequisite for
    success.

EPM helps provide quality assurance for your information. Because it’s
tied to standardization on one BI tool, a common enterprise data model, and
a common methodology, it ensures that executives and managers throughout the
enterprise work from a single version of
the truth.

Strategic Synchronization

EPM is not so much a revolution as an evolution. It builds on your existing
technology resources and infrastructure (enterprise resource planning, finance,
and numerous other databases). EPM does not require you to rip out and replace
financial budgeting, planning, and other systems that run your organization.
Rather, it complements them with powerful tools for prioritization, monitoring,
navigation, and analysis. EPM allows you to leverage your existing infrastructure
to support enterprise-wide goal tracking and metrics management.

Alignment, Visibility, and Collaboration

EPM enables strategic synchronization of different parts and new visibility
into the business as a whole. Marketing is aligned with CRM analysis. Procurement
is in step with the revenue cycle. Demand
and product planning are informed by inventory and sales. Service development
takes advantage of customer behavior and historical service information. As
a result, you can:

  • Optimize the supply chain by providing data access to suppliers, distributors,
    and customers to enhance performance and responsiveness (all while reducing
    costs);
  • Improve capacity control by providing visibility across the organization
    and supply chain to enhance just-in-time management and reduce excess inventory;
  • Minimize procurement inefficiencies by analyzing supplier performance,
    and driving negotiations and pricing structures;
  • Respond quickly to market opportunities by tracking and
    analyzing operational data from inventory, financial, point-of-sale, and
    marketing;
  • Differentiate and refine product offering by analyzing historical information
    and assessing product profitability on a geographic basis;
  • Strengthen customer relationships and increase their value by tracking
    customer behavior and service issues, better targeting promotions, and improving
    service
    delivery; and
  • Drive cost out of the business while increasing financial and organizational
    transparency.

Conclusion

Gradually, energy and utility organizations are building EPM
systems based on the strategic deployment of business intelligence
solutions
across the
enterprise. As systems mature and companies synchronize among
sales, supply chain, finance,
and other systems, business performance as a whole will improve.

The integrated cross-functional discipline of EPM, connecting
goals, metrics, and people in a closed-loop process, drives
improved productivity,
transparency,
and alignment for improved performance across the enterprise.
EPM is a big step toward prosperity, today and in the future.

Sarbanes-Oxley – A Call to Action

If you work for a publicly traded US company, chances are you’re pretty
familiar with the Sarbanes-Oxley Act (SOX). As a result of SOX, CEOs and CFOs
have for the first time personally asserted to the validity of financial statements,
exposing themselves to criminal prosecution. This was a landmark event, refocusing
the executives on “minding the mint” and raising the accounting
visibility across organizations.

What you may just be realizing is that confirming financial statements was
merely the first step in a series of evolutionary guidelines the act comprises.
What was once viewed as an accounting-only law is now being driven to all parts
of the organization. CIOs are increasingly involved as financial data guidelines
are escalating in importance and solutions are sought to support auditable
processes.

To determine your SOX readiness, consider these questions from the CEO/CFO
perspective:

  • Would I be willing to put my neck on the line that all of the material
    accounts and transactions are documented accurately and completely?
  • Am I confident that all material accounts and operations have adequate
    and tested internal controls? Would a review of these tests satisfy an auditor?
  • Do I believe a consistent rigor is applied across the enterprise to enforce
    internal controls and assure adequacy for material operations?
  • Can I be sure that documents required to support legal inquiries are
    retained as needed to meet regulatory requirements?

If you answered no to any of these questions, chances are you’ll need
to pull up your SOX.

Although the act has a number of sections, we believe that those with the
most near-term impact are shown in Figure 1.

A SOX Action Plan

Obviously, these SOX requirements will have a pervasive impact on your organization.
No surprise here because the goal of SOX is to reach across the organization
creating a pervasively ethical corporate environment and appropriate business
behaviors. Given this broad goal, what can be done to make this a reality?

Since the assertions required are at the executive level, a top-down approach
offers the greatest promise that the executive will be satisfied with the methodology
and assertions that they must make on behalf of controls. To align with executive
needs, this top-down approach is best driven by a representative from the CFO’s
office or another senior resource charged specifically as a SOX program compliance
officer (see Table 1).

