Small ships in a turbulent sea: The viability of assetless electricity retailers

Lawrence Haar, senior lecturer in finance at the University of Brighton, argues that vertically integrated suppliers with their own generation have an inherent advantage over assetless retailers which has been exposed by the recent surge in energy prices.

For energy buyers and traders, the weeks since the close of summer have been anything but dull.  Global petroleum prices have risen sharply along with the European price of pipeline natural gas as well as LNG. Even the unloved fuel, coal, has seen its price triple, as governments across the globe scramble to keep the lights on and offices and factories open.  In the United Kingdom, this has raised perennial concerns over security of supply, affordability and environmental safeguards.

Though the present situation has been driven by fundamentals, renewed concerns have been voiced over the UK’s unique encouragement in the growth assetless retailers re-selling electricity purchased in the wholesale market.  Can failures and bankruptcies among such firms be attributed to the current market fundamentals or are such firm inherently flawed and bound to be unsuccessful?

The new retail firms range widely from smaller new participants, so-called ‘suppliers in a box’, to larger, more established outfits, such as Ovo and Octopus with hundreds of thousands of customers.  Regardless of size, they all use the traded wholesale market as a source of supply to be on-sell to retail customers.

Along with entry and growth of new suppliers, many firms have exited the market, with 34 retailers going through Ofgem’s supplier of last resort process since 2016. In this year alone, 14 retailers have departed, mostly recently Pure Planet and Colorado Energy.

While consumers now have greater choice, and reliance upon on what were once the Big Six has fallen, the long-term viability of such firms was seriously questionable even before the current market conditions.

Latent problems

The rise of new retail supply firms was heralded as a gain to consumers, providing choice and a counterbalance to the dominance of the integrated majors. But it has also been beset with problems and not just because of the current conditions.

Though Ofgem has welcomed the increase in competitive choices for consumers, the growth in price comparison websites and customer switching, the trend has been with difficulties.  Inexperienced and weakly capitalised energy retailers have attracted many complaints with regard to administrative errors and customer accounts.

According to Ofgem, instances of small suppliers on the brink of collapse retaining customers’ credit balances, ignoring requests for sums owed, are common. Small retail suppliers frequently give poor customer service, produce non-sensical bills and used heavy-handed debt-collecting practices. Frequent bankruptcies have naturally exacerbated these problems.  While retail customer complaints against all providers have been increasing, the most severe complaints involve smaller retail firms lacking generating assets.

Though lack of experience may explain some of the complaints, continuing financial pressures, even before the current jump in wholesale prices, played a key role. While many small suppliers-in-a-box firms went into administration, some larger, well-established firms such as Spark Energy, Extra Energy and Economy Energy also experienced financial distress. In 2018, 11 firms went bankrupt.  Nine of these collectively owed customers over £113 million, of which £26 million belonged to customers who had switched to a new supplier.

Prior to the current situation, we might have asked if these were the teething problems of an emerging sector.  Or was their business model incompatible with the existing market structure?  Many firms without generation assets have tried their hand at retail supply but after a relatively short period have been dissolved or declared bankrupt. Do recurring bankruptcies and poor levels of service indicate a fundamental problem which has now been exacerbated by the present circumstances?

Although it is tempting to lay the blame on global energy markets, given the structure of UK electricity markets, the business model of retail suppliers without generation assets is not viable for the following reasons:

• Assetless retailers face inherent disadvantages that make them very unlikely to achieve reliable profitability.
• Given the rigours of trading in the wholesale electricity market, the capital requirements for retail suppliers without generation assets is inadequate, contributing to moral hazard and rendering such firms unable to absorb the inevitable losses arising from market risk and credit exposure.

Owing to their inherent disadvantages and inadequate risk capital, the UK approach of encouraging assetless electricity retailers has led to excessive risk taking, ultimately at the expense of all concerned. Even if the current market prices and volatility miraculously reverted to earlier calmer conditions, a business model involving uncovered speculation in the wholesale market makes assetless electricity and gas retailers unviable.

A stacked deck

The inherent challenges facing assetless retailers arises through the structure and behaviour of electricity markets.  Through owning generation assets, vertically integrated utilities and merchant plants dispatching electricity in real time – the within-day market in which electricity is priced and sold at half-hourly frequency – enjoy informational advantages unavailable to those trading only in the forward market. By managing and dispatching their generation capacity, vertically integrated anticipate the load requirements of their customers, putting non-integrated purely financial players at an information disadvantage, as well as enjoying diversification benefits. In the day-ahead market where assetless retailers may attempt to profitably cover their short positions, prices do not reflect all relevant information, making trading as an outsider is inherently challenging.

