Risk Management in Energy Trading Market: Top 3 Challenges

Risk Management in Energy Trading Market: Top 3 Challenges

Risk Management in Energy Trading Market: Top 3 Challenges

Security, Speed, Reliability

How do systems address those and what are the areas for improvement?

As stated in McKinsey’s article The Future of Commodity Trading, “recent market developments include increased price transparency, greater access to structured and unstructured data […], contract standardization, new exchanges and platforms, and regulations“ resulting in “higher market participation, transaction volumes and costs, and speed to market”.

This results in increased volatility of the traded financial and physical products, and demands a more flexible response to the constantly changing market conditions. Given this, commodity traders and risk managers are facing new challenges and demanding more and more support for technologies. In this article we are going to focus on the top three of them, how systems address those and the room for improvement.

Security

In the energy industry we operate, the risk of hacker attacks has increased due to recent geopolitical events. Data is the core of every trading business and analysis nowadays. Predictions and strategies based on this data are proprietary goods and key to financial success. The main challenge for every company is security. This becomes even more important given the regulations in the energy sector and the requirements for anonymization encryption and disclosure/reporting of transactions to the supervising authorities.

Volumes of digital, online and algorithmic trading are increasing and are supported by tools, systems or AI. The online exchange of sensitive data, as well as investments in IT security also escalate. The setup of proper encryptions, proxies, gateways, VPN tunnels and procedures to protect your data and trading systems becomes a must for every key player in the industry. With that, the area becomes more attractive for software engineers too.

As systems evolve, so do encryption algorithms. Hackers’ creativity grows and the IT security teams must follow. With the increased usage of nearshoring and consultancy services outside of a particular trading company, teams become more global. Data protection and the usage of proper authorization and authentication mechanisms are inevitable. Therefore, step number one in developing any new product, component or whole architecture is setting up the proper structures for granting functional and data permissions and securing the data transfer protocols.

This is an area where IT companies can provide expertise to trading companies, either by ways to customize the usage of already known systems and tools or by helping with the development of in-house systems to ensure the protection of this precious data.

Speed

Given the increasing data flows, speed becomes a significant challenge across the whole cycle: accessing, transforming, synchronizing, processing, storing, querying, and exchanging data. The companies that manage to implement the aforementioned process-cycle the fastest, would usually unlock trade potentials and arbitrages inaccessible to the ones who are slower. By using tools, systems and AI-based, self-learning and training programs, it is no longer a matter of minutes or even seconds – but milliseconds. The maximum response times become a key non-functional requirement in every new development. This is the area where an IT specialist can provide significant value not only for traders but for risk managers as well.

Position management in highly volatile market environments requires not only real-time monitoring and very frequent updates of data. It also requires quick reactions to new market trends. Full excellence and high efficiency can only be achieved by optimizing the whole chain of data flows to ensure maximum speed of data handling and decision making – and respectively, taking the appropriate actions. It is possible to improve in the following areas:

  • Optimizing access to data by caching or querying. This can be done either directly on a database level or via the usage of web-based services;
  • Acceleration of data transformation or processing via standardized ETL tools or own programs/algorithms;
  • Ensuring proper visualization of data to drive informed decisions using proper monitoring and BI tools;
  • Optimization of data exchange protocols and interfaces;
  • Applying proper data storage procedures provides maximum efficiency when trying to extract a particular data set;
  • Last but not least: ensure a proper orchestration of all components driving the data flows

The maximum speed in the above areas often results in maximizing profits and minimizing risks (sticking to the predefined limits) by quickly reacting to market changes, one-off events or reversing trends. This is where investments in IT can provide value and returns.

Reliability

Speed, of course, means nothing, if you cannot rely on the data and the systems. This data should be of the desired quality and without errors or gaps. The systems should be constantly available. With that said, the next challenge is reliability. Without proper validations or constant and continuous/uninterrupted access to it, even the best data becomes worthless.

With the rise of cloud-based technologies, it is possible to deploy services to new services, restart or restore not running machines, and increase computational power remotely within a couple of minutes to avoid long-lasting disruptions or outages. IT specialists can help design the cloud architecture in the best and most reliable way, increase availability and minimize infrastructure/system costs. If traders or risk managers base their decisions on outdated or faulty data, there is a high chance that the decisions are wrong as well, sometimes with significant financial implications.

That is why energy (trading) companies increasingly invest in cloud-based architectures, while still keeping the above requirements on security and speed in mind in addition to reliability and availability. Minimum availabilities are becoming part of almost every contract for IT infrastructure or components. The need for 24/7 incident management and monitoring services increases as well, as trading happens in different locations and markets around the clock.

In summary, with the increased flows and availabilities of data, the volatile market conditions and the ever-increasing online trading, investments in proper IT infrastructure become very important. To maximize returns and minimize risks supported by the proper software and experts, companies need to tackle the challenges related to those continuously and with diligence. IT systems are a powerful weapon – however, if misused, their usage may lead to self-destruction.

