A Roadmap for Today's Trading Floor

Edison Electric Institute’s Spring Legal Conference
April 12, 2003
Martha Wyrsch
Senior Vice President of Legal Affairs
Duke Energy

Good morning. Let me first thank EEI for organizing this constructive forum. With the many challenges facing our industry, events like these, the topics that are considered and the discussions that unfold are arguably more important than ever before.

Recognizing that this morning’s session is the only thing standing between you and the rest of your weekend, I promise to be brief in my remarks. But the issues we will address today are worth examining, so let’s get to it.

Change has been pervasive in the energy sector recently. In the last 18 months — in rather dramatic fashion — many of the “new,” “innovative” segments of our industry that fueled a prolonged wave of profitability and growth have smacked into an unyielding, concrete wall of diminished market volatility and low liquidity, credit crunches and scandals.

Energy trading falls squarely into the category of once high-flying growth engines now struggling to mature.

In the face of this major down-cycle, many companies have scaled back their trading businesses or exited the business all together. Duke Energy is no exception. We have realigned and reduced our trading operation to reflect the current market conditions. But we also recognize that trading is critically important to a well-functioning, competitive energy industry.

So with the benefit of hindsight and lessons-learned, we’ve recently identified and begun implementing new internal control measures into our risk management and trading practices. What’s more, we’ve partnered — through the Committee of Chief Risk Officers — with industry and regulators to restore order and trust to this emerging business.

In essence, we have helped to develop a roadmap for the new trading floor.

But how did we get here? To appreciate the controls and compliance regimens of today’s energy trading environment, one must first understand the evolution of wholesale energy markets.

For those of us who could use a refresher, I’ll quickly run through an abridged version of the early years.

* * * * *

More than a decade ago, the world began to embrace the efficiencies of competitive wholesale electricity markets.

In the United States, FERC and Congress both endorsed the competitive wholesale model — FERC with Orders 800 and 888, and Congress with the Energy Policy Act of 1992.

In quick succession, country after country began transitioning their power and natural gas industries from rigidly structured, regulated systems to models that relied more heavily on competitive markets to generate power and provide wholesale supplies of natural gas.

These policy decisions paved the way for a critical industry transition. Seizing on the growth available through competition, many companies established new strategies. Once staid utilities quickly branched out — developing regional or multiregional generation portfolios and investing in business-friendly, pro-competitive international markets.

The old regulated model relied on financial risk for building new power plants to be substantially borne by retail power consumers who committed to pay for generating plants through cost-based rates. In the new system, this risk is borne by investors who put up the money to build them.

As a rule, investors are willing to bear that risk and can usually do so more efficiently than consumers, but investors will only bear the risk if it can be managed.

Managing the risk inherent in construction and operation of power plants required that the inputs into those plants — the fuel, in most cases natural gas — and the output of those plants — power — be bought, sold and traded, similar to all other commodities.

It was this need to manage risk that created today’s energy trading and marketing business.

At its simplest, that’s all energy trading and marketing is: a means of rationally transferring the risks associated with providing these critical products among investors, producers and consumers.

Sounds simple... So what went wrong?

* * * * *

As recent events have vividly demonstrated, the evolving merchant energy sector is in its adolescence.

In many respects merchant energy’s rapid growth outstripped the controls, standards and infrastructure needed to assure orderly markets.

I’ll avoid the lengthy post-mortem since we’re all familiar with California’s energy crisis, the Enron scandal, round-trip trading investigations and other regrettable events that have put energy markets under an enormous microscope — exposing control failures and illustrating the need for industry guidelines.

But how do we begin to set the guidelines? How do we strengthen control systems? How do we get back on track?

* * * * *

At Duke Energy, the first task was ensuring our house was in order. To reduce risk and to prevent inappropriate trading activity we moved quickly to beef-up internal controls and to establish clear compliance standards.

We created a trading compliance function, reporting through our office of general counsel, to formalize our processes throughout the enterprise. At its core, Duke Energy’s trade operations compliance group has three main objectives: research, training and monitoring.

