The Issue: Do Utilities Need Online Trading Exchanges Now?

Energy-related trading exchanges are emerging daily, presenting
a bewildering array of options to each company in the value
chain. However, few of them are fully operational, which only
adds to the uncertainty. The Chief Information Officer (CIO)
must navigate this new realm, keeping the following in mind:

• Should you participate in an exchange? If so, which and
  how many?

• Should you invest in an exchange? How can you tell which
  exchanges will be successful?

• Do trading exchanges create an opportunity to fully outsource
  some business processes?

• How do you manage user desktops to access and integrate
  with trading exchanges?

Trading exchanges are poised to become a major force in your
business. Companies that effectively use the exchanges have
the opportunity to reduce costs and respond to the market
faster. For unregulated entities, this is an opportunity to
gain market share; regulated entities can reduce costs and
improve margins.

Conclusions: Online Trading Exchanges will Change Utility
Business Relationships

Figure 1 shows the pieces of a once vertically integrated
utilities industry, which is now separated to foster competition
under deregulation. Online trading exchanges fit neatly between
the pieces to form a network that relinks the operating companies
electronically. Exchanges can accomplish much to:

• Create an efficient market capable of handling a 10-fold
  to 100-fold increase in transaction volumes with the same
  people and more price transparency

• Extend the scope of each participant as the industry
  consolidates and becomes global, including both geographic
  coverage and the convergence of utility services, such
  as gas and electricity

• Become an electronic conduit to connect business processes
  that now require a many-to-many connection between corporate
  entities.

This natural opportunity will be exploited: it is just not
clear whom the winners and losers will be. Utility companies
must get involved early in the game or their competitors will
reap the rewards:

• Trading exchanges provide opportunities to reconnect
  utility business units unbundled by deregulation, expanding
  the connections from one-to-one to many-to-many.

• Value-added services are required for trading exchange
  success.

• Online trading exchanges for fuel and energy are the
  most established because of the history of brick-and-mortar
  exchanges in commodity markets.

• Procurement of assets/services is a major opportunity
  to reduce supply chain costs.

• Exchanges will accelerate the shift to virtual companies
  through the outsourcing of services.

Exchange technology will create new data services companies,
centralizing data-intensive tasks that would otherwise be
replicated by each market participant.

Energy marketers will co-brand retail trading exchanges rather
than develop their own technology. Homogeneity of the industry
will drive fast consolidation of competing exchanges.

Figure 1
Utilities Trading Exchange Universe
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Recommendations

Establish clear objectives for your participation in any
exchange. Your participation and/or investment in an exchange
should be focused on business benefits from a more efficient
market, not on market power. Reduction of transaction costs
for all parties is critical for success.

Explore and participate in emerging exchanges while they
are still in their infancy. You must learn how to use them
and how to change your business processes to reap the full
benefit. There is no reason to commit to only one exchange
in a category until your volume increases to the point where
it is your dominant style of business or the exchanges begin
to consolidate. Get involved in consortia if possible. It
strengthens their position and gives you an inside look at
how they are developing.

Be agile and ready to change your plans. View your participation
in exchanges as a portfolio requiring constant attention as
the market changes. Increase and decrease participation in
specific exchanges as you better understand your needs and
particular exchanges start winning the race for liquidity.

Plan for the inevitable consolidation if you decide to launch
your own private trading exchange. It will happen quickly,
perhaps even before any of the exchanges is fully up and running.

Look for opportunities to extend the outsourcing of services
and to further restructure through the exchanges. This model
is used in the telecommunications industry, and it will soon
move to energy.

Develop plans for integration simultaneously with your back-end
systems as your participation increases and the exchanges
evolve. You should plot an interception course in the future
when the exchanges are mature enough and your system replacements
are far enough along that the value of integration exceeds
its cost.

