Electricity and Gas Markets Have Become More Complex

Energy industry deregulation is a relatively old story, though one that continues
to unfold with new themes. Over the past 20 years, a series of changes in federal
and state laws and regulations governing natural gas producers, pipelines, local
distribution companies and, more recently, electric utilities have changed the
structure of these industries dramatically. The goal underlying legislation
enacted by Congress and state legislatures, as well as the orders issued by
the Federal Energy Regulatory Commission and state Public Utilities Commissions
during this period, has been to open major segments of these industries to competition.
With the scope of their traditional monopolies and vertically integrated operations
significantly reduced, utilities serving retail customers have had to respond
rapidly to an entirely new business landscape. In fact, participants in each
segment of these restructured markets — supply, transmission and retail
— face pressure to adapt their business practices efficiently and transparently,
and to demonstrate compliance with federal and state regulations governing the
structure of these markets, in order to survive.

Restructuring of the gas industry has been underway much longer than restructuring
of the electric industry, and its impacts have been well documented. For example,
retail gas prices throughout the late 1980s and into the 1990s were well below
pre-restructuring levels. Marketers emerged to compete with investor- and municipality-owned
utilities in all retail market segments.1 Restructuring of the electric industry
is beginning to achieve the desired effect, with increased reliance on competition
from generation to retailing. Generation companies, power marketers and energy
service providers are taking advantage of the opportunities in the new competitive
arenas for electricity generation and marketing.

To date, the participants in these new competitive electric markets have focused
primarily on cost-cutting and risk management to ensure competitive capability
and to hedge against undue exposure. Their focus is now beginning to shift toward
experimenting with new market instruments, such as forward contracts, auctions,
optimized dynamic commerce systems, and bid/ask exchanges, which help ensure
optimal asset utilization and profitability within the parameters of free-market
competition.

Along with these changes, there has been a marked increase in public visibility
of the energy industry nationwide, sparked by news reports of power blackouts
and soaring energy prices in California and elsewhere. This growth in visibility
has been accompanied by an increase in regulatory scrutiny, putting pressure
on generators and gas producers to defend their pricing practices, and on local
distribution companies (LDCs) and utilities to defend their purchasing strategies
and practices.^2,3 As state and federal authorities
ponder further restructuring of the energy industry, companies can expect to
navigate the rapid changes in their industry under the glare of publicity for
some time to come.

Figure 1 – Natural gas consumption is projected to rise, driven primarily
by electricity generators. Source: Energy Information Administration (EIA)

These developments have had several major impacts on the operation of wholesale
markets, initially for natural gas and more recently for electricity.

• The restructuring of wholesale and retail markets has forced LDCs and
utilities to shift from relying on internal resources to relying on contracts
for their supplies. At the same time, restructuring has discouraged them from
entering multi-year contracts for those supplies. This change has been most
pronounced in gas markets, where LDCs have reduced their reliance on multi-year
contracts from more than 50 percent of their peak winter season supplies in
1996 to approximately 25 percent in 2000, with a corresponding increase in reliance
on short-term and monthly contracts.⁴ These
changes in supply strategies by buyers provide suppliers both an opportunity
and an incentive to optimize the value of their assets through active trading
in wholesale markets.

• The sensitivity of retail customers, regulators and politicians to dramatic
increases in prices has placed pressure on LDCs and utilities to purchase their
supplies in a manner that keeps prices both stable and competitive. That sensitivity
has also put pressure on suppliers to optimize the value of their assets, in
a way that is transparent and capable of withstanding regulatory review.
To compound the levels of complexity, energy players are participating in unprecedented
merger and acquisition activity, as all market participants jockey for position
to take advantage of the new business landscape. The entry of new power plants,
both scheduled and forecast, increases the likelihood of even higher levels
of competition in the future. Gas pipelines are facing the same prospect as
more capacity is brought on line and existing long-term contracts expire.

All of these pressures culminate in an unprecedented new challenge to energy
players to maximize asset utilization and minimize risk across all of their
operations.

The net result has not only been a fundamental shift toward reliance on short-term
markets but also a growing recognition that these markets are highly volatile
and unpredictable, further highlighting the importance of risk management when
making forward selling and purchasing decisions.

