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Contingent risks in the electricity market

In the energy market, understanding commercial risk, where it sits and how it can be managed has always been critical to long term success.  It is easy to see risk as being purely something that revolves around the commodity markets, and measure value-at-risk, or a something similar.  However, the level of contingent risk now means the whole market is much more inter-connected than previously.   

Recent supplier failures and mutualisation of costs demonstrate this is a real rather than theoretical risk, with costs shared across those that are left in the event of an individual failure. Do you understand your whole market risk exposure from this ‘internet of risk’?

Top level risks
At the top level, Government holds the risks on behalf of UK plc, and repackages these in various forms to deliver its short- and longer-term objectives.

In simple terms, the incentive to build the ‘right’ technology is passed to developers; and the cost of paying for it is passed to customers.  Although, between these two areas lie a whole web of interconnected payment and risk transfer mechanisms.

Payment Risk Transfer
Fundamental to all these schemes is the premise that the end user is charged, and pays.  Suppliers are obligated to make payments in various forms which are then recycled to generators and lenders.  If the payment isn’t made protections are in place to mutualise underpayments.

Any non-payment risks ultimately stop with suppliers, where a collective obligation to make top-up payments exists in the event of a shortfall.  Although suppliers can notionally recover this from customers, the delay between any default and recovery may be extended; and as recovery is only made on suppliers that were in the market at the time, new entrants aren’t part of the collective risk.

Generators may also face a delay in payment in the event of a mutualisation, which they will need to be able to manage.

Performance Risk Transfer
Historically, once an asset was built, its performance risk fell squarely with the generator.  Whilst the cost stack consisted of broadly similar assets with either gas/coal marginal costs, the risk across the rest of the market was broadly limited.

Now, where the difference in marginal cost of generation between renewable and thermal is so high, the swing in energy cost can be huge.  Associated with this is a change in the value of the subsidy payments made by suppliers.

The performance risk transfer has manifested itself through increased short term energy price volatility, which also reflects in items such as the cost of balancing services (BSUoS).

Market Liquidty Risk Transfer
Recognising a risk and being able to do something about it rely on a market to trade in.  For the market to be liquid, there need to be sufficient parties with an interest in trading/ hedging. 

From an energy perspective, subsidy schemes impact the timing at which generators and suppliers want to transact, as they may want to match an index, or may be unsure of how much they will generate in future if they are marginal units.  Where customers want fixed price contracts, how do suppliers hedge this in an energy market with few long term sellers?

So what?
Having a good understanding of the internet of risk is crucial to getting the results you want, and avoiding some challenging  questions from shareholders.