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.