The Japanese Power Market with Xavier Veillard

Welcome to the HC Comortis Podcast, a podcast dedicated to the Comortis sector and the people within it. I'm your host Paul Chapman. This podcast is produced by HC Group, a global search firm dedicated to the Comortis sector. Today we are talking the Japanese power market, which by virtue of its size, its generation mix and recent liberalisation is fast becoming one of the most actively traded power markets in the world with a mix of international and domestic participants. To discuss the Japanese power market, its evolution, its structure and the opportunities is Xavier Véard. Xavier is a partner at McKinsey based in Paris and has their global power and gas commodities offering. As always you can really support the show by leaving us a positive review on the platform you're listening on and sharing it with your colleagues. As always I hope you enjoy the episode. Xavier, welcome back to the show. Thank you Paul. Thank you Paul. Happy to be back. So I'm excited for this conversation. We are talking the Japanese power market, which is all the rage and indeed you in your role as leading power and gas trading at McKinsey are going there frequently and intensively. But I guess we wanted to talk about the genesis of the Japanese power market, the reform deregulation that's gone on and then what it means is a market opportunity for incumbents there but also the global power trading community that is certainly interested in the space and already turning up in Japan. So I guess before we talk about the genesis of the deregulated market, can you give us some historical concept of how the Japanese power markets orientated and indeed some sense of what's unique about Japan, I guess in terms of its size, the amount of power consumed and the structure. Absolutely, no thank you Paul. And indeed I think it's great you do a podcast on the topic because whilst this market is a bit away and a bit far remote from us, the developments are really fascinating, sorry. And what we've observed over the last 20 years has been a rapid shift over that market. So just to characterize a bit the market, when you look at Japan, the power market is around a thousand terro-dower. So you put that in perspective, Germany is around 600 terro-dowers, so it's a massive and large power market. And the market has been changing significantly over the last 20 years in terms of supply mix. So if you go back actually even further in the 1990s, nuclear used to represent between a quarter to 30% of the total power generation. And now you fast forward today, you have nuclear which is less than 10%. And what happened in between obviously is the event of Fukushima and as a result a surge of gas in the mix. And gas compared to nuclear is directly linked to the gas you import and so the global LNG market. And so that shift in the mix led to a shift in terms of exposure to global commodities. Obviously that market was already consuming coal, so exposed to global coal prices. But that was further magnified with the exposure to natural gas into LNG market. And if you go in the years just after Fukushima, gas proportion of the mix in Japan was close to 40-45%. So just to size a bit the magnitude of the linkage to the global commodity market, take that gas, 45% and you add coal, another 25% or so in the peak year following Fukushima, you had market for 2/3 plus close to 80% exposed to global commodity prices. So what that means is that the power that you produce on the back of these feedstock, these global commodities is also much more volatile. And so I mentioned these numbers and this history in the mix evolution to put in perspective into what happened on the regulation evolution of the market. And so you could decompose a bit the history of the Japanese market in terms of three horizon. First, if you go back to 95 to 2011 period, you had essentially the introduction of the wholesale market to allow for independent power producer IPPs to essentially develop and sell their power in an open market, so in a non-integrated market. And what happened at that time was the introduction of a future market on JPEGs. And also intraday and their head market for short term. Now these markets did not really pick up at the time. So what you had at the time were still integrated utilities who were transacting off market essentially these volumes from production to consumption or to retail. And so you did not really have a pick up in the liquidity. Then you entered into a second phase with more liberalization across the different verticals. So on production and on retail. And what you had at that time was from 2011 to 2020 following Fukushima, you had the need to promote the ability for players to balance their exposure of supply and demand on the market. And so being able to fulfill the shortfall in supply or to market the excess production on the market more actively. And so you had at that time a launch on Tokam of the future market, you had the launch on EX of the future market as well. So EX opening a platform at that time. You had more standardization of the contracts also. And you started to have a pick up of trading volumes. And it's really after from 2021 or so to today that we are started to see an acceleration. And so I'll come back after on the figures on how we quantify that acceleration. But just to finish the history over the last three years in that third period that I was describing, you had a strong acceleration in number of counter parties active on the wholesale power market. You have over 60, 70 players or so active now with a share of them being foreign players. The wholesale market in terms of their head then in trade, mostly their head is picking up. You have about 40, 45% of power consumed that is transacted on the their head market. And you also have the pick up of the futures and forward market. It will be to put in perspective of what we see in other markets that liberalized a bit earlier, like in Europe, but still the uptake of activities is really interesting. And the final element of this market development is also the introduction of ancillary services. So ancillary services market where backup capacity, balance, in volume can be traded also on ancillary services