Smart Contracts To Disrupt Energy Trading
Blockchain-based applications present compelling short-term efficiencies for trading energy commodities, but their potential for long-term market disruption faces significant challenges.
A consortium of energy companies and banks recently announced a partnership to develop a blockchain-based digital platform for trading energy commodities. This BP and Shell led initiative offers compelling short-term cost reductions and efficiencies while threatening long-term disruption to the entire commodities trading market [1].
Blockchain’s distributed ledger technology provides solutions to perennial commodity trading issues like high transactions costs, low speed, single point of failure, and lack of transparency. The latest milestone in blockchain development is the “smart contract.” Smart contracts are self-executing programs performed in response to a pre-defined trigger event [2]. For example, a commodities trade deal can automatically execute if the terms of a multiparty agreement are met, such as certain price and volume conditions. What makes the smart contract unique is how the underlying, decentralized blockchain infrastructure addresses traditional commodities trading issues.
The current energy transaction life cycle is inefficient, burdened with layers of complex data interfaces, systems, and processes. Figure 1 illustrates this web of interrelated transactions.
Figure 1. Energy and commodity transition life cycle.
The life cycle’s persistent bottleneck is its dependence on intermediaries [3]. The simplest transactions require multiple iterations of counterparties verifying and reconciling transaction data from initial execution to settlement. There are also third-parties providing “trust” services, labor-intensive trade clearing entities, and independent yet substantial IT networks [4].
Herein lies the unique strength of smart contracts. Because smart contracts are a shared ledger that reside in a decentralized system, which is visible to anyone, they do not require an intermediary to execute [3]. This transparency also results in unprecedented trust, reduced risk of error and manipulation, and certainty of funding and automatic payment. The implications of this technology are profound. By streamlining the transaction life cycle, smart contracts can reduce labor costs, reduce manual and semi-automated processes, reduce capital costs through faster settlements, and reduce technology costs by decreasing dependency on redundant systems. A single company’s potential savings have been estimated in the range of 30 – 60% [3].
Over the long-term, blockchain-based applications have the potential to disrupt the entire commodities market structure with unhindered access to world-wide markets [3]. Peer-to-peer trading without third party involvement allows customers to transact directly with the global energy market, which will fundamentally alter commodities trading. Consider the elimination of wholesale and retail commodity marketing companies [5]:
- Crude oil producers would sell its product direct to refiners without an intermediary.
- Power plants would purchase natural gas directly from gas producers.
- Power producers would sell power direct to the consumer without a retail marketer or utility.
The BP-Shell consortium aims to be a leader of this market changing trend by utilizing blockchain technology as a trading platform. Their goal should be to digitally manage energy transactions from initial trade to final settlement. Enacted properly, this new independent organization will improve internal processes (such as deal validation, risk management, and compliance monitoring) and external processes (such as confirmation, trade reconciliation, chain of custody documentation, and settlements) [6]. The integration of these nine major industry players is significant given the obstacles that still need to be overcome.
Perhaps the greatest challenge facing smart contracts in energy trading is the handling of privacy-sensitive data [7]. The transparency that undergirds blockchain applications also creates impediments for companies sharing sensitive information such as consumption rates and financial transactions. Furthermore, regulatory restrictions (such as the EU’s general data protection regulation [8]) intending to keep pace with advances in technology, further restrict access to secure communications. Smart contracts require a standardized legal framework across a set of parties with no centralized authority. [2] As a result, private blockchains and consortiums are emerging. Still a bevy of regulatory hurdles must be overcome [3].
Another significant challenge is the large amount of computing power that blockchain networks require. Blockchain’s heavy computations necessitate massive energy consumption, levels that some world organizations claim is unsustainable [8]. This high electricity requirement presents a legitimate carbon footprint concern should smart contracts take hold of the commodities trading industry. Ethereum, the most popular blockchain in the energy sector, is pursuing alternate architectures that would not require such heavy computations. Other companies are exploring technologies that would create energy efficiencies, like increased dependency on renewables or computer heat capturing [8]. Still the question remains, will the carbon footprint of blockchain technology hinder its scalability and future applications?
The digitalization of trading energy commodities presents compelling short-term efficiencies. The fact that industry leaders and banks are partnering to institute this technology signals that real change is on the horizon. But what are the long-term implications of blockchain-based applications in energy trading? How will the BP-Shell consortium progress with their newly formed digital trading platform? And what are the solutions needed in regulatory reform and electricity demand? These are the crucial questions facing all participants in the energy industry.
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1. Reuters Staff. “BP, Shell lead plan for blockchain-based platform for energy trading.” https://www.reuters.com/article/us-energy-blockchain/bp-shell-lead-plan-for-blockchain-based-platform-for-energy-trading-idUSKBN1D612I, accessed November 2017.
2. Wall Street Journal, CFO. “Getting Smart About Smart Contracts.” http://deloitte.wsj.com/cfo/2016/06/23/getting-smart-about-smart-contracts/?mg=prod/accounts-wsj, accessed November 2017.
3. Deloitte. “Blockchain Applications in Energy Trading.” https://www2.deloitte.com/uk/en/pages/energy-and-resources/articles/blockchain-applications-in-energy-trading.html, accessed November 2017.
