Deregulated Energy Trading: Uncompetitive Competition

Wednesday, 07/28/2010 - 8:18 am by Wallace C. Turbeville | One Comment

The accidental protection of end user activity will ensure toxic energy trading.

In an earlier article, I described the so-called “Enron Loophole” in the Commodities Futures Modernization Act of 2001.  Deregulation of energy derivatives trading via the Loophole was touted as a way to lower cost through the efficiency of competition.  In reality, the markets are not competitive.  They are dominated by an oligopoly of banks which profits at the public’s expense.

The Enron Loophole has been partially closed, but a large portion of the energy market remains unregulated.  The new financial reform legislation permits bilateral (i.e., un-cleared) hedging transactions in which one party is an “end user.” Congress failed to consider the level of market abuse in these transactions. It was mesmerized by huge volumes in other transaction types, ignoring the fact that volume is only one factor in measuring the amount of systemic risk.

End users are companies who produce or purchase energy as an integral part of their business and use derivatives to hedge price risk.  They wanted the exemption primarily to avoid having to post collateral to cover credit exposures, as required by regulated clearinghouses.  All end users transact some business on exchanges and these transactions are all cleared.  So end users have systems in place to post collateral.  Their concern was that they would have to post more collateral unless exempted from the law’s general requirement that derivatives be cleared.

This concern is curious. End users trade mostly with banks and a few of the large oil and gas companies.  They receive special deals in which the banks and oil companies extend credit in lieu of requiring the posting of collateral. These deals are, in all relevant aspects, the same as extending a loan to the end user in the amount of the foregone collateral - except that no cash changes hands.  The deals are like unconditional letters of credit in which a bank will pay an amount if the account party fails. A letter of credit is treated like a loan by the bank and account party on their respective books.

If a special collateral deal is just like a loan or letter of credit, why don’t end users simply clear their trades and borrow money as needed for collateral?  It is because these special deals are not recorded the same way as loans and letters of credit on the books of the end users. End users wanted the exemption to preserve the opaque trading credit deals so that their debt appears to be smaller than it should.

These special credit deals are much riskier for the end users than conventional loans. They routinely include “triggers,” requiring that collateral must be funded immediately on occurrence of specified events (e.g., a credit rating downgrade). This means that cash is required at the precise time when it is hardest to come by. Credit rating agencies are put under immense pressure because well-deserved, modest downgrades could induce a death spiral and bankruptcy. Such liquidity events laid low AIG, Enron and many other firms engaged in bilateral trading. End users are exposed to liquidity risks that well capitalized financial institutions can scarcely deal with.

The banks were also keen on the end user exemption.  The special credit deals are useful to entice end users to trade with the banks.  A bank can extend only a finite amount of credit to a company. Allocating credit to a company for trading reduces a bank’s capacity to lend for purposes like capital investment. It is well known that the banks make far more money using credit capacity assigned to a company in their trading activities, rather than using it for conventional corporate lending. If the banks are profiting more tying credit to trades, the end users are paying more than they need to for the credit in order to obscure their indebtedness.

The special credit deals are not merely sweeteners for the end users; they are often crucial to the end user’s share value. Banks use them to capture and control end user business.  Sometimes this is done with great fanfare, such as a deal in which Pepco transferred all of its hedging activity to Morgan Stanley.  Sometimes it is less formal. I have been told of a major energy producer which shockingly does more than 80% of its business with a single bank. These are not characteristics of open and competitive markets.

End user energy trading volume is not as large as the volume in credit default, currency and interest rate swaps. However, it is extremely profitable for the banks.  They charge a lot for the special credit deals, in effect profiting from the end user’s reporting advantage. But the strategic value for the banks is even greater. It allows banks to dominate markets and become sole sources of hedges which can be priced accordingly.

The peculiar nature of the energy markets is at the root of this strategy.  It is useful to look at the power markets, the most extreme example, to understand the strategic play. The general principles apply to all energy markets.

The central dynamic is that power cannot be stored in any practical sense.  Its economic value is fleeting.  A quantum of power only has value at an instant in time and at a particular location where it is needed to fill a demand.

There is no single power market. Value depends on local supply and demand. There is very little relationship between the market value of power in California and the same power in Pennsylvania. This is because power transmission is constrained. There are absolute engineering constraints over great distance; and even over short distances there are “line losses” of the amount of power generated and fed into the grid.  Regionally, the market values of power at nearby points are usually correlated, but congestion on a transmission path can destroy these correlations, especially at times of high volume each day. Weather is a major factor, but congestion can be as unpredictable as a truck backing into a transformer, storm damage to lines or a generation plant outage

The power market is really a collection of thousands of delivery points, each with unique factors governing valuation.

Power at each delivery point is not monolithic.  Grid operators run day-ahead auctions to secure predictable supplies for forecasted demand. But they also run same day auctions to fine tune supply and demand during the day of delivery.  So there are separately priced day-ahead and real time markets for each delivery point. There are corresponding separate derivative instruments traded for each of these markets.  There is even a derivative for the difference between the two markets at a given delivery point and time.

The value of the transmission between two delivery points is defined by the price differential between the points.  Derivatives transactions for this value are called “basis trades.”

Power price is a composite of two values.  The grid operator’s ability to access power if required has a value since actual demand and supply can never be known in advance. This is known as “capacity” value. Capacity derivatives are traded.  The difference between capacity value and the actual value of delivered power is referred to as “energy,” also a traded derivative.

Most of the value of a power plant is the difference between the price of power it produces and the cost of the fuel required to produce it. For natural gas this is known as the “spark spread,” and for coal it is known as the “dark spread.” Both are traded as derivatives.

Finally, as demand increases, grid operators call on increasingly less efficient generating resources to supply power and to meet demand.  “Heat rate” swaps are derivatives based on the efficiency of the marginal assets called on at a given time. A heat rate swap is a derivative of a spark spread derivative.

This all means that the power market is really thousands of small markets which are separately priced.  Each delivery point is a “mini-market” which represents multiple potential derivative contracts for trading. Sometimes prices in nearby markets are related, and sometime they are not.

Each end user has regional strengths.  Since markets are really very small, a bank can easily become a dominant force in targeted “mini-markets,” effectively “cornering” strategically enabling it to dictate price. Any trader who wants to do business in one of these markets has to deal with that bank.  That is why trading under the end user exemption is so very profitable for the banks.

This all means that the end users’ cost of doing business is higher than makes sense in a truly competitive market.  As a result, consumer energy prices are higher than they should be. It also means that the cost of producing almost everything in the economy is too high.

Unregulated energy derivatives have allowed the financial sector to extract extraordinary value from the rest of the economy. It is one reason that the sector has increased dramatically as a percentage of the GDP.  There is no justification for this related to the well-being of the public and the health of the economy.  The end user exemption was misguided.  Other ways to curb these unhealthy practices through regulation must be explored, perhaps focusing on energy policy rather than financial reform.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.