market like we see in Europe, offering basically the full portfolio of products now for an established power market with future their head and andcillary service. Can you just just give us some detail around the actual contracts of just a little bit more that are available on the day ahead and the forwards and give us a little bit more about for our power trading listeners, which markets does this replicating in other regions? What does this look like? Does this look like what the US trading, European trading, etc. Can I just give us some context there? Yes, absolutely, absolutely. So look, in terms of what's traded, you have future contracts which are mostly on the front end of the curve. So what you would trade in terms of maturity for the year ahead. The contracts are based on delivery in the different regions in Japan and actually the Tokyo base month contract is the most liquid on the on the futures. Then you have the day ahead contract. So really that's where you put for auction either supply or demand volumes for next day delivery. Then after you have an intraday product for the ability to be balanced within the hours of the day. If you look at the size of the futures market, which is let's say the most interesting one, purely from a hedging and risk management perspective, it's still small with respect to the global size of the market. So if you look at the ratio of futures trading to total consumption, in a market like Germany, putting aside exceptional years like 2022, you would have a ratio between 6 to 10x. So 6 to 10x, financial trading compared to physical consumption. In Japan, we're still around 1x. So sometimes a bit less than 1x. So you're still at a small ratio, but that's still a remarkable development compared to where we were, I would say just three, four years ago. I think the other one is if you look at their head market about, I think as I was mentioning earlier, 40% of the volume consumed is going through the day ahead of. What are the most analogous markets, power markets out there just to orientate people? Yes, so actually if you look at the European markets, they're designed in a very similar fashion. So you have these three components, futures, that's what you have on most European exchanges where you can buy blocks for next month up to three years ahead, though the liquidity drops significantly in Europe after a year and a half or so, roughly after 18 months ahead. Then you have the day ahead and intraday options. Now you have some markets that are more advanced with intraday slots going down to 15 minutes, there are even some markets going to five minutes and then ancillary services market where you can trade what we call primary, secondary and tertiary reserve products. So you have essentially the same three blocks in Japan as we have in Europe. The big difference is not necessarily in the design of the market, it's rather in the liquidity and volume of trades in these markets. Yeah, which is expected to grow and I guess that will feed into the story we're about to say about which participants, which traders are headed there or started to build offices there. Just before we talk about why there's been that acceleration in detail over the last three years and who's driving that. From a public standpoint, from a public policy standpoint, from a pricing standpoint, what has been the impacts on the Japanese market of this liberalization? Are people seeing power prices drop as a more competitive market emerges? When you take that view, what's happened? So I think it's always tough to link price development with market liberalization. So I don't think that there has been a direct linkage between the two and in general, it's always hard to make a case for lower price or higher price as a result of the liberalization. I think what people see and what we observe essentially is that the market structure allows for new entrants to come in as initial liquidity provider or trader, but also in different parts of the value chain. And so if you are a producer and you have a liberalized market, it's much easier to explore how you will market your production, what exposure to prices you will have and how this will be linked to market fundamentals, which means essentially at what price we expect the power market to clear based on the cost of the last marginal unit that will run, the last marginal cost of the unit that will run. So it's a bit of a long explanation, but fundamentally, the reform brings transparency in terms of the prices you will be exposed to as a retailer, as a producer and opens the door for new participants to come in. And so if you actually make a parallel to what we saw in Europe, this was quite fundamental in Europe as a reform to do because with the rise of independent power players, predominantly renewables, you had to offer a platform for these players to market their production and understand the fundamental of prices they will be exposed to, for the ones who were exposed to market prices, some of them were still had regulated tariffs, but also after to give opportunities for players to enter different areas of the value chain. So that's really the, let's say the benefit if you look at it from that perspective. The other element I think that is important is as mentioned in the introduction, the Japanese power market is significantly exposed to international commodity prices, namely gas and coal. And so the more you allow people to trade, the more you allow people to hedge against the volatility of their margins because they can hedge coal and gas or coal and energy, but you need to also be able to hedge power. So this way you can better predict the margin you will make. And so as these market liquidity grows, that will be an improved benefit that the utilities and the different players will have. But it sticks time. Yes, interesting. So it drives investment in generation as you and across the value chain. And there is this element, which makes the the Japanese market unique in terms of just its size per capita, right? As well as that generation mix that requires that hedging and also allows that hedging. Just before I talk about why you've seen that acceleration in the last three years, given all that you've just said there, has