Although we can be certain that significant changes are coming to the
energy marketplace, the crystal ball is cloudy as to the nature and the
timing of the changes. The best we can do is to understand what is happening
today, assess the near-term impact of the digital marketplace, and then
infer what it means over the long term. This white paper will focus on
these issues in energy markets where e-trading has already been adopted
by a significant number of companies: electric power, natural gas, and
natural gas liquids.

What Is Happening Today?

While the digital marketplace is growing rapidly across a broad range
of energy commodities, the rate of adoption is uneven, reflecting the
fragmented nature of the energy business itself. In the natural gas liquids
market where propane, butane, and related products are traded for heating
and chemical feedstock uses, e-trading dominates the spot market, with
almost 50 percent of transactions already online. Penetration of e-trading
in the natural gas market has escalated rapidly over the past year, with
hundreds of digital natural gas transactions consummated each day. There
is a robust natural gas e-trading market for delivery of the physical
commodity in the next-day to next-month timeframe, and a growing e-market
for for OTC (over-the-counter) derivatives. Although the immaturity of
the spot market for electric power has hindered the rapid development
of e-trading, still millions of megawatts are traded online each day.

Altra, Bloomberg, HoustonStreet, EnronOnline, and others are competing
aggressively for a share of the digital power market, alongside several
next-hour and next-day power exchanges.

Across each segment of the energy marketplace, all signs point to an
increasing rate of e-trading adoption. Almost every energy trader has
one or more of these systems on his or her desktop. Major industry players
are investing in e-markets and joining coalitions formed to address the
e-commerce opportunity. Clearly, the “screen” is becoming the market for
energy commodities. E-trading is becoming so integral to the energy marketplace
that the trading systems are becoming inseparable from the market functions

As the energy market moves online, much more is happening than simply
replacing a phone and fax with a computer and an Internet connection.
Conducting transactions online transforms the dynamics of the marketplace.
In the near term, e-trading changes how transactions are conducted. These
First Order changes include: how pricing information is disseminated,
how transactions are consummated, and how transaction processes are administered.
In the longer term, Second Order changes have the potential to drive a
fundamental reshaping of the energy marketplace, involving the nature
of the spot market, financial structures for handling counterparty credit,
and ultimately the competitive position of every participant in the energy

First Order Changes

First Order changes resulting from the transition to e-trading are visible
today. A critical mass of spot market transactions in natural gas liquids
and some sectors of the natural gas market have moved online, impacting
price transparency, trade execution, and transaction administrative processes.

Price Transparency

The most obvious impact of e-trading is price transparency. By aggregating
a critical mass of transactions into a liquid marketplace, an e-trading
system can reflect market prices in real time. This does at least four
things for buyers and sellers of energy. First, it is no longer necessary
to make a series of telephone calls to assess the market. When the best
market prices are on the screen, price discovery is more efficient, and
more reliable.

Second, reducing dependence on broker and marketmaker telephone calls
increases the demands on these players to provide more value-added services.
Third, by increasing price transparency, bid-ask spreads will narrow.
Price spreads on simple transactions in liquid markets will approach zero.
Fourth, improved price transparency builds confidence in the spot market,
as well as the ability to conduct spot transactions. This will tend to
increase spot market activity.

Fast, Anonymous Trade Execution

Electronic execution of transactions is fast and efficient, which is
critically important when energy prices are moving quickly. Multiple phone
calls can be replaced by a few keystrokes, which triggers the instantaneous
dissemination of a buy or sell offer to thousands of potential trading
partners. Documentation and confirmation are automatic and immediate.
Additionally, most e-trading systems are designed to support anonymous
trading, giving companies the ability to execute transactions without
“showing their hand.” In a phone-based spot market, information gleaned
from multiple phone calls by market participants can have a significant
impact on prices. For example, if a big chemical company or generator
enters the phone/fax market, the information spreads quickly and prices
move accordingly. Most e-trading systems address this issue by providing
an anonymous marketplace in which parties do not know the identity of
their trading partner until after the buyer and seller have been matched.
In some systems, the e-trading system operator participates in credit,
delivery, and payment processes, maintaining full anonymity throughout
the transaction.

