Select Committee on Business and Enterprise Written Evidence


Further supplementary evidence by energywatch

COMPETITION REPORT ON THE GB GAS AND POWER MARKETS

AN ENERGYWATCH DISCUSSION PAPER

1.  EXECUTIVE SUMMARY

  Research by energywatch has uncovered evidence showing systematic uncompetitive behaviour in the wholesale gas and electricity markets. The last four years have seen gas producers and power generators increasingly bypass their open, forward markets in favour of off-market long-term contracts. The resulting impact on wholesale market competition was cited as a recurrent problem by a majority of the 45 industry respondents we spoke to. Electricity buyers had complained of generators spurning the forward power exchange whilst a recently growing number of gas buyers reported a similar pattern evolving in the behaviour of gas producers, who have essentially "boycotted" the long-dated wholesale market when it comes to delivering gas in very large volumes.

  The role played by off-market transactions has significantly reduced liquidity in both forward markets. This has restricted competition in the wholesale gas market and almost cancelled competition completely in the power market. The suppression of liquidity has induced a vicious circle of deteriorating price transparency and higher volatility, preventing market-makers from entering the market and thus lower liquidity still.

  Ultimately the wholesale market becomes so susceptible to significant long-dated buying activity and bereft of trustworthy forward prices which buyers can lock into (or hedge against) that they find themselves having to enter into costly "off-market" deals (such as so-called "flexible contracts") with the same producers or generators whose off-market trading policies caused liquidity to shrink in the first place. Another response has been for buyers to buy a financial swap from a merchant bank. However, such price insurance introduces its own new cost and this rises with increasing volatility in the underlying wholesale market. Whichever way buyers seek to mitigate the liquidity problem, an additional layer of commission is involved which is ultimately borne by the end-user.

  Mergers and acquisitions among gas producers and vertically-integrated generators, combined with the exit of US merchants from 2003, had combined to altar the competitive structure of the GB markets. In our research, we found that today's market incumbents have collectively curtailed their over-the-counter trading activities in their forward markets. Instead of selling volume on a forward basis in the wholesale market, producers and generators have increasingly made long-dated deliveries only possible on off-market "long-term contracts" or via "flexible contracts". Both these contracts are non-standard and not generally re-tradable; they also keep all transaction prices and related energy volumes secret from the marketplace. This practice was widely believed to have significantly reduced transparency in the forward market. It has also caused liquidity levels to fall further still as new entrant traders, merchant generators, independent suppliers and industry buyers found themselves effectively "shut out" of the forward market. The "market exit" and "non-entry" of these players has caused liquidity to decline further and this cycle is essentially self-reinforcing. This has increased volatility in both prompt prices and especially in long-dated prices posted out on the forward curve. Consequently, market volatility has reached unprecedented levels and it has risen in unison with the higher forward prices posted by producers and generators.

  Wholesale prices are being driven higher still as the higher volatility is being used to justify higher "risk premiums" for selling on a long-dated basis, whether the volume is supplied on the wholesale market or, increasingly, under "long-term contracts" or under "flexible contracts". Energywatch calculates that the resulting increase in the risk premium alone has increased long-dated wholesale gas and power prices by around 15%.

  Another competition-distorting impact identified was the regime of oil-price indexation in long-term gas contracts. The effect of fixing gas prices to oil also rolls onto the power market since gas sets the marginal generating cost in winter. Oil prices, directly or indirectly, were found to dictate final long-term gas prices.

  An underlying long-term gas contract now covers almost 90% of all supplies into the GB system. International oil markets are thus fixing both wholesale gas and power prices. This contractual price distortion only exists because the gas producers are collectively selling such a high percentage of their long-dated volumes off-market, instead of making this supply available on the wholesale market. Energywatch has learned of gas producers collectively curtailing their forward trading operations. In just one case, a significant North Sea gas producer/UK marketer had its forward gas trading operation closed by the acquiring gas producer soon after these two US majors had merged.

  Oil-indexed long-term contracts exert a coupling-effect on wholesale markets. They tie up the main gas volumes on long term contracts ranging from anything between 5 to 25 years and this significantly reduces forward market liquidity. They also undermine gas-versus-gas competition as a long-dated market is made superfluous when the forward price is steered by oil prices.

  Consequently, the wholesale gas and power markets are structurally flawed. The chosen trading policies of producers and generators are responsible. The companies have behaved in a coherent fashion simply because the current regime gives them all common incentives to restrict supply on forward market in favour of off-market deals. This has inevitably led to widespread suspicion of tacit collusion. It is simply policy fixing, not price fixing as such, although the competition and price impacts will be identical.

  The market evidence that illustrates the absence of effective competition in gas and power is also emerging. For example, some 15 years after privatisation, the forward GB power market is practically closed for business. No meaningful forward trading exists more than two months out on the UK Power Exchange today. However, electricity trading liquidity in German power market has already overtaken the GB market whose liquidity has fallen by almost 75% since 2003. Despite a head-start over its EU peers, the GB market also has one of the lowest churn rates in Europe. Even on the gas side, most of the respondents we discussed this with expect the Dutch Title Transfer Facility to overtake the National Balancing Point as a principal liquidity hub very soon. Again, it is not a question of physical gas, pipeline or terminal capacity, which are plentiful, but the forward trading policies of producers and generators which have led to this new situation.

