Liquidity is a moving target

Many in the industry are sceptical that Ofgem’s effort to increase liquidity under EMR will work, and fear that the CMA inquiry will render the whole project redundant anyway, says Jillian Ambrose.

How comfortable would you be placing a £45 million bet on the success of a scheme which at best may have no clear impact at all?

For energy traders, taking a calculated punt has always been part of the game. But most agree that Ofgem’s latest gamble on the wholesale electricity market under Electricity Market Reform (EMR) offers terrible odds: there is little chance of measurable success and will hit the big six for an estimated £45 million, and potentially their customers into the bargain.

At the end of March Ofgem imposed costly new liquidity rules on the biggest players in the UK electricity market, in a bid to “break the stranglehold of the big six” by increasing the amount of power traded on the open market while boosting market access for small suppliers.

As it stands, trading levels in the UK power market are less than half 2002 levels, which Ofgem blames on the increase in vertical integration through mid-2000s. The structure of the sector now poses a hurdle to potential new market entrants, the regulator claims.

“In order to support competition and efficiency in a market, liquidity is vital,” Ofgem says.

Few would disagree with the need to act. Late last year, Labour leader Ed Milliband vowed to tackle competition concerns by separating the generation and supply sides of the big six if his party wins next year’s election. The possibility of a split was raised again after Ofgem referred its own competition investigation to the Competition and Markets Authority, which has the power to order a break up of the big suppliers within the next two years.

In the meantime Ofgem has controversially opted for a different raft of solutions, which may prove to be more costly than they are beneficial, and which could ultimately be irrelevant in the face of far bigger interventions.

EDF Energy pointed out in the consultation phase of EMR that the total cost of Ofgem’s plans could exceed £45 million, and they may still have little impact on market liquidity.

“The question is whether or not the benefits of the measures outweigh the cost of implementing them,” says the chair of the UK’s Power Trading Forum (PTF) Stephen Harris.

Ofgem’s solution to a lack of liquidity in the power trading market is to force a major change to the way the largest power market participants trade long-term power contracts.

Through the regulator’s mandatory market obligation, the utilities are expected to act as “market makers”. This means they need to simulate a functional market of buyers and sellers by putting forward the prices at which they are prepared to buy and sell long-term power contracts.

Specifically, prices need to be posted into the market during the two one-hour “liquidity windows”, which are held at 1030 BST and 1530 BST every day, for deliver-periods up to two years in advance. The measures will guarantee smaller market participants the opportunity to either buy or sell power with a large generator, without which they might not have been able to.

Whether the measures are successful or not, the cost and burden to the power market’s dominant players is undeniable, the PTF’s Harris said.

“For obligated parties I can imagine that the mandatory market-making is a bit of a headache. Traders will need to be concerned not only with whether they are compliant but also if they are trading in a way that makes sense for their position, so it is definitely an extra burden,” Harris says, adding that new systems and processes will come at a “significant cost”.

Ofgem hopes that by creating greater opportunities for smaller players, competition will flourish and cause prices to fall. But if the plan fails, the price paid in pursuit of market reform could be passed on to consumers.

Ultimately, the success of the plan depends on two strongly criticised assumptions: first, that market making is the best way to boost liquidity; and second, that liquidity even matters to the end-consumer bill. The consultation triggered an avalanche of criticism from big six participants, who questioned both these assumptions. They said greater liquidity was not necessarily a likely result and even if it did occur, this would not have any impact on the bottom line for consumer bills.

“EDF Energy has argued throughout the long debate that liquidity has been driven by factors outside the energy market, and in particular access to credit for new suppliers,” the company said.

Scottish Power added that even if greater liquidity was achieved, the impact on consumer bills was far from certain. Not only might there be no apparent decrease, but the measures could increase costs.

“[I]t is unclear to us that prices in the electricity wholesale market are currently above the efficient level – indeed many observers think that current wholesale power prices are well below new entry costs, leading to the need for capacity interventions,” said Scottish Power’s response.

