It is generally accepted that market competition reduces prices. Similarly, prices in competitive commodity markets are primarily driven by supply-demand fundamentals. And the consequence of over supply and poor demand in a competitive market is continual falling prices. With UK electricity prices falling 18 per cent in the past year, UK energy minister Brian Wilson is now reported to be pressing for changes in the way electricity is traded. He believes electricity prices are falling to unsustainable levels, which could both make the UK's emission targets untenable and endanger future security of supply. While this scenario is largely confined to the UK market it could act as a barometer for other European markets as the UK is one of the most advanced markets in terms of competition.
It now appears to be open season for making pronouncements on the dangers of falling electricity prices. In the week preceding Wilson's comments Michael Flinn, head of European operations at Dynegy, made similar comments, suggesting that British industry could face power rationing as early as next March.
The 'rationale' for Flinn's comments is that with a large number of power plants being taken off line due to falling wholesale electricity prices the market could face a power shortage when demand picks up, probably during the peak winter months in January and February next year. In theory this is true, but in practice it is highly unlikely.
Both off line and mothballed plant can still be brought back on line to generate electricity. And with forward price curves becoming more reliable, generators can turn plant back on when the economics are favourable, ie market prices are above the marginal cost of production, and demand increases.
As for the UK government, Brian Wilson is reported to be considering various options to secure viable electricity pricing. One such consideration is reportedly to provide Ofgem with more powers to intervene if it feels the trading system is threatening certain generators.
While there are tangible concerns over falling electricity prices the option of extending the intervention powers of the regulator would not be in the interests of the UK market. Only last month the regulator removed all pricing controls in the market, effectively taking away any price caps to prevent excessive prices. Now the suggestion is that Ofgem should have the powers to introduce a pricing floor to prevent unsustainable prices.
There is little logic behind such a suggestion. In a competitive market prices should, and must, be determined by supply and demand fundamentals. It is the case in the UK market that there is over capacity and reduced demand due to unseasonably warm temperatures. The introduction of Neta has gone a long way to bringing about a more supply-demand based pricing structure and it is for the market participants to manage their portfolios using the trading structure now in pace. It is not for the regulator to constantly change the goal posts as this will only serve to undermine market confidence and potentially devalue market trading.
Clearly, falling prices undermine investment in new generating plant - both conventional thermal plant and new renewable sources. However, it is also worth pointing out that in a competitive commodity market there has to be a degree of price elasticity, particularly on the downside. Electricity prices cannot, in theory, fall below a certain level as all suppliers would go under. Indeed there are indications that electricity prices have started to find a floor in recent weeks.
It is also worth pointing out that in a competitive and increasingly liquid traded market there are numerous trading options available to the market to protect revenues. Derivatives are a valuable tool to hedge risk and, if properly managed, participants should be able to proactively manage their portfolio. For example, electricity has a high degree of optionality and participants can enter into put option contracts to limit the price at which electricity can fall. Similarly, with domestic prices at a significant premium to wholesale prices, suppliers can offset the risk of wholesale prices through their retail portfolio.
In a competitive market, which the government was keen to introduce, prices will initially fall. Indeed the government has pointed to falling prices as evidence of the success of Neta. But the government cannot determine the level to which prices can fall as it undermines the primary value of a competitive market.
With consolidation on the increase the number of UK suppliers is reducing. Within the next year or so the number of suppliers will reach an optimum level. At this point some pricing floor will become apparent and it is more likely that prices will then increase rather than fall.
The government should be less concerned with the falling price of electricity and more concerned with future security of supply. By its own doing, the value of CHP plant has been reduced due to the inflexibility constraints of the balancing mechanism within Neta. Similar concerns are also evident for renewable energy sources such as wind power, which the government is keen to promote.
Within the current market scenario two issues seem apparent. First, those companies complaining about low electricity prices should look at their trading management and ask whether they have properly managed their portfolio. And second, in introducing Neta the government should have taken a longer term view and factored in the current market scenario.
At present there is no suggestion that Neta is broken and as such it does not need to be 'fixed'. Increasing regulatory intervention powers will only serve to undermine market confidence and do more damage than good. Of more importance is for the market participants to look at their trading management to ensure they are properly hedged and protected against volatile electricity prices.
This last point is equally applicable to other European markets. The onset of liberalisation in gas and electricity has seen a plethora of new trading initiatives launched, from on line brokerage and trading platforms to the clearing of OTC energy derivatives and development of new trade support technology and analytics. As such there can be little excuse for blaming the market for falling prices and damaging revenues when companies not only contribute to the pricing scenario but also have the tools available to hedge the price risks themselves.
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