  With the pricing problem entrenched in the forward markets, the suppliers simply pass down the price increases to their customers. The higher posted prices in the forward market (in the instances where the same producers and generators supply on a forward basis) are then used to justify these higher prices. Despite an improving GB supply and demand picture, the "Gas Year 2008-09" contract for gas increased by over 44% while that for electricity increased by 45% between 1 June and 31 December last year and forward prices have continued rising since. Contractual gas price indexation to oil prices remains a major distorting factor that explains this increase. Further, barely one third of this price increase has yet been reflected in domestic energy price increases. A new wave of price rises is thus inevitable unless urgent action is taken to resolve the liquidity stalemate and also the contract issues which have been driving up wholesale prices in both markets to artificially high levels. Above all, the market anomalies which incentivise producers and generators to boycott their forward markets need to be removed. Obligations on them to trade more volume openly, on a forward and over-the-counter basis are required now. The market evidence and witness statements that Energywatch has gathered underline the need for an early referral to the Competition Commission.

  The GB wholesale markets are not working well and a "business as usual" stance is no longer viable. We also need to refrain from the almost Kafkan logic of asserting that there can be no role for a Competition Commission inquiry until definitive evidence of policy collusion or of direct price collusion is produced. Indeed, the Competition Commission was specifically set up and given the effective investigative powers required so as to find this very evidence. No previous inquiry by Ofgem has concluded there is any problem in wholesale markets that needs to be addressed. So the anti-trust lawyers and international industry specialists in the Competition Commission, who should recognise any "de facto" cartel behaviour problem, must be allowed to tackle this matter once and for all.

  A referral to the Competition Commission may well impose some compliance costs on the gas producers and generators involved. But in this equation, we also need to consider the financial burden on the consumer. Regulatory inaction is already weighing heavily on householders, British industry and increasingly on the stability of the economy.

  The market investigation regime contained in the Enterprise Act exists to address the very type of competition concerns that the majority of our respondents identified. The market distortions and perverse incentives that encourage anti-competitive behaviour can however be ameliorated by the Competition Commission, promptly in our view.

  On a final and positive note, energywatch believes that intervention options already exist which could have a positive and early impact on wholesale market competition. These may include tried and tested measures, as implemented successfully in the US and UK markets during the 1980s. Indeed, the requirement on producers to foster (rather than boycott) their trading exchanges and to support over-the-counter trading generally are already working now to various degrees in Continental Europe. Robust liquidity-enhancing measures are also required for the GB gas and power market to recover and not a moment longer should be wasted.

2.  BIOGRAPHY

  I, Dominic Whittome, have worked in the industry for 19 years, having trained as an economist. I started analysing the energy markets in 1987 when I prepared my postgraduate dissertation into cartel behaviour and pricing in oil futures markets. I went on to work as commercial analyst, contract negotiator and trader for Statoil UK, Mobil North Sea and Agip UK. In 1997, I moved to power and worked for EDF Energy as Head of Gas Trading. Since 2004, I have served as an advisor to commercial and government energy organisations.

  In January this year, Allan Asher asked me to assess the efficiency of the GB gas and electricity markets. With a background as a buyer and a seller, I hope to provide an impartial and insider's account on what is happening in our wholesale and retail markets today.

3.  APPROACH

  This report is essentially a qualitative analysis, based on the viewpoints and actual evidence provided by some forty people working within the industry. They were chosen from a wide cross-section of the gas and electricity supply chain. Throughout this paper, I also interweave trading experience of my own. The assertions made will be on the basis of supporting evidence and testimonies provided over the interviews; forty in total.

  The report incorporates contributions made by Allan Asher and his colleagues at energywatch. It also benefits from additional insights provided by the Department for Business, Enterprise and Regulatory Reform, the Office of Gas and Electricity Markets and DGCOMP and DGTREN of the European Commission.

  The interviews were conducted either over the telephone or in person. The market participants offered their own views on the matters affecting today's markets. In many cases, the respondents also volunteered evidence based on their own experiences working within the companies concerned. These comments, as they relate to evidence of collusion and copycat behaviour, are included in this report. Also included is factual market and circumstantial evidence which I have assembled.

4.  OBJECTIVE

  The main task of this exercise is to establish whether or not GB gas and electricity prices are being determined efficiently. It will try to identify whether dominant players are acting in active collusion or tacit collusion, both with the same effect. This last point is important because a structurally-flawed market will involve specific, common commercial drivers that induce players to act in consort and distort end-user prices as if they were actively colluding.

  I will include verbatim quotes from witness statements and discuss supporting evidence[186] where this is relevant. As well as the markets and price changes themselves, I will focus specifically on the new competitive situation in both wholesale markets, notably in power which has become more centralised. The main aim will be to establish whether or not prices have been over-reacting to market fundamentals, which may result in additional costs that consumers could avoid in an efficiently-operating market. In this regard, I will also examine the evolving role of the derivatives sector and the role played by financial intermediaries. I will discuss the price-fixing services (or market in "swaps") provided by merchant banks. While such services can be very useful, they could be avoided altogether in markets that make adequate long-dated forward supplies available, with robust, undistorted forward price signals so users can hedge directly.

5.  DEFINITIONS

  To ensure everyone is conversant with the terms and jargon that is unavoidable in such a report, a quick run-through of definitions should be useful. Some of you may wish to skip to Section 6.

(i)Wholesale Market

  The wholesale market; forward[187] market (which here refers to "long-dated" delivery, ie over six months forward or "on the curve"); spot market (short-dated, prompt or balancing) and "over-the-counter market" (abbreviated to the OTC) are one and the same.

  The wholesale market is where gas and electricity volumes are sold openly; traded between counter-parties under standard and hence tradable contracts. Delivery can be agreed for any supply duration and may commence at any forward delivery date. OTC trades are usually executed through a broker or exchange, electronically or over the telephone.

  The executed OTC trades can be registered with pricing reporters and published in pricing bulletins, such as Heren and Argus. OTC trades are also posted on the electronic bulletin boards of energy brokers and power exchanges. OTC transactions therefore play a key role in establishing "headline" wholesale prices for next-day, next-month, next-year delivery, and so on. It is this open, public display of OTC-traded prices that enables "price discovery" to develop along the forward curve. Buyer and sellers alike thus have a degree of certainty and confidence in price transparency of the markets they are trading in and possibly also investing in.

