As the UK faces a fuel crisis, Kevin Moore, Senior Manager at 4C Associates looks at the lessons in risk management that we can learn from the current market disruption.
One of the biggest news stories over recent days has been the failure of several smaller domestic gas suppliers following the rise in Gas Market pricing and subsequent and knock-on effects into other markets sectors such as disruption to CO2 supplies into food sector. Whatever way you look at it, the increase in UK Natural Gas prices (see chart below from Mintec) has been sudden and steep with prices on most indices doubling since July when values broke out of the trading range that had existed for more than 5 years.
Key drivers as always in commodity markets were imbalance between Supply (low stocks, disruption on deliveries) and Demand (lower contribution from renewables, industries restarting and winter approaching). Add to that the uncertainty on why Gazprom has slowed gas exports to Europe in recent weeks, raising questions on whether there are wider political implications between Russia, US and Germany at play and you can see why gas markets are spooked.
This Blog is not to focus on reasons for Gas increases which have impacted most of European and Asian Gas markets, but to look at lessons in Risk Management from collapse of smaller UK Retail Gas Suppliers
A key pillar of Commodity Risk Management strategies is the recognition of risks. Textbook examples are:
- Cost (input) risk: arises when adverse movements in the price of commodities impact business costs
- Reduced profitability risk: arises for businesses consuming such commodities if the business is unable to pass on the cost increases in full
So, all fairly classic risks that a well-managed retail reseller of gas would have had strategies in place to manage the risk profile of its core commodity between the wholesale and domestic markets (the price it buys gas and the price it sells) through hedging and other pricing mechanisms.
So what happened?
In August, with wholesale prices already surging, the UK Regulator Offgem announced that the energy price cap will increase by 12% for an average domestic consumer using both oil and gas.
The price cap is designed to offer a safety net making sure that suppliers only pass on legitimate costs to consumers
The Price Cap is calculated by taking an average of the relevant forward contracts that were sold in advance during an ‘observation window’ before each six-month price cap period. The observation window for the winter price cap period (October2021 – March 2022) is the previous February 2021 – July 2021.
In a fairly stable market e.g. August 2020 – Jan 2021, the system has worked. However if you look at the charts below from the Offgem website, you can see that the basis of the price cap was already about 40% below the effective price at the end of the reference period and as previously shown in first chart prices have continued to soar since July.
Therefore, applying a process designed for a generally non-volatile market to one with soaring wholesale prices, the outcome was that the price cap effectively became an uneconomic price ceiling for gas costs.
Peter McGirr, CEO of Green Energy speaking on Sept 20th after the company ceased trading summed it up:
“Green Energy was effectively hedged in the wholesale market with regard to the 60% of its customers on fixed tariffs, but was “curtailed by the regulator Offgem” from increasing its variable tariffs for the remainder of its customer base due to the UK’s regulated price cap, we just don’t have deep enough pockets to ride out this storm,”
So, a system designed to protect customers effectively became one that subsidised the consumers with prices below current market rates, will in the long run reduce competition and would suggest lead to higher costs in long term for the same consumers.
In addition, there will be another interesting dilemma for Offgem (with further risk for Gas Resellers) on whether we continue with the same system when prices fall to historic norms and the price caps are significantly higher than the market!
So, a lesson for Commodity Risk Management is not to forget one of the other text book risks in your Commodity Management strategy.
- Political risk: arises from compliance or regulation impacts on price or supply of commodities.
4C are a specialist procurement and supply chain consultancy, supporting organisations to deliver maximum value from their supply chains. Please contact Kevin Moore at email@example.com to find out how we can support your organisation.