December’s article looks at the UK energy supply market and digs into wholesale energy procurement and the concept of ‘hedging’ to reduce cost uncertainty. The combination of shorter hedging strategies and falling wholesale energy prices has benefited independents over the past four years. Should wholesale prices continue to rise then the Big 6’s longer hedging strategy is likely to become a strength rather than a weakness. Such a scenario would also test the financial strength of independent suppliers and it is highly possible for a few more to go out of business in addition to GB Energy. Going forward, expect to see greater scrutiny of supplier’s risk capital and risk management practices.
1. Why do suppliers ‘hedge’ energy prices for customers?
Suppliers purchase energy ahead of delivery to reduce their financial exposure to changes in the wholesale energy prices. This ‘hedging’ activity increases the certainty of a supplier cost base, which reduces the difficulty in passing on wholesale energy cost changes because either the:
- tariffs is fixed price and cannot be changed; or
- market dynamics mean that passing through costs to customers would to likely incur greater losses from customers leaving to competitors with a lower price.
Consumers also benefit because hedging reduces the volatility of their bill (Figure 1 and 2). Purchasing energy further in advance means consumers are less exposed to short term variations in supply or demand and instead pay a price which is more closely aligned to fundamental costs of electricity production. It also allows a supplier to use an ‘averaging in’[1] strategy, which purchases small proportions of the total energy volume required for a delivery date over a period of up to three years. This can be compared to a ‘one shot’ procurement strategy, which purchases the total volume required at a single point in time and is highly dependent on luck as to whether the purchase point was advantageous or detrimental.
Figure 1: Longer term hedging strategies have lower price volatility (UK power – baseload)
Source: ICE.
Notes: The M+1 is the month ahead price. The M+12 is a 12 month ahead hedging strategy and the M+24 is the 24 month ahead hedging strategy.
Figure 2: Price volatility reduces considerably from month ahead at over 40% (annual standard deviation) to 25% at around 18 months ahead
Source: ICE.
Notes: Annual standard deviation is calculated by multiplying the standard deviation of daily returns by using the square root of time rule.
One concern with hedging is that consumers do not value fixed price deals very highly. Surveys completed by Ofgem show that consumers are motivated by relative prices between tariffs and much less by the stability in bills. I expect, however, that if consumers were exposed to the full volatility of prices (i.e. spot prices on a time of use basis) then I expect that they would place a much higher value on stability than they do today.
Figure 3: Only 6% switched to get a fixed priced deal, but 91% switched to save money
Source: Ofgem, 2016, Consumer engagement in the energy market since the Retail Market Review.
There is also a cost associated with hedging in advance of delivery. Estimates suggest that the cost of hedging 24 months ahead rather than 12 months ahead is £27/customer/year for a dual fuel bill.[2] Further, the use of hedging reduces transparency of costs. It makes it difficult to determine when changes in the wholesale price will translate into changes to customers’ bills. Politicians are regularly frustrated when suppliers do not immediately pass through falling wholesale prices into bills because of the hedges they already have in place.[3]
2. What does a rising wholesale price mean for suppliers?
Wholesale gas (Figure 3) prices have fallen by 58% since Dec-13 at £24/MWh to £10/MWh in Jun-16. Wholesale electricity prices also fell from £55/MWh in Dec-13 to £32/MWh in Jun-16 for baseload power, a 42% decrease. Such a decline has favoured new independent suppliers who buy a larger proportion of their energy requirements closer to delivery than the Big 6. The Big 6’s standard variable tariffs (‘SVTs’) have been relatively more expensive because they are hedged across a period of 3 years prior to delivery when prices were higher. Compare this to a fixed term contract which will have an average hedge period of 6-9 months and can benefit from recent lower prices.
Figure 4: UK Wholesale gas prices (averaged month ahead)
Source: ICE.
Figure 5: UK Wholesale electricity prices (averaged month ahead)
Source: ICE.
The falling price has helped new independent suppliers be highly competitive in the UK energy supply market and ultimately increase market share from 1% in 2012 to 16% today.[4] Wholesale prices have, however, risen sharply since September 2016 because of a range of factors including expectations of a colder winter, nuclear outages in France and a small capacity margin in the UK. If prices continue to increase then the Big 6’s longer hedging strategy will become a strength rather than a hindrance. The Big 6 have announced price freezes through the winter in until March 2017.
Should wholesale prices rise significantly or for an extended period of time then it is possible that SVT tariffs become cheaper than fixed price tariffs. This would occur if the trailing longer term hedges from an SVT tariffs are cheaper than forward wholesale costs for new tariffs. Greg Clarke MP, Secretary of State for BEIS, recently commented that “Customers who are loyal to their energy supplier should be treated well, not taken for a ride”. In this wholesale price scenario, customers would get a loyalty discount, but only through luck rather than deliberate action by the Big 6. It would also inhibit the growth of Independent suppliers who have been able to capture market share through their favourable wholesale cost position.
3. What risks do energy supply businesses have and will some go bust?
Energy supply is not capital intensive. Instead, the business model is exposed to significant risk because of cashflow mismatches between tariffs and costs (wholesale, networks). The low operating margins of supply businesses (2.9%[5]) mean that small differences can quickly wipe out this profit buffer. There are three major reasons why energy suppliers go bust:
- wholesale procurement mistakes – insufficient hedging for the suppliers exposure, cost disadvantages relative to competitors, shape risk;
- wholesale price volatility – energy imbalance, swing or weather risk;
- billing failures – inability to bill customers for the energy they consumer.
GB Energy went bust in November 2016 because it had insufficient cash available to cover its wholesale purchases and energy imbalance charges. It is highly likely that several more independent suppliers encounter similar financial difficulty over the coming winter because they typically have very limited capital relative to the risks that they are exposed to in the wholesale market.
One main advantage that the Big 6 has relative to independent suppliers is their size and superior access to finance. This significantly reduces their probability of default should their supply business be subject to adverse financial shocks. Smaller suppliers have avoided scrutiny surrounding their much higher probability of default because they have much smaller numbers of customers (hundreds of thousands rather than million). I expect this will no longer be the case following this winter if a number of other small suppliers also fail.
[1] The ‘averaging in’ strategy is equivalent to a moving average and is used in other industries. For example, it is best practice for wealth managers with new funds (which form a large proportion of a portfolio) to deploy into equity/fixed income markets should do so over a period of months or even years.
[2] Nera, 2015, Energy Supply Margins: Commentary on Ofgem’s SMI, Table A.3
[3] This is not just a problem in the power and gas markets but also for petrol/diesel prices where input prices are often hedged up to a year in advance.
[4] Ofgem data portal, 2016.
[5] Ofgem, CSS, 5 year average EBIT margin for all Big 6 suppliers.
Energy Envelope 