*Corresponding Author.

Energy Policy. Vol. 26, No. 14, pp. 1099—1104, 1998( 1999 Published by Elsevier Science Ltd. All rights reserved

Printed in Great Britain0301-4215/98/$ — see front matter

PII: S0301-4215 (98) 00047-0

Communication

Wholesale power marketing in restructured

electricity markets

Fereidoon P. Sioshansi* and Art AltmanConvector Consulting, Inc. (CCI), 750 Menlo Ave, Suite 200, Menlo Park, CA 94025, USAElectric Power Research Institute (EPRI), 3412 Hillview Ave, Palo Alto, CA 94304, USA

Prior to 1992, very few people had heard the term power marketing. Today, power marketing is well-recognized, however, few people know what is behind the industry’s exponential growth.

This communication, which is based on a major study recently completed for the Electric PowerResearch Institute (EPRI), explains what power marketing is, who the power marketers are, what theydo, and what’s behind the industry’s explosive growth in the past few years. It also explains what types ofproducts and services power marketers offer, and what are the fundamental drivers of this demand.Understanding the last item is particularly significant, namely the growth of power marketing in thecontext of the rapid restructuring of the wholesale — soon to be followed by the retail — electricitymarkets in the US. ( 1999 Published by Elsevier science Ltd. All rights reserved.

Introduction

Prior to 1992, mentioning the term power marketingwould produce a blank look for most people in theelectric power industry. Today, owing to several years ofexponential growth (Figure 1), nearly everyone wouldrecognize the word. The industry’s volume of trade in1997, for example, was 1.2 billion MWh; more than fivetimes what it was in 1996.

This paper explains what power marketing is, whopower marketers are, what they do, why they do it, andwhat’s behind their explosive growth in the past fewyears. This paper also explains what types of productsand services they offer, why these products and servicesare in demand, and what are the fundamental drivers forthis demand. Understanding the last item is particularlysignificant: namely, the rapid restructuring of the whole-sale — soon to be followed by the retail — electricitymarkets in the US. Another equally important impetusfor the industry’s growth is the passage of the highlysignificant Energy Policy Act in 1992 and, more recently,the promulgation of the Federal Energy RegulatoryCommission’s Order 888 and 889 in 1996, in the absencesof which there would be no power marketing industry aswe know it today.

Power marketing: definition

The term power marketing refers to any number of finan-cial and/or physical transactions associated with theultimate delivery of a host of desirable energy-relatedservices and products to wholesale — and increasinglyretail — customers. Power marketers, those engagedin such trade, however, need not — and generallydon’t — own any generation, transmission or distribut-ion facilities or assets, but rely on others for thephysical delivery of the underlying physical services.Moreover, power marketers operate primarily as con-tractual intermediaries.

Power marketers provide a number of highly-valuedproducts and value-added services designed to fit theindividual needs of their clients. Some of these productsand services are aimed at reducing the costs, improvingthe performance, increasing the revenues, or increasingthe profits associated with the clients’ underlying energygeneration, transmission, or delivery business. Other de-sired services are associated with reducing the clients’ riskexposure to price fluctuations or other market volatil-ities. For some clients, power marketers offer a measureof performance or security in an otherwise risky businessenvironment. Some customized services are designed toaddress a particular concern, cover a menacing risk expo-sure, finance a complicated transaction, or facilitate risk

1099

Figure 1 Power marketing’s phenomenal growth in recent past

Source: Edison Times, March 1998, Edison Electric Institute

and profit sharing among a diverse group of parties whowould not otherwise engage in the risky and/or complextransaction.

Many of the products and services offered by powermarketers have gained in significance in the last few yearsbecause of the introduction of price volatility — andconsiderable risks — in the competitive wholesale electric-ity markets. The underlying risks, which have alwaysbeen there, have now become exposed and explicit. Theymust be understood, and properly managed. Risk man-agement is one of the critical services offered by powermarketers. As retail markets are opened to competitionacross the US over the next several years, similar pres-sures — as well as opportunities — will emerge in thecompetitive retail markets.

The energy related services provided by power mar-keters typically include the actual physical deliveryand/or a financial obligation or promise to do so. Theproducts may include electricity, natural gas, or theirenergy-equivalent in a particular time, delivery point,and with a fixed or variable price. The delivery of thegoods may be firm or non-firm, short-term or long-term, a one-time deal or an agreement stretching overtime. If the price is variable, it may be indexed to anynumber of other commodities, or may be derived froma combination of underlying commodity prices, hencea derivative price.

