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Buying energy in the land of the free

By Benedict De Meulemeester

By Benedict De Meulemeester on 27/04/2015

Topics: Energy Trading



In April 2014, E&C has opened its New York office and started working for clients in the US energy markets. This first birthday of our trans-Atlantic presence is a good moment to make a first round-up of our experiences with buying energy in the land of the free.

American energy markets go through a period of abundance. The rapid growth of production of natural gas and oil from shale layers has put the country on a path towards energy independence. Wholesale gas prices on a month ahead basis have traded in a $2 to $6 per MMBTU range since 2009. Recently, prices have dropped back towards the lower end of that range, with the month ahead currently trading at $2,684 per MMBTU. That is 8,63 euro per MWh, a price that European gas consumers can only dream of. In power production, coal-fired power stations are rapidly being replaced by stations using the cheaper natural gas.

However, anyone thinking that all over the US, natural gas and electricity are cheap could be quite surprised. An industrial client of ours with his plant in Massachusetts pays an all-in electricity price of more than $125 per MWh (113 euro per MWh). When the (European) owner of this company expressed his wonder over the height of this price, we joked that he was unfortunate enough to have located his plant in the energy market equivalent of Germany in the US. Indeed, the high power prices in Massachusetts are partly caused by an ambitious renewable energy program, comparable to green zeal in Germany. What’s causing this diversity?

Transatlantic Energy Conference

The first thing that strikes European observers is that in the land of the free the energy markets are in many aspects not as free or liberalized as in Europe. For electricity, for example, only 16 States have a liberalized market as we traditionally understand it, namely with consumers having a free choice of electricity supplier. However, free enterprise is involved in many aspects of the American energy markets. Even if the end consumer markets are regulated in many States, the infrastructure for supplying electricity and natural gas to the Americans has been developed through a myriad of private initiatives and not centrally planned by a government.  Moreover, the US is a federal country with regulatory competences spread over the different levels (Federal, State and even local). This means that as a market place it is definitely less orderly than what we’re used to in Europe. Nevertheless, the basic challenge for an energy buyer is the same. As you can see from the $2 to $6 range of the gas prices, volatility is high. US energy buyers often have such big difficulties seeing through the complexity of the pricing in itself that they don’t manage to implement a hedging strategy to protect their companies against that volatility. A six-step comparison of US and European energy markets can offer some understanding of this complexity

  • Lack of a clear federal competence for energy market regulation

In Europe, energy market liberalization has been driven forward by the European Union which once started as the European Coal and Steel Community. The EU Member States have granted the EU the authority to decide how energy markets should be structured. The EU uses this power to draft Internal Energy Market Directives that Member States are obliged to implement in their national energy market legislation. This means that many main aspects of energy market design in the different European countries, such as third party access or unbundling, are very similar as they are all based on the same text in the Directive. The US Federal Government has less legislative powers in the energy markets, meaning that there is a much larger variety of systems in the different States.

  • Bottom-up versus top-down market development

Before liberalization, national governments in many European countries often had a strong impact on the organization of their national energy markets, not in the least because in many cases they actually owned the monopolist energy suppliers. That power was often used to build an orderly, centralized energy supply system. It was the national government that ordered where centralized power production plants and gas injection systems were to be built and it was that national government that designed the transport and distribution systems. They made the power- and pipelines neatly stop at the borders. Europe entered its energy market liberalization (as of 2000 in continental Europe) with energy markets largely organized in unified national systems. That made it easy to rapidly push through the liberalization in a top-down fashion.

As I’ve already remarked, the US energy infrastructure has been largely built on private initiative with the government (on a federal, State and local level) limiting themselves to granting authorizations and regulating prices. Some investor company at some point decided to build a power station or a gas production facility somewhere in the US. It was again that same company or another one that decided to start building the transportation infrastructure to bring the power or gas to the end clients in the surroundings. Those power- and pipelines didn’t stop at the State borders, so supply systems were created that crossed the State Borders and within one State different systems were supplying different parts of the State.

