Monday, 3 November 2008

Is Centrica Running the Northern Rock Risk ?

Northern Rock, it will be recalled, foundered on the egregious strategy of not attempting to balance its lending with savers’ deposits, but rather with borrowing in the interbank markets. When liquidity in the latter dried up, the business model - otherwise potentially viable - imploded. To use jargon familiar in other industries, they were not ‘vertically integrated’ and accordingly were heavily exposed to wholesale market conditions.

Which brings us to the gas and electricity sectors. Since privatization, the development of wholesale markets, and the introduction by Enron of the ‘merchant’ model, energy companies do not need to be vertically integrated. In other words, they don’t need to produce from their own fields all the gas they sell, nor generate all the electricity in their own power plants. Conversely, if they produce gas or generate electricity, they do not need to find end-user customers for it all. Either way, they can rely on liquidity in the wholesale markets to balance their energy positions. In good times, it’s arguably more efficient than forcing an artificial energy balance on, say, a specialist North Sea gas producer or a specialist energy retailer.

That is, until liquidity starts to look shaky. And, as we reported earlier, this is starting to happen, as the banks and other financial shops, who since Enron have been amongst the biggest players and indeed market-makers in the gas and electricity sectors, are experiencing credit-crunched reductions in risk capital available for any trading activity.

So – who is running the Northern Rock strategy in the UK energy markets ? Answer: well, several of the big players are not at all closely integrated, but some are more so than others, as this handy Ofgem report reveals (fig 2.4)

In electricity, E.on and Scottish Power are nearest to balanced, with Centrica the biggest short position and British Energy a big long. Uniquely, Centrica cannot even meet its residential-sector sales from its own generation: and EDF can barely meet its residential + SME demand.

This changes, of course, with EDF’s acquisition of BE, balancing them off rather nicely. Centrica’s balance improves a bit too – if they use the £££ from their rights issue for a quarter-slice of BE, as planned. But they will still be running a significant short - a situation they have recognised for years.

In gas, the picture is quite different: of the big retailers, only Centrica has any substantial gas production of its own: but it still covers a mere 29% of its sales to small customers.

So – any prospect of a Northern Rock outcome here ? Bankruptcies are implausible. And, of course, it is argued that conditions in the energy retail sector are not truly competitive: if this is even partly true, there may be a degree of undeserved cushioning available to the exposed retailer.

But margins must surely be at risk, if liquidity in the wholesale markets continues to suffer from the crunch. Centrica will be glad it got its rights issue away, to at least ameliorate its exposed electricity position with a slice of BE.

ND

10 comments:

Mark Wadsworth said...

Apart from the fact that the energy companies appear to be a rather nasty oligopoly, this isn't an issue any more than the normal interdependence of manufacturers, wholesalers and retailers.

What is a worry is all the power cuts that we will be having if we continue as we are doing.

Nick Drew said...

avoiding power cuts obviously top of the priority-list, Mark

but personally I haven't given up on aiming for genuine competition

for which we need a genuinely liquid & properly-functioning wholesale market, so that vertical integration isn't the only risk-averse business model available

because that makes the entry-barrier too high

competition & security-of-supply needn't be incompatible

Blue Eyes said...

Isn't there quite a difference between banks and energy companies in that energy demand does not change much from year to year. Someone will still have to generate the electricity or import the gas whatever happens to margins or competition.

Nick Drew said...

whatever happens to margins

well, BE, but (a) actually, demand may go down significantly in bad times - ask the Eastern Europeans - & last year was the first year ever in the UK when residential demand fell (on a temperature-corrected basis), as people were tightening their belts as early as last winter

(though not as much as, e.g., demand for mortgages, I grant you)

(b) an individual energy co can go bust, and cause no end of problems for its creditors (including banks and other energy co's)

e.g. when Enron went under, starting a domino-process (coupled with low elec prices) 2001-03

sometimes the stakeholders were left holding the keys (Drax, Teesside Power et al); in other cases (British Energy) the govt felt obliged to step in

in this period there was a small positive margin for carrying on generating (although the co's were unable to service their debt etc) so the stakeholders kept the show on the road until things improved

and the banks were not themselves in any particular trouble at the time

(c) who is the 'someone' you have in mind ? the system operators (actually National Grid now for both power and gas) have reserve powers to keep the lights on, designed for operational failure or individual co's defaulting on (some) short-term supply obligations: they charge the cost of doing this to all the other players (which kinda assumes there are such players able to do this) and are not geared up for doing it on a large scale or for a long time

you may posit an orderly slow-domino process, perhaps ending in a 'last man standing' scenario who becomes a monopoly and cleans up

and as you know, I am a proponent of slow-domino theory meself: & this certainly helps

but it isn't without casualties & consequences

and I have to say, it isn't a recipe for the much-needed new investment that's urgently required !

*carries on muttering to self*

rwendland said...

ND> last year was the first year ever in the UK when residential demand fell (on a temperature-corrected basis)

Do you think this could be from improving gas use efficiency due to the slow switch to condensing boilers, and better insulation?

A condensing boiler is about 25% more gas efficient I believe (about 85% thermal efficiency compared to around 65% on average for old boilers). If we are on a 15 year replacement cycle trend (optimistic?) we would see an annual 1.7% residential gas use reduction, other things being equal. Add improved house insulation and maybe we should expect an underlying annual 2% to 3% residential gas use reduction?

There is an opposing increasing number of households - but that seems about 1% per year, and the average household is becoming smaller.

Mark Wadsworth said...

ND, don't worry, your post as Energy Secretary is safe! Surely it can't be too difficult for MMC to say that no single company may own or control more than x% of electricity generating market? Crude, but it might help.

On a lighter note..."last year was the first year ever in the UK when residential demand fell (on a temperature-corrected basis), as people were tightening their belts as early as last winter"

Doesn't one button up one's cardigan in these circumstances, rather than tightening one's belt?

Nick Drew said...

Mr E - my friends in the industry tell me it's not the effect of greater efficiency. Efficiency has of course been improving steadily over the years, but until now has always been outweighed by the 'affluence factor', as people discarded more and more of Mr W's cardigans and turned up the thermostat relentlessly. Nope, it's yer actual Stafford-Cripps style austerity

(note for younger readers & non-historians ...)

Mark - oh yes, I'd have lots of ideas for promoting competition. Bringing back 'Saint' James McKinnon would be high on the list

Anonymous said...

Blimey!! Will they be energyrupt?

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