How Dynamic Trading and Auctions Can Help

Moving commercial transactions online can make energy transactions faster,
less expensive and less error-prone, and frees up high-value intellectual resources
for strategic decisions. Internet-based commerce technologies are seeing widespread
adoption throughout the industry, with e-commerce predicted to affect 20 percent
of the total energy business trade by 2004.⁵
To date, more than 120 energy exchanges — consisting of independent, company-sponsored
and consortia-driven enterprises, — have come online to trade both physical
and financial energy products. Although many early independent exchanges have
not survived the current economic downturn, they successfully raised awareness
of the capabilities and benefits of online trading technologies to Fortune 1000
companies. With the FERC backing Web-based trading through such directives as
Order 637, and with ERCOT mandating the use of auctions for the sale of electricity
generation capacity, Web-based commerce mechanisms are gaining widespread consideration
across the entire energy sector. In particular, many energy players are evaluating
Web-based dynamic trading technologies as a means to enhance their liquidity
and lock in better margins within fair market guidelines. They can do this by
utilizing an online marketplace for the sale of products such as natural gas,
pipeline transportation, and electricity in both spot and forward markets.

Web-based dynamic trading — which encompasses formats such as auctions
and bid/ask (stock-market like) exchanges — can help energy players respond
more rapidly to fast-changing markets while gathering the information needed
to cope with the increasingly challenging job of asset optimization. Because
the dynamic trading process automatically determines a product’s fair market
value, sellers can be assured of capturing the best price possible under virtually
all market conditions no matter how volatile. This automated process is significantly
more efficient and effective than cumbersome phone, fax, and electronic bulletin
board methods. It also helps mitigate the effects of changes in supply and demand,
since prices can adjust to these factors in real time. Web-based auctions and
exchanges can be designed and implemented to encourage open bidding in accordance
with federal, state and local regulations, thereby ensuring compliance through
automated rules and procedures. This helps energy players demonstrate their
compliance to the public at large. In short, Web-based dynamic trading provides
energy companies with a completely fair and public way to maximize their revenues
in practically every market circumstance.

Figure 2 – Web-based dynamic trading enables auctions for a range of energy
products, including electricity generation capacity. Here, an online multi-round
auction for capacity tracks demand, supply, bids, and bidding opening and closing
times for capacity sold in “blocks.”

See Larger Image

Web-based energy auctions and exchanges also have the potential to help allay
one of the most challenging aspects of deregulation and competition: the fragmented
nature of energy markets. By delivering access to the broadest possible range
of suppliers and buyers through convenient Internet marketplaces, Web-based
dynamic trading can enable generators, pipelines, marketers and utilities to
reach buyers who might have been otherwise difficult to reach, and to access
these buyers at very low cost. Further, because prices and other factors can
fluctuate according to buyers’ unique and sometimes unpredictable demands, Web-based
exchanges increase the chances of making a sale, even in volatile and fragmented
markets.

In addition to enhancing revenues, Web-based dynamic trading can cut costs significantly,
both by eliminating time-consuming manual processes and by enabling optimal
asset utilization. Leveraging the ease and instant communications of the Internet,
energy providers could conceivably establish and manage multiple auctions and
bid/ask exchanges for gas, pipeline capacity, or electricity supplies simultaneously.
They can use the real-time data generated by these markets to continually adjust
their plans for storage, transmission and delivery facilities.

Web-based dynamic trading generates the kind of information energy players need
the most: real-world feedback coming directly from buyers and suppliers in the
open market, created and delivered in real-time for quick analysis and action.
Data from dynamic Web auctions and exchanges enables companies to understand
their customers better and to respond to their requirements directly and rapidly.
This information can be leveraged to manage demand against supply through improved
demand forecasting, fostering better allocation decisions.

Some examples of Web-based dynamic trading applications in energy include sales
of:
• Interruptible pipeline capacity by pipeline operators to LDCs
• Natural gas storage capacity by storage operators
• Gas products by gas producers to their diversified customer base including
large industrial companies, intrastate pipelines and LDCs
• Parking and lending services by pipelines to LDCs and other natural gas
customers
• Excess released capacity by LDCs to marketers or other LDCs
• Electricity generation capacity by power companies to industrial buyers,
traders and utilities.

