Managing the threat of transition in UK energy markets | Daily News Byte

How the United Kingdom’s governments, energy companies and traders respond to the energy crisis in the coming months will have an impact on the future of the energy industry and, by extension, the UK economy.

In the run-up to the 2008 global financial crisis, a steady trickle of bankruptcies, failed mergers and other bad news eventually gave way to a market contagion that forced national governments to bail out individual companies — and in some cases entire industries — virtually overnight.¹

Today, parallels can be seen in European energy markets. Factors including the post-Covid economic recovery coupled with Russia’s invasion of Ukraine have skyrocketed energy prices and uncertain physical supplies, which in turn fueled higher inflation and economic growth. As a result, there is growing uneasiness about other market contagions.²

That uneasiness is particularly acute in the UK, where several issues began to roil energy markets long before the current events. Before 2021, some suppliers did not hedge their exposure. While this decision allowed them to gain quick share in relatively benign markets, it also caused them trouble when prices began to rise. Weakly hedged suppliers whose tariffs were capped by regulators could no longer serve customers, resulting in the collapse of more than 30 suppliers since early 2021.³

Against this background, the war in Ukraine and associated sanctions have exacerbated an already fragile situation by increasing energy prices for consumers.⁴ and squeezing liquidity for energy companies.⁵

Government intervention

To counter the rapidly rising cost of living and reduce the likelihood of market volatility, the UK government has recently instituted additional pricing support and other consumer-friendly measures to reduce further uncertainty. The new energy price bill, introduced in September 2022, is designed to cap monthly costs for both consumers and businesses.⁶ Similarly, the Energy Markets Financing Scheme would theoretically prevent a 2008-like liquidity squeeze for suppliers by giving them access to a pool of capital.⁷

However, both bills, while necessary to address short-term issues, do little to improve the fundamentals that contribute to the current situation.⁸ And it is unlikely that the UK economy will be out of the woods anytime soon. With these factors in mind, corporations, energy companies and traders must take steps here to address the current crisis while building more stable and robust operating models for the future.

Prepare to hedge

All businesses crave stability. But UK energy firms are unlikely to find much of it anytime soon. Will energy prices continue at their current high levels? And if so, for how long? These questions will likely remain unanswered for some time, so company leaders must prepare for various scenarios to deal with uncertainty.

A comprehensive hedging program is an important step companies can take to help manage future risks. Hedging is especially important for energy companies and energy-intensive industries because energy prices drive their overall profitability. Although this practice is not a panacea (eg, it does not prevent the risk of production outages due to energy rationing, which is a real possibility this winter), hedging provides stable cash flow beyond the immediate crisis.

Manage liquidity

In a market transition, the collapse of one trading firm creates a domino effect that spreads to other firms, as happened in 2008 throughout the mortgage and insurance markets.⁹ Given the interconnectedness of today’s global economy, contagion within the energy market is a real threat because credit risk is shared equally across businesses and industries. If one company defaults, others are likely to follow.

Collateral is one way to manage such risk. But that doesn’t come without consequences: today’s high and volatile market prices are forcing energy traders to provide unprecedented amounts of collateral, straining an already challenging liquidity situation.¹⁰

Two primary lessons from the 2008 financial crisis can be applied here. First, to reduce the likelihood of contagion, it is necessary for energy companies to create stability by managing liquidity and trading positions, as well as supporting stakeholders by developing contingency plans to ensure that directors can continue to trade in the event of a transition.

Second, ensuring ongoing dialogue between energy traders and government officials and regulators must help weather the storm in the short term.

Basic effects

As with the financial crash of 2008, an inevitable byproduct of the current UK crisis may be reduced competition. In fact, some energy suppliers are already refusing new customers and closing their existing hedge portfolios, suggesting that they will close their doors soon.¹¹

Another parallel is the growing push towards clear trading. After the financial crisis, derivatives were cleared centrally due to fears of further market contagion; That is, the trade needs to be backed with collateral.¹² Similar developments are likely to occur in energy markets. Although this requirement may reduce the likelihood of future contagion, it will also reduce liquidity for hedging. And low liquidity will affect further investments and slow the energy transition.

These developments will have fundamental, long-term effects on the energy sector as a whole, resulting in consolidation, not unlike the rash of mergers among US mortgage originators after the 2008 financial crisis.

The silver lining?

While the UK government is prepared to deal with the current liquidity crunch by pumping billions of pounds into the economy, such support mechanisms cannot last forever. Energy traders emerging from this immediate crisis should prepare for tighter regulation, enhanced collateral requirements and a greater focus on risk management.

It may be too early to look for a silver lining in the current crisis. But there is collective hope that the austerity will finally bring long-needed reforms to UK energy markets that will allow a stronger industry to emerge.