Select Committee on Business and Enterprise Written Evidence


Supplementary evidence submitted by E.ON UK plc

WHOLESALE MARKET LIQUIDITY

  1.  At the Select Committee hearing on 24 June 2008, it was indicated that Ofgem had suggested that the value of the total Over the Counter (OTC) market in 2007 was £31 million. A question was raised about the limited size of this market, with the underlying concern being that the companies before the Committee (in the particular session, E.ON UK, EdF and RWE) were not trading in the market but instead were only trading internally, hedging between their generation and supply businesses, without this volume ever reaching the market.

  2.  Initially, it is worth correcting the picture given above. In fact, the value of the UK wholesale market that is screen traded through brokers (ie part of the OTC market), was nearly £31 billion in 2006-07 (April to March) and more than £41 billion in 2007-08. The volume in 2006-07 was 767TWh and in 2007-08 was 928TWh, where physical output volume in each of those years was around 332TWh. Trades through brokers are available to anyone who uses that broker (brokers are, for example, GFI, ICAP, Spectron, Tullett Prebon), subject to credit risk. In addition to the brokers, a small amount of trades (perhaps 1-2%) go through exchanges and there are also some bilateral contracts on OTC or bespoke terms.

  3.  It is certainly not the case that the players in the market who are vertically integrated do not trade in the market. They all do so, to greater or lesser extents. This may be for a variety of reasons—including because they run their supply and generation trading businesses entirely independently of each other; because they need to add "shape" to their trading profile to meet their retail demand which their own generation portfolio cannot provide; because they may be "short" or long" in generation and therefore need either to make up volume or to sell it on; or because they wish to optimise their trading position—the "make/buy" decision.

  4.  For E.ON's part, it trades more than 100% of its generation volume through the wholesale market. Indeed, in 2007-08, this was more than 200% of its generation volume, as shown in the table below. All of this volume was through brokers.[272]
ESI YearGeneration Volume (MWh) Wholesale Market Sales Volume (MWh) Sales as a % of Generation
April 2006 to March 200737,049,369 49,560,875134%
April 2007 to March 200841,480,605 92,239,488222%


  5.  In fact, as was set out in our written evidence, liquidity in the electricity wholesale market is not falling[273]—it is increasing. We provided graphs in our response that demonstrated that, as do the figures in paragraph 2 above This has also been independently confirmed by the Financial Services Authority (FSA)—the FSA analysis of activity in energy markets 2007 states that UK traded power volumes increased 52% in 2006-07 over 2005-06.[274] The electricity wholesale power market is actually quite disaggregated, with low levels of concentration. Based on the number of counterparties we trade with, we believe there are about 50 active participants.

  6.  However, we do believe that the trading market structure can be improved. As the market is currently set up, liquidity is dispersed across the various different product pools and there is no robust reference price that can be used as a basis for a simple, cash-settled futures contract. This contrasts with many European markets that have a centrally organised spot market with a single, published, reference price that encourages the use of financial swap and futures contracts, reducing credit risk and the need to take power to physical delivery.

  7.  This was recognised by a number of players in the industry and therefore the "Market Design Project" was initiated by the Power Trading Forum (registered to the Futures and Options Association (FOA)) in March 2006 to review the current market structure and provide alternatives, with the goal of stimulating forward power liquidity. A Market Design Project Steering Group was set up on which E.ON sits, together with representatives of other major players in the wholesale market, including Drax and International Power, as well as representatives from the FOA and others.

  8.  The following rationale was developed for the project:

    —    In order to attract additional forward liquidity, the correct products, easy access and financial and physical contracts must be developed;

    —    To trade financially settled contracts, robust reference prices are required;

    —    Reference prices are best established day ahead from the underlying physical market, and it is proposed to do this through both continuous trading and an auction process—this suggests a platform which hosts continuous and auction based trading;

    —    For reference prices to be robust, all (or a significant majority) of trades must be captured. A central clearing platform (energy exchange) is the most efficient way of achieving this goal (this in addition provides a revenue stream to the platform provider);

    —    This platform should then form the starting point for the future development of financial trading, once the reference prices have been accepted.

  9.  The Market Design Project proposal, therefore, is for a platform which hosts continuous and auction based trading, capturing all, or a significant majority of trades, through a central clearing platform (energy exchange).

  10.  A request for proposals from potential service providers was issued in June 2007 to try to find solution providers who could host the auction and intraday platforms and provide clearing services. The process was delayed due to the time required for providers to submit detailed responses and for the Market Design Project to evaluate those proposals thoroughly. Commercial negotiations began with the leading provider but subsequently broke down due to issues with commercial arrangements between the two parties that had put forward that solution. The RFP process has now begun again with the short-listed parties and it is hoped that a recommendation for a way forward will be made in August 2008, with implementation as soon as possible after that, but realistically likely to be in Quarter 2, 2009.

  11.  The aim of the Market Design Project is to encourage players operating on the fringe of the wholesale market, or operating indirectly, to participate. Many industrial players and brokers take part in other European markets such as Nordpool and EEX because of the ease of entry and the fact that credit risk is reduced via the use of cleared instruments, as described above. So, for example, Bizz Energy and other independent suppliers will be able to participate more fully and the new arrangements should also attract new risk capital that will further enhance liquidity. Other large players on the demand side such as Corus, SCA, Linde Group, and Ineos Chlor are also interested in these developments and E.ON has worked to keep them informed of development.

  12.  The Market Design Project is an example of the market seeking its own solutions—the market is not perfect and is looking to evolve and improve through its own initiatives and actions. The proposed structure will allow a better range of hedging instruments, thereby encouraging companies without their own generation assets, or large industrial companies to enter the market and enabling more active hedging and trading by market participants.

June 2008








272   E.ON also trades a small amount through the APX, a power exchange. Back

273   It did fall between 2004 and 2006. Back

274   This gave a market size of 984.8TWh in the period August 2006 to July 2007, with a value of £31 billion, see: www.fsa.gov.uk/pubs/others/analysis_energy_2007.pdf Back


 
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