The Third Wave of Convergence in Energy Markets by Chris Trayhorn, Publisher of mThink Blue Book, November 15, 2000 Wave One: The Traditional Regulatory Framework The traditional regulatory framework created a convergence of energy prices with the costs of constructing, maintaining, and operating energy assets and networks. This grew out of the economic belief that the production of energy was a natural monopoly. This belief that energy markets were natural monopolies arose from the belief that economies of scale in production combined with network economies. Essentially, long-run marginal costs were considered to decline with the level of production. It was thought that a competitive market could not achieve the lower costs associated from large-scale and network production. Thus, allowing for a single-franchise provider minimized the average cost of production. Rate-of-return regulation assured the firm a fair return on capital while preventing monopolistic behavior. Consumer interests were protected by requiring the franchise provider to demonstrate its capital investments were prudent and benefited consumers by reducing average costs. It is easy in 2000 to forget just how pervasive regulation was throughout the U.S. economy. Since airline deregulation in 1978, natural gas, telecommunication, cable, banking, and financial sectors have undergone sweeping economic reform. This change in the regulatory environment is global. The last decade has seen sweeping deregulation and privatization of energy markets. Energy prices under the traditional regulatory framework were based on the following: The capital employed A fair return on that capital The costs of maintaining and operating energy networks What happened? The view that all points of the vertical production chain were individually natural monopolies was rejected. While pipelines, wires, and cables – the delivery networks – might be natural monopolies, the upstream production processes (exploration and production), electric generation, telecommunication services, and electronic media content were not considered natural monopolies. This realization and resulting deregulation of the energy industry brought an end to the first wave. Wave Two: Btu Convergence The deregulation of both the natural gas and electricity markets led to a new wave where these formerly separate markets converged. The reason for this was simple energy physics: an electron is merely energy in an electric form created from the energy stored in some other form, irrespective of the particular power generation technology. Since transforming a fossil fuel (oil, natural gas, or coal) to electricity creates most electric generation, owners of generation assets quickly (and correctly) concluded they operated not in a single-commodity market (electricity) but in a market where profitability is determined by spark-spread economics: The cost of fuel The costs of convergence The revenues from the ultimate product – electricity Btu convergence has led to the following convergence economics: Electric generation assets are convergence vehicles that transform energy from one form to electricity Demand growth for fuels is driven largely by the demand growth for electricity Natural gas competes against oil and coal as a fuel for electric generation A diversified energy company must be able to manage price risk and volatility across the entire energy spectrum Globalization of energy markets requires expertise in both domestic and international energy markets Electricity and natural gas markets were, until very recently, considered local markets. However, at recent domestic natural gas prices, the economics of liquefied natural gas (LNG) have comparatively improved. LNG is relatively more important in the deregulating European energy markets. Through liquefaction, natural gas produced in the Caribbean and Africa can be transported. International coal use in the United States increased in the second half of the last decade, driven primarily by emissions standards imposed on power plants. The Second Wave of energy convergence has not expired; it has led to the birth of a Third Wave of energy convergence. The Convergence of Risk Management and Information reflects both the risks faced by producers and consumers and the desire by consumers to exercise their choice for a greater variety of products and distribution channels. Wave Three: Risk Management and Information Convergence The end of regulated franchises exposes energy firms and consumers to a complex set of risks. When combined with the information revolution correctly anticipated by Mr. Toffler, both producers and consumers face unparalleled opportunities to manage risks. The convergence of risk and commercial opportunities will forever change the energy industry. The owners of energy assets face capacity, commodity, and capital risks. Capacity is the brick and mortar of the energy industry – natural gas storage, pipelines, and power plants are examples of capacity. Capacity is used to transfer or transform the commodity outputs, or Btus. Natural gas storage facilities transfer BTUs across time while a power plant transforms energy from fuel to electrons. Asset owners face financial risks arising from the manner in which they have raised capital to fund their investments. For each of these types of risks, decisions are required that affect profitability. This has led to a convergence of alternative, commodity, and capital market risk management and created hybrid organizations that manage those risks. Commodity risk is familiar to energy market participants. The volatility in electricity prices during June 1998, July 1999, and in natural gas prices during the first quarter of 2000 are recent examples. Natural gas and electricity are the two most volatile commodities. A $1 change in the July/August electricity forward contract generates profit and loss swings of approximately $70,000 per 100 megawatts. For a 5,000 megawatt generation portfolio, that amounts to a P&L swing of $3.5 million. The traditional approach to mitigate commodity risks is to execute a hedging strategy to buy or sell forward energy derivative contracts such as futures, forwards, and options. To paraphrase Tip O’Neill, “All energy is physical.” This creates an alternative form of risk for which traditional hedging strategies are poorly designed. A traditional forward contract in electricity is firm with liquidated damages – known as “firm LD.” This means the supplier is obligated to deliver physical power. The failure to meet that obligation results in the buyer purchasing replacement electricity at prevailing market prices. That creates a liability for the seller. The alternative risk faced by producers is caused by the fact that physical assets do not always operate. An owner of a 500 megawatt generating plant may wish to mitigate price exposure by selling forward the power from the plant. Liquidity and price transparency in the electric forward markets are in the “firm LD” instrument. If the owner enters into a “firm LD” forward contract, the failure of the plant to operate at times when market prices are high creates a significant risk. An asset owner who enters into a 500 megawatt forward sell at $50 per megawatt hour faces liquidated damage charges of $975,000 per hour when the spot price of electricity reaches $2,000 per megawatt hour. This exposes the asset owner to volumetric risk. While the owner has eliminated price risk, the owner is now exposed to the volumetric risk if the plant does not perform. Retail aggregators face a similar type of volumetric risk. This risk emanates from the interaction of retail load with price. Weather events are strongly correlated with energy demand. Thus, energy demand is strongly correlated with energy prices. Traditional derivative contracts (futures, forwards, and options) are designed to manage price risk for a fixed quantity. Retail aggregators can hedge this exposure through traditional forward, futures, and options contracts. However, energy price volatility is not solely determined by retail demand. A nuclear unit outage in a region might cause high prices with no accompanying increase in retail load. Traditional hedging instruments can be expensive, since it is the correlated volume and price risk the aggregator seeks to mitigate. Finally, the manner in which capital is raised to support asset investment generates financial risks to investors. A myriad of financing structures exists relying on mezzanine financing structures with layers of debt and equity. The combination of capacity, commodity, and alternative risks had led to a convergence of companies offering a wide variety of risk management services. These companies come from the traditional commodity field, investment banks, and reinsurance companies. The distinctions between these three participants have been blurred as asset owners seek to manage comprehensive enterprise risk. The rise of the Internet and the globalization of information, energy, and commodity markets create a convergence between the provision of risk management services and information. The point-and-click approach for the procurement of products and services means providers of wholesale and retail products may be exposed to new types of risks and may wish to include risk management services as part of their product offerings. The Internet has changed distribution channels. Consumers and producers have instant access to information. A plant manager may have historically acquired supplies and risk management services through customer representatives. Remember the Rolodex? That plant manager today can access and execute transactions at the computer via the Internet. Conclusion “Lately, it occurs to me, what a long strange trip it’s been.” The Grateful Dead A quick review of the last 20 years in the energy industry suggests that The Grateful Dead might have been thinking of the 21st century energy industry when they penned those lyrics more than 30 years ago. This isn’t your father’s industry anymore. The changes brought on by deregulation and the information revolution transformed the energy industry. Just four years ago, conferences were offered on the coming convergence of natural gas and electricity. Now we sit at the dawn of a new wave of convergence of risk and information. 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.