Along with these “sell-side” auction and exchange applications, Web-based dynamic
trading can be employed for the procurement of:
• Gas by LDCs from gas marketers, using “reverse auctions” with descending
price bids
• Electricity by utilities from generators, using reverse auctions with
descending price bids

Case Study: Multi-Round Auctions

One example of a Web-based dynamic trading application in the energy industry
is provided by a large energy company based in Texas. In 1999, the state’s PUC
mandated the use of multi-round auctions for the sale of electric generation
capacity. The mandate stems from the Texas Legislature:”Senate Bill 7 . . .
will change how the electrical energy industry operates in the state. The forces
of supply and demand will be allowed to produce a more efficient and innovative
industry, benefiting both customers and industry organizations.” — PUC
of Texas⁶

The first local power company to act on this directive chose Web-based dynamic
trading technology from @TheMoment based on the company’s ability to rapidly
establish the unique multi-round auction type and to deliver exceptional speed,
reliability and robustness.

Figure 3 – Buyers and sellers in an online exchange can view orders graphically
by reviewing bid and ask prices plotted on a radar-like screen, or they can
view them in the classic “order book” format.

In its simplest form, a multi-round auction begins with the supplier specifying
an ask price for which buyers of electric generation capacity bid a quantity
(the first round). At the end of the round, an evaluation of the balance of
supply and demand is conducted. If the supply is greater than the demand, then
the auction is over, and all bidders receive the quantity for which they have
bid. If demand is greater than supply, a new ask price will be proposed (the
price is established using complex algorithms), and a new round of bidding will
ensue.

Once deployed, the Web-based dynamic trading technology will enable additional
online trading applications such as Yankee, Dutch or Vickrey auctions and more
than 1,000 others, as well as bid/ask exchanges in which the generator can adjust
ask prices in real-time to respond to the market.

Fig. 4 Buyers and sellers in an online exchange can view orders graphically
by reviewing bid and ask prices plotted on a radar-like screen, or they can
view them in the classic “order book” format.

Choosing Dynamic Trading Technologies

Although many dynamic trading technologies offer promise, energy participants
would do well to review their options in this area with several key criteria
in mind. The ideal Web-based dynamic trading technology should be able to:

• Leverage the Web and streaming technologies to handle large volumes of
transactions in real time. This means the technology must be able to negotiate
multiple bids, locate the right bid at the right price, and close the deal in
minutes — or even seconds. This requires scalability to handle volume,
as well as reliability to ensure performance. The underlying technology must
be a robust, transaction-level system capable of performing operations rapidly.
For example, one large electricity generator is implementing dynamic trading
technology to handle simultaneous bidding on 56 lots by up to 150 traders in
45-minute blocks.

• Deliver the right market or auction type to solve the business problem
at hand. One of the oldest forms of commerce in the world, auctions and exchanges
have evolved into hundreds of formats, ranging from English and Vickrey to Dutch,
classic Dutch, and multiple variations of each. The ideal commercial transaction
technology would support the full range of options and make it easy to change
auction types, which enables energy traders to use the best vehicle for their
needs at any time.

• Integrate with related technology applications, such as revenue management
and risk management technologies, for future expansion of the auction or exchange
and for leveraging the data generated by each market to improve asset utilization
or pricing efficiency. In addition, the ideal dynamic trading system will offer
open integration with adjacent technology infrastructure, such as credit systems,
order entry systems, and existing database applications.

• Capture all the data needed to continually hone and improve business
processes. The ideal dynamic trading technology should enable utility managers
to collect large amounts of data about each trading partner’s bidding and buying
behavior, the overall demand for power in various market conditions, specific
price resistance points, and much more. This data is extremely valuable, especially
when fed into an analytics system such as a revenue management or dynamic pricing
package.