“It is therefore unclear to us whether additional liquidity will create a downward, rather than an upward, pressure on wholesale prices. In any event, if generators are required to fund the costs of liquidity measures then this will create upward pressure on wholesale prices.”

Eon agreed that it was difficult to provide a quantitative estimate of the potential impact on consumers’ bills from greater liquidity. “Consequently, the risk is that Ofgem’s assumptions are wrong and the industry incurs net costs, which in the long term would inevitably have to be met by customers,” Eon said.

As Ofgem’s rules came into effect over April, liquidity did indeed pick up compared with the same time last year. But not only was the increase in trading more likely to have been due to the Russia-Ukraine crisis, but it also proved short-lived.

Trade data from energy market specialist Icis shows the average market volume of winter-delivered power in April was 6,224MW this year, up 124 per cent from April last year. But the strong increase in volumes failed to continue in May which (for trading days up to and including 28 May) saw a 36 per cent decrease in volumes to 3,970MW.

“Strong liquidity in April was definitely supported by volatility in the gas market due to developments in the Russia-Ukraine crisis,” Harris said. “I would say increased volumes were mainly due to these events.”

But perhaps the most damning indictment of Ofgem’s plans to level the playing field for smaller suppliers is that they go directly against calls from the suppliers themselves.

In their consultation responses, independent companies including First Utility, Smartest Energy and Co-operative Energy consistently called for measures previously proposed by the Labour party, and widely expected from the CMA intervention: a restriction of big six self-supply.

“We believe the best and simplest solution to promote liquidity would be a self-supply restriction,” said First Utility.

“Such a solution focuses not on the specific detailed trading activities such participants must undertake, but it instead describes the one activity that those participants cannot undertake: internal energy transfers,” it added.

Smartest Energy agreed: “Self-supply restrictions would be a more effective intervention not only to improve liquidity but also to improve transparency in the market, especially in the current media and political context.”

“[It] would have had a greater impact on liquidity than Ofgem’s proposals,” Co-operative energy said.

UK power traders told Utility Week that Labour’s plans made sense from a market point of view.

“They really need to break up the generation and retail arms and limit internal trading to make power a real market –
with producers and users – rather than integrated utilities that can internalise it,” a trader said.

 “It has always been argued that what Ofgem proposed was never going to increase liquidity. The only thing that will do that is more counterparties, or traders, making money. You either need more people needing to trade – therefore more trades take place – or a market that is conducive to traders making money,” he said, adding that a proper market would see the return of speculative financial players too.

“The big six in general have said this all along. It’s just that Ofgem needed to be seen doing something,” he added.

A spokesman for Ofgem claims it is just too soon to tell if the market-making plans are a success. “We have been monitoring the market and taking opportunities to engage with stakeholders to gauge early experiences with the reforms. However, it is too early to draw conclusions about the results of this intervention,” a spokesman says.

Even over the longer term it could still prove difficult to determine the success of the measures, given the strong influence that external factors will continue to have.

“We can imagine scenarios where liquidity could naturally increase,” said EDF Energy, pointing to tightening surplus margins after 2015, and changes to asset ownership and the wider financial markets, as key drivers of liquidity in the future.

Harris added that predicting future liquidity was particularly difficult as the energy sector moves into a time of flux.

“Reduced surplus margins by 2015 could bolster trade but the uncertainty regarding the impact of capacity market measures set for 2018 could cause further withdrawal of non-generating players,” he said. “There are lots of changes coming for the UK power market, some of which could improve liquidity while others might have the opposite effect. We just don’t know yet.”

With the results of the CMA investigation still to come, and a 2015 Labour government a real possibility, a wider shake-up of the market could trump all current predictions.

Perhaps the safest bet might be that whatever the future for UK power liquidity, Ofgem is unlikely to be responsible for it.