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Detailed Analysis: Trading Exchanges Provide Opportunities
to Reconnect Utility Business Units that were Unbundled by
Deregulation

More Communication is Required Under Deregulation

As vertically integrated companies before deregulation, utility
companies had one-to-one internal communications and business
processes to connect the value chain. Then came deregulation,
which is intended to create open markets at several steps
in this value chain and requires the following:

• New company-to-company communications between the unbundled
  groups and new market participants, including retailers,
  large end-users, and new suppliers

• Many-to-many interactions at each step, as the local
  distribution company must coordinate delivery under hundreds
  of agreements among users and suppliers

• Increased total number of interactions between participants
  both because of the number of participants and the increase
  in risk management trading

If you continue to use manual processes, the administrative
staff needed could cost more than the savings from market
efficiency under deregulation. AMR Research has surveyed the
market interest in a more automated approach, and we find
that Internet-based trading exchanges are arising at each
of these natural markets (see Figure 1).

Exchanges Focus on a Particular Business Process

There are four major types of exchanges, each delivering
a basic business need. The vast majority of the exchanges
are sticking to one type of business thus far, but this could
change as the market consolidates. (See Figure 2.)

New exchanges are announced every day, often to counter a
competitor’s announcement the previous day. Our experience
in other markets indicates that over a relatively short time,
some will fall by the wayside while others will consolidate.

Figure 2
Business Models for Trading Exchanges

Value-Added Services are Required for Trading Exchange Success

As users of trading exchanges become more sophisticated,
the simple websites of the past are no longer enough to generate
fees and high valuations. AMR Research tracks hundreds of
exchanges in all industries and sees the depth of services
provided around the basic trading as necessary for the long-term
success of an exchange.

Content, Community, Commerce, and Connectivity

The value of an exchange to the user depends on the services
offered by the exchange. As illustrated in Figure 3, the value
rises quickly with the level of services. More mature exchanges
have moved up the curve through the following steps:

• Basic content starts a site off in the information stage.
  All exchanges provide this, but those that are only content
  providers, such as Energycentral.com, are operating on
  a publishing model, with subscriptions and advertising
  as the primary revenue.

• Getting site visitors to communicate with each other
  builds a community. The exchange doesn’t actually complete
  transactions, but facilitates them by bringing buyer and
  seller together through bulletin boards, postings, Request
  for Quotations (RFQs), and auctions. Some are attempting
  to show market pricing, such as bid and ask prices, but
  unless the exchange takes a role in the transaction, knowing
  whether and when the deal was actually consummated is
  difficult.

• The value of an exchange starts to rise quickly when
  it becomes a real vehicle for commerce in the market.
  By providing services to complete, clear, and settle the
  transaction, the exchange reduces the costs for all participants.
  In addition, the exchange can provide services related
  to the transaction, such as credit verification, arranging
  transportation, and tracking the status of the order.
  In some cases, the exchange may utilize existing Electronic
  Data Interchange (EDI) services, saving each participant
  from setting them up. Time saved on these tasks can now
  be applied to increasing the velocity of transactions
  with the same staff.

• Eventually, the exchange needs to direct connectivity
  to the business. This integration step can be both necessary
  and expensive (see The Report on E-Business Infrastructure,
  May 2000, “Integration – For Trading Exchange Survivors
  Only” for more details). The bookkeeping of the transactions
  automatically flows, further reducing the time and costs.
  More importantly, integration can extend workflow for
  business processes beyond a single company, tying together
  the sequence of events necessary for the transaction to
  be completed by all sides. Other trading exchanges providing
  services to support the transaction can also be electronically
  involved.

Figure 3
Value of Trading Exchanges to Participants

Online Trading Exchanges for Fuel and Energy are the Most
Established

The commodity markets for fuel and energy are ripe for Internet
exchanges, as the concept of each and Over- the-Counter (OTC)
trading are well established there. Figure 4 shows commodity
exchanges as the most numerous and mature type.

Figure 4
Types and Maturity of Selected Utility Exchanges

Early Success Spawns Competitive Announcements

The success of early commodity ITEs, such as Altra Energy
and HoustonStreet Exchange, Inc. (Portsmouth, NH), has finally
attracted the attention of the masses. Or was it Enron Corporation’s
(Houston, TX) high-profile launch of the Enrononline PTE?
The other large energy companies suddenly realized that these
operations were building enough liquidity to threaten their
position in the market. They didn’t want to pay fees to an
independent or cede market share to a competitor.