So, in top-down regulated Europe, in most countries, one market was created based on one nation-wide supply system. Regulations for organizing those national markets were similar as they were based on the same directives. All that was needed then, was the organization of cross-border trading to move towards one internal European market for energy, a process which is still going on. In bottom-up USA, State regulations had to be applied to different supply & transportation systems and one supply & transportation system is often subjected to different regulations as it’s supplying in different States. Moreover, as these regulations are not based on common Directives, they can diverge widely. In some cases, one supply and transportation system supplies energy to a deregulated, free-choice market in one State and a regulated monopoly market in the next State. The Federal Government has tried to bring some order to the electricity markets by grouping different supply systems in so-called ISO’s (Independent System Operators). But that hasn’t reduced much the regulatory complexity. Moreover, as I will explain in the next paragraph, it has even failed to reduce the often large locational price differentials that we see in the US.

  • No development of entry-exit zones

The places where energy is produced are not always close to the places where it is consumed. Moving energy from one place to another can be quite expensive. Moreover, in the US, with its wide diversity of companies operating transportation systems, moving natural gas or electricity around often means that you have to use the infrastructure of different companies, each of them charging you for the usage, or rather reservation of capacity on their system. Due to these many differences, large differentials in the pricing of energy occur. In the electricity market there are no less than 41 different wholesale price references for forward price fixing. And in the spot market, in Texas alone, you can find more than 4.000 different prices. For natural gas, the situation is somewhat different. The wholesale price of natural gas is almost always linked to the price at the Henry Hub, a physical location in Louisiana. However, for the end client, a basis price will be added to the wholesale value that for a large part consists of costs to buy access to the different transportation systems that a supplier needs to use to get the gas from the production site to the client’s site. Price differentials between two gas supplier’s offers can often be quite large as they might use different production sources and physical routes to go from those sources to a client.

One of the great accomplishments of European energy market liberalization has been the creation of so-called virtual Hubs to solve the problem of locational cost differentials. To understand how this works, I first have to give a clear definition of my usage of the container term “Hub”. In the energy world, a “Hub” is the location where the ownership of the energy is being transferred from seller to buyer. A virtual Hub will be defined as one large entry – exit zone, for example, the whole Netherlands with the TTF Hub. This means that wherever the seller puts its natural gas on the grid (entry) it is considered to be no longer his property, wherever the buyer takes that natural gas from the grid (exit) it is considered to be taken off the grid. The place where the ownership changes is the place where the gas is injected into the Dutch grid for the seller, the place where there is a connection with that Dutch grid for the buyer. Anything that happens in between that entry point and exit point is the responsibility of the transportation grid operator, which is one operator for the whole geographical area encompassed by the Hub. (Note: for a client connected to a distribution grid, the exit point is defined as the connection of that distribution to the transportation grid. However, this nuance doesn’t have any impact on the wholesale pricing).

The creation of such virtual Hubs over large geographical zones offers a myriad of advantages that facilitate the development of liquid, transparent wholesale and retail energy markets:

  1. Energy companies no longer have to go into the markets to obtain the capacity rights to get access to clients in different places within one of those large zones. That makes it much easier for them to launch commercial activities in those zones.
  2. Costs of usage of the transportation grid are no longer billed through commodity pricing but exclusively through the transport grid fee, which (in Europe) is regulated and one price regardless of the physical location. Therefore, there are no more differences in wholesale prices within those Hub zones. This causes the number of wholesale price references to go down.
  3. As one price reference is applied to a large geographical zone, the liquidity of the wholesale trading on that reference goes up, making it possible to develop exchange trading on that price reference. Such exchange traded wholesale prices make the energy pricing much more transparent for end users.
  4. Price levels offered by different suppliers converge more as there are no more differences based on routing of natural gas or electricity.

In the European electricity markets, straight after liberalization almost every country launched a Hub encompassing the whole country with the designation of a single transport system operator delivering balancing services in the whole countries. Today there is for as good as all the European countries one single wholesale electricity price, often traded on a reasonably liquid exchange. Attempts at unifying electricity pricing in the US have been taken through the creation of the 7 ISO’s, but so far they are not run as single entry – exit zones, leading to a huge proliferation of wholesale electricity price references.