The services associated with the energy-relatedproducts typically include measures or features thatprovide some degree of price stability or offer someperformance guarantee. The level or degree of firmnesswith which the goods are to be delivered, notably price

stability, firmness of physical delivery, and the timeand place of delivery, can be adjusted to fit the client’sneeds and risk tolerance. Providing such services be-comes increasingly more significant as both wholesaleand retail markets become competitive and subject tomarket price fluctuations, exposing both the buyers andsellers to risks they poorly understand and, in manycases, can ill afford. Moreover, many new generators,energy providers, and retailers entering competitive en-ergy markets will not be able to properly function orprovide the services their clients expect without thepower marketers.

Who are the power marketers?

The number of entities with FERC-approved market-based rates, who can engage in power marketing,has seen a steady growth in recent years (Figure 2).The industry’s top ten players (Table 1) currently accountfor the lion’s share of the business, as defined bythe volume of trade handled. As time goes on, however,the concentration of trade handled by the top playersis expected to shrink (Figure 3). In the fourthquarter of 1996, for example, the top ten accountedfor 74.5% of the industry’s total volume of trade.By the fourth quarter 1997, this figure had droppedto 56.5%. The volume of trade, however, may be a poorindicator of business profitability.

The ranking and composition of the top ten playerschanges over time. Enron Power Marketing Inc. hasbeen the top contender for some time now, reporting

1100 Wholesale power marketing in restructured electricity markets: F P Sioshansi and A Altman

Figure 3 Market share of power marketers; 1997

Table 1 Top ten US power marketers; for full year 1997

Top ten marketersRank Marketer Sales (Million MWh) Change; old rank

Market share; (%) (From first quarter)

(1) Enron Power Marketing, Inc. 72.0 (16.0%) #94.1% 1(2) Electric Clearinghouse, Inc. 38.1 (8.4%) #133.7% 2(3) Duke Energy Trading and Marketing

(formerly PanEnergy)!36.1 (8.0%) #101.7% 4

(4) Vitol Gas & Electric LLC 29.5 (6.5%) #136.0% 3(5) Southern Energy Trading and Marketing, Inc. 28.3 (6.5%) #167.0% 6(6) Aquila Power Corporation 24.6 (5.5%) #110.3% 5(7) PacifiCorp Power Marketing, Inc. 19.9 (4.4%) #521.9% 21(8) LG&E Power Marketing, Inc. 19.9 (4.4%) #105.2% 7(9) Ilinova Energy Partners 14.5 (3.2%) #81.3% 8

(10) Engage Energy US, LP 12.9 (2.9) #72.0% 9

!Includes pre-merger sales by Duke/Louis Dreyfus, LLC.Source: Edison ¹imes, March 1998, ¹he Edison Electric Institute.

Figure 2 Growth of power marketers, 1993—1997Number of power marketers entering business in a given quarter

Source: Federal Energy Regulatory Commission

nearly twice the volume of the second-ranked ElectricClearinghouse. Despite its continued dominance, Enron’smarket share for 1997 stands at 15.6%, consider-ably below 35.7% in the first quarter of 1996. Duke

Energy ¹rading and Marketing (formerly PanEnergyTrading and Market Services) in combinationwith Duke/¸ouis Dreyfus ranks as the third majorplayer.

Wholesale power marketing in restructured electricity markets: F P Sioshansi and A Altman 1101

Table 2 Services offered by power marketers

Services offered by power marketers

Power marketers continue to introduce and refine the variety of products and services they offer in response to what the market demands and alsobased on the profit margins associated with these services. As the business becomes more competitive and profit margins in the standardized servicesare squeezed, more emphasis will be placed on higher value-added (and therefore higher profit margin) products. For illustration purposes, however,the services most commonly offered are categorized as follows:

Facilities management — Many utilities and customers can benefit from improvements in the utilization, maintenance, and operation of their existingassets, plants, infrastructure, and personnel. This is particularly true for some of the smaller utilities that may not have adequate in-house or internalresources for such services and outsource them to others.

A number of power marketers have specialized in such work and are highly successful at it. These services are usually provided in addition to moretraditional power marketing functions such as selling the excess output of the plant (eg, what is not needed to serve the utility’s native load) to thehighest bidders outside the utility’s immediate service area.