New Players Target More Participants or Different Commodities

With much of the market still handled by phone and fax, new
entrants still see an opportunity to differentiate themselves:

• Unlike some exchanges that only admit principals to the
  deal, True Quote LLC’s (Louisville, KY) exchange is also
  appealing to brokers.

• RedMeteor.com (Sugar Land, TX) plans to also trade crude
  oil and add analytical value to market information and
  news feeds.

• eSpeed, Inc. (New York, NY) is entering the commodities
  market after successfully launching a securities and financial
  instrument trading exchange.

• New York Mercantile Exchange (NYMEX – New York, NY) recently
  announced eNYMEX, which will leverage the NYMEX trading
  infrastructure.

• Specialty marketplaces, such as the KEFI-Exchange, Inc.
  (Calgary, AB), are popping up to trade emissions credits.
  These markets may be limited by rules, such as those New
  York State is considering to restrict New York utility
  companies from selling credits to neighboring states.

Services for Completing the Deal will Separate the Winners
and Losers

Merely facilitating deals that must be closed offline on
paper will not cut it in the future. Exchanges must reduce
the cost of doing business in order to earn fees. AMR Research
sees several important services that will be demanded of exchanges:

• They must provide settlement services and the coordination
  of transportation for physical commodities. These tasks
  take considerable time and effort for the trading companies,
  and there is value in automating them.

• They must provide integration to mid-office and back-office
  systems at the trading company. Trading exchanges will
  increase the volume of trades, but companies will not
  want to scale staffs proportionally.

Level of Fees is Driving Consortium Trading Exchanges

The largest user companies are realizing that exchanges may
become a major factor, and that ITEs and PTEs are threatening
to control parts of their market and extract substantial fees.
Fees are a sensitive issue: no one wants to raise the cost
of doing business.

Some naive exchanges that started in the surplus equipment
market are asking for fees that are an order of magnitude
higher than typical broker fees. As one trader told us, “I’m
going to do an auction on eBay to see who will give me the
lowest pricing structure!”

The response is to create CTEs and get in on the action.
The group of six trading subsidiaries – American Electric
Power (AEP), Aquila (Utilicorp), Duke Energy, El Paso Energy,
Reliant Energy, and Southern Company – is an example of this
trend.

Motivation is a key issue for those starting exchanges. While
ITEs must justify the cost of startup with returns to investors,
CTEs have different needs. To companies that trade billions
in commodities every month, the few million to start an exchange
is less material. They benefit far more from more liquid markets
and lower costs enabled by the exchange.

Growth of Volume is Tied to the Emergence of the Deregulated
Market

The commodity markets are tied to the success of deregulation.
If strong market competition emerges, companies will turn
more to trading to manage their risk and make additional profits.
Low-fee exchanges are a prerequisite for volume trading, but
a more dynamic energy market is required.

Procurement of Assets and Services is a Major Opportunity
to Reduce Supply Chain Costs

AMR Research estimates that utility companies spend over
$40 billion on goods alone each year in the United States.
While utility companies each have their own design specifications,
they buy essentially the same or similar components from the
same suppliers. Both buyers and sellers are consolidating,
creating the potential for optimizing this enormous supply
chain. Companies must make sure, however, that they look for
cost reductions in the right places when joining procurement
exchanges.

Supply Chain Services are More Important than Unit Cost
Reductions

The simplistic view is that if buyers aggregate their purchases,
they can squeeze the supplier for a lower price. In reality,
the margins can’t support it. The automotive industry has
also toned down such talk after the Federal Trade Commission
took interest in the potential abuse of market power.

The real opportunity is to reduce the supply chain costs
of both the buyers and sellers – a win-win proposition. A
trading exchange can aggregate demand, helping manufacturers
plan better. It can also shorten delivery cycles and redirect
product to reduce the inventory needs of both sides. Finally,
it can simplify commercial interactions for purchasing and
delivery, eliminating paperwork and costs.

Catalog and Part Numbering will be a Major Hurdle

The major hurdle to exchange efficiency is mapping utility
part numbers to common industry or vendor part numbers. Even
without exchanges, this process will be a major expense as
utility companies merge. Each company, and even each district
in a single company, may use different part numbers for the
same item. Other industries, such as Electronics, have tackled
this problem by using Component Supplier Management (CSM)
software. There is an opportunity for the exchanges to provide
this normalization as part of their value-added services,
saving the utility company from the upfront cost of buying
and implementing CSM applications.