this spurred liberalization reform discussion in the broader Asia region around power markets? So if you look across Asia, you have had a number of markets that have started this liberalization pathway. And some of them more advanced than others. But if you look at Singapore, for example, where you have a power market there, if you look at Thailand or Malaysia in terms of the opening of the gas and power market, you have examples. Obviously, if I go beyond in Asia Pacific down to Australia, you also have an open market there. So I think what you start to see in general from a number of these countries is opening towards a liberalization pathway and journey, but this takes time. This takes a lot of that. Yeah. And Australia has not the same scale, but also just has very cold dependent. So there's not the conditions necessary for that rapid growth that we've seen in Japan. What is driving? So you mentioned we've seen volumes increase. There's obviously an expectation that they will increase up to that six to ten times in terms of the futures markets that you see in Germany or like markets. What is driving the the interest? What is driving the volumes and who? Yes. So look, I think the extreme volatility that can happen on the on the gas market like we saw in 2022 yields to a lot of the risk that a utility space if they are able or not to pass through this price risk to their to their customer portfolio or as an independent power producer if you'll be able to preserve and avoid margin compression. And so generally you had in the recent years a number of players who wanted to be able to better risk manage their portfolio. And so when you look at the six strategy energy plan in 21-22 one of the key pillar was to further advance in the development of the market and so stimulate liquidity. And earlier on you saw also an investment from Tocom and from EX in trying to stimulate liquidity and contract adoption. So to answer your question essentially the extreme volatility on international market plus the promotion of these instruments as a way to risk manage portfolio exposure has been a catalyst in the last three years for players to see the benefit of a more liquid market and to drive participation and adoption. Now what you actually saw is if you look at the number of players active on that market over the last let's say three years you had about less than 20 players or so in 2021 compared to almost 70 players in 23. And so that's important because it means that there are more market makers, there are more liquidity providers and so you can rely more on the instruments treated to risk manage your exporters. Yeah and who are the international participants that have arrived to make it up to that 17 number is this large utilities that have the you know have been exporting LNG to to Japan that now get the ability to hedge on the power market. It's like who's turning up? So you have a mix so if you look at all the announcements you had international LNG players for example Shell you had international utilities for example PDF or NG you have had clock trading players like Donskir, commodity for example. So you really have a mix of different archetypes of foreign players. So if you look at the the thesis behind the number of them, they all have a bit different agenda. So to take a few examples. Coming back to what you said, I think it's interesting for LNG players to try and test how the power market in Japan will be linked and correlated to the LNG market and whether it's worth to have an active position in that power market and whether or not it may be a number of years from now you could have LNG delivered on prices much closer to power prices. Okay, even though we're not there yet, I just don't want to speculate too much, but it's important for LNG players who sell into Japan. Japan is the biggest LNG import market to anticipate that this market could extend naturally into power and being able to be active in the power market is key from that perspective given the high correlation. That's what I think too. If you take a proc trader for them, the core investment thesis is around market making. So in a market that is less liquid, you have higher bid-ask bread and for someone who is you can see how to risk manage these positions and who is able to sit on a certain level of exposure, then that becomes also interesting to start market making and eventually also taking some directional threat. And so for the last group for the international utilities, the investment thesis for them is a bit different. So some of them will look at developing part of the value chain in Japan for generation for example which could be via Co-investment or a JV or a minority stake or a standard-owned investment in conventional or renewables and as you do so you want to understand how the power generation electricity or power generated electricity will be marketed. And so developing a position in power training allows you to better understand the market and anticipate also how you could then manage your future power exposure. So you have these three investment thesis playing out and that's interesting because they're playing out a bit at the same time in parallel which is driving a bit that inflection point in terms of a number of counterparties active and volume being treated. The energy and resources sector is experiencing unprecedented change to help companies navigate this world and capture its opportunities. HC Group launched Enco Insights in 2023 Enco has rapidly become the leading global experts network dedicated to energy and resources. Enco Insights leverages HC Group's 20 years of connections and dedication to the sector to give clients the expertise they need to take decisions fast. Connect with Enco's experts for anything from a one-hour insight call to a longer term consulting project at Enco Insights.com. And who is actually doing the trading? You know who are the individuals because this is a very nascent market it's only got you know as you highlight it's been 20 years since even the foundation of liberalisation and you know you have to go from 20 to 70s obviously a significant jump in demand for all of the skill sets that sit around a power trading desk not just the traders but of