Energy Market Participants: The Risks of Being a Jack-of-All-Trades
June 1, 2003
By Lloyd Spencer
Those that attempt to participate in more than one area of forward energy markets will be internally conflicted in terms of performance measurement and risk profile.
In the past year, much consideration has been given to the design of the wholesale power market. This effort has been directed primarily at the market structure of the physical system and the definition of the markets necessary to create incentives for delivery of reliable power. Yet, scant attention has been paid to identifying the conditions necessary for maintaining a successful and liquid forward market and the various roles that a participant may play. Identifying this aspect of market development is especially important, as there exists a critical relationship between the market structure in which a company operates, the assets it controls within that market, and the role of the company as a market participant.
Forward markets are particularly important in power because they provide the pricing signals necessary to make decisions on major capital investments that are necessary to ensure reliable power delivery. While it is important to have well-functioning spot markets for power, these provide insufficient information to decide on capital investment in this sector. Forward markets provide the insurance mechanism for buyers and sellers wanting to lock in price certainty. Price certainty contributes to cash flow certainty, which is critical to definition of the funding structure of any business.
In the current environment, the funding structure of energy market participants is under renewed scrutiny as business models are put to the test. Forward price discovery allows for informed capital investment decisions, based on market demand. The decision to hedge or not can be made separately, but in an informed way.
Defining Market Roles: What's Your Bread and Butter?
One of the many problems that contributed to the over-investment in energy trading was an unclear definition of market role by participants. In general, the lesson from other markets is that each market participant can only inhabit one market role. Those that attempt to participate in more than one area of the market will be internally conflicted in terms of performance measurement and risk profile.
Speculators provide a critical and often misunderstood role in markets. They are needed to fill the gap between natural buyers and sellers in a market. Natural buyers and sellers are those that have a short or long position in the markets by nature of their business or other activity. There is a continuous spectrum from natural buyers through speculators/market makers to natural sellers (see Figure 1).
If there is inadequate speculation in a market, then the forward market will trade at a premium or discount to the expected future spot price. This has broad implications for energy markets. For example, a forward market will trade at a premium to the expected future spot price if there are more hedgers on the buy side. In equilibrium, this premium will also reflect the risk-adjusted return to speculators of taking that net risk, including the frequency and severity of losses.
Moreover, the natural position of a market participant refers to the net long or short position derived from the company's principal business activity. For example, an owner of generation has a natural long power position, whereas a retail power provider has a natural short power position. Integrated utilities may have combined positions that create a net position that fluctuates between long and short. Furthermore, a company's position may be predictable, in the case of a baseload generator, or unpredictable in the case of a peaking generation owner or retail supplier. Thus both the nature and dynamics of the net position will influence the ideal market role.
Price Impact
For natural buyers and sellers such as retail suppliers or generators, it is critical to understand the price impact of trade size. Price impact refers to the movement in clearing price caused by transaction size.1 For most markets, price impact is an increasing function of transaction size. That is, larger volumes will have a greater impact on the settled price for that trade. If price impact is large, that will force natural buyers and sellers to assume some amount of active market activity to disguise their position and improve the average price achieved. In other words, if the market is thinly traded, then the optimal strategy for a natural buyer or seller may include active trading and risk taking beyond the natural position, to provide the best risk mitigation at the best all-in cost. The decision to make proxy hedges in related markets also might be justified by the price impact in the proxy market compared with the price impact in the original market. Clearly the execution price improvement from proxy hedging must exceed the risk of proxy hedge failure.
In addition, market microstructure suggests that in general, the more volatile the market, the wider the bid-offer spread will be, all other things being equal. This is because the returns from market-making activities (the spread) must be commensurate with the risk from having an open position (volatility). However, overall liquidity levels also play a major part. Therefore, power markets exhibit larger spreads in less volatile markets such as off peak, since the low liquidity effect dominates. This suggests that market makers in low liquidity products may be able to earn greater than normal returns if willing to take the liquidity risk.
Capital requirements of trading also play a big part in the cost structure of a commodity market maker. The lack of widespread cash margins prevents a market maker from minimizing capital requirements of a market neutral position. This translates into a higher business cost from this activity and again to higher spreads and less liquidity.
Regulatory Intervention: A Heavy Hand on Markets
Regulatory intervention can create market distortions. For example, many utilities that have divested generation and are therefore natural buyers are limited in their ability to participate in forward markets. This may take the form of an outright prohibition, as in the case of California utilities, or an implicit understanding that losses from hedging activities cannot be passed through to ratepayers, while losses from unhedged high market prices can be. In addition, the possibility of forward contract abrogation by state or federal government creates a perception that contracts may be subject to renegotiation in extreme market scenarios. This creates a wider bid-offer spread due to the uncertainty of final outcome for long-term contract holders who may think they are hedged but discover otherwise due to contract negotiation.
Conclusions
A company's market role cannot be decided in isolation. The asset position will drive the company's broad choice of market strategy (see figure at left). The natural long/short position as well as the nature of the position will drive the degree of active participation that is necessary to achieve maximum value for the asset. The structure and liquidity of the individual market will drive the company's specific market strategy. It is difficult for a company to create the correct internal mechanisms to support more than one market role. Therefore it is important to identify the role that matches the specific company circumstances of assets and market structure.
Endnote
- "Market Microstructure: A Practitioner's Guide," Ananth Madhavan, Financial Analysts Journal, September/October 2002.
Lloyd Spencer is a manager in the Energy Trading Risk Management practice at Pricewaterhouse Coopers in New York. He can be reached at 646-471-2512.
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