• Research: Our compliance group ensures that all external laws, regulations and rules that apply to Duke Energy’s commercial activities throughout the world are continuously identified and incorporated into the internal policies and procedures that govern our commercial activities and risk management actions. The group also serves as an information resource should any business unit have questions.
• Training and education: Our trade operations compliance group develops training curriculums and offers mandatory training sessions for commercial and risk management personnel to fully understand the intent and specific components of the laws, regulations and rules, along with Duke Energy’s internal policies and procedures that govern their respective responsibilities. As part of this training, commercial and risk management personnel must successfully complete a certification program.
• Monitoring: The group has oversight responsibilities to ensure the actions associated with Duke Energy’s commercial activity are in accordance with internal policies and external laws, regulations and rules. While commercial leaders perform real-time monitoring, the trade operations compliance group monitors via reports and direct communication with commercial and risk management personnel.
  Monitoring includes review for: unauthorized or restricted transactions, market and earnings manipulation, artificial congestion, anti-trust activity, trade irregularities, disconnects between actual trade activity and commercial strategy, violations of corporate and business unit policies, and violation of Duke’s Code of Business Ethics.

Our trade operations compliance group is busy implementing its critical objectives: studying trading rules and regulations, creating policies and procedures, clarifying standards, providing training and monitoring our operations for compliance. For Duke Energy, this process is mission critical for the future success of our trading business.

* * * * *

But it takes more than piecemeal company-by-company efforts to fully address systemic issues threatening the sector. The crisis in confidence in energy trading is industry-wide and requires industry leadership and solutions.

As a founding member of the Committee of Chief Risk Officers (CCRO), Duke Energy is working with more than 30 other companies to develop best practices for energy trading and marketing. These standards will make wholesale energy businesses easier for investors, customers and regulators to understand and compare, through better reporting of the risks and financial aspects of their operations.

The CCRO, after receiving significant input from regulators, credit rating agencies, securities analysts, accounting professionals and industry trade association financial experts (including EEI), has identified best practices in a number of areas. These new guideposts were developed for issues that include: corporate governance, price reporting, financial controls, risk management and measurement, including credit risk, and disclosures about trading and marketing operations.

For the purpose of today’s discussion, let’s focus on the first two best practices I mentioned — governance and price reporting.

Any organization needs as a foundation strong, clear governance signals. In November, the CCRO developed guidelines to provide commonality for observers to evaluate quality of governance and control structures at energy companies.

These guideposts include: defining roles and responsibilities for board of directors, senior management, etc.; minimizing operational risks by strictly segregating responsibilities for trading, valuation and accounting; establishing a company-wide risk management framework; and setting comprehensive process descriptions for the “life cycle of a deal.”

And most recently, in late February, the CCRO unveiled a set of best practices for achieving robust and reliable price indices.

The CCRO recommended companies provide relevant data about all transactions on a transaction-by-transaction basis, including identifying both the buyer and seller in every transaction, after measures are in place among traders — and also between traders and index publishers — to protect the confidentiality of this information.

Submitting transactional data such as price, a buy-or-sell indication, the time frame involved and the volume, along with other information, is integral to improving liquidity and thereby meeting the industry’s and the consumers’ need for price discovery.

It’s worth noting that last year Duke Energy implemented new procedures to formalize and improve its process for reporting pricing data to industry indices. As now recommended by the CCRO, our company’s process requires that all pricing data provided to indices be validated and conveyed by risk management staff reporting to the company’s chief risk officer, rather than directly from the trading floor.

The risk management standards envisioned by the CCRO are feeding a growing appetite for transparent, meaningful information about energy companies. The commonality that will result from implementation of these recommendations will quickly begin to restore confidence in energy trading.

* * * * *

But how will we know if we’re headed in the right direction? What are the signs that we are making progress?

Trading is essential to a healthy, competitive energy industry. But it is still somewhat new to the industry. At Duke Energy, we’re taking a two-pronged approach: working from the inside out, calibrating our controls and policies; and from the outside in, collaborating with industry partners and regulatory bodies to restore order and trust to this emerging business.

We’ll know we’re on the right path when other companies begin to implement formal processes such as those recommended by the CCRO. Once these standards spread out across the industry, more efficient, less risky markets will take shape.

From there, much of the regulatory uncertainty clouding the sector will start to dissipate and new trading entities with hefty balance sheets will begin to emerge.

This roadmap should measurably enhance investor and regulator confidence while boosting the understanding of the critically important role the merchant energy sector plays in securing competitively priced energy supplies for consumers. Long term, proper controls and compliance standards will bolster the trading markets — enhancing liquidity and reducing the cost of providing energy, benefiting consumers and investors.

Thank you.