Research & Education Needs in Energy

Market Risk

Ralph Masiello

Local Distribution Companies

Marketing Companies

Power Distribution

Gas Producers

Aggregation Companies

Electric Generation

PipelinesTransmissio

nTrading

CompaniesTrading

Companies

Residential Industrial Commercial

Wholesale energy - a $5 trillion new competitive market

Source: Forrester Research

Wholesale energy is the world’s largest commodity market

Over 4,000 participants in the U.S. alone

$1.4 trillion physical wholesale market vs. $350 billion retail market

Additional $3.6 trillion in financial wholesale energy trading

Europe also competitive and growing - estimated at over half the U.S. market

Anyone taking a position in energy must manage risk

Extreme price volatility

Electrical power is naturally the most volatile commodity

Weather and grid unreliability produce shortages and supply imbalances

Enron, California, Regulatory Risk, etc all exacerbate volatility

Market complexity is growing

Convergence of gas and power require operation in multiple markets

Need to compete across multiple geographic/regional markets

Introduction of complex energy derivatives

Fuel Procurement, Watershed inflows, Emissions Limits and Trading, Wind, Transportation, ………

Wholesale energy - the most volatile commodity market

Creating the need for energy specific application software

• New solutions are needed to manage trading and risk unique to energy

• No viable heritage systems exist

The leading provider of trading, transaction processing and

risk management software and strategic consulting services

to the global wholesale energy market

Over 300 Energy Companies Use Caminus Software and Services

We enable companies to compete effectively in wholesale energy markets

Trade all major energy-related commodities, and instruments

Manage the physical and financial process across the entire energy value chain

Manage the full spectrum of energy related risks

500 Energy Trading/Risk Specialists

>100 Professionals Engaged in R&D

>60% of North American Energy Traded on Caminus software (more in UK)

Who is

“déja vu all over again”

“What on Earth is Happening” – Eric T B Gross American Power Conference – 69

Context: Huge R&D response to the great ’67 Blackout

Academic Feeding Frenzy – InterDisciplinary Funding Fest

Any IEEE PES over 50 in this room Raise Your Hand

His concern - too many new programs and “unqualified” entrants – we

should have had grad school re-regulation and an Independent School

Organizer allocating capacity and research

Net Result was all Positive – lots of new technology for planning and

reliability

State Estimation, Security Analysis, Optimal Power Flow, the marriage of

Operations Research and Network Analysis, -----

Took half a decade to sort out the real contributions from the drivel

Back Then we Didn’t have Venture Capitalists throwing money at the next

big thing, however !

Risk Assessment and Optimization – Trading and Production

Already lots of work going on in areas to help producers and

traders

They’re unregulated and highly incented to innovate

Probably 10-20 specialized software firms and consulting

companies focused on energy real option modeling, risk

assessment, and optimization aimed at these companies

They all have in-house quants developing models and methods,

and they don’t share information

Completely unlike the regulated sector!

They demand proprietary solutions as part of competitive

advantage

R&D Hot Topics

How can a poor LDC or RTO keep up with all those quants? (the

CERS / CDWR experience)

“Derivatives” is a dirty word – but LDCs and Munis need to

hedge retail volumetric risk

Volumetric Risk is an Energy-specific problem; the

“volume” of a retail sale; is unknown and correlated with

price; all correlated with weather and supply/transportation

outages

They also need to analyze and hedge “potential credit”

risk – the cost of replacing supply when a supplier

defaults. (Enron again !)

Regulators needs Education about these issues !!

Need for LDC Best Practices

More LDC Points – Why Best Practices are Needed

To “enable” intelligent hedging politically

To disseminate methods and elevate business

practice

To justify hedging costs to the PUC and correctly

allocate it in either regulated energy tariffs or

distribution services tariffs (big point of contention)

To maintain bond ratings (S&P has figured out that

this is a credit rating issue)

A Plea: We don’t need Software – there are plenty of

tools out there already. We need education and air

cover for the LDC

Long Term Asset Valuation and Planning

Given a forward curve we can “value” a generating

unit, a PPA contract, a retail deal, etc etc.

But who has a 10 yr valid forward curve? (Enron

did)

Path Contingent Real Option Valuation is a Challenge

– when to invest/divest over a multi year horizon

Solving these problems critical to producers and to

obtaining financing; ultimately linked to ensuring

sufficient supply.

How to avoid the “boom and bust” cycle in energy

supply

Transportation

Energy is the only commodity with Transportation Risk

Curtailment, congestion, LBMP

LBMP makes risk assessment very hard – to value

a TCC you have to look at 300 correlated locational

prices in NE, for instance. If the risk can’t be

valued there will not be a liquid market for hedges

LBMP can impose congestion costs when “small”

paths are congested in the grid – sometimes just

opening the line works better

How will predominantly bilateral markets co-exist

with day ahead multi-part bid auctions and LBMP?

Markets

Better Solution than gate closing clearing price market

Argument of economic efficiency not pragmatically

valid absent continuous bidding and price discovery

“as bid” not politically correct

More work down CA ISO path of Rational Buyer

approach – time sequential ancillaries markets

Ways for RTO/ISO to contract ancillaries outside day

ahead markets – forward contracts, hedges, etc

Static market designs are made to be exploited

Should Ancillaries be allocated other than on a “peanut

butter” approach (spread it out on average)

Regulation

Expensive ancillary

Tie Line Bias Control is an old paradigm – and the 2 or 4 second

cycle is rooted in analog control

Do we need a replacement for the NERC control area criteria

(A1, A2, etc etc) in the RTO era ?

How does ACE relate to reliability today

What is economic value of frequency/time today in the digital

age?

Can regulation cost be allocated to “users” differently- eg a cost

applied to intermittent generation; to large variable loads, etc

Maybe wind generators should internalize storage costs ?

Or – be subject to “permissive control” mechanism

Demand Elasticity

Risk Perspective – how to build models, forward

curves, etc

Lots of new derivatives to be designed !

Focus on two “Enablers”

Market structure to allow competition in aggregating

demand response – not a bureaucratic RTO

function

Low Cost ways to calculate/verify demand

response w/o expensive real time metering

Collect Commercial Demand and allow customer

decision making

Demand Elasticity - example

Alternative approach to Real Time Demand Metering

Avoid “revenue accuracy” and meter changeout

Avoid communications

Assume voltage is nominal and measure current cheaply at panel

Build it into the circuit breakers

Use X-10 or Firewire and PC software in building to communicate

out to Internet and to the office purchasing manager’s PC

Final Value settled after balancing market/day ahead markets

clear and the entrepreneur absorbs the inaccuracies/variabilities

Think of it’s value as fast reserve !

Break the Mold of Utility Think re command and control, revenue

measurement

Broad Conclusions

Don’t worry about the for profit market players – they

will take care of themselves

Do elevate market sophistication of market operators

and regulated buyers

Look for market structural solutions to reliability

problems

Distributed and localized control will deploy faster, cost

less, and be more reliable

Keep the market math transparent and simple; let the

complexity accrue to the players.