Something needs to be done to improve price discovery in the physical energy market. The question is what? Investigations by the US Federal Energy Regulatory Commission (FERC) into whether Enron and others manipulated natural gas and electricity prices revealed that misleading information was given to the price reporting services, raising questions about the validity of some published price assessments that are used as price indices in both short and long-term contracts. As a result, the Commodity Futures Trading Commission (CFTC) and the FERC are taking a close interest in the way in which the reporting services collect and interpret the market data used in producing price assessments. At present, the FERC and CFTC are undecided about whether to introduce new rules covering price reporting and the use of price indices – but disagreements within the energy industry about how to improve price transparency could prompt the regulators to set mandatory standards for energy price indices used in contracts.
Market-related pricing has become fundamental to the way in which energy companies operate. But the entire system is in danger of falling into disrepute as there are not enough fixed-price deals done in some markets to ensure the integrity of published price indices. Since there are relatively few truly liquid markets for energy, companies have come to rely heavily on the price reporting services to keep track of the changing pattern of relative prices in the physical energy market and to provide them with an independent source of prices that can be used in contracts. Although the price reporting services make an important contribution to the process of price discovery in the physical energy market, they are being challenged by the regulators (who are concerned that price indices could be manipulated in thin markets) and other vested interests (who see a role for themselves collecting, processing and publishing energy trade data for use in price indices).
If the energy industry wants to go on using price indices in contracts it needs to take urgent action to improve the process of price discovery since it is clearly inadequate in a number of key markets. Otherwise the regulators will take independent action to set the standard, which could limit the number of price indices available for use in contracts. Although the price reporting services are taking steps to improve their methodology and the quality and quantity of data used to construct price indices, there are limits to what can be achieved, which need to be recognised by all concerned. In practice, the best way to improve price discovery is for energy companies to do more fixed price deals and fewer market-related deals – even if this creates new risks, since the alternatives could be more expensive. At the same time, the regulators need to recognise that the physical energy market cannot easily be organised into convenient “buckets of liquidity” based on reported transactions and that the industry needs independent interpreters such as the price reporting services to fill in gaps that would otherwise exist in the web of price relationships. If standards are set too high, price discovery will be incomplete and transparency will be diminished – undermining the real aim of regulation, which is to improve the operation of the energy market.