The E-Market Imperative: Digital Transactions are Transforming the Energy Marketplace by Chris Trayhorn, Publisher of mThink Blue Book, November 15, 2000 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 themselves. 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 marketplace. 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 price. 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 diminish 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 transactions. 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. Conclusions 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 marketplace. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.