Energy Auctions and Bid/Ask Exchanges: Design is Key

As with any new technology, Web-based dynamic trading should be carefully planned
and deployed to maximize benefits while minimizing disruptions and problems.
Using a phased approach, energy players should deploy these technologies following
a few simple rules for success:

1. Optimize the structure of the product. One of the keys to a good auction
is offering the right product, at the right time, to the right bidders. This
is especially important for electricity, which cannot be stored in large quantities
economically. Here a change in product structure (quantity, duration, delivery
location, spot/forward) can make the difference between a lost opportunity and
a sale. One way to optimize the product structure is to set up trial auctions
in representative local markets to test a variety of configurations. Another
is to employ revenue management software, such as that offered by PROS Revenue
Management and others, to perform sophisticated analysis on existing sales data,
and utilize business objectives to generate recommended configurations. This
information can also be generated manually; either way, the resulting recommendations
should be reflected in the structure of energy product or capacity to be offered
at auction.

2. Carefully select the ideal auction or exchange format. There is a wealth
of academic data covering how to leverage different dynamic trading formats
to meet varying business objectives. While it is beyond the scope of this paper
to explore all this data in detail, selecting the correct auction or exchange
type is critical to success. Using such mechanisms as business and pricing rules
embedded in the auction software, energy companies should be able to specify
the auction format that most closely meets their goals, then detail rules for
each auction or bid/ask exchange. For example, an exploration and production
company wishing to generate maximum revenue from a known supply of natural gas
capacity may choose the Yankee auction format, in which multiple bids are accepted
for the capacity up to a specified deadline. Alternatively, if the production
company wants to deplete capacity at a certain pre-determined rate, they can
create a set of pricing rules within the software that automatically adjusts
prices to keep depletion on track at the pace specified.

3. Create the best possible design for the actual auction or exchange. Prior
to implementing the dynamic trading market, it’s critical to determine the scope
of the auction or exchange and the “rules of the game.” These parameters include,
among many others:
• Who can access the market
• Who can bid
• What bidding information should be revealed, and to whom
• How winning bidders are selected
• How bidding is structured in time
• Any special treatments that should be extended to some bidders, and under
what conditions

4. Think through data integration requirements. Dynamic trading technologies
should use open-architecture design and application programming interfaces to
enable easy integration with back-office systems for credit and risk management,
order processing and the like. Before implementing a Web-based dynamic trading
market, it’s often worthwhile to decide which auction data will be utilized
by which other systems, and to build preliminary links to these systems from
the auction or exchange software. These links enable market managers to test
the integration by passing limited data sets among the relevant systems, and
to thereby spot and isolate any potential integration challenges.

5. Make sure bid awards are open and clear. Many people assume that dynamic
trading bid awards are straightforward; after all, the highest bidder gets the
award, right? This is not always the case in a variety of auctions, because
business requirements do not always place price at the top of the market’s priorities.
For example, if a generation company places the highest priority on generation
capacity allocation, the company may accept the bids for the largest amounts
of capacity first, regardless of price, or may award bids that most closely
match the capacity configuration that is optimal to full facility utilization.
Those rules must be defined and implemented in a manner that will be transparent
to bidders and to regulators.

Summary
Stunning advances in Internet-based commerce technologies today present energy
managers with a unique opportunity to leverage Web-based dynamic trading solutions
to address some of the most pressing needs created by the rapid pace of change
in the industry. Energy companies can benefit from evaluating and pilot-testing
new dynamic trading software systems that, when implemented under the guidance
of a rigorous design and deployment methodology, can help speed and optimize
commercial transactions while reducing costs and errors. At the same time, such
technologies can serve as the starting-point for the development of more advanced
asset management strategies and systems for the future.

Footnotes

1 EIA, Natural Gas 1996: Issues and Trends, “Consumer Prices
reflect Benefits of Restructuring.”
2 Energy Information Administration, Status of the California Market Situation;
www.eia.doe.gov.
3 Energy Information Administration, U.S. Natural Gas Markets: Recent Trends
and Prospects for the Future; www.eia.doe.gov.
4 American Gas Association. LDC System Operations And Supply Portfolio Management
During The 2000-2001 Winter Heating Season; and LDC System Operations And Supply
Portfolio Management During The 1996-97 Winter Heating Season.
5 Forrester Research, 2001.
6 Public Utility Commission of Texas , Senate Bill 7