  However, the GB wholesale markets operate in parallel with an "off-market" trading environment: the arena of "long-term contracts". These contracts are secret, bespoke agreements negotiated between large buyers and large sellers and their price remains confidential throughout the contract term. A long-term contract can commit a gas supply for anything between five and 25 years. The contract terms can be longer still in the case of electricity.

  Individual long-term contracts can contain any variety of contract price indexation terms, against which the base price will escalate over the contract term. In the case of gas, the contract price is generally indexed to the price of oil and petroleum products.

  For example, the escalation formula for a gas contract price P(t) in a long-term contract, where the base price P(0) is agreed at the outset of the negotiation, might look like—

P(t) = P(0) x (50% Crude Index + 25% Heating Oil Index + 25% Producer Price Index

  Indexation formulae, off-take volumes, nominations and delivery terms will vary from contract to contract. This is in stark contrast to the open OTC market, with only the price, the supply rate (volume) and contract term (start and end dates) to decide.

  There has been a trend in recent years to escalate long-term gas contract prices, especially those of shorter length, to OTC prices[188] as traded for delivery at the National Balancing Point (NBP). However, a long-term contract is still an off-market transaction and the volumes they govern will not be registered on reporters' or brokers' price bulletin boards.

  It is worth appreciating that there is nothing to prevent a producer or importer deciding to sell a long-term gas supply on the OTC market. A largish volume of gas could just as easily be sold in blocks on standard and tradable agreements. In fact, much of the gas volumes are sold on an OTC basis in the States, ever since the FERC[189] liberalised the US market in the mid-1980s. Subject to adequate market liquidity, any forward volume can be sold and risk-managed using the standard trading contracts used on the OTC market. If wholesale market liquidity is robust, the necessity for keeping long-term contracts will decline. We will later explain statements given by respondents who will testify to the sheer dominance of long-term contracts, which account for over 85% of all sourced gas sold into the GB market today. These contracts were asserted to "crowd out" liquidity in the wholesale market and reduce trading volumes and price transparency levels that are required for efficient forward pricing to be possible.

(ii)  Reference Prices

  As we are interested in trend prices, we will refer to forward Gas Year prices as traded in the wholesale market. This Gas Year price pertains to both gas and electricity volumes. The price is unaffected by transitory events, seasonal or short-term factors, which should affect only the shorter-term prices during the year. In short, we are looking at the "bell-weather" price, which enables us to compare successive prices against one another. It will thus give a snapshot of the wholesale market price level at any one time. This Forward price is also often used as a guide price for establishing P(o) when buyers and sellers sit down to establish the base price at the start of their long-term contract negotiations.

  The electricity prices discussed as shown on graphs will be for base-load power volumes covering the same periods as gas. So "Gas Year 2008-09" electricity volumes will start from 1 October, 2008 through to 30 September, 2009; Gas Year "2009-10" volumes from 1 October, 2009 to 30 September, 2010, and so on.

6.  BACKGROUND TRENDS

(i)  Overview

  The forward curves below show a relatively stable picture in the gas and electricity wholesale markets between 1997 and 2004. The significant price rises that followed were accompanied by stark increases in market volatility. Prior to this, Gas Year prices proved generally much more resilient to transitory factors and to changing market perceptions as to future supply and demand. In fact, the forward year price should only reflect changes in long-term supply and demand expectations. They should not, in theory, react to transitory factors or within-year effects, unless very significant changes have happened which are perceived permanent, or to last into the next Gas Year, ie up to 12-24 months ahead or 24-36 months in the case of the following Gas Year.

  In the background, it is important to dispel the urban myth about "gas shortages" when in fact there is no shortage of gas or any perceived shortage. Whether sourced from the UK or Norwegian North Sea, North Africa, Russia or from other African and Eastern countries, the actual point of production is irrelevant once prices exceed the long-run marginal cost of delivery.

  Indeed, the GB market will enjoy access to a greater diversity of gas supplies than ever before due to infrastructure improvements. If the wholesale market was efficient, then one would expect traders' expectations as to forward supply and demand to be reflected into forward Gas Year prices. It would seem odd therefore to see Gas Year prices gyrating dramatically as we enter an era of improving fundamentals.

  Long-term electricity fundamentals are more of a concern perhaps, although the diversity options are greater still. However, the graph of forward Gas Year prices below shows electricity prices taking their cue almost directly from gas. Gas prices essentially "set" power prices in winter when gas is the marginal generation input fuel, being more expensive than imported coal. Because power prices track gas prices, the impact of any anomaly felt in the gas market will automatically roll onto the power market. Indeed, much of the forward trading in electricity today is on a spark-spread basis, ie with an equal and opposite trade in gas executed each time. As we shall discuss later, genuine forward trading in GB electricity has practically been stopped.

(ii)  Prices in Perspective

  From the start of 2003, which marked the end of a period of relative stability, to the middle of 2006, gas and electricity prices soared by over 220% and 195% respectively. While market expectations as to the future supply and demand picture had been changing somewhat, the underlying fundaments alone did not come close to justifying price increases of this magnitude. Global oil prices had played a part and it is important to assess this impact. The question to ask is whether the jump in wholesale prices has been exaggerated, by players actively colluding or by a market that is so deficient that it essentially "rigs itself" and players behave tacitly: they needn't bother colluding if their commercial incentives are so obvious and common to them all.


Source: Heren Energy

  The price of any commodity that trades above its long-marginal cost will be determined by the structure of the market into which it is sold. Our discussion will need to look at not just the wholesale market but at the "parallel world" of long-term contracts, "off market" agreements that are being fixed to oil prices.