Managing Construction is a Sleeper Opportunity

Much of the utility infrastructure is constructed and overhauled
under competitive contract rather than by utility employees.
A hidden cost of this work is the bidding and contract management
process, which requires communicating and negotiating based
on technical design documents, such as plans and specifications,
and ongoing project status tracking.

The General Construction industry has started turning to
the Web to speed up these communications. For example, at
the low end of the spectrum, sites from vendors like Buzzsaw.com,
Inc. (San Francisco, CA) offer collaboration areas for posting
and negotiating RFQs and working through contract issues as
they arise. More substantial efforts are underway from large
project management software vendors, such as Primavera Systems,
Inc. (Bala Cynwyd, PA), which recently established partnerships
with Bentley Systems, Inc.’s (Exton, PA) VIECON.com and PSDI’s
(Bedford, MA) MRO.com, to tie together project management
and purchasing. This eliminates the physical paper duplication
and express delivery charges, thereby shortening the turnaround
time for all involved.

Consortium Trading Exchanges may Overcome Supplier Reluctance
to Participate

Suppliers are not anxious to give up margin or direct contact
with their customers to ITEs. The ITEs are seen as an additional
middleman, and both buyers and sellers are unwilling pay high
(less than 1 percent) fees for the privilege of continuing
longstanding business relationships.

As with commodities, consortia of large buyers can create
lower-fee exchanges, where the savings to each side by centralizing
supply chain services make both willing to participate. The
original PTEs in the automotive industry quickly became a
consortium as major Original Equipment Manufacturers (OEMs)
joined their exchange plans together.

Exchanges will Accelerate the Shift to Virtual Companies
through the Outsourcing of Services

Utility companies need to look to future business models
when replacing their internal systems and hooking up to exchanges.
A key place to look is the use of third-party contract crews
for both routine and emergency maintenance. This is already
common for some procedures, such as tree work, but it could
become far more prevalent as regulated local distribution
companies spin out some departments to reduce costs and become
more profitable. To do this, several capabilities will be
required:

• An exchange listing for each work item, including equipment
  and skills required – CES International, Inc. (Minneapolis,
  MN) has been demonstrating the use of the Internet to
  trade emergency crews as part of its MyCentricity product,
  scheduled for release in 4th quarter 2000.

• A means of exchanging technical information about the
  assets-Ideally, all crews will be able to participate
  with mobile computing platforms to directly view Geographic
  Information System (GIS) data and report work completed.

Business integration of this type has already emerged in
the telecommunications industry. For example, Figure 5 shows
how a virtual organization has been created to support the
emerging Digital Subscriber Line (DSL) market using Vitria
Technology, Inc.’s (Sunnyvale, CA) Businessware for DSL product.
While the customer is on the phone with the Internet Service
Provider (ISP), provisioning is arranged through electronic
contact with one or more DSL providers, which must check with
the local exchange (ILEC) to see what level of service can
be promised. In addition, arrangements must be made for a
customer premises equipment provider to deliver and install
the necessary equipment. Some of these interactions may require
contacting multiple competing service providers to find the
best price and availability of technicians. ESP Utility.com
is adopting this technology to automate connections with its
partners.

Figure 5
Virtual Organization for DSL Service in Telecommunications

Exchange Technology will Create New Data Services Companies

When utility companies were monopolies, providing all services
to a customer in a geographic area, data about customers and
the market could be centralized in the company’s computers.
In a deregulated market, every participant needs the data
on their customers. In addition, most jurisdictions have rules
on sharing the data on customers that are considering changing
suppliers.

Core Data Services Technology Used Today for Operations
and Marketing

Some organization, usually the local distribution company,
is currently responsible for settlement and billing. Applications
from vendors such as LODESTAR Corporation (Peabody, MA) take
actual usage data and conditions to profile individual loads
and calculate actual energy usage for settlement. This same
information is also used to provide value-added services to
customers via utility or independent Websites, such as from
Energy Interactive, Inc. (Oakland, CA).