course all the risk management and P&L people and so forth. You know and where are people trading this from European desk? Is this European traders that are moving to Japan? Is there a local talent pool? Can you give me some sense of that? Yes yes so you have a futures that are traded outside of Japan so you have people with desks for example in Singapore and trade in the Japan future market so you don't have to be in Japan to trade and obviously if you trade from a place like Singapore with a big talent pool where although people are mostly on other commodities you have people who trade power for example on Australia market with Japanese market in addition to Singapore market from Singapore that's one option but then you have actually people who trade in Japan and so if you look at foreign utilities who have set up their desk in Japan they have either brought experienced power traders from their European desk or US desk into Japan or they have taken a local talent that they have trained as power traders so that's a theme that has been accelerated but it's interesting your question on talent because you really have I would say three archetypes of players active on the power market you have traders from foreign markets like based in Singapore but trading Japan market you have foreign traders who came into Japan as desks were open to bring the power expertise and then you have people who have now been trained or have some history from the pioneer traders who are also a local power trader now this is only on let's say a front office trading you have to imagine that the whole infrastructure needs to be set up to trade now for some players like the foreign utilities they try to leverage as much as they can an extension of their infrastructure their existing infrastructure that they use elsewhere to create a custom instance for example of their system to trade in Japan you have others especially the Japanese utilities who are building completely their infrastructure and these are significant investment when you think about the front to back office setup when you think of the ETRM or energy trading and risk management system that they need to put in place these are really significant sizable investment both in terms of people and system yeah and for them time and time and time and for them it's a big it's big yeah and I imagine well firstly just to say yes we as HC group have been busy through our Singapore office Alex Walsh on the energy side for this demand both as you say in Singapore but also in Japan but it is definitely thin on the ground of course talent and you do need those pioneers those trading leaders who are willing to ultimately come from Europe and go set it up and it does take a long time to build a a nascent talent pool as we all know but as you say I also imagine you look on the commercial and industrial side yeah that's gonna change the talent they need in terms of understanding and being able to hedge their exposure to power prices and so forth so it's a wholesale switch from the generators to the consumers and everything in between absolutely absolutely and I think you know we released a report earlier this year about our latest perspective on global commodity trading with my colleague Walden Rennstein and power and gas the trading value pool is the largest and fastest growing and so what you have to think through is that there is a fight for talent especially on power everywhere globally in the US in Europe because it's the most volatile and it's the fastest growing commodity yeah every every trading house you know all organizations in a world that's electrifying through the energy transition needs to have a power lens but also actually now if you're a metals trader there's a convergence going on in the commodities sector itself if you're metals you probably start need to be in power because a major driver of consumption is going to be grids batteries all that piece likewise on the ag side you need to be an energy because a major driver is biofuels and so forth so you're you're absolutely seeing that and it's worth saying though as we all know we spoke about an our Q2 market review and and funny enough Roland and I had this discussion this morning you had that 10-year period where there weren't many new power traders being developed right you saw massive consolidation in both Europe and the US from 10 merchant utilities down to two and so forth and also money of the the nursery pond rolls if you'd like to become a power trader whether that's the 24-hour desk or whether that's a P&L and an analyst or a market risk analyst many of those roles got automated away or you know we're shrunken in the desire to try and remove costs so you don't even have that that junior group coming through but on the flip side as well you know it's the market will correct itself over time so do you is this just to go back to that market opportunity is this kind of the you know what's sort of the the mix I guess from sort of domestic power trading to international power trading and it also seems to me as well kind of the international large global companies that are active in the space, kind of similar to what we've seen in Brazil, right? There is a seat, they are trying to find new markets where they can apply and essentially utilize, like you've highlighted, these very expensive systems and capabilities that they've built. Yes, so it's actually roughly half half interestingly. So if you look at a number of domestic participants and a number of foreign participants, it's actually half half. So it's quite interesting. So I would say the success that we see from the Japanese market is their ability to attract these numbers of foreign players because it's not a small investment as we said, right? So these are rare talents in strong demand globally. It's a complex infrastructure to put in place, which goes with the whole kit around the licenses, compliance, legal, obviously the IT infrastructure and so forth. And so the fact that the Japanese market attracted so many foreign players to established desk, even if some of them trade futures on the back of foreign desk is an achievement. And again, we should put that in perspective of a long journey that was initiated in the 90s, but I