Energy Bill: capacity mechanisms

Capacity mechanisms and decreasing margins are threatening Europe's thriving energy trading ­­­­­­­market. Jim Fitzgerald and Marc-Felix Otto report

European utilities have fundamentally transformed their business models in the past decade. Instead of being organised along the traditional functional lines of making, transmitting and selling electricity, a centralised trading function now sits at the core of most companies. This drives enormous economies of scale and portfolio benefits across the business.

This transformation has taken many years and considerable investment in people and resources, not least the complex Energy Trading and Risk Management systems now at the heart of utility businesses. It is now largely complete and the realisation of benefits is under way.

Market liberalisation, first in the UK and now in the rest of Europe, has driven the transformation, through a series of national and European directives. This has, as a central aim, the breakup of monopoly vertically integrated utilities and the replacement of long-term contracts on both the fuel side and customer side with open access to highly liquid, traded markets. Although a single energy market is not yet complete (particularly in gas), most utilities have already taken the necessary steps to transform their businesses under regulatory pressure.

The early experience of energy trading was dominated by the spectacular growth and devastating collapse of asset-light traders such as Enron. That particular business model failed for reasons which are now known not to be linked to market fundamentals, and the idea of energy trading has survived and been adopted by asset-heavy energy majors. A key difference is the core business focus on asset-backed trading, with limited risks, rather than proprietary trading.

Growth in European trading, in particular in German, French and Dutch hubs, has been very strong (up to 20 per cent for gas) in recent years. European cross-border power exchanges are also rising strongly: first quarter 2012 flows were 13 per cent higher than the same period in 2011, on the back of a 5 per cent rise in traded volumes and despite a 0.2 per cent fall in consumption.

Indeed, all the major European utilities are active players in the traded energy markets. Their large, centralised trading functions allow them to commercialise market know-how and physical assets through their ability to hedge price risks in ways impossible just a few years ago. This creates transparency for internal risk management, incentives and controls, as well as for rising external regulatory scrutiny under new Remit (Regulation on Energy Market Integrity and Transparency) rules. As traders buy and sell increasing amounts of fuel and power at transparent market prices, they are realising economic efficiency as single energy market policymakers intended.

However, this successful model is now facing threats from fundamental market and regulatory changes. The first threat arises from decreasing trading margins, particularly in power, due to a number of fundamental market factors. As the European traded energy exchanges mature and integrate, standard products become commoditised and markets become increasingly coupled, so the ability for traders to realise arbitrage opportunities fall. This is being exacerbated by the exit of banks and small proprietary traders, potentially leaving an increasingly homogenous set of asset-backed utility traders with lower risks and margins.

The exit of some players may be partially offset by new market entrants such as upstream energy players and large industrial energy users who are finding that directly trading energy can offer greater near- and long-term hedging opportunities. Nevertheless, it is unlikely that the high trading margins realised in recent years will re-occur. Therefore, successful utilities will be required to place greater focus on high quality trading execution and best-in-class back office operational efficiencies and controls.

The second major threat to the energy trading model arises from concerns about security of supply. Across Europe, many countries are considering capacity payments as a way to ensure enough generation capacity remains on their systems in the coming years and to deal with expected intermittency from renewable generators. As well as the physical challenges to transmit the rising intermittent power generated, the mechanism of market price discovery becomes increasingly distorted in cases of renewable generator feed-in subsidies and must-run priority. Negative power prices were reached on the German system on five days in January 2012, with negative prices reaching -€100 per megawatt-hour for one hour. This is widely expected to be a taste of things to come across Europe and Britain.

The flip side, in a fully functioning market, should be that power prices rise sharply in periods of low intermittent generation, to levels unacceptable to customers and politicians alike. The result of these distortions is that flexible generators fear they will be unable to recover their capital costs, leading to underinvestment in flexible power plants and deteriorating transmission grid conditions.

Two very different approaches are being touted to fix this problem. One the one hand, the European Commission is urging more interconnection and trading so member states can support each other where intermittent sources at the national level are unable to meet demand. This makes sense when climatic conditions are considered at the continental rather than state level, where the need for significant excess capacity can be avoided by pooling resources (for example, the existence of a natural negative correlation between wind and solar resource in southern and northern Europe).

On the other hand, member states are concerned about overreliance on neighbours coming to their rescue in times of shortage when there are many examples in the not too distant past of such support failing to materialise and of unacceptable volatility in energy prices and investment. Capacity payments are being increasingly viewed in Britain and elsewhere as a fix to the conundrum of achieving a clean, secure, affordable energy system.

The Commission’s decision last month (October) to refer Poland and Slovenia to the European Court of Justice for failing fully to transpose European internal energy market rules is the starting gun in what will likely be a long struggle over the coming years to decide which of these two approaches will prevail. In the meantime, utilities will face increasing political risks as they consider how to develop and execute trading and investment strategies to navigate the energy and capacity markets.

Many players are considering a move to multi-­commodity trading while power margins are lower than other commodities (gas, oil, coal) to realise additional portfolio benefits. The winners will be those with the best-in-class operational backbones, the sharpest market insights, and the most rigorously controlled and efficiently executed strategies.

Jim Fitzgerald is an associate partner in London and Marc-Felix Otto a partner in Zurich at The Advisory House

This article first appeared in Utility Week’s print edition of 16th November 2012.

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