Fast, anonymous execution impacts energy buyers and sellers in three
ways. First, it increases the number of transactions that any one individual
can handle. Faster execution translates to more effective utilization
of market decision-makers. Second, fast execution puts a premium on real-time
market information. Fast decisions must be based on the best available
information at a point in time, delivered in a usable format to the decision-maker.
Third, the nature of electronic transactions influences the tactics that
market participants use to implement marketing, purchasing, and trading
strategies. While anonymous e-trades shield the identity of market participants,
pricing information is widely disseminated to all market participants.
Companies must consider issues such as (a) whether to post new offers,
or to “hit” offers posted by others, (b) how to break up large trades
to mask trading strategies, and (c) whether to conduct business at points
with the greatest e-trading liquidity, or points with the best location-adjusted

Transaction Administrative Processes

Administrative processes used by companies to manage energy transactions
are notoriously inefficient. Processes for scheduling energy flows, managing
energy risk, and financially settling transactions have been designed
around traditional phone/fax-based trading, requiring manual deal capture
and after-the-fact credit checks. E-trading gives companies the opportunity
to redesign these processes in ways that can reduce transaction costs
and minimize clerical errors. Straight-through processing can electronically
pass trade information from an e-trading platform directly into mid-office
and back-office systems. Such systems can utilize real-time electronic
price delivery to constantly update price curves and position reports.
In addition, e-trading can provide mechanisms for companies to manage
credit and counterparty exposure in real time, as transactions are executed.

These First Order changes are only now beginning to work through the
marketplace. Today, most energy trades are still completed the old-fashioned
way – by phone and fax. Thus the greatest impact of improved price transparency,
faster execution, and more efficient administrative processes is yet to
come. It is likely that significant market shifts will not surface until
a majority of energy transactions (above 50%) move online. At that point,
“screen” prices will be consistently viewed as the market, and the phone
market will be viewed as a secondary source of information. Fast, efficient
electronic trade execution will become the only cost-effective way of
participating in the market. Transaction processes will be redesigned
around electronic transaction data flows, taking maximum advantage of
straight-through processing. As the market fully absorbs First Order changes,
the stage is being set for the real revolution.

Second Order Changes

Second Order Changes have the potential to literally reshape the energy
marketplace – not just how energy is trading, but why, how often, and
by whom. Second Order changes involve the nature of the spot market, financial
structures for handling counterparty credit, and ultimately the competitive
position of every participant in the energy marketplace.

Nature of the Spot Market

Today’s energy spot market has developed around phone/fax based transactions.
As the majority of transactions migrate to an electronic format, the very
nature of the spot market will change.

The velocity of market trading will increase

Even in today’s energy spot market, the physical commodity typically
goes through several transactions from the point of production to the
point of consumption. The OTC derivative market also adds significantly
to the velocity factor of energy trading, which can be defined as “the
number of transactions per unit of energy in a given market.” Because
it is easier, faster, and cheaper to execute transactions in the digital
marketplace, market players will execute more transactions. This does
not imply an inefficient marketplace with middlemen taking a slice of
the value chain. To the contrary, the increased velocity will improve
the liquidity and the reliability of the spot market. Market liquidity
will ensure that the right products are consistently available in the
marketplace at prices that truly reflect supply/demand conditions.

Energy products will tend to standardize

E-trading encourages (or requires) the standardization of delivery rules,
contract terms, counterparty prequalification policies, default procedures,
and other parameters that describe energy products. This standardization
facilitates the transaction management process and makes it easier to
compare prices across a large number of transactions. The e-trading market
tends to focus on standardized products and to price unique product offerings
as differentials to the standard. This standardization will bring further
efficiency and transparency to the marketplace and will tend to cluster
trading activity around hubs of concentrated liquidity.

The value of traditional relationship-based spot market trading will

Where standardized products are traded in any anonymous, electronic market,
price will drive the transactions. Where unique energy products are sold
and purchased at specific locations, relationships will continue to be
an important part of the transaction process.