 

Planning

Planning is critical given the regulatory guidelines and time frames involved.
Assigning a goal-oriented compliance program manager helps drive compliance
activities within the organization. Frequently, outside support will be required
to help the program manager get up to speed and develop the materials to communicate
and train the staff. Since there are inherent conflicts between the external
auditor used by the firm and the SOX compliance process, companies typically
engage consulting firms with strong change management practices to drive the
change. In cases where particular issues of the Financial Accounting Standards
Board or generally accepted accounting principles apply, other audit firms
also are frequently engaged to provide deep technical expertise.

Technology

A number of vendor software solutions exist to support a centralized compliance
capability. Most solutions focus on a component of compliance (e.g., 404 or
802). However, a few bridge the gap. Some solutions have the added feature
of predefined control templates that help to expedite documenting controls
and increase overall SOX efficiency.

However, it’s important to note that software alone isn’t the answer.
With culture change and creation of a pervasively ethical business environment
as a goal, the project must be managed top-down to drive change in the organization.

Some Good News

The vision and direction provided by SOX provides the promise of simplified
accounting processes, enhanced technical capabilities, and ultimately increased
investor confidence in the coming years. Companies, now recognizing the SOX
work in front of them, are using it to drive process and organizational changes,
breaking through entrenched resistance and looking for opportunities to recast
the financial reporting landscape. In fact, over the next few years, a significant
portion of financial systems investments will be driven solely by SOX compliance
needs.

SOX is looming as a major “to do” for 2004. Many companies, still
in the (404, 802) awareness stage are unclear on the full scope of actions
required. Given the possibility of civil and criminal charges, as well as the
almost certain impact to share values if initiatives fall short, it’s
clearly time to get the compliance house in order. Key actions include:

  • Defining a compliance program management role;
  • Creating a SOX plan to meet requirement deadlines;
  • Determining what technologies will be employed to document and report
    activities;
  • Working top-down to define controls and objectives; and
  • Monitoring compliance testing to verify the program is on track.

A critical point is that SOX is pervasive; it changes the way business is
conducted. As a result, SOX requires a hands-on effort and senior management
commitment. Chances are that there is still time to comply with requirements,
but the clock is ticking. For section 404 in particular, compliance can be
no later than the end of the third quarter of 2004, and it could be much earlier
depending upon your fiscal year.

How do you get started? Take the initial step to get a compliance office
up and running and identify your SOX reporting milestones. Hitting these
milestones
is critical. Remember, with SOX, there are no second chances.

Gas Markets in the New World Order

Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.

Closing the Renewable Energy Gap

The US depends on large, centralized power plants that run on
fossil fuels and nuclear power. As a result, it has an electricity system that
is increasingly vulnerable to volatile fuel prices, supply disruptions, and
dependency on foreign imports. Fossil fuels also pose serious risks to health,
air quality, water supplies, and the earth’s climate.

Fortunately, this growing reliance on fossil fuels and nuclear power can be
reduced with clean renewable energy sources such as solar, wind, geothermal,
and bio-energy. These safe, homegrown energy sources are readily available,
increasingly cost effective, and highly popular with consumers. Recent studies
have shown that increasing America’s use of renewable resources would
create a more diverse
and secure energy system that pollutes less, creates jobs, benefits consumers,
and stimulates rural economies.

Despite the benefits, there exists an enormous “renewable energy gap” in
the United States. Significant market and commercialization barriers force
renewable energy to compete
on an uneven playing field with fossil fuels. As a result, renewable energy
sources (not including hydropower) generate about 2 percent of our electricity
today. Worse, there is no significant national
policy to help renewable energy overcome these barriers. Without new policy
support, the US Energy Information Administration
(EIA) forecasts renewable energy generation will increase to just
3 percent of the nation’s electricity by 2025.

The good news is that a few states are taking the clean energy lead by setting
an example for other states and the nation to follow. These states have adopted
policies like renewable electricity standards and funds, which are designed
to remove barriers and establish long-term markets for renewable energy. But
do they go
far enough to put us on the path toward energy sustainability and independence?

Boundless Potential

Of all the barriers that face renewable energy, an adequate resource base
is not one of them. The United States is blessed with a wealth of diverse renewable
resources. Combined, the major non-hydroelectric renewable technologies (wind,
solar, geothermal, and bioenergy) have the technical potential to provide more
than five times the amount of electricity this country currently uses.1

Renewable resources are well-dispersed throughout the country. Every state
has enough renewable energy technical potential to generate at least one-quarter
of its electricity needs. Thirty states have the technical potential to generate
all of their electricity from renewable energy.

