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Articles Archive
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June 2003
ETRM Software — The Market Moves On
By MICHAEL HEPBURN, Prospex Research Ltd.
The long awaited shake-out of the European energy trading and risk management (ETRM) sector has begun in earnest and is set to continue. It comes as no surprise that the European energy market is not big enough to financially support over fifteen electronic trading platforms and a similar number of major trading and risk management solutions vendors. Despite this simple truth, substantial numbers of companies are digging in for a battle of attrition that they hope will see them emerge victorious. The fact is that trading platforms and those selling risk management solutions are competing in a zero-sum game for revenues provided by a dwindling number of European market participants. Furthermore, the pace of deregulation throughout Central and Eastern Europe is unlikely to create a sufficient number of new market participants to support the existing number of competitors. The economic reality of 2003 is that the transaction platforms are competing for shrinking amounts of liquidity in many key markets and hence lower trading commissions. The risk management vendors must contend with fewer energy merchants and banks with large IT budgets seeking comprehensive enterprise-wide risk management solutions.
The question that naturally follows is who will survive the shake-out and thus be well positioned for the end-game when the European energy market recovers? For the last two months Prospex Research have been researching the European marketplace in an attempt to answer this question. Our research focused on both the technology providers and end users. The results proved to be very interesting and have enabled us to identify important emerging trends that we believe will determine the winners and losers. Important lessons have been learned regarding the development of ETRM solutions and the failure to observe them will likely result in further money being invested in ETRM solutions that fail to ever make a return on their investment. Importantly, market participants are now dictating how they want to see ETRM solutions developed and are asserting their collective strength. The major market participants no longer want to have dozens of technologies pushed at them that only serve to make the market more complex and fragmented.
Continental Legacy Market: Focus on Niche Solutions
It is widely accepted amongst ETRM vendors that the future market for their solutions will be a replacement market. In the mid to late 1990s many energy firms purchased systems or built in-house ETRM systems that no longer meet the new physical and financial trading requirements of the market. In some cases, energy companies bought systems when they were uncertain about what role energy trading would play in their business and consequently they were not in a position to plan for their future ETRM requirements. In other cases, multiple systems, each designed to solve a specific problem, were integrated over time in a rather incoherent fashion without a collective strategy. In theory, these factors should create demand in the marketplace for more sophisticated, enterprise-wide solutions.
While this logic is sound in theory, we believe the legacy or replacement market in 2003 represents only limited opportunities for vendors who can provide competitively priced niche solutions. Several important findings support this position. First, examples abound where companies have paid seven figure sums for a complete enterprise wide ETRM system that promised to deliver all of the functionality that they required. However, the ability of the large ETRM vendors to provide comprehensive solutions is questionable. Nearly all of the major vendors claim their system is scaleable, robust, flexible, customizable and can be configured to meet specific needs. But many large energy merchants and banks are highly doubtful that vendors can deliver a total ETRM solution tailored to their company's individual needs while being capable of dealing with the regulatory and physical asset characteristics of each country in which it operates. No two energy merchants/banks define their enterprise risk in the same way, nor do they possess identical business strategies.
Secondly, the sales process for replacing a legacy system is much different than the sales process faced by the ETRM vendors when they first sold their systems in the 1990s. Today, the ETRM vendors must often convince IT Directors and senior management to write-off substantial investment in systems that are still fulfilling certain requirements. Given the integration issues involved with replacing an entirely new system, the political path of least resistance for many companies is to seek a low cost niche solution that can be deployed quickly.
So what does this mean for existing ETRM vendors? For established European major players such as KWI, Vedaris, SunGard/Caminus and OpenLink Financial, if they are going to win new replacement business they must be able to unbundle their existing offerings into market specific and functional components that can be easily integrated into the client's in-house systems.
OpenLink, for example, acknowledges the new reality of the replacement market and has launched Endur Express, which allows them to sell their traditional Endur solution pre-configured for certain markets with other functionality effectively turned-off. As the requirements of Openlink's clients evolve over time, they can simply activate the required functionality with a license key. Openlink's European Managing Director Jean-Claude Riss explains, "Since Endur's extensive coverage for the power market takes in front- through back-office and financial to physical trades and settlement, OpenLink needs to offer the market a more component based approach to system replacement. A flexible core system architecture and powerful systems integration capabilities are key issues in addressing this market. However, OpenLink's services based system architecture was always designed to enable the creation and packaging of niche market offerings and our ADI (Adaptive, Dynamic, Integration-enabled) technology addresses both complex global and simpler localized integration needs based upon our OpenConnect suite of integration tools. This approach ensures that OpenLink will continue to provide its clients with the tools they need to support their business activities."