(iii)  Value Chain

  The diagrams below illustrate the approximate costs and profit margins secured along the supply chain. It should be noted that generation margins do vary considerably. These may be obscured by the almost complete degree of vertical-integration in the electricity sector.

  In some interviews, respondents have suggested that power generators have been selling electricity to "larger, prized customers" and also to their own supply businesses at wholesale prices below those posted on the forward market in order to thwart competition. This matter was commonly cited as a "barrier to entry" by new entrant operators, some wishing to build and operate merchant power plants as well as others simply wanting to trade electricity and become suppliers in the market.

  Overall, healthy margins are visible along the supply chain, although the wholesale to retail balance is probably muffled by vertical-integration.

  In the case of gas sold into the wholesale market and via long-term contracts with base prices fixed against wholesale prices, the margins are simply colossal.



(iv)  Recent Trends

  The last in-depth efficiency analysis by a Whitehall department into the wholesale markets was instigated more than three years ago. It concluded that no evidence could be found of market inefficiency although it could benefit from more liquidity. This work was eclipsed by the subsequent rises in wholesale price increases which are depicted on the above graph. We shall go on to discuss the body of recent market evidence gathered and the new facts and marketing situation that has emerged since. The situation has changed mostly in respect of long-dated trading by the market incumbents.

  A cursory look at the last six months of last year, ie from 1 June 2007 to 31 December 2007, shows forward GB gas and electricity prices rising up again by 44% and 45% respectively. Again, it is not easy to explain increases of this magnitude by long-term supply and demand fundamentals over that period. These had not altered much and the outlook after 1st October 2008 was and still is improving.

7.  THE SUPPLY CHAIN

(i)  Flow Chart

  The diagrams below depict the supply chains for gas and electricity direct to industrial customers and the commercial and retail sectors.



  Large industrial users generally buy gas direct from the wholesale market, whereas commercial customers buy from the suppliers. However, many large gas and especially power users now find they have to buy through a third party intermediary, like a merchant bank who will fix their forward prices for them. In theory, they should be able to do these themselves by hedging on the wholesale market (ie simply buying forward), provided there is adequate liquidity along the forward curve. In the electricity sector, most suppliers are vertically-integrated so the supplier and generator shown in the supply chain are usually one and the same. In fact, many generators are increasingly offering to sell forward volumes on so-called "flexible contracts" that price the energy at par with the forward market although they are essentially off-market agreements.

  For their part, utilities and generators also rely largely on the wholesale gas market. But they are exposed to this forward market to varying degrees, depending on the size of their assets and portfolio contract pool consisting of long-term contracts and forward wholesale contracts that are still running.

  These supply-cost estimates provided are purely indicative. But they do serve as a sensible guide and they also corroborate with figures discussed during several of the interviews held with some of the actual utilities. The profit margins highlight clearly where the significant profits are being made and it is evidently in the wholesale market where the big profit is made at the moment.

  The retail market is not (in isolation) especially profitable and here are taxes and payments uncertainties which must also be factored in. This may partly explain the lack of new entry into this sector.

(ii)  Forward Prices

  Referring back to our definition of the Gas Year 2008-09 contract; disappointing gas flows from Norway, delays to LNG terminals and closure of nuclear facilities have certainly affected the prompt market and the mid-term part of the forward curve as well. However, transitory events should not be affecting Gas Year 2008-09 or Gas Year 2009-10 prices in the way seen. Looking again at the second half of last year, between 1 June and 31 December, 2007 there were no significant changes in industry perceptions as to UK demand, gas supply or generation capacity for periods after 1 October 2008. Yet prices jumped by almost half. While the forward curve is bound to be driven by shorter-term factors on the prompt market, it becomes harder to explain forward-year price increases of 44% and 45% in this instance, assuming we had a genuinely competitive market.



(iii)  Oil Market Effects

  Oil prices have driven gas and electricity prices through oil contractual indexation effects in long-term contracts. With oil prices threatening to pass $100/bl, gas and electricity prices have simply been dragged up contractually. However, this oil-price distortion should illustrate that GB is suffering a structural market problem. All too often the matter of oil indexation is used to explain, to justify even increases to GB gas and GB power prices whenever this question is raised in the context of market efficiency. The high prices that we see today would not be sustainable if the wholesale markets operated competitively and without this completely irrational distortion maintained by the policies of oil and gas company executives. From a "sub-optimal pricing" perspective, the effect of oil-indexation completely undermines pricing competition in the forward gas and power markets.

  However, oil-indexation is just part of the story. The predominance of the long-term contract themselves has also had a serious adverse effect on the forward markets by starving them of liquidity that they need to work properly. The consequent dearth of forward trading activity has created a self-perpetuating situation of ever weakening competition and thus artificially high prices posted in the wholesale market.

(iv)  Causes

  With the background issues now discussed, we can look to the evidence and statements offered by the industry respondents who agreed to be interviewed.

  The majority of respondents believe that the forward gas and the electricity markets are intrinsically flawed. A distinct pattern was observed. Rising gas and electricity prices have coincided with falling liquidity, which has followed on from the changing company supply policies and the greater market concentration in the wholesale gas and power markets.

  The causes of the liquidity problems in both markets were very similar. We can classify these matters as "contract foreclosure" caused by long-term contracts for the wholesale gas market and "vertical foreclosure" caused by consolidation by vertically-integrated generators in the electricity market.

8.  CONTRACT FORECLOSURE IN GAS

(i)  Forward Market

  The majority of our respondents reported a very severe weakening of trading liquidity in the forward gas market. A graver impact still was reported in the forward electricity market, which we shall cover in Section 9.

