Wednesday, June 12, 2013

Small Electricity Suppliers Have No Right To An Easy Life

Ofgem, whose uselessness over the past decade is a disgrace to the excellent work done by its predecessors Ofgas and Offer in the 1990's, is at it again.
Britain's big six energy companies will face fines unless they open up the electricity market to competition from smaller rivals, under proposals by the regulator designed to "break the stranglehold" of the biggest suppliers.  (DTel)
The details of this are less dramatic than one might imagine: they intend to 'force' the biggest 8 generators (not just the 'Big 6') to become market makers in the forward market out to 2 years.  Since liquidity in the 2-year energy forwards is pretty unsatisfactory - and since that, in turn, is pretty damaging - no one can be happy with the status quo.  Ofgem have been farting around worrying aimlessly about energy liquidity for 8 years now and the only positive development has been the advent of hedge fund and PE money since around 2006 - mostly in the gas sector because electricity trading is fiendishly difficult.  On the downside, banks have been progressively scaling back their commodities trading altogether.

Of course, the real issue is that in the '00s, Ofgem and the competition authorities (against their better judgement but under instruction from Gordon Brown) allowed dumb vertical integration to take hold once more in the electricity market, after the successful efforts of 15 years to break it up.  EDF being allowed to buy BE was the final straw in the structural undermining of liquidity, a point I made at the time. The European authorities, who ought to be a back-stop against this kind of thing, were equally supine.

What I don't understand is why anyone thinks small, under-capitalised electricity suppliers have a God-given right to thrive.  This is the most capital-intensive of industries - whether or not a player intends to back ts energy positions with physical assets (power plants, gas production or storage facilities etc).  Even if they intend to operate on a 'merchant' model - just buying wholesale to meet retail demand - huge quantities of risk capital are required to back the big, long-term deals that are required for that business model.  That is the lesson of 'asset-lite' Enron:  it's a game for big boys with a credit rating of at least A, preferably higher.

What's needed is real competition between ten or so properly-capitalised players. Boutique energy marketing outfits with no credit won't be able to transact 2-year hedges anyway - unless the new 'rules' force the Big 8 to take the credit risk, the merest featherbedding.  Along with the free ride that is currently given to windfarms in terms of not being charged the full cost of their intermittency, plus a heap of social obligations as regards 'poor' retail customers, and even more nonsense contained in the Energy Bill, the burdens being heaped on the big players will one day make some of them decide it's not worth the candle.  Obvious candidates for giving up in disgust are cash-strapped RWE of Germany (nPower) and Spanish Ibderdrola (Scottish Power).  It's not too much of a stretch to see E.ON having second thoughts as well.

See how we like it when Big 6 becomes Big 3, eh?  No amount of flaky, subsidised suppliers called 'Nice Clean Energy' or 'Friendly Power' will help us then.

This post first appeared on the Capitalists@Work blog

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1 comment:

Sackerson said...

This piece ia a gnarly one for me, Nick, because I don't begin to have your technical expertise.

You refer to "dumb vertical integration, yet without it an organisation can be caught out by dislocation or adverse moves in the open market, as Northern Rock was with its borrowing-to-lend.

Or one player can spoil things for others by having a selfish strategy - as I recall, one of your energy security pieces speaks of the French buying up energy on the open market to maintain their generous reserves, so depriving others of needed supplies and raising the market price.

I understand e.g. McDonald's is vertically integrated to prevent dislocation and being held over a barrel by external suppliers.

I think I grasp the point about economies of scale, and the relative cost-effectiveness of different kinds of energy generation (wind farms are a target for many commentators for many reasons).

And in principle I see how subsidies, quotas, partisan regulation etc distort the market so that economically incorrect decisions are made. Though there is the knotty question of how we perhaps should intervene in order to head off tomorrow's problems as well as satisfy today's needs.

I need help with the comments about liquidity, trading and hedging as I don't understand the processes, but perhaps this is for you to explain to me (if you will) when we meet again.