Vedaris has also realized their Contango ETRM solution is too prescriptive and needs to be more flexible to address diverse market requirements. They are currently developing a new platform architecture called Dynamic Risk Intelligence which will underpin the new ETRM solution they hope to launch in September this year. Bob Bridger of Vedaris believes, "... what companies are asking for is less prescriptive solutions and more flexibility. What they mean by that is the ability to implement functionality for specific needs but run their own models and algorithms, integrate it with their other systems, and be able to extend functionality as necessary into areas like green certificate trading or operational risk evaluation to match their unique asset profiles. That's not a prescriptive, packaged solution."
While the established ETRM players attempt to unbundle their offerings and price them lower to win business, some of the smaller players with specialized offerings are winning substantial business. In the Nordic region, for example, both Viz and OM have had success selling their respective ElViz and POMAX ETRM solutions. Unlike the larger British and American vendors, they sell their solutions at a much lower price point and can deploy them in a matter of weeks. Managing Director of Viz, Frank Carlsen states, "You can call it skill or luck, it's a small distinction, but we have been able to provide our customers with a solution that our competitors cannot match; a low risk alternative that provides a quick implementation period but still provides a solution that covers their needs in financial trading and complex energy risk management." Our research indicates that nearly 75% of the ETRM systems sold in Europe in the last fifteen months were smaller, less expensive systems such as those provided by the VIZ and OM.
Emerging Market ETRM Opportunities
Given the limited opportunities for replacement sales in the established European market, it is natural for the ETRM vendors to look at Central and Eastern Europe as a potential large opportunity. Deregulation is prompting a number of utilities to enter the market for ETRM solutions as they evolve from formerly state-owned utilities to energy merchants. Our research confirmed this fact, noting contract wins in Hungary and Slovenia and bidding activity in Poland, the Czech Republic and Slovakia.
Our research indicates that the established ETRM vendors such as KWI and OpenLink are well positioned to win business with the former public utilities. The larger players have a proven track record helping former utilities migrate from a utility to an energy merchant and can bring substantial consulting experience. KWI's win in Hungary with MVM is evidence of their success in this regard.
It will be important for the vendors to quickly establish themselves in these markets as local knowledge will be critical for winning future business. Forming partnerships with regional software developers will be the quickest way for the vendors to complement their existing knowledge. Dave Bucknell, CEO of KWI Europe, explains, "Our approach in newly deregulated markets is to combine the global knowledge we have in deregulating energy markets with the local knowledge of a system delivery partner. This is the best way to handle the rapid and fundamental change that clients undergo. KWI's software and business service offerings have been developed over a ten year period of direct involvement in deregulating energy markets. Putting our domain expertise and software alongside high quality, local delivery expertise has proved extremely effective in Italy, Hungary, the Czech Republic and Poland. MVM in Hungary is an excellent case study. We partnered with Accenture to deliver a market entry solution in a record time of nine weeks."
Many vendors are also conscious of the fact that Western energy players will likely enter the Central and Eastern markets to make acquisitions. In many cases the Western European players will already have an ETRM solution for their existing markets but it is not guaranteed they will extend the use of their existing solution to the new markets. Instead, they will look at which ETRM vendors have a proven track record in the local market.
Based on our research we believe that the smaller ETRM vendors will not be significant players in the Eastern and Central markets. In many cases the smaller ETRM vendors such as the Nordic players and more recent market entrants such as Sakonnet have developed sophisticated ETRM solutions that are beyond the needs of the former utilities. Consequently, they are not focusing on the emerging market opportunity and are focusing instead on the more mature western European markets.
The Battle For Liquidity: Technology Does Not Ensure Success - But It Can Guarantee Failure
The battle for liquidity in the European energy market has been characterized in recent years by heavy investment in bespoke electronic trading platforms. Many different models of electronic trading platforms have evolved, including the regulated exchanges, the OTC Inter-Dealer Brokers and finally the independent e-marketplaces. In each case, technology was viewed as a key way to differentiate the value of the service and attract traders to the site. Incurring high development costs for a bespoke system was also viewed as acceptable since it was believed the costs could be recovered through an eventual Initial Public Offering of the company.
However, over the last two years the energy trading community has developed 'electronic platform fatigue' and is fed up with multiple screens being pushed at them from all directions. Traders do not want to learn how to trade on dozens of screens and their IT departments do not want responsibility for integrating each unique platform into their middle- and back-office systems. Desktop real estate is limited and hence the ideal solution for traders is to be able to aggregate the prices of the various liquidity pools onto a single screen that provides traders with the ability to both enter prices and execute trades. However, this will require the industry (the brokers, the exchanges and the independent market places) to agree on the standardization of contracts, the technical standards for data communication and the releasing of read-write Application Protocol Interfaces (APIs).
In retrospect, important lessons have been learned regarding how to successfully launch an electronic platform. First and foremost, the energy trading community is not overly concerned about a particular platform's unique functionality. Furthermore, they have no loyalty to a particular trading platform. Research amongst the trading community has established the simple truth that all traders want is a system that allows them to quickly view the market, execute with the minimum of key strokes and integrate the trading platform seamlessly via an API with their own internal systems.