  While the prompt market remains liquid and robust, trading in the back end of the curve, most notably in forward Gas Year contracts, has deteriorated significantly over the last four years. It was also reported that forward volumes that were once being made available by producers on the OTC market are increasingly being sold on secret long-term contracts instead. This company policy appears to be a coherent one. Essentially, producers have been selling more and more of their long-dated supplies away from the market. This was widely observed to have a "crowding out" effect on liquidity in the forward gas market.

  The decline in liquidity was found to coincide with a rising percentage of physical gas which these long-term contracts now account for. Consequently, most of the gas that initially enters into the GB system bypasses the forward market altogether. Furthermore, whereas details of OTC trades are disseminated to other players in the forward market, long-term contract prices remain hidden throughout the contract's duration. Price, volume and all delivery information remain secret: unknown to price reporters, brokers or other players in the market. This privileged information question and the lack of market knowledge of actual transaction prices, has a negative impact on price transparency. The market simply has fewer "blocks" of priced gas with which to establish a forward pricing curve. In fact, "weak price discovery" in long-dated prices was one of the most commonly cited reasons by new entrants and merchant traders for their decisions to abstain from the market or to exit the market altogether in some cases.

  Some positive reports on forward trading gas liquidity were reported by a small number of merchant banks and financial institutions. However, these entities will have had physical assets to trade against. Indeed, much of the reported "gas trading" could be accounted for by forward hedging operations, matched against the crude oil and power markets. As for physical players aiming to buy significant volumes and hedge their positions directly, little forward trading seems to be taking place.

  In theory, it should be quite possible for long-term contracts and wholesale markets to co-exist, provided there is a sensible degree of balance between the two. But this is not so today. The vast bulk of long-dated physical volume is sold on long-term contracts. The actual proportion is, if anything, increasing. This is partly due to successive mergers and acquisitions in the North Sea and on the Continent as well as more imports from Europe. However, it is ultimately down to the policies of the producers. These have had the effect of limiting the supply of gas that is now traded on the OTC market.

  Any efficient forward market will require a critical mass of liquidity to develop before buyers and sellers will enter the market. In relation to forward gas, a "contract foreclosure" problem was claimed to exist by many of the traders and industry buyers we spoke to. The shrinking volume in long-dated transactions was also evident in the market price reports, such as Heren and Argus. The suggestion is that this deal reporting problem is also getting worse.

  Consequently, industrial buyers and even gas buying utilities fear that the prices they are being charged for long-dated wholesale gas supplied have been contrived and are even manipulated from time to time. Meanwhile, the "new entrants" which include traders, suppliers and merchant generators are effectively "closed out" of this market as they will not risk trading in a market that they are so deeply suspicious of.

  With fewer and fewer supplies made available on an OTC basis, the forward market has become increasingly illiquid. A shallower trading pool has resulted in opaque, sometimes non-existent forward prices posted in specific supply periods out on the forward curve. Price discovery has become "a guessing game" to quote one respondent and "fair game" for dominant players with large volumes to throw around if they want to. A shallow market that can be spooked higher just by minimal buying interest represents a significant barrier to entry for UK investors and UK traders wanting to use the forward market to buy and hedge. Even the market-makers, merchant banks and hedge funds (who have a valuable liquidity-enhancing role to play) are wary of entering a market that is overly sensitive to market information shocks and also prone to manipulation. "We will not be liquidity providers" sums up the overall position. The truth is: only the physical gas producers can make this initial, meaningful contribution to liquidity that is needed. The same applies to vertically-integrated generators in the power market, which we will discuss later on in this report.

  A market overly prone to the buying or selling actions of a few traders will become inefficient over time and will be likely to remain so. While the producer and supplier numbers might suggest the gas market is quite competitive, numbers alone can paint an illusory picture. The number of traders in wholesale gas market may well rank in the twenties or thirties, but if just two or three are active traders on the curve, then any one morning or afternoon, between them they can "practically invent their own gas price". Correspondents have suspected "wash trades" or "phantom deals" from time to time which serve to distort the forward picture. So, the actual number of players active in the forward market may be tiny compared to the headline figures.

  Consequently, it is in no individual new player's interest to inject liquidity and risk the consequences. As merchants, traders and buyers then start to withdraw, market liquidity falls further. Market risks and price volatility increase as a result and so a vicious circle is established. This has happened in spite of an improving gas supply picture and more physical flexibility offered than ever before. Only one of the respondents that we interviewed believed that the wholesale gas market will correct itself.

(ii)  Cost of Foreclosure

  Poor forward liquidity has affected the wholesale gas market significantly and in a variety of ways.

  First, low liquidity creates an impression of scarcity of supply along the forward curve which has driven prices higher. In commodities generally, low liquidity helps to keep prices high and establish what some call a "buyers' market". The very use of this term, however, surely suggests that something is wrong with competition, especially in market where the commodity is known to be in plentiful supply. Low liquidity also causes bid/offer spreads in OTC trading prices to widen. This fact is quite visible on electronic screens of exchanges and brokers. Forward year gas volumes are currently trading spreads approaching 1½p per therm, equivalent to almost 3% of the price when they have been less than this in the past.

  Second, low trading volumes make wholesale prices vulnerable to over-reacting. It was frequently claimed that wholesale prices have been supported from time to time by players with a commercial interest in maintaining a high "headline price" on the forward curve in order to secure a higher base price in their long-term contracts. This question relates to "flexible contracts" in the power market just as much.

  The fragile forward curve was also reported to be deterring buyers from using or even entering the wholesale market lest they drive the price up in the process of purchasing. Consequently, some industry buyers have claimed that they are avoiding the OTC market and instead are entering into the long-term agreements which fuel the liquidity-constraining effects on the rest of the market.

