Electricity Market Reform, Pandora Is Out Of the Box

Published 14 January 2014 by Aily Armour-Biggs

Electricity is the most volatile commodity in the world; and our markets are undergoing profound change.  This means for a number of game changing reasons, for example, Electricity Market Reform, European Market Infrastructure Regulation and global commodity flow: the price of power in the UK market could become very volatile.  As experts in energy trading and finance we would warn that the potential price risk in the UK power market has never been so high.

Electricity Market Reform (EMR) represents the biggest change to UK power market since the Industry was privatised nearly 25 years ago.  EMR is complex, being a mixture of policy changes, new markets and existing code reviews all interacting with each other.  From our modelling of EMR we see the consequences being lower short term wholesale prices associated with highly volatile balancing price risks.

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The Department of Energy and Climate change (DECC) have fashioned EMR to their vision of a low carbon market place but they also have a problem with market liquidity so they want to protect future renewable power investors and promote competition in generation.  To this end EMR consist of two main changes:

  • A new Contract for Differences (CfD) market, which is designed to provide certainty of income for investors (subject to despatch risk).  However it is controlled through the Levy Control Framework (LCF), which cannot exceed just over seven billion pounds in 2020.  So it is not clear how the current investment plans (consisting of mainly offshore and onshore wind, biomass and a small amount of solar) will be developed.
  • A new Capacity Market which is an “insurance policy” against system stress.  It works through a series of penalties and availability payments, to incentivise generators to be available when the Grid needs them.  It is the decision of the Minister to decide if he wants to hold a capacity market in any given year and on the 17th of July he decided that he did.  It is hoped that existing gas stations will participate in this market along side demand side response.

EMR is also supported with a carbon floor price and an Emission Performance Standard.  The Carbon Price Floor, which is essentially a tax underpinning the price of carbon emissions in the UK, was introduced in April 2013.  However, controversially, the House of Lords tried to pass and amendment on the Energy Bill to have our old coal plant have the same requirement as new build by having them meet the Emissions Performance Standard (which will be agreed next summer) which puts an annual limit on carbon emissions from new fossil fuel plant.  Luckily this was over turned but the purpose of the amendment was clear: to drive coal off the power system faster and more completely than even the current set of regulations would deliver.  Furthermore at the end of December 2013, Energy Minister Michael Fallon said the Government is not planning to challenge European environmental legislation (Large Combustion Plant Directive) which has forced the closure of coal-fired power plants already.

However to us at Global Energy Advisory, we have for some time, been very concerned about the increasing cash-flow and collateral needs of the UK power industry, which we believe this is a key strategic issue for the industry, and unless you had read the 10,000’s of pages of all of the EMR productions, you wouldn’t have a picture as clear as our own.  This is what is really at the heart of EMR: there are new markets, and new power stations that have to be paid for by “mums and dads” and commerce, because as we know that some large users will be exempt.  So how much is it all going to cost and when will prices rise?

The bill received Royal Assent on the 18th of December and with it came some new regulations, such as the Supplier Obligation, with it.  This gives the suppliers the obligation to collect new payments and to provide collateral to cover their credit risk.  It’s now dawning on supply companies that they have more revenue to collect at a time when there is already public alarm over energy prices.   This short note therefore focuses on our insights and outlines our concerns about future cash-flows in the UK power market.

EMR is Complex

Saying that EMR is complex is an understatement: so advising in this field has become highly specialised[1] and these complex changes are coming in very soon.  We also expect to be working on the CfD’s under the enduring regime in the second half of 2014 but more likely they will not be ready before November.  We will also have the first capacity auction in November 2014; this is for delivery during winter 2018/19, (subject to State Aid approval of course).

At the core of EMR cash-flows is a government owned limited, liability company, which we know as the “Counterparty”.  This company will be at the core of the industries cash-flows.  Its two main roles are to firstly, to contract with generators to provide the new CfD contracts; and secondly, and in our view crucially: to forecast the size of the payments to be collected in accordance with the Supplier Obligation.

The Counterparty has to collect payments from suppliers and pass then to generators and vice versa (however, trusted Elexon will in reality perform this role), and in doing so holds and manages reserve funds (security for the CfD market place).

We hope this new company is well staffed and very expert in cash-flow forecasting because the Counterparty will have to calculate the Intermittent Market Reference Price with reference to the EU Price Coupling Algorithm used in the day-ahead EU market coupling arrangements.  So the Counterparty has a lot to manage and this is at the core of our concern: how can the Counterparty forecast, difference payments amounts, against an uncertain market price, varying technology type and deployment timescales?  Satisfactorily, we believe that he can’t.

Can the Suppliers Obligation Put the Lid on Pandora’s Box?

The Supplier Obligation is a compulsory levy and it will be enforceable as if it were a licence condition.   The Supplier Obligation will be collected on a unit cost fixed rate which will be a pound per megawatt hour rate (£/MWh).   Each supplier will therefore collect it in line with its market share.