think the takeaways that we were at an infection point. And then I guess this is a public service announcement. If you are thinking about off the back of this or of course already thinking about it, how long is that set up period just to get the licenses to get the infrastructure in place? What timelines are we thinking? Is it going to be quick? Is it a two-year operation? Give us some sense of that. So if you want to set up a desk in Japan, which means the license, the people, the system, all the legal aspects of the entity registration and so forth, it's a two-year plus journey. Think about it roughly in that. So some people will go faster, some people will go quicker, etc. Or we'll take a bit more time, but you have to look at it as that kind of time horizon. But can you, I guess, are organizations familiarizing themselves with the markets by trading from Europe, from Singapore, as you say, just understanding it and trading it pretty, just through the futures market or does that also take a bit of set up? That's obviously an easier way to do it. But that will only allow you to be exposed to futures financially settled. Yeah, but you can, I guess, build that familiarity whilst you're going through that two-year journey. Right, okay, let's change gears. What can you give us some sense of what the risk is and what the opportunity has been for those that are participating in this market today? I mean, has this been a lucrative venture and give us some sense of the returns if you can, more broadly, without specifics on the market opportunity for those participants? I think in short, Paul, it's probably too early to say. And sorry for that answer. However, I think from the number of hires and people being deployed on this desk, I would say that the players are seeing the return from the investment. But it's probably too early to say the level of profit and let's say return on risk or return on risk adjusted capital that these players are making from their Japanese desk operating. I guess there's also, though, that if you are a global LNG participant, there's significant opportunities and returns and or risk management capabilities that you get by having that granular detail on the sandy, what's going on in the Japanese power markets that better enables you to hedge your global LNG business. Yes, yes. And I think that thesis is what people will watch over the coming years because that's the thesis for some of the big LNG player to see how they can leverage the correlation between the Japanese power market and the LNG spot market, namely JKM, in their training strategy and their portfolio risk management approach. So that will be a very exciting play over the coming years. Okay, turning towards the future, I'll get you to outline your thesis on how rapidly you think it will grow. But I guess one question first, you've seen this, you've already mentioned it, so dicing down of the time periods of day head contracts and mainly in response to renewables, right? So the power markets are much more front-driven, much more volatile in the very short term, just because of renewables. Do you think we'll see that and indeed where does renewables stand in the Japanese generation mix? Yes, so this has been the story of the last 10 years, the growth in renewables. If you look in 2023 from a generation perspective, about a tenth of the generation has been from an intermittent wind and solar and then on top of that you could add hydro as well, so there's also a good share hydro, but let's say if we focus on pure intermittent, it's about 10%. Now, if you look at the investments in renewable capacity, it's massive. It's massive and so the picture will change quite a bit, but we're adding intermittent power and so obviously the role of gas and probably at one point also of battery will still play a key role on top of what you have as a legacy of coal and you clear. So that's took a bit in perspective and if you go back 10 years ago, intermittent renewables was non-existent almost. So it's quite also remarkable to have done that that development for intermittent renewables to represent about 10% of the production share today in volume. Right, okay, so can you just give us, I know it's hard with these things and who knows what events are going to happen to spike volatility once again? Can you just give us some sense? Are we on a path to Japan's power market looking very similar in scope and size in terms of trading volume and interest to the major European market? So if you look at what we observed over the last three years, we're on that trajectory. Now there will be some challenges to address. In Japan, when you look at the overall market, you have two different frequencies, 160Hz, 170Hz, so they are technical differences. It's not a one single, let's say, harmonized grid and then you still have a long way to reach the volume of liquidity we describe, like we see in Germany, for example, close to 6 plus X, the volume of what you have on the consume. So there's still a journey to get there. Now, if you again look at the momentum of players establishing this, if you look at the volume of developments from incumbent, from independent players or foreign players, and if you look at the adoption of risk management and the more familiarity that players have using the locally traded instruments to risk manage their portfolio, to combine that together, there is very good prospect for the Japanese market development to accelerate. That's a key conviction at the end. Fascinating, and hopefully part of a broader march of liberalisation in a market working, and obviously a large opportunity for many market participants around the world, and I guess they should come to you for insight and advice on how to build and structure their businesses and come to us with a talent. Thank you very much Paul for the opportunity to speak on your podcast. Yeah, always a pleasure and it's a happy time to catch you in Paris as opposed to in Tokyo because I know you're doing a lot of travel. But anyway, great to have you back on. Thank you Paul. Thank you. Thank you for listening. To find out more about HC Group, our global offices, and our expertise in search within the commodities sector, please visit www.hcgroup.global.