Of course, not all of the technical renewable energy potential will
be tapped, due to economic, physical, and other limitations. But these resources
are certainly sufficient to support a gradual increase in renewable energy
use of 1 percent per year, to at least 20 percent by 2020 or 2025. This level
has been advocated by a growing number of environmental and consumer groups,
and energy companies as an achievable and appropriate mid-term goal in the
transition to a more sustainable energy system.

Despite the boundless potential and strong interest from consumers, only a
few states are currently generating electricity from renewable energy at meaningful
levels. In 2001, renewable energy provided more than 5 percent of total electricity
use in just seven states – Alabama, California, Hawaii, Maine, Nevada,
New Hampshire, and Vermont – and less than 1 percent in 23 of the states.
Sadly, most of the states with low penetrations of renewable energy also have
significant renewable energy potential.

State Leadership

A growing number of states have recently implemented policies to increase the
use of these clean, homegrown resources. Renewable electricity standards (RES),
for example, have emerged in the past several years as an effective and popular
tool for reducing existing market barriers and creating new markets for renewable
energy.

The RES (sometimes called a renewable portfolio standard or RPS) is a simple
market-based policy that increases power supply diversity
by establishing a minimum commitment to generate electricity from renewable
resources. RES requirements and design varies from state to state, but the
policy essentially requires electricity providers to gradually increase the
share of renewable energy in their electricity mix. To date, 13 states have
established minimum renewable electricity standards.

Renewable electricity funds, often referred to as public benefits funds,
also emerged as a popular policy tool for supporting renewable power during
restructuring
of the electric industry. Funds are collected through a small fee on consumers’ monthly
electricity bills. Funding is then distributed to support programs promoting
renewable energy development, with the focus varying from state to state based
on local priorities and interests. To date, 15 states have implemented renewable
electricity funds that, cumulatively, are projected to collect more than
$4 billion to promote clean, sustainable energy by 2017. Eight states – Arizona,
California, Connecticut, Massachusetts, Minnesota, New Jersey, Pennsylvania,
and Wisconsin – have implemented both funds and renewable electricity
standards.

Together, state standards and funds have created significant new markets
for renewable energy that will provide important economic
and environmental benefits well into the future. We estimate that these state
policies will lead to the development of 17,310 MW of new renewable energy
capacity by 2017 – enough to meet the electricity needs of 11.7 million
typical homes (see Figure 1). An additional 7,325 MW of existing renewable
energy capacity receives ongoing support from these policies, for a total of
24,635 MW. Though there are 20 states with standards and/or funds contributing
to this total, it is important to note that more than 80 percent of the development
is supported by policies in just five states.

By 2017, the new development resulting from states with standards and funds
could reduce annual carbon emissions from fossil fuel plants by an estimated
14.3 million metric tons (MMT). This is equivalent to taking 7.8 million cars
off the road.

Renewable electricity standards and funds are not the only policies that states
have adopted to stimulate the growth of the renewable energy industry. States
policies such as net metering, generation disclosure, financial incentives,
and state government purchase requirements have been effective at removing
some market barriers
and promoting some renewable energy development. In addition,
energy consumers in every state now have the opportunity to support renewable
energy directly through voluntary green power purchases. However, the development
from these policies and voluntary approaches has been relatively small and,
in many cases, difficult to attribute to specific policies. For example, a
recent National Renewable Energy Laboratory Study found that voluntary programs
may add only enough renewable generation to equal 0.1 percent of US electricity
sales by 2010, while we project that existing state standards and funds will
add 11.6 times as much by that date.

National Policy

Significant renewable energy commitments
by a handful of states
are a laudable start, but it is not nearly enough
to ensure a national
shift toward a cleaner, more sustainable
energy system. Poor performances and the lack of commitment by most states
to date speak to the need for a comprehensive national renewable energy policy.

While important to the renewable energy industry, national tax incentives
alone are not a comprehensive enough policy. The federal PTC helps level the
playing
field for new renewable energy facilities that otherwise would have to pay
higher taxes than competing fossil fuel
and nuclear plants. It does not, however, create new long-term market demand,
which is critical for an industry with high up-front capital costs. The PTC
has contributed to significant wind power development in
the past few years. But this growth has mostly occurred in states with standards
and/or funds, effectively demonstrating how well these policies can work together.

A national standard would address the fact that the majority of states have
yet to make any specific commitments to renewable energy either through funds
or standards. It would also provide an opportunity to create a more level playing
field among states that have already enacted standards, by enforcing a minimum
standard that states could still choose to exceed.