(iii)  Market Evidence

  We can check this question on liquidity effects by referring to the Heren Report.[190] It shows that, at the close of trading on 6 February 2008 only 100,000 therms of gas per day were reported traded for delivery this coming winter.[191] This contrasts with a final UK winter demand figure well above 100 million therms per day. So this reported[192] volume, which is used to establish posted forward prices, accounted for less than 0.1% of forward physical demand. Successive low deal volumes like this imply that the lack of physical forward trading is serious. With regards to trading in Gas Year 2008-09 and Gas Year 2009-10, no deal was reported as done that day at all.

  The impact of weak liquidity is also evident in the posted prices' section of the Heren Report. Whereas forward prices were often published on a day-to-day basis in the past, it is increasingly common nowadays to see an * appear just above the price so as to signify an "indicative price". Here we see a direct relationship between weak liquidity and poor price transparency. This corroborates with the claims that were made by many of the people we have interviewed who still believe that far too little gas is traded today on a forward season and a forward year basis.

  The third and more significant price distortion due to low liquidity is the growth of the so-called "risk premium": the extra premium which producers and suppliers command for making a long-dated delivery. This forward premium has increased to a record level. It is calculated to add perhaps another 10 p/therm (nearly 20%) to the wholesale gas price.

  It represents a new cost that eventually passes down to householders and commercial users. In our example, the Heren Report of 6 February, 2008 quotes a gas price of 62.5*p/th for forward delivery over the first quarter of 2009. This price starkly contrasts with the outturn "day-ahead" price quoted on 6 February, 2008 at 48.5p/th. Assuming that prevailing weather, demand and supply conditions are roughly similar next year (they are likely to have improved even), the implied risk premium works out at 14 p/th, which adds roughly one quarter to the wholesale gas price.

  The concept of some level of risk premium in forward gas and forward power markets is not new. They do fluctuate over time and they correlate very closely to forward price volatility. However, an implied risk premium of around 25% seems very high for a competitive market. It contrasts with the 1990s when UK gas market exhibited a much lower premium, in the region of 10%. Many commodities, notably crude oil, exhibit a "backwardated" or downwards-sloping forward curve. Although the level of uncertainty in gas has increased to a degree, 25% does look excessive.

  A risk premium in the 10%-15% range would be more consistent with supply and demand fundamentals, which should have improved further by next year in which case the premium should have been falling.

  One justification expressed by some respondents for higher risk premiums today has been the unprecedented increases in price volatility. This was frequently blamed on poor liquidity levels. With so few merchants and market-markers trading, the forward market is left much more vulnerable to price spikes; caused either by players over-reacting to market events or possibly contrived by two or three dominant players, who see that they have the forward field all to themselves.

  There is a fourth cost factor to consider, which again concerns power markets as well. It closely resembles the "risk premium" argument. Large industry buyers need to forward-fix the price of their supply and low liquidity puts them in a difficult predicament. They can avoid buying forward, delay purchasing and simply buy gas on the prompt market where liquidity is still very good. However, this is an exceptionally risky strategy. The alternative is to approach a third party intermediary, such as a merchant bank, to fix the forward gas price for them by selling them a swap. This derivative contract will guarantee them a forward price as if the forward market were liquid. However, swaps are expensive and derivatives' premiums have risen sharply due to underlying gas market volatility. However, if the wholesale market were properly liquid along its forward curve, industry buyers would be not need to approach the merchant banks in the first place. It is another example of market inefficiency introducing a new layer of cost in the supply chain.

(iv)  Oil Indexation Effects

  The fifth factor concerns price distortions caused by oil-indexation in long-term contracts. There is an automatic impact on gas prices due to indexation to petroleum products in clauses written into many of these long-term bi-lateral agreements. Consequently, GB gas prices are fixed to international crude prices and thus forward gas prices fail to respond effectively to changing supply or demand fundamentals that should be relevant.

  The market impact of oil-indexed long-term contracts resurfaced again at the end of the 1990s. This had followed a seven year period during which gas prices appeared to have successfully de-coupled from oil prices. Correspondingly, the forward gas market then saw good liquidity along its forward curve. However, three industry events played a significant part in re-establishing the impact of oil prices on gas and electricity prices.

(v)  Changes in the Market

  Firstly, the UK started limited imports from the Continent where prices are linked to oil[193] on long-term contracts. Secondly, the market suffered a significant increase in supply concentration following the wave of "super mergers" involving North Sea producers, UK and European utilities. Thirdly, trading activity contracted sharply following the collapse of Enron and the subsequent exit of other US merchants[194] in 2002-03.

  The US merchant traders had played an important liquidity-providing role and this had countered the impact of oil-indexed contracts that operated in parallel with the evolving forward market. Their departure saw the mantle of "liquidity provider" pass to newly-merged producers, UK and European utilities. Their number included many of the "Old Guard" energy majors who have been resisting European energy market liberalisation. They have fiercely defended long-term contracts and this regime they perceive will be threatened by greater liberalisation in the EU energy market.

(vi)  Impacts on Competition

  It should come as little surprise that the interest of producers in fostering over-the-counter trading has been limited. However, this cursory investigation has already uncovered some evidence of supply policy decisions taken by energy majors, aimed at reducing the amount of gas for supply to the forward market.

  Two interviewees who had worked for one very large gas producer gave separate and consistent accounts that forward selling on an over-the-counter basis was halted when their company merged with another large gas producer. The incoming management reportedly "killed off" this formerly significant UK gas marketer's forward trading activity. Initially its traders struggled to have their credit lines extended and were said to be trading "with their hands tied behind their backs". Ultimately, the trading floor was reduced to a mere "balancing function", simply to support the wider long-term contract activities that were now to take precedence. This is no isolated example. The trend has been copied by other gas producers, many of which also merged over the last six years.