The savings resulting from the improved operations and maintenance practices are usually shared among the two parties under pre-arrangedterms. In some cases, the power marketer may assume a significant portion of the up-front investments and/or may assume the risks associated withthe poor performance of the proposed scheme in exchange for a higher percentage of any resulting savings. The power marketer’s willingness tomanage certain critical O&M functions, assume risks, and arrange financing makes such schemes highly attractive to many clients who do not havethe internal resources or expertise to engage in such functions. Since no up-front investment may be needed, and no risk is borne if there are noimprovements in performance of the plants, there is no risk to engage in such deals with power marketers.

Risk Management—Offering a variety of services to provide price stability and risk hedging is among the most sought-after services provided by powermarketers. Since many customers and smaller utilities are not familiar with and do not have the necessary skills and capabilities to manage the risksinternally, they rely on power marketers for such services.

¹otal energy services, solutions, maintenance, etc — By combining many types of input fuels (eg natural gas, coal, oil) and end-use energy and/orservices (eg electricity, natural gas, steam, hot water, and other) it may be possible to reduce a customer’s overall energy costs while at the same timeproviding an improved level of service. For example, by switching from natural gas to coal on the fuel side, and/or by switching from electricity tonatural gas on the end-use side, a customer can take advantage of lower price opportunities.

Some power marketers specialize in providing these types of services, usually with little or no costs imposed on the customer and little or no riskson the customer’s operations. Through their broad knowledge of the markets and prices, the power marketer may assume the role of the fuelprocurement for the unsophisticated customer, managing the risks and sharing in the resulting cost savings.

¹olling Services — The power marketers’ ability and willingness to buy raw energy at low prices in one location or time and to deliver a portfolio ofdesirable energy services and customized products at another location or time is highly attractive. Although customers can, in principle, performthese functions on their own, many do not have the market reach or the risk management capabilities of the power marketers. Moreover, powermarketers, by virtue of having many offsetting tolling transactions, can balance the risks of market price fluctuations through pooling and otherarrangements, thus reducing the risks to the individual customers.

Structured/customized products — Structured or customized products are increasingly emerging to meet the specific needs of sophisticated customers.Another reason for their increased popularity among power marketers is that customers are willing to pay significant premiums for these types ofservices. Offering a package of customized goods and financial services that meet specific customer needs, their financial resources, and risk tolerance,however, tends to be time and resource intensive, hence the higher premiums.

These types of services cannot, by their nature, be standardized. They require extensive effort to negotiate and consummate. But the results couldbe worth the extra effort. For example, a power marketer may be able to structure a tolling arrangement among a coal mine operator, a natural gaspipeline distributor, a generator with multiple plants, and a large customer. If carefully structured, such an arrangement could, over a period of time,make all parties better off by switching from one fuel to another as market prices fluctuate. The end-use customer would, in effect, get the benefit ofthe lower fuel costs depending on the prevailing market conditions.

What business are they in and what’s drivingtheir exponential growth?

The fast evolving power marketing business is part hardwork, part hard science, and part old fashioned marketing,product packaging and deal making. The hard work is tofigure out what the clients need and want, and the best wayto offer it to them at prices they can afford. The hard scienceis understanding the considerable risks, and managing themthrough mitigating and/or offsetting hedging strategies.

Small, uncorrelated risks may simply be managedthrough risk pooling. The marketing and deal makingis particularly important in packaging and offeringthe so-called structured (ie, non-standard) products.

Non-standard products have higher profit margins — butalso higher risks, and higher costs — and add considerablevalue to an otherwise mundane transaction.

As previously reported, US power marketers reportedsales of over 1.2 billion MWh in 1997. More amazing isthe fact that power marketers have experienced con-tinued growth in quarterly sales in every quarter since thefourth quarter of 1994 with the exception of the fourthquarter of 1997 (recall Figure 1). This, however, may bethe tip of the iceberg. According to Jim Lee, an industryanalyst and Vice President of ¹he Power Company ofAmerica ¸P, an energy marketing firm based inGreenwich, CT, the annual volume of wholesale electric-ity commodity trading may reach $2.5 trillion by the year

1102 Wholesale power marketing in restructured electricity markets: F P Sioshansi and A Altman

2003. If this prediction comes to bear, it will make elec-tricity the country’s single largest traded commodity bya wide margin. More amazingly, the $2.5 trillion figurewill amount to roughly 10 times the retail value of elec-tricity trade in the US for 2003.

