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| Statement before the Peak Load Management Alliance Fall 2003 Conference,
New York, NY |
| Presented by Neal Wolkoff, Executive Vice President and Chief Operating
Officer, New York Mercantile Exchange |
| 09/08/2003 |
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Good morning. My name is Neal Wolkoff, and I am the Executive Vice President
and Chief Operating Officer of the New York Mercantile Exchange. I would like
to thank the Peak Load Management Alliance for inviting me to be the keynote
speaker this morning. It is, indeed, an honor.
Before beginning with my formal remarks, I want to say that the comments and
views that I am expressing this morning are my own, and not necessarily the
views of the Exchange or its Board.
The New York Mercantile Exchange was established in 1872, its origins starting
with the vibrant wholesale dairy market that was centered in lower Manhattan.
We have evolved over time, and now NYMEX is the largest energy futures exchange
in the world and the only futures market in the United States devoted exclusively
to pricing, hedging, and trading industrial commodities. The merger in mid-1994
with Commodity Exchange, Inc (“COMEX,”) which provides a forum for
trading gold, silver and high grade copper futures contracts, created the world’s
largest physically-based commodity exchange. The Exchange pioneered the development
of energy futures and options.
The Exchange provides the world's most efficient forum for energy price risk
management. The visible and highly competitive daily trading of energy futures
and options on the exchange provides a true world reference price for each of
the commodities traded.
The Exchange has no stake in the direct outcome of the electricity market.
It draws no direct benefit from either higher prices or lower prices. The New
York Mercantile Exchange only seeks the opportunity to compete in the provision
of marketplace services, having never sought the role of government granted
franchise to provide these services. The Exchange has been an active participant
in regulatory and legislative proceedings related to electricity deregulation
and restructuring at both the state and federal levels since 1994.
The Exchange has not evolved in a vacuum. As energy markets started becoming
deregulated in the 1970s, the Exchange offered products, rules and a transparent,
competitive environment necessary for the price discovery and risk shifting
needed by participants (many of whom were unwilling participants) in a newly
deregulated environment.
In March, the New York Mercantile Exchange marked the 20th anniversary of crude
oil futures trading, the market's first successful crude contract. This contract
provided an entirely new form of pricing that went right to the soul of the
petroleum industry. This industry, which prided itself on doing multimillion-dollar
deals on a handshake, where price and other market data were held close to the
vest, suddenly found that prices were out of the closet, quoted on a computer
screen available to anyone with the price of a wire service subscription. And,
most startling, these prices were determined by an anonymous auction in lower
Manhattan, about as far from an oil well as you could get.
To a great extent, though, I think we have forgotten what the oil markets were
like before March 30, 1983. If in the early '80s, you had told just about anyone
who worked in the energy industry, that the markets in energy, not just crude
oil, but refined products and natural gas as well, would be so competitive that
there would be all sorts of exchange-based and over-the-counter instruments
to mitigate price risk and lock in supply commitments, that person would have
looked at you as if you had just arrived from Mars.
To date, the level of market competition in electricity has generally not followed
the rapid course seen with the development of competitive markets in the other
areas of energy that were deregulated, and deregulated comprehensively and rapidly.
When talking about the deregulation of power, it has been treated differently
from other energy products. Indeed, for its first century and more, power –
at least in well-populated regions of this country - has been a concern of each
locality. The intervention of the federal government was largely to bring the
huge benefits of electrification to areas so spacious and rural that sufficient
local public resources could not be mustered to do the job on their own. The
development of a localized power industry helps to give perspective on why we
are where we are today.
Unlike natural gas, which was mainly produced in specific regions, not tending
to be the major population centers, electricity could be generated locally with
indigenous natural resources like water or coal, and distributed locally. For
natural gas to make its way from regions of production to populous consuming
areas, interstate pipeline companies needed to establish cooperative arrangements
to cross-connect, and adopt uniform standards and procedures. Given the truly
interstate nature of the commerce, federal involvement was natural, and over
time the industry developed a strong federal regulatory program.
Power, on the other hand, has endured a lengthy and jurisdictionally inconsistent,
transition from a fully regulated environment to a fully deregulated environment.