  The long-term supply policies of producers have converged. Whether this was by design or coincidence, the detrimental effect on market competition has been the same. Common incentives have led to common actions, which have starved forward markets of liquidity, which leads to a greater potential for market manipulation, less competition, higher market volatility still and higher risk premiums, which all combine to force prices above levels that an efficient wholesale market would otherwise dictate.

  While the majority of respondents suggested that contract foreclosure was caused by the unwillingness of producers to trade openly in the forward market, only one of these traders expressed the belief that the market liquidity problem would remedy itself. A majority of traders believed the liquidity problem is worse still in the electricity market, which we will now come onto.

  A final point concerning gas contracts: the policy decisions here that affect the wholesale market are made entirely or partly by UK-based organisations. While gas imports from the Continent are a factor and EU market liberalisation is important, we are here dealing with a UK problem that requires a UK solution. EU liberalisation is unlikely to resolve this problem. Meaningful European market liberalisation remains some years away. More to the point, the EU Commission's "Third Energy Package" does not address the matter of long-term contracts. Its focus is the unbundling of energy utilities. A "weak" third directive in this respect will not remedy this UK problem, even when it does arrive. A national initiative is required for our home wholesale market therefore.

9.  VERTICAL FORECLOSURE IN ELECTRICITY

(i)  Buyers and Merchant Generators closed out of the Forward Market

  The issues in the electricity market relating to liquidity constraints and adverse impacts on wholesale market competition are almost identical to those in gas. So we will not repeat this part of our discussion here; the pattern of events that leads up to higher prices is much the same. However, we should note the following differences:

  Firstly, because gas accounts for a high proportion of the grid's marginal generation capacity, forward prices formed in the wholesale gas market set those in the electricity market. So any anomalies present in the forward gas market automatically rolls onto power.

  Secondly, the market has six principal vertically-integrated companies. These are each dependent on the wholesale gas market and long-term gas contracts (which are often priced against this forward market) although the extent of gas dependence varies widely between these companies.

  Because they are vertically-integrated and churn in the retail market is quite limited, they can effectively pass down any price increase in the wholesale markets down to their customers. In short, they lack the proper commercial incentive to compete in the forward market.

(ii)  Perceived Impact on Competition

  One observer commented that generators do actually not need to trade in the forward market at all in order to manage their risk, precisely because of this captive customer base. Respondents repeated there was no commercial incentive for generators to trade in the forward market while the status quo is so favourable to them. Weak liquidity is serving to keep power generation prices at high levels.

  There seems little prospect of market forces or an internal industry initiative breaking this cycle. Merchant banks, traders and other new entrants, with no physical generation assets of their own to trade with, expressed that they were unwilling to enter a market which has virtually no liquidity at beyond one month forward and is prone to day-to-day manipulation. One respondent asserted that "there are just two companies who trade two months out and they have learnt how to fix this market as well" (referring to the former UK Electricity Pool).

  Other respondents have asserted that the incumbent generators have systematically spurned the long-dated forward market. The steady rise in the spark spread[195] underlines the increase in the profitability for gas-fired generators. However, we have witnessed very little entry by new companies into either the power generation or the power supply markets during the last five years.

  Increasing wholesale power prices have enabled the vertically-integrated generators to benefit both ways: higher generation margins to industrial customers and higher retail prices to their domestic and commercial customers. This doubling-up of profit margins is illustrated in the flow diagramme in Section 6 (iii). It suggests that price rises imposed on household customers are being justified by the very same price increases in the wholesale market, which generators may be exacerbating by boycotting their forward market.



(iii)  Forward Prices

  Rising gas prices, the changing competitive climate in the power generation sector and a severe reduction in liquidity have been instrumental in base-load electricity prices soaring by over 210%, from barely £16/MWh just five years ago to over £50/MWh today.



  The fall in GB power market liquidity has been more recent and even more severe than that witnessed for natural gas. However, the wholesale power price is influenced by anomalies in the gas market in addition to its own.

(iv)  Evidence of Market Failure

  In fact, the collapse in power market liquidity has been so dramatic that virtually no genuine[196] long-dated trading is believed to be done in the GB market. Even the sporadic few trades that are done on a forward basis are related to a spark-spread or another hedge by a merchant bank or other financial intermediary.

  Numerous industry buyers have complained that electricity exhibits the same symptoms of market distortion that they have witnessed in the wholesale gas market. These include fatter bid/offer spreads which tend to widen almost immediately after buying takes place.

  To avert exposure to the prompt and forward markets, the electricity buyer again faces the two options. He can either buy a financial swap from a merchant bank, which will fix the forward price for him. Or else he can approach his own supplier. In this case, he will buy a forward volume of electricity on a so-called "flexible contract". However, these contracts generally tie him to the supplier for a longer time period. The forward price can be fixed at the outset, indexed to the wholesale market (which his supplier may be able to influence), or completely flexible so as to allow him to lock or unlock the price from time to time. However, in all three instances his effective "base price" is still determined in the wholesale market which is prone to manipulation. Further, because the supply is now made under a bespoke (off-market) contract, there is no price reporting or deal transacted through a power exchange. This serves to reduce market liquidity further still.

  In fact, quite a profitable sideline business has sprouted among the generators who are now marketing "risk-management services" to industry buyers: "flexible contracts" packaged to protect buyers against volatile and illiquid forward markets that are arguably of the generators' own making.

  Traders and new entrant merchant plant operators have reported that they have been affected by the collapse of forward trading. They have claimed that the extensive liquidity risk that now exists has forced them to approach the incumbent generators for assistance in order to enter the market, which will undoubtedly affect their entry project economics. In other cases, plans to build power stations are understood to have been thwarted altogether.[197]

  The power generators themselves have partly blamed uncertainties over carbon prices for new risks and this is preventing them from selling forward electricity volumes. However, a fairly liquid forward year market for carbon already exists. With regards to longer term trading, the logic is probably the reverse. Failing GB gas and power markets may be thwarting the development of a forward carbon price. This would introduce a new risk factor in the economics of new-build power stations.

