A major transition is taking place with European energy asset ownership structures. Thermal power and midstream gas assets have traditionally been owned by utilities and producers. But asset write-downs, balance sheet pressure and changes in strategic focus are paving the way for large scale asset divestment.
Power plants, interconnectors, pipelines, gas storage facilities and midstream LNG assets are increasingly being sold to infrastructure and private equity investors, who are also funding the development of new flexible infrastructure projects. Most of the assets involved have significant associated market risk exposures which need to be optimised, dispatched and hedged in traded energy markets.
Some assets are being purchased with commercial functions already in place to manage market risk exposure. But in many cases, the trading & commercial capability and associated support functions remains with the utility or producer selling the asset. This is creating a growing requirement for investors to outsource commercial, trading and risk management services to 3rd party providers.
In today’s article we look at how investors are managing to access ‘route to market’ services via contracting with third parties.
Overview of market access structures
There is a spectrum of 3rd party market access structures. At one end are simple execution based agreements where the asset owner retains full commercial control of the asset, using a 3rd party trading desk as a market execution service. At the other end of the spectrum are complex contracts that effectively transfer the commercial management of an asset to a 3rd party in exchange for a fee. Most contracts currently being struck sit somewhere in the middle ground.
Two important factors determining the approach an asset buyer takes to negotiating a market access contract structure are:
- Risk/return profile: The extent to which the owner wants to be actively involved in management of asset risk & return.
- Commercial capability: The existing level of in-house commercial capability, or strategic ambition to develop this.
The common feature of all market access agreements is that the asset owner is contracting with a party that is active in the traded markets required to monetise the value of asset flexibility. This includes commercial & risk management expertise, counterparty and exchange agreements, analytics, systems and processes.
In order to understand how market access agreements are being structured, we have grouped contract structures into three approaches that sit at different points on the spectrum described above. These three groups are summarised in Table 1 and described below.
1. Deal execution
The simplest form of market access agreement is a deal execution service. The asset owner retains and manages all market risk exposure and control of hedging and optimisation of asset(s). The asset owner effectively pays the 3rd party trading desk to transact in the market on their behalf, rather than transacting directly in the external market.
The reason for contracting a deal execution service is that it means asset owners can avoid the overheads of establishing multiple counterparty trading relationships e.g. the setup costs of master agreements, credit lines, complex trading & risk management systems and 24/7 commercial operations. 3rd party deal execution can also mean access to better market prices i.e. lower bid/offer spreads.
The asset owner typically pays a fee, usually in the form of a variable charge for each transaction. This covers external market costs (e.g. bid / offer spreads) and risks (mainly a credit risk charge). An allocation for trading overheads may be covered via a fixed fee (e.g. monthly) or via a surcharge on the variable fees.
Deal execution agreements are typically signed by asset owners with a strong in-house commercial capability, but who lack an established presence and access to information in specific traded markets, or lack the required physical capabilities and licences. For example a US or Asian fund may have strong commercial capabilities in their domestic markets but not in Europe. Or alternatively a generator may have a short term asset dispatch capability but lack access to forward markets.
From an asset owner’s perspective the key areas to watch out for with deal execution agreements are:
- The level and mechanism of transaction fees, which can result in ‘death by a thousand cuts’ via transaction fees eroding value if they are not properly structured.
- The extent of the 3rd party contractor’s access to counterparties and market liquidity, as well as an assessment of their overall market & commercial expertise. This includes how the costs and risks associated with periods of market illiquidity are dealt with.
- The credit risk of the 3rd party.
The good news is there is growing competition to provide deal execution services in Europe amongst banks, commodity traders and larger utility/producer energy trading desks. This is helped by the fact that traders typically like providing execution services (for the right fee), because they generate a regular deal flow (i.e. provide liquidity).
2. Incentivised exposure management
The most common form of market access contracts currently being negotiated by asset investors, involves the transfer of asset exposures from owner to 3rd party provider, along with incentives to monetise asset value. If a contract is structured well, it allows the asset owner to retain a degree of control over managing asset risk/return. But it also allows for the 3rd party provider to add value through its trading expertise.
CCGT ‘exposure transfer’ case study
Consider a simple case study involving a CCGT power asset. The asset owner may want to retain control over hedging of asset margins in the forward market. For example the timing and volume decisions on hedging of forward spark spreads may be made by the owner, even if individual trades are executed via the 3rd party provider.
But the owner may want to transfer plant exposures to the 3rd party provider prior to the day-ahead stage. This allows the owner to avoid the overheads and complexities required to deal with factors such as hourly auctions, nominations, plant dispatch and balancing.