In the past two years, the Senate has twice passed a comprehensive energy
bill that included a national renewable electricity standard. This standard
would
require major electric companies to increase sales of renewable electricity
by an average of 0.6 percent a year starting in 2005, reaching 10 percent by
2019. A recent study by the Union of Concerned Scientists (UCS) found that
by adopting the Senate standard – along with extending the PTC through
2006 – the US can meet a significant portion of its electricity needs
with renewable energy while generating substantial economic and environmental
benefits. 2

Under a 10 percent standard, the US would increase its total homegrown renewable
power to nearly 80,000 MW by 2020 – which would provide enough generation
to meet the needs of 57 million typical homes. While wind power would provide
most of the new development, bio-energy and geothermal would also make important
contributions. The new power generated by this development would be 3.4 times
as much as the new generation supported by state standards and funds (see Figure
2).

A national RES of 10 percent would stimulate significant economic benefits
through 2020, including:

  • $18 billion in new capital investment;3
  • $1.2 billion in new property tax revenues for local communities; and
  • $430 million in wind-power-related lease payments to farmers and rural
    landowners.

UCS also found that the Senate RES and tax credits would reduce long-run energy
costs to consumers. Increased competition from renewable energy would reduce
natural gas use for generating electricity, which in turn would lead to slightly
lower natural gas and electricity prices. As a result, total annual consumer
energy bills would be $8.3 billion or 1.5 percent lower in 2020. The present
value of total consumer savings would be $17.6 billion between 2002 and 2020.

In addition, increasing renewable energy use in the United States would help
reduce air pollution. Power plant carbon emissions would be reduced by approximately
38 MMT nationwide by 2020 with a national RES of 10 percent. Other pollutants
that harm human health would also be reduced, as would the damage to water
and land resulting from extraction, transport, and use of fossil fuels.

Congress has also introduced several bills over the past few years proposing
a national renewable electricity standard of 20 percent by 2020 or 2025. While
neither the Senate nor the House has yet supported a 20 percent RES, a UCS
study found that doubling the RES requirement is achievable and affordable,
and would substantially increase economic and environmental benefits.

For example, under a 20 percent standard, total renewable capacity would increase
to more than 170,000 MW by 2020. The new renewable generation supported by
this standard would be 3.3 times as much as the Senate-passed 10 percent RES
and tax credits, and 11.3 times as much as existing state standards and funds.

Between 2002 and 2020, a 20 percent national renewable standard would produce:

  • $80 billion in new capital investment;4
  • $5 billion in new property tax revenues for local communities;
  • $1.2 million in wind-power-related lease payments to farmers and rural
    landowners;
  • $4.5 billion in consumer energy bill savings; and
  • 150 MMT of annual carbon emission reductions by 2020.

Recent RES analyses by EIA have reached similar results, despite using pessimistic
renewable energy assumptions and low natural
gas prices. A 2002 EIA study showed that an RES of 10 percent by 2020 would
result in slightly lower electricity and natural gas prices, generating savings
for energy consumers of $13.2 billion through 2020.5 EIA also found that increasing
the standard to 20 percent
by 2020 would reduce natural gas prices enough to offset nearly all of a modest
4 percent increase in electricity prices, resulting in virtually no net cost
increase to consumers.6

A robust commitment to renewable energy in the US
can provide many economic, environmental, health, and security benefits. A
few states recognize this and have become clean energy leaders. But the bigger
picture is one of inaction and wasted opportunities. A strong national policy
with specific targets for making renewable energy a key element of the US electricity
system
is needed.

Endnotes

1 Deyette, J., S. Clemmer, and D. Donovan. 2003. “Plugging In Renewable
Energy: Grading the States.” Cambridge, Mass: Union of Concerned Scientists.
May. Online at www.ucsusa.org/clean_energy/ renewable_energy/page.cfm?pageID=1180.
2 Union of Concerned Scientists. 2002. “Renewing Where We Live:
A National Renewable Energy Standard Will Benefit America’s Economy.” Cambridge,
Mass: Union of Concerned Scientists. September.
Online at www.ucsusa.org/documents/National_Senate_RWWL__2003_ September_Update.pdf.
3 Results presented are in 2000 dollars. Cumulative results are in net present
value using an 8 percent real discount rate.
4 Results presented are in 1999 dollars. Cumulative results are in net present
value using a 5 percent real discount rate.
5 Energy Information Administration. 2002. “Impacts of a 10 Percent Renewable
Portfolio Standard.” SR/OIAF/2002-03. February. Online at www.eia.doe.gov/oiaf/servicerpt/rps/pdf/sroiaf(2002)03.pdf.
6 Energy Information Administration. 2001. “Analysis of Strategies for
Reducing Multiple Emissions from Electric Power Plants: Sulfur Dioxide, Nitrogen
Oxides, Carbon Dioxide, and Mercury and a Renewable Portfolio Standard.” SR/OIAF/2001-03.
June. Online at www.eia.doe.gov/ oiaf/servicerpt/epp/pdf/sroiaf(2001)03.pdf.

