More liquidity is essential to get more competition: First Utility

If the underlying wholesale market were more liquid, with a wider range of products available to all participants, retail competition could materially improve, says Jonathan Smith.

In order to sell a retail product there is usually a more fundamental wholesale purchase required, so problems or changes at the wholesale level can cause difficulties, or opportunities, in serving customers and competing at a retail level.

This is particularly true of energy markets. News of falling oil prices, for example, leads to expectations of immediate energy bill reductions. But it is, not unexpectedly, far more complicated than that.

Trading and pricing in an independent energy supply company is both a science and an art, involving buying wholesale and selling retail energy. It also requires accurate forecasting and management of many other costs and risks into the future.

A successful supplier will combine these disciplines to create keenly priced retail products to attract and retain customers. To add further complexity, wholesale and retail activities are affected by general political and economic developments, changes in the rules and regulations governing the sector, and crucially, by the weather.

The Competition and Markets Authority is currently investigating retail energy supply, and wholesale electricity markets, so this is a good time to take a closer look.

In 2001, the wholesale electricity market was changed from the old “Pool” system to the New Electricity Trading Arrangements (NETA) for England and Wales, and later expanded to Great Britain. These rules cover market trading and settlement arrangements for electricity, under which competition in all electricity market segments could develop. This also takes into account system balancing (as electricity cannot easily be stored, market participants must purchase the right amount of energy to serve their customers, or face high costs for any imbalances).

Despite NETA having been in place for more than 14 years, small signs of domestic retail competition beyond the incumbent energy providers only started to emerge in the past two to three years. This is a welcome development for domestic customers: those who have switched supplier have saved £200 or more annually by moving away from the “standard” tariffs of the big six, which are anything but standard and can be some of the most expensive tariffs on the market.

If the underlying wholesale market were more liquid, with a wider range of products available to all participants, retail competition could further materially improve.

Lack of wholesale market liquidity and some of its underlying structural drivers in the industry are arguably among the key reasons for this ten-year delay in the emergence of retail competition.

It may be more helpful here to refer to “markets”, as suppliers typically buy power in advance on the forward market, and refine trading requirements in the spot markets closer to the time when the power is actually delivered to customers.

Ofgem has tried to address the lack of liquidity by introducing a number of measures under the label “Secure and Promote”. These measures were intended to increase trading in standard products, and provided for specific trading windows to facilitate this.

However, we are not seeing significant increases in the number or types of products being traded: instead there is a concentration of trading within the trading windows. But access to continuous liquidity throughout the day is important – as new supply and demand price signals driving wholesale prices changes occur throughout the day, not just in the trading windows.

Market participants would prefer to be able to react to those price signals in real time rather than risk having to wait for the arrival of the next trading window to react; otherwise it may already be too late to react to the new risk or opportunity.

Finally, and perhaps most importantly, the rules do nothing to force “product discovery” into the wholesale forward electricity market, instead focusing on far simpler “baseload” and “peakload” forward products. While these products provide some ability to hedge retail demand, they do not form a complete market as they are necessary but not sufficient to fully hedge shaped domestic demand.

Supply business trading risk managers make the best use they can of the limited forward market they operate in. Here, the advantage of operating within a company which also has generation capacity becomes clear: this allows suppliers to effect internal trades in the absence of wholesale market liquidity.

While being an understandable ­strategy, this in our view adds to the illiquidity of the markets for those without generation capacity. Purchasing generating capacity should not be the only answer to the lack of liquidity. The market arrangements were after all designed anticipating the emergence of independent suppliers operating downstream of the market with no direct linkage to upstream generation and should provide products to facilitate this business model.

The importance of a liquid market becomes even greater following the government’s Electricity Market Reform and the introduction of Contracts for Difference feed-in tariffs that make a top-up financial payment (from a market index price) to low-carbon generators. As the number of generators under the scheme grows, there will eventually be billions of pounds paid out annually by suppliers via these financial contracts, which will ultimately be collected from British consumers, including domestic electricity customers. It will become hugely important that the market reference prices are based on a vigorously liquid, transparent and robust wholesale market, so that retail electricity prices do not increase by more than they reasonably should.

The past five years have seen some relatively benign wholesale electricity market price conditions from which the seeds of domestic retail competition started to grow. This might mask the issue of lack of liquidity to a certain extent. Wholesale market liquidity concerns need to be addressed so that competition is not adversely impacted in more volatile market conditions.

This is the best way to ensure that all market participants, who may have a wide range of business models, can compete for customers on fair terms and access the wholesale products they need to operate their business and effectively manage risk.

Jonathan Smith, head of trading and ­pricing, First Utility