Centralizing Data Services Eliminates Redundant Operations
and Provides Security

When more than one participant needs to assemble this data
and analyze it, there is an obvious duplication of effort,
software, and staff. As more participants enter the market,
it would be more efficient for them to acquire the processed
data as a service rather than build the capability and data
connections in-house. This need will only intensify as more
service locations add interval metering for multiple utility
services.

Emerging New Organizations could Take On this Role

The biggest unknown is who will end up providing these services.
Potential providers include the following:

• Local distribution companies have made some moves here,
  including the recent contract announced by Logica, Inc.
  (Lexington, MA), which will develop a market data system
  for AEP in its Ohio and Virginia territories.

• Independent System Operators (ISOs) need the information
  for market settlement and would be a logical participant.

• Meter data management companies, such as Invensys Measurement
  Services (IMServ – Raleigh, NC), have been established
  in some jurisdictions.

As markets become more competitive, the neutrality of the
party providing these services will become important. An ITE
is a natural location organizationally. It is also technically
ideal, because all participants can access it relatively inexpensively,
eliminating the need for new EDI services for the new participants.

Energy Marketers will Co-Brand Retail Trading Exchanges
Rather than Develop their own Technology

While the retail opportunity for energy and related sales
has exploded, potential Internet-based marketers, including
the traditional energy companies, face an expensive technological
challenge to put up a site. Early movers in this space, including
Excelergy Corporation’s (Lexington, MA) E-Choicenet, energyguide.com,
and Enermetrix.com (Maynard, MA), are taking a different tack,
providing exchange services to the marketers. Though their
functionality is quite different, each has pursued cobranding
and private labeling agreements with marketers needing the
functionality and content of their sites. The marketer can
embed the capability in its own site and tailor the content
for the desired service area. We expect this type of cobranding
service to dominate the market as service providers try to
move their routine contacts with customers to the Internet.

Homogeneity of the Industry will Drive Fast Consolidation
of Competing Exchanges

The energy industry is a natural place for trading exchanges.
While each utility company may have its own unique way of
doing business, the technical problem of delivering energy
is highly standardized. This commonality should accelerate
consolidation of the dozens of trading exchanges popping up
in the Energy industry.

The first steps of consolidation have already begun, following
a pattern AMR Research has seen in other industries, such
as chemicals and automotive. This consolidation starts even
before all the announced exchanges are up and running. The
emergence of CTEs means everyone now recognizes that exchanges
will be a force in the market. Too many exchanges run up costs,
so market consolidation is inevitable. The big question is
which ITEs have the financial reserves to hold out for a good
deal.

Consortia are Fragile and Subject to Internal and External
Attack

As nominal competitors, the consortia members need to figure
out how to work together. Many forces will conspire to break
them apart, including the following:

• Abuse of market power in either trading or procurement
  will drive away participants and attract government regulators.
  The Federal Trade Commission is closely watching large
  consortia, including the automotive trading exchange COVISINT.

• Excessive fees or unrealistic expectations of return
  from the investment in the exchange will limit growth.
  Consortia members may profit from future equity sales
  of exchange ownership, but they must keep their primary
  goal – cost reduction and liquidity – in mind.

CTEs Need to Behave like ITEs to be Successful

CTEs will be most successful if the consortia members separate
their ownership interests from their trading interests. To
attract traders from outside the consortia to the exchange,
the operation must go to great lengths to be independent and
treat all parties identically. To reap the benefits of lower
costs through the exchange, their goal should be to keep costs
low for everyone and attract traders. Attempts to exert control
over daily trading will only help competing exchanges.

CTEs and Existing ITEs will End Up Working Together

The consortia have been announced, but they need to build
the exchange platform to launch. AMR Research expects that
most consortia will end up teaming with operating ITEs, a
marriage of liquidity and technology. ITEs must evaluate these
offers carefully. While such an action might seem like selling
out, it may be the best way to ensure their exchange is still
standing at the end of the consolidation phase of the market.
The operating ITEs must be wary of well-funded new entrants,
such as eSpeed and the New York Mercantile Exchange.