If electricity markets were fair to all players and prices reflected all useful information, an energy retail supplier without generation assets would be unlikely to consistently beat the market. But the informational disadvantage of assetless retailers, means the cards are stacked against them.

Managing price risk

The exposure of an assetless electricity supplier is inherently riskier than that of an integrated utility which has the natural hedge of its long physical generation through its short customer. Unlike a vertically integrated electricity firm, a purely retail supply firm without assets is creating a large short position in the retail market which it attempts to offset through purchasing electricity in the wholesale market.

A retailer without generation assets must try to match expected demand through purchasing in the wholesale market on a day-ahead basis or into the future through long-term contracts.  The extent to which demand is not matched to supply results in indirect exposure to the balancing market in which one is charged a penalty pricing for being too short or too long.

Assetless retailers have customers and make promises but run the risk of being unable to meet these commitments profitably. Given the volatility of electricity markets, a small energy company committing to a fixed price or a saving on market price faces considerable risk. Promising to offer retail prices below market averages is even more difficult as penny differences in supply costs can transform exposures into losses.  Moreover, an assetless retailer must pay the bid or ask price, which is more than an integrated utility would internally transfer the price of electricity.

Assetless retailers have little scope for hedging their exposure to wholesale electricity prices and are at a distinct disadvantage compared with integrated utilities. Trading with integrated utilities or merchant generators requires approved credit lines and collateral, while entering into futures contracts on an exchange requires both initial capital as well as sufficient resources to meet variation margins, as positions are remarked daily.  Purchasing options to hedge exposure to electricity on the Intercontinental Exchange requires up-front payments. As well, moral hazard may arise because retail supply firms commonly attempt to gain customers through offering attractive fixed prices, promises of savings or other inducements, so exacerbating price risk exposure.

Absorbing losses through capital

To absorb losses while discouraging excessive risk taking, financial institutions hold capital for market, credit and operational exposure. Such regulations do not apply to those involved in physical commodities on the presumption that such participants, miners, oil firms or electricity generators can naturally hedge their long-short exposures. As assetless retailers have no scope for naturally hedging their short positions, it is fair to ask whether they should enjoy the same exemptions.

How much capital would a financial entity require for managing market and credit risk exposure?

Beginning with market risk, a bank supplying 100,000 retail customers with an annual consumption of 3,000 kWh (an average UK household), with a day-ahead price volatility of 167 per cent and a rolling exposure of £13.5 million in the wholesale market (100,000 customers x £45 per MWh x 3,000 kWh per customer), would require around £2.2 million in market risk capital.

For credit risk, if the probability of retail consumers not paying their electricity bills were 25 per cent and resulted in a loss of 50 per cent on the amount owed, a financial institution with 100,000 customers consuming 3,000 kWh per annum would be required to set aside over £2 million of risk capital, under Basel III rules.

The fact that under the current market conditions the size of exposure has grown with the risk of default, “wrong-way risk” in trader parlance, further shows how precarious minimally capitalised assetless retailers are.  Prior to the latest huge increases in prices, we see that the combined risk capital needed for a financial institution supplying 100,000 customers with 3,000 Kwh per annum would be around £4.4 million.

If a financial institution had the market and credit risk exposure of a small electricity supply company, its required capitalisation would be considerable.  Although retail electricity suppliers don’t have depositors and their failures have no systemic impact, requiring no capital seems odd.  Without any risk capital, their ability to absorb losses inherent to their business model is non-existent. Requiring at least some risk capital of assetless retailers, through squeezing margins, might even be a deterrent to market entry.

Summing up

To promote competition the UK authorities have promoted assetless retailers but given their inherent disadvantages and weak capitalisation, their viability is questionable which the current market conditions have made abundantly clear. Though in 2019, some tougher requirements on purely retail suppliers were imposed, these were insufficient to address the risks inherent to electricity trading, especially as prices and short-term volatility have increased.

Along with price caps, arguably, it was hoped that through competitive forces, assetless retailers would reduce the upward pressure upon prices arising from the support of renewable energy. But given the inherent challenges to their business model, writ large by current market conditions, it would be better for government to be candid with consumers, business and industry on the true costs of the green transition.  Policies must work with markets and not against them.