Exposure transfer is typically achieved by agreeing a benchmark for optimised asset value at the point of handover (e.g. day-ahead). Once asset exposures have been transferred, incentivisation mechanisms can be used to align the interests of owner and 3rd party trader in managing asset risk/return into delivery.
In the situation described above, the value added by the 3rd party is focused on managing power plant exposures in the prompt forward and real time markets. Significant incremental value can be generated over this shorter term horizon, given ability to optimise CCGT flexibility against price shape and volatility.
This type of market access agreement is a structure that allows the 3rd party provider to maximise the value of asset exposures within the incentives and constraints imposed by the agreement. In return the provider receives compensation for this service based on a portion of the value delivered.
The key to structuring a successful agreement of this type is defining:
- A fair & transparent benchmark for incremental value added by the trading desk (vs the inherent value of asset flexibility which should accrue to the owner)
- An appropriate incentivisation mechanism that aligns party interests and allows a fair sharing of realised value
The asset owner may also choose to handover a greater degree of control for asset margin management to the 3rd party provider. This is typically achieved via adopting more of an ‘open book’ approach to asset value management as set out in the case study below.
Gas pipeline ‘open book’ case study
Consider another simple example involving a European gas pipeline asset, where margin is managed via a combination of long term and shorter term contract sales.
In this situation the asset owner may want to retain control over the sale of long term contracts (typically large and infrequent). But the owner may have an agreement with a 3rd party service provider to manage the day to day sale of shorter term firm and interruptible capacity products.
Under this type of structure, the 3rd party has a greater degree of responsibility for monetising asset value, given a broader commercial freedom to market capacity not already sold via long term contract. But value management is done within a governance framework controlled by the asset owner. This allows the owner to have a relatively small commercial team to support the asset (e.g. 2 or 3 people), something which is often an advantage for a fund with multiple investments.
The asset owner is typically looking for commercial creativity and an ability to access sources of value are difficult for the owner to achieve (e.g. given a lack of critical mass). But the asset owner can be faced with the issue of conflict of interests, if the 3rd party has a portfolio of its own assets in the same class, as is often the case.
This type of agreement is typically structured around an ‘open book’ approach, where both parties have full transparency of deals being made. However for this structure to work, a clear set of constraints (e.g. risk/return boundaries), incentives (e.g. aligned value sharing) and performance benchmarks are critical. It can also create a significant overhead for reporting & auditing of P&L and commercial decisions for both parties.
3. Value transfer
The third grouping of market access agreements involves a more structural transfer of asset value management to a 3rd party provider. This is typically done via some form of exposure transfer pricing structure. The 3rd party provider pays the asset owner for what is usually full control of asset margin and flexibility. In exchange for this payment, the 3rd party has access to 100% of asset value generated. In other words its profit and loss is the difference between realised asset margin and the transfer pricing payment.
The most common type of deal here is a tolling contract. The asset owner receives a capacity fee, for transferring asset management and margin via contract to a 3rd party. Examples include the tolling of thermal power plant capacity, oil refinery capacity and the sale of US LNG export capacity. The tolling fee is typically fixed but can also be indexed to market price benchmarks or even volatility.
But more flexible structures are also used. Utilities and producers commonly use a ‘rolling transfer’ mechanism to pass asset exposures from the ‘asset owner’ business unit to the ‘trading’ business unit. Exposures are typically transferred over a rolling forward curve horizon, based on prevailing market conditions at the time. For example, transfer of asset exposures from a CCGT priced at prevailing spark spread.
The toughest challenge in structuring deals in this group is typically associated with defining a fair value for transferring asset exposures. The intrinsic or hedgeable component of value can be benchmarked against forward market prices. But defining a robust mechanism for pricing and transferring the extrinsic (or flexibility) value of an asset is complex.
There is often an asymmetry of information here. The 3rd party trader typically has strong commercial expertise and market knowledge that supports definition of asset value. The asset owner on the other hand is often a step removed from this detailed expertise.
Structuring market access contracts
The growth in 3rd party market access services in Europe is being driven by an increasing business model separation of asset ownership from trading expertise. As a results, market access services and contract structures have matured significantly over the last two or three years.
However the degree to which market access contracts are standardised will always be limited by the unique characteristics of individual assets and owner requirements. The approach taken on fee structures, pricing mechanisms, exposure transfer, incentivisation and performance benchmarking, define the difference between a deal that adds or erodes asset value.
We return shortly with a follow up article to set out our experience of the 5 key success factors underpinning a robust market access deal.
Article written by Olly Spinks, David Stokes and Nick Perry