To keep the mechanism well funded: suppliers will be required to contribute to a

  1. Reserve fund;
  2. Insolvency reserve fund to ensure payments due under CfDs can always be paid.
  3. Suppliers will be also be required to post a rolling 21 calendar days of collateral to cover generator payments.  Invoicing for these payments is daily, eight business days after the billing period, with 5 day payment.  Cash-flow rules are strict and if a supplier has not paid an invoice within 2 calendar days he will be reported to Ofgem, the regulators office.
  4. Generators will be paid 28 calendar days after the initial billing period, this is to allow the Counterparty to build up a cash-flow buffer.
  • Predicting short term reference prices for the CFD difference payments is difficult and could require expert modelling[2] ; and
  • Collecting these difference payments through suppliers who face a climate of demand destruction, seasonality and quarterly billing is not simple or scientific.
  • Working with our financial partner, we structured Center – this could eliminate the credit risk through the provision of non recourse cash to the Counterparty, but it is also flexible in size and payment duration which would allow Center to match the collection of collateral, therefore minimizing the cost to customers.  Furthermore the global bank group that support the structure have ratings which are better than the participants in the UK power market.  Another advantage to Center is that it provides non-recourse cash (read this as no strings attached) which is a superior asset when compared to Letters or Credit (LC’s) and interestingly EMR does not allow for Parent Company Guarantees (PCG’s).

    However, with the current financial challenges facing many of the banks in Europe, gaining access to margin capital is proving to be a complicated and expensive process.  The margin capital needs of the industry will also increase with the introduction of new European Market Infrastructure Regulation (EMIR).  Therefore credit risk is increasing and the ability of the banks to support the industry with margin capital is not improving.  We are receiving reports that Center is the only credible option for cash-flow need of the energy market place in Europe.

    Immediate Access to Collateral Cash: Center

    Center is a credit risk management product, which has its origins in supply chain finance and it is available for use in the energy industry immediately.  At the core: Center is a proprietary financing structure and payment platform which allows for a pool of collateral to be created from global multibank funding sources.  By using Center suppliers would not need to call their banks to raise cash.

    It has to be stressed that Center is a collaborative effort between companies engaged in trading.  There could be significant benefit to the smaller suppliers being part of this portfolio solution, because some of them do not have access to bank lines and rely on equity financing.

    How Could Center Work for the Supplier Obligation?

    • On day 1, the central counterparty, with authority under the Supplier Obligation, will issue instructions to suppliers to recover say £100mn in 90 days.
    • The suppliers could take a risk adverse view and say aim to recover £120mn from their customers base on the understanding that it may take longer than 90 days to recover the sum.  This uncertainty in revenue collection could certainly be increasing the cost of the levy to end customers.
    • By using Center the supplier can put an approved payment instruction into the Center payment platform for £100mn payable say in a more reasonable collection period of 120 days.
    • On that basis, the central counterparty can view the Center platform and see that the invoice has been approved.  The central Counterparty then elects to receive payment within 2 days. So by using Center, the action of the supplier putting the approved payment instruction for the date by which he is sure to have collected the capital, eliminates the need for him to use his own cash facilities or even approach his banks.
    • Consequently the central Counterparty has received cash on a non-recourse basis; within only 2 working days which means regardless of the credit situation of the supplier because the finance is “non recourse” it’s the banks who took the payment risk on the suppliers who take any potential default.
    • Once the suppliers have recovered the £100mn sum in 120 days they repay the banks by making use of the platform.

    The cost is LIBOR plus a margin which is based on the credit risk of the supplier.  If DECC considered using Center as an industry solution, then arranging the finance on a portfolio basis, could make the price, for all market participants lower.  The industry could finance say for a few percent all in; or over half a percent per quarter.  This is more attractive than financing on equity rates of around fifteen percent.  This would be an important factor in keeping the costs for the smaller players on a level playing field.  Like most financial programmes, if the stronger energy credits initiate the use of Center then the cheaper the facility becomes for all (especially the small).

    Global Energy Advisory would encourage the larger players to co-operate in this way as we believe the smaller players have special credit risk vulnerability in wholesale market.  For example if a small retailer had an In The Money Position (ITM) with a large player, who then fails, then the supplier may not have the cash resources to replace the hedge at the higher market level and then may also fail through no fault of their own.  We also believe that market integrity is the responsibility of all market participants and firms should adopt the best possible risk management practices at all times.  Global Energy Advisory is keen to dispel the concept of “credit skew” which is biased against small suppliers is often discussed in industry circles.

    The structure of the propriety financing is also attractive to banks as they are not syndicated at a lower level, therefore not exposed to bank to bank credit risk.  They also find Center very attractive because they can participate up to their own level and the product is better for them in regulatory terms than letters of credit.

    Center

    • Is an alternative to posting cash or letters of credit to mitigate credit risk;
    • It’s a competitively priced source of capital at scale which is free of fees or legal costs;
    • Does not interfere with existing banking relationships;
    • Was reviewed by the specialist credit committee of European Federation of Energy Traders (EFET) who readily saw its benefits;
    • Is an “approved instrument” of the Bank of England; and
    • Mr Cameron wants to see this mechanism used and has referred to this as a “win-win” for Industry and Commerce.

    Conclusions

    With investment confusion and the introduction of these new markets through EMR, then we believe the collection of funds through the Supplier Obligation could be problematic; especially as new markets evolve as traders strategise and pricing can often have unexpected outcomes.

    If there are financing mechanisms that provide a win-win and while mitigating credit risk for all players at minimal cost then we believe that they need to be examined carefully in the context of market integrity and cost to the already over-burdened consumer.

    Written by Aily Armour-Biggs, Advisory CEO 11th January 2014



    [1] We stopped counting what we had read when it was over 11,000 pages and that is not to mention the 1,000 pages in November 2012 and the recent 425 in 18th December with the Final Delivery Plan.  We need a complete view because we are advising on EMR, and Power Purchase Agreements.

    [2] This is one of the services of our firm as we specialise in complex modelling and valuations.

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