(v)  Evidence from the Continent

  Liquidity is becoming less of a problem on the Continent compared to the GB market. European power exchanges benefit from both peer pressure and regulatory pressure on generators to foster their wholesale markets by trading openly and injecting liquidity. Capacity/release auctions of the type once used in the UK gas market have contributed to growth in liquidity. For example, the German power exchange traded over 5000 TWh of electricity last year while Nordpool in Scandinavia traded over 2,500 TWh. This contrasts with the forward trading by UK generators. Here, openly-traded volume on the UKPX barely managed 600 TWh. GB liquidity had previously been increasing steadily and it peaked at 2,300 TWh in 2003.

  A very significant change to competition, company trading policies generally or both factors must have played a role in this. Fifteen years after privatisation, the GB wholesale market sees a forward curve which simply no longer operates. The UK Power Exchange has essentially been reduced to a "balancing market". Respondents have claimed that it does not allow them to trade effectively and this is thwarting their long-term investment plans. The incumbents on the other hand have no obvious commercial incentive to change their supply strategy, nor to go out and build the new power plants expeditiously.

  Two respondents also suggested very similar accounts that suggested some kind of "understanding" between the generators and UK authorities not to intervene in the market. They said this was due to the need for their wider co-operation in matters ranging from climate change objectives, peak winter cover and the building of a new fleet of nuclear power stations. It was suggested that any referral to the Competition Commission would introduce "inevitable costs and uncertainties" that could serve to delay major projects that only the big companies can build.

10.  CONCLUSION

  When we talk about these costs, we do need to weigh these against other costs now imposed on the consumer. The impact on British industry and wider UK economy also need to be factored in. The cost of a "business as usual" approach in dealing with the energy contracts and market liquidity problems will probably prove to be inflationary. In fact, there is also evidence of this already.

  Our existing gas and electricity trading markets are both defective. They each give commercial incentives to gas producers and generators to act uniformly in blocking the development of a forward market. They have lead to significant distortions and a self-feeding cycle of ever reducing competition. The market prices, price premiums, extra layers of price insurance and adverse liquidity impacts have each been identified.

  The overall impact on competition is equally clear from much of the corroborated reports and other evidence given to us in the course of this research.

  The irony is that rising forward Gas Year wholesale prices are still increasing while the underlying gas supply and demand fundamentals are improving into the next two years.

  The prospect of a second wave of retail price rises later this year is very possible, as utilities seek to fully reflect the impact of the respective 44% and 45% price increases in wholesale gas and electricity in the last six months of last year.

  These market realities, analysis and submitted evidence underscore the importance of an immediate referral to the Competition Commission.

  This referral should lead, directly or indirectly, to subsequent market initiatives[198] that may succeed in persuading the companies concerned to foster the forward markets instead of boycotting them. We believe that this will have a significant and early impact on current Gas Year prices.

  Only the actual producers and the vertically-integrated generators possess the flexibility to offer the liquidity and transparency improvements required. So neither one group should be excluded. Common, market-distorting incentives need to be rectified in both cases. In each one, we believe tacit collusion exits on a very wide scale although it is subtle: it relates to "inaction" rather than action as such. The adverse competition impact as it plays across these two inter-linked markets is another reason why producers and generators need to be assessed jointly. We do remain optimistic that a solution does lie close to home. A referral to the Competition Commission may well lead to short-term remedies which have worked in the past, akin forward market fostering initiatives that appear to be showing progress in Continental markets now.

April 2008


















186   On the question of obtaining the "hard evidence", this is not strictly the role of a watchdog or a regulator but a body such as the Competition Commission with the proper investigative authority; this report should simply assess whether or not there are sensible grounds for any referral. Back

187   As distinct from the futures market, which is operated by ICE (Intercontinental Exchange, formerly the IPE (International Petroleum Exchange)). This derivative is cleared through the exchange, not between counter-parties; futures contracts are cash-settled whereas a forward contract may lead to physical delivery. Back

188   But this raises a second question: if you price against an OTC index anyway then why are parties still keen to trade off the OTC and on bi-lateral contracts instead? Back

189   The Federal Energy Regulation Committee; essentially the US equivalent of Ofgem. Back

190   Daily European Spot Gas Markets price publication of Heren Energy. Back

191   For period 1 October 2008 through 31 March 2009. Back

192   Not all OTC deals are reported to the price publications. Some trades are executed via brokers who establish their own indices, eg Spectron's daily "Spectrometer". However, they still are reliable indicators as to the true amount of gas being transacted along the forward curve. Back

193   The argument that "oil-indexed imports from the Continent mean UK gas prices are linked oil prices" would not strictly be so if the UK market were competitive. Any spare gas that is available for exporting to the UK has to be sold somewhere if it is subject to take-or-pay obligations and gas is expensive to store. So the exporter concerned should take whatever the going price is: he should not be setting the price in the UK. Back

194   With the departure of Enron and other US merchants who helped provide early liquidity into the forward market including TXU, Dynergy, Duke Energy, America Electric & Power, Reliant, AES, NRG, Williams. Back

195   Essentially, a proxy for the generation margin power price minus the efficiency-adjusted input gas price. Back

196   For industrial purchasing, ie unconnected with spark spread and/or financial hedging by merchant banks. Back

197   There is a parallel with gas here vis-a"-vis international suppliers of LNG. Back

198   eg liquidity and price transparency initiatives, such as US and UK 1980s-style release programmes; alternatively, mandatory sponsorship of OTC markets and trading exchanges, as in the improving German and Scandinavian markets. Back


 
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