Author: Konstantin Grigorov

2021 – HOW IS THE ENERGY SECTOR DOING?

2021 – HOW IS THE ENERGY SECTOR DOING?

2021 – HOW IS THE ENERGY SECTOR DOING?

The EU energy transition created situations of deadweight, and this could not be any truer in 2021. The transition was initially triggered by the vulnerability of the RES in the EU primary energy sources. Мeanwhile the gas supplies were disrupted and the storage levels were critically low at the beginning of the cold season. The natural gas price skyrocketed and caused spill-over effects on electricity. Interestingly, no other key energy commodities underwent the same stress. The crude oil price, on the other hand, did not follow the same price momentum.

Тhe energy sector, and more noticeably the gas sector in 2021, were marked by a recovering demand, but still a low output with tighter-than-expected production. It turned out that demand recuperated faster than supply. Producers who were experiencing downturns could hardly catch up amid the largest EU price jumps in decades. The anticipated COP26 came to a close, making its mark through the Global Methane pledge and determination for fossil fuels abatement, although all this ended up with a phase-down rather than a phase-out.

Timeline

>> Jul 2021 — The European Commission released the largest Climate law package Fit for 55 on its ambitious way towards GHG emission reduction. Тhe maritime sector would be included in the scope of EU ETS scope from 2023 onwards.

>> Sep 10th — The $11 billion Nord Stream 2 saga was near an end. EPC was finalized with just an admission certification remaining to be issued.

>> Oct 1st — Consolidation of the largest gas market in Europe, Germany, under the THE (Trading Hub Europe), after converging NetConnect and Gaspool market zones.

>> Based on the TTF historical data, the natural gas average close price, used as a standard benchmark price for performance, was around 46.16€/MW throughout the year 2021, as opposed to 10.46€/MW throughout 2020. The price briefly jumped to 180.27 €/MW in December. Compared to the highest corresponding cost of 21.70 €/MW in 2020the new one accounted for a nine-fold increase.

>> Oct — Nov — COP26 took place. Hydrogen was officially earmarked as the climate silver bullet for decarbonization and was promoted as such.

>> Gas prices in the EU followed a W-shaped recovery (double-dip recession). This can be attributed to the COVID-19 waves and in Q2 2021 it retained the price level from Q3–2018 at 25€/MW. Despite its expansion and price momentum stemming from the supply shortage and recalling the Beast-from-the-East-scenario, gas is not a true proxy for the economy. The steep and rapid surge in the second half of 2021 was an impulse rather than an accurate representation of the economic growth.

>> Dec 8th — EU Carbon emissions hit the highest price since the foundation of EU ETS— 89.47 €/t as opposed to 33.55 €/t at the corresponding time the previous year, which marks a triple jump on a YOY basis.

>> Dec 31st — As a consequence of the EU primary energy sources strategy, there was an increasing share of intermittent non-dispatchable energy sources. This led to decreasing conventional flexibility with the Nuclear plants decommissioning. The last German nuclear capacities will be phased out at the end of 2022. After abating nuclear energy, the coal plants will remain in function until 2038.

>> Dec — The tightness in the gas supply had a detrimental effect on the clean spark spreads and resulted in ramping up the electricity wholesale prices. It further aggravated the high price by including the carbon-intensive coal electricity and pricey carbon emission allowances, thus breaking a record, hovering around 400€/MW in the EU

>> Q4 of 2021 — The price differential between natural gas and crude oil got larger. Widened inter-commodity spread could boost oil demand. By convention, the natural gas commodity is priced below crude oil. Regarding the inter-commodity spread (Brent; TTF) in 2021, the two price curves intersected at the end of Q3 202, when natural gas reached $100/bl, while Brent anchored at $71.59/bl. This represents a price anomaly. In Q4 2021 this deviation gets even more pronounced with TTF following its upward trend and crude oil (Brent) tending to decrease. We can conclude that at the end of 2021, natural gas was more expensive than crude oil, which may incent consumers to switch to oil alternatives.

>> 2021 — Coal-fired electricity was set to rise. The increased electricity demand resulted in coal-fired electricity generation growth and an all-time peak of 6% in 2021. This was another example of why electrification must not be performed before fully developing the RES. Lack of sufficient base-load energy sources and decommissioning the existing ones, such as nuclear plants, appears to be the right recipe for the comeback of coal.

 


2021 will be remembered with the largest global electricity demand and by the predominant use of gas and coal plants, along with the largest progress coal-fired power has seen recently. The key role of natural gas for the EU gross electricity production triggered a domino effect of surging wholesale prices for electricity. The prices were exacerbated by the coal-firing power plants and carbon emission allowances.

The year reaffirmed the main LNG arbitrage route, bringing the imports into a tug-of-war situation between the Pacific and Europe with a strong positive linear relationship, at a correlation of 0.93. With South America recently included, the EU would have to deal with the challenge to lure more LNG supplies, unless it comes up with a long-term solution.