Gas Markets in the New World Order

Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.

Gas Markets in the New World Order

Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.

Open Letter to California”s Governor

Dear Gov. Schwarzenegger:

As academics and former government officials with a broad understanding
of energy and regulatory issues, we followed with interest your discussion
of
these concerns during your campaign. We would
like to take this opportunity to share some thoughts to help your new administration
address California’s energy future. We therefore offer this open letter
for your consideration.

By way of background, we were among a larger group of industry experts who
authored two manifestos on the California electricity crisis. The first, written
at the height of the crisis in January 2001, spelled out timely, workable remedies
that were largely ignored by those in authority, to California’s detriment.
The second, drafted two years later, suggested reforms to move ahead from the
aftermath
of the crisis in a positive manner. We draw from each of these, and from intervening
developments, in framing our advice to you. We also note that our suggestions
are consistent with many of the specific recommendations that were offered
in your energy policy agenda during the campaign.

Here are the energy policy priorities we recommend:

Complete the Recovery

From a short-term supply adequacy perspective, the crisis has been over for
some time. As a longer-term institutional and financial matter, this is not
the case, and significant challenges persist.

As of this writing, the state Public Utilities Commission (PUC) has approved
a settlement in the PG&E bankruptcy that would repay creditors and re-establish
a viable utility under California jurisdiction. Southern California Edison,
operating under an approved recovery settlement, is laboring to become fully
credit-worthy as its finances gradually improve. The high-cost, long-term
electricity contracts (signed by the state against our advice at
the height of the crisis) have been alleviated slightly by renegotiation
and slightly more by mandated refunds. However, the contracts are still expensive,
and California advocates continue to press federal authorities for further
relief. In short, the financial fallout has persisted long past the turmoil
that created it.

This fallout has had its own consequences, particularly in impeding
the ability of major utilities and independent power generators to invest
in California. Litigation and financial uncertainty discourages investment
in
our state.
A stable climate is a necessary base for the new policies and initiatives
that can take us forward from here.

Therefore, completing the recovery from the crisis should be the first,
necessary energy policy objective for your administration. This includes
the successful
implementation of the two major utility recovery plans, along with a recognition
that the outstanding claims and litigation against power producers should
be settled soon, once and for all (realistic terms are inconsistent with
the large
sums some advocates have advanced). The benefits of just about any other
policy initiative can occur only when California’s energy markets are
again made attractive to investors.

Rationalize State Agencies

A related priority that stems in part from restructuring and the crisis
(but also has earlier roots) is the need to rationalize the state’s energy
bureaucracy, which has become fragmented, complex, and duplicative. Beyond
questions of cost and effectiveness, the current structure contributes to a
harmful ambiguity of policy that augments the risk associated with investing
in California’s energy infrastructure. At present, California has the
PUC, the California Energy Commission, the Oversight Board, the Independent
System Operator, the California Power Authority, and all the related agencies
and boards that can affect all energy infrastructure decision-making (such
as Cal EPA).

It is not clear, for example, which agency or agencies have the authority
over the approval of new electricity transmission lines. In theory, the ISO
determines
when new lines are needed, after which the PUC determines proper routes for
them, before the Federal Energy Regulatory Commission sets rates for their
use. But both the PUC and the ISO believe they are in charge of what new
lines are needed and have demonstrated their ability to disagree on specific
projects.
Analogous turf wars and policy conflicts have played out between California
energy agencies for decades, even before recent additions led to the roster
of departments we have now.

It is probably time for some agencies to be eliminated or consolidated. The
governor’s office itself can play a pivotal role in coordinating energy
projects if it so chooses, and such a role could be an important facilitator
in getting things done within the state bureaucracy.

Appointments Are Critical

The quality of regulatory oversight, and those who conduct it, can make or
break successful energy policy. Good regulatory policy starts with good appointees
who understand the importance of balanced regulatory outcomes that send the
right signals, and who are willing to challenge a highly regulatory status
quo, with continuing support from the governor and his staff. California
has more than enough rules, mandates, and threats. What’s needed is some
aggressive trimming of the regulatory underbrush to eliminate costly and
problematic requirements that are no longer needed or wanted.