Energy companies will rely on the spot market for a greater percentage
of their total market activity. As the e-trading makes spot transactions
easier, cheaper and more reliable, energy companies will shift a greater
portion of their portfolios to more flexible, shorter-term electronic

Credit Structures

Traditional energy markets expose companies to counterparty risks that
include both performance on unsettled contractual obligations and financial
payment for completed transactions. Today these risks are managed via
a complex and inefficient mix of parental guarantees, letters of credit,
and cash security extended from one trading firm to each of its counterparties.
This bilateral approach to credit has evolved around the phone/fax market
where there is no central repository of transactions across multiple companies.

The transition of a critical mass of transactions to the e-trading environment
creates the opportunity for a centralized clearing organization that would
stand as a single, neutral counterparty to every transaction, guaranteeing
physical performance and financial payment to both buyers and sellers.
Rather than posting guarantees and other collateral to cover individual
exposures to each counterparty, each market participant would instead
post a single guarantee to the clearing organization to cover its net
exposure as both a buyer and a seller across all of its counterparties.
This would create value by (1) reducing the financial and economic costs
to the trading firm of managing bilateral credit relationships, (2) eliminating
the need for individual company credit checks, leading to faster, more
liquid trading, and (3) expanding each firm’s transactional capacity,
enabling increases in transaction volumes without increases in the risk
capital required to support market activities.

There are many different organizations, which could serve as centralized
clearing facilities for the energy industry, and a number of proposals
are already being actively promoted. The ultimate impact on the industry
will depend on the criteria for membership, the structure of the organization,
and the processes that are used to clear transactions.

Competitive Positioning

As First Order changes become ingrained and Second Order changes emerge,
the competitive position of every participant in the energy marketplace
will be affected.

To a much greater degree than today, market participants will gravitate
to the role of price maker, or price taker. Price makers will have the
scale and systems to actively trade the digital marketplace, capturing
trading opportunities and arbitraging price differentials. Price takers
will transact business around energy operations and assets, using the
digital market to build flexibility into supply portfolios. Price makers
will drive e-market liquidity by actively posting offers to buy and sell
across a number of energy products and markets, while price takers will
tend to accept transactions posted by others and concentrate on energy
products that support asset-based strategies. Market participants must
decide which role is right for their company, and they must then organize
around that decision. In the digital marketplace, there will be little
tolerance for an in-between strategy.

The standardization and interconnection inherent in e-trading enable
a new approach to the design of energy transaction processes. No longer
will it be necessary for individual companies to manage all of their internal
business processes on their own. Processes can logically migrate to a
many-to-many platform – either hosted by, or interconnected with, one
or more digital markets. These processes will utilize the Web to handle
tasks such as managing price risk, deal confirmation, energy scheduling,
and administration of other settlement processes. In the past, this functionality
would be handled with internal software applications. But increasingly,
the functionality will be delivered over the Web as a service, provided
by digital exchanges or other Web-based companies. Market participants
that embrace this new approach to transaction processes will ultimately
realize a significant cost advantage compared to companies using in-house
systems designed for phone/fax based trading.

The importance of scale and information systems to successful participation
in the digital energy market will likely drive further consolidation in
the energy industry. Companies will focus on strategies designed to maximize
the benefits of e-trading. Large trading companies will continue to increase
the scope of their operations and the level of automation in their processes.
Asset-based companies will use the digital marketplace as a lever to reduce
transaction cost and build flexibility into their portfolios. All companies
must build scale to develop and maintain these technologies, or they must
make the decision to outsource e-trading support technologies to others.


The digital energy marketplace is not simply a new set of tools for conducting
transactions. It is driving a restructuring of the market around a new
way of doing business. The impact can already be seen in increased price
transparency and faster trade execution. The anonymity of electronic trades
is giving companies the ability to execute transactions without showing
their hand. And many companies are reducing their transaction costs by
integrating electronic transactions directly into their mid-office and
back-office systems.

But this is just the beginning. As the majority of energy transactions
move online, a revolution will reshape the energy marketplace, encompassing
the nature of the spot market, credit structures, and the position of
every competitor in the market. This revolution gives rise to the “E-Market
Imperative”: Energy companies must transition their businesses from a
traditional view of energy transactions to a new, Web-based world, where
the entire market interacts in real time using processes, systems, and
trading strategies designed to meet the demands of the digital energy