Do trading and power operations mix? The case of Constellation Energy Group in 2008

ABSTRACT For the first seven years following its creation in 2000, Constellation Energy Group was a leader in the merchant power business, and its stock significantly outperformed the industry. Then, in 2008, in the space of less than two months, the company found itself in a liquidity crisis in which its stock lost more than 70% of its value, leading to a forced sale at a low price. What happened? Constellation's crisis illustrates the hidden dangers that arise when a power company's trading operation stops playing a subordinate function and becomes the strategic focus of the business. The case highlights the illiquidity of many commodity trading portfolios, which increases the danger of potentially large contingent capital requirements. These are often overlooked in traditional value-at-risk calculations. It is therefore easy to underestimate exposure and the capital implicitly dedicated to the trading operation, exaggerating its profitability. When the trading unit shares a balance sheet with other operations, such as generation and customer supply, the capital required for trading is often borrowed from these other units at zero cost. Trading can improve the profitability of generation and customer supply if it is organized as a support function. If it is to be a profit center of its own, it should be organized on its own balance sheet, separate from the other operations.