Why we need transparency in energy pricing

Credible clarification of business model will help build trust in a company

All over the world, energy companies constantly assert that the reason that they raise prices is either due to the wholesale price going up or increase in the cost of exploration.

The US natural gas commodity market is among the most transparent of all the commodity markets in the world. On the other hand, a controversy is raging over current gas pricing in various parts of the country.

Credible clarification of the business model and how a company creates value will help in building trust and avoid unnecessary controversies.

Success in commodity markets often comes from maintaining an information edge on supply and demand. However, there is a consensus that transparency is the key issue. Physical commodity trading, which had been an enclave of secrecy, has got severely affected post-2008. Opaque business models will be facing increasing public scrutiny – the discussion around commodity pricing, where confusion around the value creation of a market participant has fuelled social concerns, leading to escalation into some political drama.

For companies, the benefits of transparency are not always straight forward. Some of the requirements are perceived to be expensive with no return on investment.

There is sometimes a fear that being more transparent could mean facing more troubles as adhering to the self-declared ethical standards would make them liable to a wider public scrutiny.

Ironically sometime ago, the CEO of Cargill had warned that companies must embrace ethical and transparent business practices or they may risk being vilified by the public and regulators as banks have been.

In Nigeria, the State sells over one million barrels of crude oil every day, bringing almost 50 per cent of the Government’s total budget revenue.The Government cleverly allocates export licenses to so-called “briefcase companies”. Since there is no reporting on sales, the actual buyers remain unknown. 

Without transparency, there is no way to prove or disprove rumours. Improved transparency is important not only for the market participants but also for regulators, who can only intervene if they know what is happening in the market. Although a variety of sources of information currently exist, there is uncertainty in terms of data quality and timeliness, particularly with respect to inventories.

No doubt, it needs to be appreciated that, however big one may be in terms of networking and financial prowess, working on transparency has some clear advantages for companies and management.

Whether the allegations prove right or not, there is a lack of confidence about pricing in India’s energy sector – people just don’t trust it any more.

Published in  Business Line on February 27, 2014

Why we need central counterparty clearing house

In India, futures contracts in commodities are required to be settled through clearing and settlement department of the commodity exchanges and there is no separate central counterparty clearing house. In the light of the recent “exchange collapse”, there is an impending need to guarantee execution of settlements on behalf of the respective counterparties in the exchange where a chain reaction of defaults (breaches of contract) can be prevented.

Execution venue

It is important to understand that an exchange-trading requirement has nothing to do with clearing and they are completely separate issues. The exchange is just the trade execution venue. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.”

In India, people tend to think of exchanges as synonymous with clearinghouses as the transactions are cleared through exchanges’ clearing and settlement department, unlike in the US or Europe where mitigation of counterparty risk is achieved by contract “Novation”. This is a process through which a Central Counterparty or the clearing house acts as a buyer to all sellers, and vice versa.

Similar to banks’ role

The clearing house’s role as a credit risk intermediary does not require any particular relationship with any commodity.

A credit risk intermediary is similar to a banking intermediary since banks perform the role of a common counterparty to savers and borrowers, and banks do not normally benefit from narrow specialisation.

Thus, clearing house reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing the margin and collateral requirements for its members, centralising the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral).

A clearing house addresses operational risks by means of adequate auditing procedures (i.e. compliance with technical infrastructure requirements) that ensure the necessary operational know-how of their current and potential members.

The clearing entities’ discipline and independent roles from the exchange is indispensable for the purpose of improving commodity market credibility and develop an environment enabling trading activities by market participants with a stronger sense of security.

It is important to appropriately secure financial resources to cover breaches and reinforce the financial base of the clearinghouse (as an entity separate from the exchange) from the perspective of developing an environment in which market participants are able to participate in trading with a sense of security and reinforcing creditworthiness.

Published in The Business Line on 13 Feb, 2014