The local make-up of the power industry, which has resulted in many powerful
and competing decision-makers rather than a single czar-like federal hand, and
even the absence of uniform interstate standards because of the historical underpinnings
of local generation and distribution, have combined to prevent a quick and uniform
deregulatory transition.
Natural gas, which deregulated shotgun fashion, is now one of the major feedstocks
of electricity generation, particularly so with those generation facilities
built over the past five years. There has developed a strong relationship between
short-term gas prices and electricity prices – including between gas price
spikes and electricity price spikes. Infrastructure problems in gas affect power
prices. Yet the ability of the gas industry to deal with the risks of price
movements in a competitive environment is far different and more evolved than
the ability of the power industry to deal with price risks in a much less competitive
environment.
The introduction of fungible, standardized benchmarks, price transparency and
counterparty credit risk mitigation through clearing allowed for the growth
in forward planning in the natural gas market – and other deregulated
energy markets. The existence of liquid secondary markets, which depended on these benchmarks for pricing and confidence in transactions,
opened the door for new participants. A new generation of “trader”
developed who was determined to enter the
fray against even the largest companies. He or she could compete with the “big
boys” because prices were easily ascertainable, and profits earned could
be quickly secured through reliable
hedges. Competition, in turn, lowered prices for consumers and provided more
consumer choices for services.
Time and again we have seen the availability of transparent pricing and market
competition restore “unbalanced” markets, markets which have spiked
or fallen into a trough, to equilibrium in short term corrections. We see that
forward planning and open and competitive market mechanisms work.
In power, the term “deregulation” has taken on some baggage, much
of it coming from the complete misuse of the word, particularly with the California
experiment with the Power Exchange (the “PX”). To call the product
of the 1995-96 regulatory and legislative process “deregulation”
flies in the face of all generally recognized and accepted definitions of the
term. Indeed, as a result of the implementation of AB 1890, and California Public
Utility Commission rulings and orders, the regulatory “overburden”
of the electricity market in California arguably increased dramatically. Utilities
were compelled to buy and sell their electricity through the PX. The rules in
California forced its market to rely artificially on the spot market. It did
this through mandating participation in the spot market by utilities, applying
the add-on competition transition charge (“CTC”) to artificially
render competitive transactions as uneconomic, and not providing an effective
program for competitive access to firm transmission. The net effect of the legislation
and rules was to create a monopoly power exchange, and, worse, force the bulk
of the California electricity market into a “day ahead” spot market,
instead of allowing the market to choose its own venue of exchange, and terms
of commerce. The CPUC went even further in attempts to “micromanage”
to effectively forbid the use of commonly used financial instruments such as
direct contracts, forward contracts, futures and options, with the sole exception
being that of the use of the Power Exchange’s “block forwards.”
In almost all other markets, be they energy or agricultural, the spot market
has been used to balance short term changes in business needs, not to fulfill
the majority of those needs.
Adopting the word “deregulation,” without adopting the transparent
and competitive practices of a deregulated market, where commercial decisions
are made by market participants accepting performance and price risk, does not
make a market deregulated. Of course, deregulated markets do not operate without
basic rules to assure competition. In power, because of the nature of the grid
with the need for reliability to trump profit, it is also necessary to have
rules governing use. An apt analogy might be to the deregulated airline industry.
As consumers, we all like the benefits of being able to shop for inexpensive
tickets, which competition among carriers has brought. But, we would not want
a cheap seat if it came at the cost of planes crashing into each other. The
presence of an air traffic control system does not prevent air travel from being
called, properly so, a “deregulated” industry. In certain industries
with zero tolerance for failure of reliability and safety, where that standard
cannot be assured by competitive means, there needs to be rules and processes which are designed to protect us and which should be
supportive of the growth of a competitive market, as air traffic control is
with air travel.
Notwithstanding the vast blackout of August 14, the power industry has done
an enviable job in providing power safely and reliably. However, as a result
of the blackout, there are troubling signs for maintaining those standards in
the future given a status quo approach to the grid. Kurt
Yeager, president of the Electric Power Research Institute, was quoted in the
Washington Post in the context of mechanical versus solid state switches that
“ The irony is that we are trying to run a digital economy on a mechanically
operated power system.” The New York Times reported on the strain placed
on electricity system operators by an ever more complex use of the electrical
grid.
