Opinion Piece - What Price, Trust?
Scarcely a day goes by without news of another small UK energy supplier going broke. Their demise is received almost with glee in some sectors of political establishment, especially by those who had little belief in a deregulated energy market in the first place. The general public isn’t exactly in tears either, although marooned customers are justifiably very worried about their future energy supply and its increased cost.
The UK energy industry could do worse than publish its views on the exact reasons for this sudden ‘mass extinction’ of new entrants to set the record straight. The most prevalent belief outside the industry is that companies failed purely due to their own mismanagement, especially their failure to hedge out far enough along the forward curve. While the managers of some companies clearly took a very ‘relaxed’ view of hedging and arguably got their just deserts, there were many who took a very robust approach, and hedged well in to 2022. They hedged via third parties backed by some very big names in the industry, only to be left stranded high and dry when the third party upped and left, effectively defaulting on their obligations. Their resulting demise is certainly no fault of their own, and warrants further investigation.
It’s too early to say yet how many of these cases are true defaults as opposed to the legitimate activation of force majeure clauses, a characteristic of physical markets since their inception. There is little doubt that some of these cases will come before the courts, and given the reputational risk and breach-of-trust that will result from any adverse judgement, at first glance it’s stunning that some big names have walked away in this fashion.
Arguing over force majeure clauses has always been fruitful ground for lawyers. There is a fine dividing line between a failure to perform on a contract due to poor foresight, planning and execution, and being the genuine victim of a catastrophic natural or human event demonstrably beyond the control of the counterparties. History and the courts will judge whether the current upheavals in the gas and electricity forward prices are attributable to preventable human incompetence, or unwelcome divine intervention.
Whatever the outcome, the echoes from these defaults will reverberate around the industry and colour the judgement of risk managers for some time to come. They will raise some fundamental questions around the delegation of risk management to service providers, counterparty risk, and ultimately, trust. At the basic level, new entrants will ask that if they can’t trust the big names over the management of a straightforward hedging transaction, who can they trust?
Dismissing this as an abject lesson in counterparty risk rather misses the point, as it implies that risk transfer mechanisms fail as soon as the risk to be transferred becomes manifest. It’s a bit much to ask new entrants to comprehensively vet established service providers, and hire expensive lawyers just to trawl through contracts looking for force majeure clauses that undermine the purpose of the contract. Future new entrants will be very wary about who they trust based on past performance, either as risk management service providers or counterparties.
For sophisticated players, the risks presented by force majeure clauses, counterparty risk, and issues of trust just get priced in to contracts as premia. Everybody may pay more as a result, but at least the market can find an equilibrium. If the current upheavals in the UK market does result in the mass extinction of new entrants due to service provider default, is this the kind of lesson that Ofgem and the politicians want future new entrants to learn?
Ofgem needs to act, and look at the regulation of these risk management service providers. If all have walked away for genuine legal and commercial reasons, then that is unfortunate, and just another risk that raises the cost of market entry. If withdrawal was sharp practice, or arguably illegal under contract law, then Ofgem should tighten the regulations.
Users of Matrica’s Nominator software can model many forms of energy risk including market price spikes, unscheduled outages, credit and counterparty default. These risks can be quantified in both volumetric and financial terms.