For natural gas, many European countries now have one or maximum two Hubs (and price references) within their borders. Think about NBP for the UK, ZTP for Belgium, TTF for the Netherlands, NCG and GPL for Germany, the two PEG’s in France, PSV in Italy, Polpx in Poland, etc. The development of these Hubs have revolutionized Europe’s natural gas markets. Wherever you consume natural gas within these countries, your price will be based on the same wholesale price reference. In the US, no virtual Hubs for natural gas have been created yet. Therefore the buying of natural gas is more complex, with the physical routing having a material impact on the price levels in different places.

  • More complex, less transparent pricing

With a larger diversity of price references referring to the wholesale supply of natural gas and electricity, it is harder to get a good idea in the US of what energy costs. When we talk to European clients, they almost always have an idea of what the underlying price level is of the energy that they have to buy. That’s because European consumers can go and have a look at the websites where the wholesale energy for their market is traded and the price is published, wide and open for everyone to consult. That is impossible for the US. You can find information free of charge for Henry Hub in the natural gas markets, see Side 2 of this document: http://www.cmegroup.com/daily_bulletin/current/Section61_Energy_Futures_Products.pdf. But there is no source where you can find all the information necessary to make an estimation of the cost of routing the gas towards your facility free of charge. And for electricity, daily pricing data on the 41 price references can only be obtained if you’re willing to pay for it. Therefore, we observe that compared to their European counterparties, most US energy buyers have much less insight into the daily movements of wholesale energy prices. Many of them only get an idea of how high or low the energy markets are by asking offers to suppliers.

To this lack of transparency regarding wholesale energy pricing, we can also add a lack of transparency regarding the non-commodity components of the energy bills. In Europe, grid fees and taxes are almost always regulated in a top-down manner with government sources disclosing information on their price levels. Also, we’ve seen governments in Europe impose transparency upon suppliers, obliging them to disclose full details of price components on their bills. In the US, energy bills are often very opaque with no details at all about the often complicated underlying pricing mechanisms of non-commodity components.

  • More market mechanisms for setting non-commodity price component

The lack of transparency in US non-commodity energy pricing is also due to the fact that in many cases market mechanisms are used to determine those prices, e.g. for the setting of reserve capacity prices. Whereas a top-down regulated grid fee or tax will only change when the government decides (and publicly announces) such a change, these market-based prices change the whole time. And again, there is a lack of transparency, so consumers are often unaware of such changes. Variable non-commodity price components also mean that as a client, you have to make a choice between fixing the price up-front (e.g. in a fixed adder to the commodity price) or leaving it open. But with no information on the price levels or even the structure of the price components, that choice is often very difficult to make.

  • Less usage of advanced price management techniques

It is often true that energy is cheaper in the US than in Europe. But that doesn’t make it easier to buy it. To resume the observations above, compared to Europe, the US energy markets have:

  • Less unity in legislative systems,
  • More geographical disparity,
  • More different pricing references,
  • Less transparency regarding those prices,
  • More market mechanisms influencing non-commodity components rather than having them fixed by a government.

Therefore, a US energy buyer has a much harder time than his European counterparts simply finding out what is on his energy bills and what the drivers are of those prices. He often completely depends on energy suppliers and brokers for information on the energy markets in all their different components. That complexity is often enhanced by the fact that US suppliers and brokers disguise as consultants. Many US companies remain stuck in the mud and never manage to develop the sort of advanced price management techniques that have been widely adopted by European companies. Price management is often limited to a choice between one-shot up-front fixing of the price or leaving it 100% open for spot market indexation. Only big US companies have rolled out contracts and fixing strategies for layered purchasing, fixing prices at different moments, using different forward products and the spot market. US energy companies are therefore often over-exposed to rapid increases of wholesale and non-commodity components of energy prices, such as witnessed in the cold winter of 2014. Fortunately, they now have E&C to help them see through the complexity and take firm control over their energy procurement.


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