Appointments to positions such as PUC commissioner are critical and require
a maturity of judgment and perspective that is not always easy to find in
prospective appointees. These selections merit the full attention and care
of the governor
and his senior staff.

Stand With Markets

For the production of energy, the market needs to win the great debate against
central planning. Contrary to some popular accounts, the problems of the
crisis did not stem from reliance on markets but from
a half-hearted and poorly executed market process.

The production of electricity is not a monopoly function. There is no good
reason why a particular firm (or the state, in its place) needs to own all
power plants. Costs will be lower and service more effective and innovative
if multiple producers compete to produce the electricity California needs.
The existence of wholesale electricity markets is also an irreversible fact
that is backed by many years of federal regulatory policy. Wholesale electricity
markets are here to stay regardless of California’s preferences.

Any sensible policy approach to electricity procurement is compatible with
competition for the production of electricity. Efforts to turn back the clock
to deny a role for market alternatives will only prove costly and counterproductive
to the people of California.

Seek Realistic Pricing

Most customers still pay for their electricity on a simple, cents-per-kilowatt-hour
basis through prices that are uniform during all times of day or all seasons
of the year. However, the cost and value of electricity varies widely over
the time of day and season. Electricity on a hot summer afternoon is a completely
different commodity than electricity
at midnight in winter. Yet both are priced the same. It is as if all restaurants
were required to charge a uniform price per pound for all food they serve,
no matter what its quality or cost.

There is an urgent need to move toward pricing electricity more closely with
its unique economic characteristics. Encouraging realistic pricing through
use of time-of-use meters and options for term pricing for utility service
are logical steps. Beyond using our resources more efficiently and effectively,
such pricing will also give consumers new opportunities (e.g., to control
their bills by using power at less costly times or to save money through
a longer-term
buying commitment). While it will take some time and investment to create
these opportunities, California should take advantage of new metering technologies
to let customers distinguish gourmet electricity usage from its fast-food
equivalent.

Further, the lack of realistic pricing can create unacceptable market
risks for utilities and suppliers in a direct-access environment, as
we saw all too regrettably in the electricity crisis. Therefore, realistic
electricity pricing will also permit California to consider potentially beneficial
market options, such as a core/noncore division of electricity consumers
to again open up direct access to competitive wholesale supplies for large
customers.

Alternatives Are Good, But …

Alternative energy sources have lately received new press coverage, spurred
in part by your campaign statements favoring such technology. California
has also embarked on an alternative fuels commitment for utility generation
that
will ultimately require a fifth of the state’s electricity to be so
generated.

Here, we need to sound a cautionary note. Alternative technologies have an
inherent appeal, and can appear to promise much. Some
new technologies succeed terrifically. But others never deliver on their
promise, especially to become affordable and economically viable as
a large-scale source of energy. The problem is public policy favoring alternatives
inevitably puts customers and/or taxpayers at risk when
the results fall short of the promise. If the technology fails (or even falls
short of the state of the art), then rates go up and taxes are higher.

Therefore, while we share everyone’s enthusiasm for innovative technologies,
we observe that the demand for such breakthroughs calls forth its own supply
of promoters seeking subsidy or governmental favor, just as it always has.
To protect the interests of the public will often require you, or your appointees,
to say no.

Don’t Forget Natural Gas

Natural gas remains a critical and attractive fuel, and one upon which
California has become highly dependent. The price and availability of
natural gas were
critical concerns at key points during the crisis. The environmental advantages
of natural gas over most other fuels remain important today, even as other
energy sources are sought through alternative technologies.

Although the price spikes of the crisis have passed, concerns about supply
constraints and cost volatility are genuine. Market prices have not returned
to the relatively benign levels that prevailed for years before the crisis.
California will always have to import most of the gas needed to sustain
current consumption levels. It is time again to pay attention to this
infrastructure, and we encourage your administration to lead in promoting
new resource
development,
including facilities needed for California to take advantage of liquefied
natural gas.

In Closing

Gov. Schwarzenegger, you have an opportunity to move California past
the aftermath of the crisis and on to a new and productive course
of energy
policy. We wish
you well in that critical effort. We are delighted to have had this
opportunity to share our thoughts and recommendations with you on these
critically
important issues. We encourage you or your staff to contact us for
further specifics
of these proposals or any other assistance we might be able to offer
to your new administration.

Gas Markets in the New World Order

Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.

Gas Markets in the New World Order

Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.