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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