4. Randolph, Shane and McBride, Shane. Oil & Gas Financial Journal. “Blockchain Technology – The Hype the Hope.” http://www.ogfj.com/articles/print/volume-14/issue-8/features/blockchain-technology-the-hype-and-the-hope.html, accessed November 2017.
5. Opray, Max. The Guardian. “Could a Blockchain-based Electricity Network Change the Energy Market?” https://www.theguardian.com/sustainable-business/2017/jul/13/could-a-blockchain-based-electricity-network-change-the-energy-market, accessed November 2017.
6. Ernst & Young LLP, Commodities Market. “Overview of Blockchain for Energy and Commodities Trading.” http://www.ey.com/Publication/vwLUAssets/ey-overview-of-blockchain-for-energy-and-commodity-trading/$FILE/ey-overview-of-blockchain-for-energy-and-commodity-trading.pdf, accessed November 2017.
7. Gibbs, Sam. The Guardian. “EU Seeks to Outlaw ‘backdoors’ in New Data Privacy Proposals.” https://www.theguardian.com/technology/2017/jun/19/eu-outlaw-backdoors-new-data-privacy-proposals-uk-government-encrypted-communications-whatsapp, accessed November 2017.
8. Engerati. “The Downside of Energy Blockchains? They Consume Lots of Power.” https://www.engerati.com/article/downside-energy-blockchain-carbon-footprint, accessed November 2017.
Kyle, you did a great job distilling a really complicated subject with fascinating implications for the energy industry. The largest unresolved issue in my mind is whether the clear efficiency benefits of blockchain-based smart contracts outweigh the costs to energy companies of making sensitive information publicly available. For example, I can’t picture the refinery where I used to work logging its crude oil purchases in a blockchain ledger, effectively giving local competitors insights into their production forecasts. These privacy issues of course spill into the consortium itself. Still, I think partnerships like the BP-Shell consortium are a good way for energy companies to limit their risk while still influencing the implementation of this disruptive technology.
Kyle, I loved your article! It is honestly so well written and such an easy read. One more problem of blockchain I see is that with growing importance of data mining and machine learning to use transactional data for predictive analytics is making this data an asset to a company. I wouldn’t be surprised if soon we see people trading or bidding for this data. Blockchains will make these transactions transparent and publicly viewable, aren’t companies losing out more than just privacy of sensitive data?
Not an expert on this so would love to hear your inputs.
Fantastic summary of the issue- I wasn’t expecting this take on how digitalization will impact the energy industry in such a fascinating way. As you and Mike discuss, how the privacy issue is tackled has critical implications for how widely this trend will impact the commodities industry. As we saw with commodities trader Noble in FRC yesterday, companies have strong strategic reasons for not publicly revealing their cost and competitive information. It will be interesting to see how blockchain platforms can be paired with and adapt to cloud-based computing. Just as companies choose to transition to private/on-premise, public/off-premise and/or hybrid cloud computing, perhaps these blockchain platforms may transition to networks of companies choosing to band together on a platform together without joining completely public platforms that expose their information to everyone.
Good job taking a topic which has a lot of lingo and breaking it down in an easy way to understand, Kyle! In terms of the long-term implications of blockchain in energy trading: As you’ve mentioned, it sounds to me like it will bring about a lot efficiencies in the way energy is traded today and also potentially cut out the “middlemen.” I wonder if this means that many companies which exist today and have business models built on energy trading, like ones we learnt about in our other classes, will no longer exist or have to radically change their business models in order to survive. Apart from much of their functional role being replaced, their core business models are also threatened by the price transparency which would ensue from having publicly available pricing.
However, given that blockchain is only a digital ledger, I think that there will still be a number of “middlemen” functions which will need to be performed (e.g. logistics, storage), but as mentioned, business models will have to evolve since their margins will be pressured by the price transparency.
Insofar as whether having smart contracts across the industry is feasible – I am curious as to whether having such platforms requires that all transactions in the industry move towards this platform (or at least all transactions of a certain kind), or whether it’s possible for the current systems to exist with these new mechanisms. My initial instinct is that it will be difficult for these things to coexist, since it will be unclear as to what business volume should remain where, which players are using which platform, and also those who use the platform may be disadvantaged due to the transparency v.s. those not. Also, who will pay to build, maintain, and enhance this platform? How will it develop if there is pressure from “middlemen” to stick with status quo? This is perhaps where regulation could play an interesting role. I wonder if it can, and needs to push the industry towards adopting uniform standards, and whether there need to be new entity licenses for the bodies which maintain these platforms.
Lastly, I wonder if there are any geopolitical implication of this coming about, given that energy is very sensitive for countries. Does it “democratize” the industry too much to the extent that there is room for malicious actors to say buy out supply and starve those who need it? Or create concentrated vulnerability which is subject to digital attacks?
Fascinating read, especially in light of the FRC Noble case yesterday! I wonder how the “new” commodity speculators will carve a niche in this industry of huge computing power and peer-to-peer trading. I also wonder who will provide many of the services traditionally provided by a commodity trading platform (i.e. delivery of off-take, etc.). Lastly, given how computationally intensive this block-chain trading would be, I wonder if we would one day see something similar to the “front running” that exists with high-frequency trading firms on Wall Street (i.e. commodity firms investing heavily in servers, locating their servers as close as possible to block chain servers where the “market” resides and then front-running orders or manipulating the market in some other way, and those with the most computing power being the victor.