The best example is provided by the electronic trading screens of the OTC brokers. Both Spectron and GFI launched hybrid electronic/voice trading in 2000 with Trayport's Global Vision trading software. The software can be downloaded to the traders' screens quickly and it is extremely intuitive to use. Global Vision quickly became the accepted broker platform amongst European energy traders and competing brokers were forced to follow Spectron and GFI if they wanted to introduce an electronic platform. Traders became reluctant to accept new broker platforms and basically told other brokers to launch 'the Trayport screen'. Prebon, for example, invested in a proprietary system that did not have an API and that was considered by the industry to be less user-friendly. In the end, Prebon licensed the Trayport system and has launched it in all of their major energy markets. More recently, APB Europe has launched Trayport in the Dutch market.
The exchanges face a similar situation with eight of them targeting the same clients as the brokers with multiple screen offerings. However, unlike the brokers, no one technology has emerged as a de facto standard for exchange trading. Again, the traders are unhappy with this situation as they must undertake the time-consuming task of integrating the various exchanges' APIs into their in-house systems. Our research indicates there are over nine competing systems being used by the exchanges for trading spot and futures. One example of where a trading system is gaining some traction is the power exchange solution SAPRI Elweb, jointly developed by Nord Pool and Orion Consulting. Elweb is used for trading the spot market by Nord Pool, EEX and most recently Powernext. When deciding on the most appropriate business model, Powernext wanted a system it felt would be quickly accepted by the market and hence it chose Elweb. Powernext CEO Jean-Francois Conil-Lacoste's approach was simple and he has no regrets, "Let's not reinvent the wheel. Nord Pool's Sapri had a good track record, we could take advantage of it and concentrate on other issues. Our technical record is excellent with not a single failure." Many traders from tier one energy merchants supported the decision since they were already familiar with the system, thus removing a major source of risk for any new trading platform — acceptance of their technology.
But simply choosing a proven trading platform does not ensure success. Many OTC brokers, for example, have had to close or reduce their operations as a result of poor trading volumes. In many cases, they had successfully launched with the Trayport platform and were offering comparable hybrid voice/electronic services to other brokers. Examples include Norway's ePower, EnergyPlus in Ireland, IEB and ICAP. Many of the exchanges are also having great difficulty in generating sufficient liquidity to achieve profitability and ensure their long-term survival.
The lesson for exchanges and OTC brokers seeking to grow their liquidity levels is that their choice in technology should be dictated by the needs and preferences of their end-users. In most cases, the traders do not care what platform they use provided it is familiar, user-friendly and reliable. Therefore, it is an extremely risky strategy to invest heavily in developing a proprietary system. Software development is inherently risky and subject to frequent cost over-runs. Traders are faced with a wide array of bespoke systems and are reluctant to integrate bespoke systems. Exchanges and brokers must ask themselves if they will ever get a return on their investment if they develop a bespoke system versus licensing a widely accepted and proven system.
But having a reliable and user friendly platform is simply the cost of admission to compete in the European energy trading market. The trick is to minimize the cost of admission by not taking on huge IT development costs. In many cases, success in the energy market comes down to adding value in non-technical areas, such as providing timely and accurate market intelligence. The OTC brokers continue to dominate in this area and it is now common to see the exchanges or e-marketplaces hiring ex-brokers to help them improve volumes by picking up the phone and calling traders. The more things change the more they stay the same!
Balance of Power Shifting
On a final note, our research also reveals a clear shift in the balance of power between technology providers/vendors and the market participants. We believe the pattern will eventually be broken whereby the market participants sat helpless while vendors pushed competing ETRM technologies at them. It is, after all, the market participants who pay the exchanges and brokers and who buy risk management systems. Consequently they hold all the power.
Co-operation between the major players is increasing through organizations such as the European Federation of Energy Traders (EFET) and soon the market participants will be dictating most technical standards to the ETRM vendors. The recent release by EFET of their eCM (Electronic Confirmation Matching) open standards regarding the definition of business and technical processes for trade matching and confirmation is a good example. The eCM open standards were the result of an agreement between seven of Europe's largest energy traders to help back offices realize their main objective — reduction of operational costs and risks. By taking the initiative and cooperating, market participants will increasingly be able to influence the ETRM vendors and force them to comply with certain technical standards. In the future, only the ETRM vendors with flexible solutions which can be quickly configured to comply with market requirements and easily integrated with other systems will survive.
Michael Hepburn is a Consultant with Prospex Research Ltd. Prospex Research analyses strategic and financial issues for the international electricity business. Their work includes reporting, consulting, trading business recruitment and conference development.
As seen in Commodities Now magazine - June 2003
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