How would this be physically possible? Many inthe industry, including Mr. Lee, believe that the 10-foldmultiple is not far fetched based on the experienceof the deregulated natural gas industry. In thatindustry, the volume of trade is estimated around $600billion, roughly 10 times the total retail value ofnatural gas sold nationwide. This is possible becauseof developments in financial trading instruments suchas futures, forwards, swaps, and options which allowthe same electrons to be bought and sold multipletimes before they are actually generated andconsumed.

What explains the industry’s phenomenal growth, andhow long will it continue? The growth may be explainedby several factors, notably:

— the emergence of exposed market risks due to marketprice volatility;

— the emergence of new and small players who must relyon power marketers for many critical trading, broker-ing, and information services;

— the existence of considerable locational, temporal, in-ter-, and intra-fuel price disparities which offer arbitr-age opportunities that were previously unexplored;

— the emergence of previously unattended customerdemands for customized energy-related services;and

— intense pressures to better control and manage costs,increase operational efficiency, and increase the perfor-mance and utilization of fixed assets and underutilizednetworks.

These fundamental drivers of demand are not expectedto be fully satisfied any time soon. Having said that,the phenomenal growth of the last couple of years cannotbe expected to continue indefinitely. Once the basic(and finite) needs of the clients in the post- restruc-tured energy industry are understood and satisfied,the industry’s growth rate will diminish. The most-likely time horizon for continued growth is expectedto stretch through 2003, when most of the retailelectricity markets in the US are expected to becomecompetitive.

What products and services do powermarketers offer?

The range of products and services offered bypower marketers has been increasing as more playersenter the field, as existing players refine and perfect theirskills and competencies, and as new niche markets andservices are identified and served. Table 2 provides

a summary of the range of services currently provided bypower marketers.

Is power marketing profitable?

Figures on profitability of the industry are hard to comeby because, in most cases, companies engaged in powermarketing combine their revenues and costs with manyother activities and only report their consolidate perfor-mance. This practice makes it frustratingly difficult tofigure out the profitability associated with their powertrading activities.

Moreover, because of the rapid growth of the industryand equally rapid evolution of the power marketingbusiness, many players are primarily focused in establish-ing market dominance. This objective is driving manya players to sacrifice short-term profitability to gainsignificant market share. Consequently, any current in-dustry or company-specific profitability results would beof dubious value at best. Furthermore, any profitability(or lack thereof) trends experienced over the past severalyears would be a poor predictor of the longer-term trendsin the industry.

Future growth prospects and long-termimplications for power industry

Although no industry can indefinitely sustain the ex-ponential growth experienced in power marketing overthe past several years, there are a number of indicatorssuggesting that power marketing still has plenty of roomto grow. While the ultimate number of power marketersshows no signs of slowing down, the market is gettingcrowded and some consolidation and shake out is inevi-table. But the volume of trade and the range and type ofservices provided can be expected to grow both in theretail and wholesale markets, for at least the next severalyears.

More significantly, power marketers, like the indepen-dent power producers (IPPs) before them, are no longermerely marginal side players. As time goes on and morepower marketers merge or form affiliations with tradi-tional utilities — or vice versa — the distinction betweena utility and a power marketer may become fuzzy. Manyutilities already have significant wholesale power tradingoperations, competing head on with power marketers incritical markets and regions.

Moreover, as a number of major integrated energyservice companies with national (and global) aspirationsemerge, the whole definition and makeup of theenergy services business is dramatically changing. Tenyears from now, it will be an entirely different industrywith new market institutions, with new players, newrisks, new customers, new expectations and standardsof service. Looking back, it will be hard to say what

Wholesale power marketing in restructured electricity markets: F P Sioshansi and A Altman 1103

was responsible for so much change in so few years. And asfar as most customers are concerned, it will be irrelevant ifit was the IPPs, the power marketers, the Federal EnergyRegulatory Commission, or the individual state publicutility commissions that initiated, facilitated, or causedthe change. What will matter will be whether there isa more efficient industry with vigorous competition, of-fering increased and improved services at lower prices.

Acknowledgements

This paper is based on a major report prepared for theElectric Power Research Institute (EPRI). The report,TR-111004, July 1998, is available from EPRI, PaloAlto, CA. The funding and support of EPRI, and theEPRI Project Manager, Mr Art Altman, is gratefullyacknowledged.

1104 Wholesale power marketing in restructured electricity markets: F P Sioshansi and A Altman