Letter from RWE Npower plc
HISTORIC AND
CURRENT WHOLESALE
PRICES
Since 2004 the UK wholesale energy markets have
experienced unprecedented growth in price and volatility. The
chart below shows the change in the monthly out turn wholesale
gas prices over the last five years indicating both increased
price levels and volatility.
Throughout this year UK winter 2006-07 gas has
been the highest priced hydrocarbon in the world.[4]
There are a number of reasons for this:
— Fears that 2005-06 conditions would
persist.
— The fire on the Rough platform creating
concerns that it would not be available or sufficiently full this
winter.
— Concerns as to whether new infrastructure
would be available to time.
These factors are now abating. However, whilst
prompt prices have fallen back over recent months (see diagram),
this has been from record highs. Also, although prices have fallen
for Winter 2006-07 they remain very high. The forward price for
Winter 2006-07 (around 65p/therm) is still above the out turn
price during Winter 2005-06.
FUTURE WHOLESALE
PRICES
The UK market does appear to have increased
levels of available supply as new infrastructure comes on stream
such as new pipelines, storage capacity and LNG terminals.. It
is not yet clear what effect the new infrastructure will have
on price but UK wholesale gas prices will be set by a combination
of three factors:-
— The European gas price which is heavily
indexed to oil.
— The Global LNG market—the UK
gas price could become an arbitrage between US and EU prices.
— Gas on Gas competition—the
UK will probably have the most diversified gas supplies of any
country.
The forecasting of any one of these drivers
is difficult but forecasting the overall effect of all three is
particularly problematic. However, we do expect that the UK will
have a highly dynamic wholesale gas price mechanism.
RETAIL RISK
MANAGEMENT POLICY
AND STRATEGY
RWE npower's retail business does not take speculative
positions in the wholesale market. The retail business's principal
activities are managing the risks and customer service requirements
of energy supply to domestic and business consumers.
Domestic customers
Energy tariffs provide the customer with a fixed
price for a variable consumption volume, which the retailer then
hedges at fixed price and fixed volume in the wholesale market.
For such an apparently simple retail product the Retail suppliers'
portfolio risk is complex and includes among other things:
— Changes in customer numbers, the
UK market has the highest churn rate of any energy market.
— Changes in customer profile and location.
— Weather influences on demand and
so price both long term and short term.
— Hedging the movements in the wholesale
market versus price exposure to our customer base.
RWE npower, and other retailers, do not leave
the wholesale hedging decisions to the last minute. The wholesale
price risk is hedged at the same time as the retail price risk
is recognised. This is a function of forecast customer numbers
and the uncertainty surrounding customer retention in a competitive
market. It is a complex relationship that is very difficult to
assess accurately particularly in a market as dynamic as the UK.
Broadly, a lower proportion of expected customer volume is hedged
as we move further into the future.
The effect of this hedge strategy is that customer
prices are protected from the high volatility and seasonal variations
of wholesale prices and benefit from smoothing wholesale costs
over a longer period of time. The only gas hedged in the prompt
wholesale market is due to changes to short term demand associated
with weather effects. This in itself is a significant risk which
the retailers bear as temperature is correlated to demand and
demand is correlated to price.
The retail price has out of necessity followed
the wholesale price upwards as purchase costs rise and retail
margins get squeezed.
RWE npower's hedging has dampened the volatility
in wholesale gas costs although hedged costs lag wholesale costs
movements by a period dependant on the proportion of customer
sales volume hedged prior to delivery. Nevertheless, increases
in hedged gas costs have not been accurately and continuously
reflected in domestic retail prices and, in these instances, RWE
Npower's margins have been adversely affected.
Industrial & Commercial customers
Larger industrial customers are more sensitive
to price and often willing to take more risk. Many industrial
and commercial (I&C) customers take gas on daily or month
ahead index rather than fixed price or tariff. This means that
they will see more price volatility: some customers of course
choose to modify their demand in response to price. It is becoming
clear that demand-price elasticity increases with price. Retail
product development in the I&C sector has responded much more
quickly to the changes in the wholesale market and customer implementation
of energy price risk management strategies. Retail product development
is something that RWE npower anticipates will extend to residential
customers in a simpler form.
THE FUTURE
The retail energy market is still evolving and
the price rises are prompting competitive changes to the products
on offer to the market including more tailored products to suit
customers' own personal situations. Retail pricing, for example,
may develop in a similar way to the mortgage market, where customers
can choose fixed price deals, tracker products, capped rates etc.
The move to a more diverse product suite has certainly been experienced
in the I&C sector.
The energy retail industry has largely fixed
its wholesale energy costs for many months into the future and,
because of the smoothing effect of hedging, its costs now may
be lower than the peak prices that prevailed for a few months
earlier in the year. Nevertheless, as noted above, these prices
are higher than those incurred last year and, therefore, RWE npower
would need to see a significant and sustained fall in wholesale
prices before the reduced purchase costs could be reflected in
domestic tariffs.
3 October 2006
4 Source Citigroup Global Markets. Back
| 