There are clearly issues to be addressed in how the grid is maintained, enhanced
and managed.
Some in the industry have said that the solution to our problems, that is the
way to prevent any further blackouts, is to return to the days of local monopolies
in control of generation and distribution. It is difficult to argue in the abstract
about such a homey idea as returning to the past, I suppose the good old days,
and conjure visions of lights on and the family sitting around the TV. I could
be facetious, and also recommend that planes should be required to stop and
refuel every five hundred miles, or that the internet should be dismembered
because of the dangers of content or conduct by anonymous users.
However, practically, now that so much generation has been transferred to private
merchant companies from the utilities, how does that genie get put back in the
bottle? FERC does not have such broad authority with respect to electricity.
Further, if we attempted to make power a local endeavor once again, wouldn’t
there almost unquestionably be a need to build additional generation facilities
to compensate for the loss of power which no longer travels region to region?
It is unlikely that issues with the complex web of power transmission will
be solved by re-regulating generation and wholesale price. That is not to say
that the grid does not need additional capital investment, or more consolidation
in the management of traffic, and clear authority to act to prevent troubles,
or, for that matter, much greater use of Demand Side Management to mitigate
the weaknesses in our infrastructure.
The ongoing issues surrounding the full competitive development of power are
many. The accompanying chart shows graphically that demand for power and use
of the grid have far outpaced infrastructure spending over the last number of
years. That lag cannot continue unabated. However, who pays for the needed improvements
will be a challenge.
While we are waiting for solutions to the mega-problems facing the power industry,
there are some pieces of really good, hopeful news. The forward markets, at
least in this region, have begun to trade with more liquidity. As of September
4th, PJM Monthly contracts had an open interest of 8797 contracts; New York
ISO had almost 21,000 contracts open.
The Exchange has become part of the reason for this phenomenon of a newly burgeoning
longer-term market, because we have opened up our trading and clearing mechanisms
to participants in these contracts. Given what we saw with the turn in financial
condition of the merchant class, the need to mitigate counterparty credit risk
is enormous. In the New England region some 25% of summertime generation capacity
comes from entities in Chapter 11. In New York, according to Moody’s one-
third of summer generation capacity comes from entities whose bond ratings are
at “junk” ratings.
Further, the need to plan on a forward basis is more important than ever where
a company’s cash liquidity is an issue. The industry’s heavy reliance
on spot pricing and hourly planning, does not allow the ability to budget and
plan, and gauge costs and profits, in the way that weekly or monthly forward
trading does.
The purpose of this conference is to review Demand Response, but I have not
yet touched on that subject. Given the need to have brakes on the use of the
grid during times of stress (brakes which fall far short of brownouts and blackouts)
the implementation of Demand Response programs is critical. The use of sophisticated,
price sensitive technology has been made commercially available through The
Demand Exchange, and perhaps others. From an engineering or sales perspective,
I really cannot add much to your knowledge of how Demand Response should best
work. However, given the increase in generation and load, and the failure to
make commensurate investments in transmission – not to mention the environmental
constraints in quickly, cheaply and efficiently improving any aspect of the
infrastructure – the ability to relieve congestion through a sharing of
benefits is brilliant and must be further employed.
What I would like to add to the discussion as food for thought, is how the
improvements in information flow about prospective system use and longer term
pricing can add significantly to the popularity of Demand Management programs.
By integrating Demand Management into the forward planning process, it becomes
more programmatic, less of an emergency implementation, and more comprehensively
useful since it can be implemented on price and transaction signals days ahead
of any event.
Further, as Demand Side services become more widely used, they inevitably will
become subject to ever greater interest because of the information that Demand
Side bids have on market value.
With respect to the PJM market, for instance, the Exchange has implemented financially
settled instruments with durations ranging from next day, balance of week, weekly,
balance of month and monthly. There is an enormous new pool of immediately available
pricing information for various periods forward, which makes the use of Demand
Response as a forward planning tool more efficient and more accurate. This convergence
of transparency of information and price further into the future will only enhance the relevance and necessity of Demand
Management for users of the system, particularly the industrial load. |
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