Advantages and Disadvantages of Independent Energy Suppliers

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1 Maintaining a healthy competitive fringe Addressing issues facing independent electricity suppliers 1. Background This short paper sets out some background information on the independent energy supplier community, the competitive benefits it brings and outlines issues facing to different degrees many of its constituents. It then goes on to suggest a number of possible responses that warrant debate to tackle distortions in the market. This briefing provides the context for the presentations to be given by independent suppliers at the afternoon session with external stakeholders on 18 June. The purpose of the event is to raise awareness of smaller suppliers, their aspirations, the issues they face and the differences between them. For over four years a number of supplies outside of the Big Six have participated in an informal Energy Suppliers Forum, which provides a monthly focus for its members to meet, exchange information and discuss issues of common interest and concern emerging out of policy, regulatory and industry governance agendas. The independent community tends have little resource to assimilate external policy and by sharing information and views they help each other prioritise and target their efforts. 2. Who s who In all twelve participants are presently associated with the forum, and this involves most of the players outside of the Big Six in the electricity sector. Some are also active in the gas sector. There is no such thing as a typical small energy supplier. Box 1 ESF members and associates Bizz Energy: supplies predominantly business customers British Energy supplies business customers Ecotricity is a green electricity generator and supplier Electricity4business: supplies business customers EN.D.CO: an independent electricity supplier, who also offers direct access to the electricity wholesale market Gaz de France ESS: a gas and electricity supplier to major energy users Good Energy: Supplies 100% renewable electricity to domestic and business customers Green Energy: a niche supplier of green and low carbon power to domestics and small businesses Haven Power: an electricity supply company established specifically to serve the energy needs of smaller business customers Opus Energy: an independent supplier of electricity to the business sector SmartestEnergy: an independent energy trading operation giving embedded and renewable generators access to the energy market in the UK, and who is just moving into the direct supply market to non-domestic customers Utilita: a multi-utility company offering customers an incentive to save energy. The forum is convened and facilitated by Nigel Cornwall of Cornwall Energy. It has no representational status and its deliberations have no formal status. This document is not a manifesto. It has been written by the group s convenor to provide a sense of current debates and some of the issues of concern. ESF members have different views on the gravity of some of the issues described in this paper, relative priorities and possible responses. However there is a high level of shared concern that current trading arrangements disadvantage them in different ways and that policy makers are out of tune with real problems arising from industry and regulatory rules. 1

2 3. Advantages of independent suppliers There is real value from an independent supply community actively engaged in competitive energy markets. Some of these are summarised at Box 2. Box 2 Policy benefits of smaller suppliers competition now the market share currently held by independent suppliers in power 50,000 or so of 26.3mn household accounts and in gas less than 10,000 of 21.6mn household accounts is small but they have a real impact in a number of segmented and niche markets that keep larger players on their toes, stimulate innovation and choice, and generally enhance the health of the market; competition in the future newer entrants are invariably smaller participants and they enable issues about market entry to be kept under closer focus by policy makers and regulators and help barriers to entry going forwards to be better understood and where necessary tackled; security of supply independent players bring diversity, broaden the funding burden, including facilitating the participation of venture capital providers. On both the generation and supply sides they have introduced a number of innovative financing techniques, some of which would not be undertaken by incumbents and which consequently broadens the range of developments brought to market; diversity a further and very important factor with regard to security of supply is that the commoditybased energy market models that have been introduced in the UK depend on diversity and a multiplicity of parties. They presume liquid trading occurs across a variety of time-scales to enable representative prices to be discovered that support investment decisions in new capacity. Independent (that is, not vertically integrated) and smaller players enable more diverse participation in these markets, thus increasing liquidity. If this design objective is undermined, it restricts the potential for significant new investment to the large incumbents because they have strong balance sheets. And without the threat of new entry, consumer prices will inevitably over time be higher; environment smaller players have been market leaders in energy services. Energy service companies are beginning to emerge that actively pursue low carbon programmes and bespoke customer offerings in both mainstream energy and new green markets. A number of important advanced metering developments have been stimulated by smaller supplier activity. On the generation side, independent developers provide a key incubation pool for schemes that effectively underpin the market in development for the larger players who can subsequently seek to take stakes of their own in particular projects; and fuel poverty small suppliers introduce a wider diversity of commercial offerings across all types of customers, and they are a major source of innovation of whom the larger players often take note. Energy service solutions incorporating smart metering and targeted customer usage advice are already being offered to domestic consumers by several smaller suppliers. Vigorous and well-run businesses should be able to operate and grow irrespective of their size. Their progress can provide a clear signal to entry with new parties trying to emulate and improve on them increasing diversity of participant within the sector. 4. Issues facing smaller suppliers There are important issues arising from the operation of wholesale and retail energy markets that overhang and distort their efficient and effective operation to the detriment of smaller suppliers. Unprecedented energy price rises have proved cyclical and have returned, resulting in well-publicised problems for some independent suppliers. There is a distinction between high prices triggered in response to supply and demand conditions and the legitimate operation of the market (which all well-managed participants should be able to manage the risk of) on the one hand and turbulent prices that are aggravated by structural distortions and one-sided rules on the other. There are also issues that arise from the dominance of incumbent players, who because they are vertically integrated are able to bypass the wholesale market for large volumes of power. Further there is an increasing body of evidence that suggests a disjoint between forward traded and physical markets, which 2

3 means that parties who cannot trade because of market illiquidity are more exposed to imbalance trading. This in turn disadvantages them relative to their competitors. Particular issues across most of the members are set out below, and are summarised at Box 3. Box 3 Market failings impacting adversely on smaller suppliers wholesale markets, especially for electricity, are illiquid; there is so little trading that the basic design objectives of the Neta market reform have not been met; incentives arising from the central trading arrangements do not allocate energy imbalance costs correctly and discriminate against small and one-sided players; they create additional strong incentives for participants to integrate their operations, further undermining wholesale market liquidity; at the same time there is no transparency of integrated players and the terms at which they sell to their affiliated operators; credit arrangements for centralised trading and networks are excessive and overlap; there is excessive market complexity, which has many manifestations, increasing barriers to entry and the cost of doing business; and the energy sector is rife with persistent change in market rules (for instance, network charges) and regulatory policy (for instance, treatment of green tariffs), driven often by concerns about market efficiency but which tend to disregard competitive side-effects. 4.1 Market illiquidity Many suppliers outside the Big Six tend not to have access to significant amounts of generation and must match their customers needs on the traded markets. Quantities of power may be available but are concentrated in periods close to delivery and are not over the right timescales to enable independent suppliers to hedge new supply contracts. They are also often not available in the appropriate shape to match these demands. In the past independent suppliers had the choice of more complex wholesale risk management products to help them manage the demand fluctuations inherent in a supply portfolio. These products are no longer available, largely as a consequence of acquisition of marginal plant by large vertically-integrated players. Some well-known business failures, such as those involving Enron and TXU were very active traders, greatly reducing trading options. In contrast the verticos can source necessary flexibility from their own generation and in addition have the advantages of their diversified supply portfolios. In effect there is a 10MW minimum wholesale trading threshold, below which trading effectively dries up, and this is too large a volume for some of the smallest suppliers to trade. It implies a need to have in excess of 50,000 domestic customers to be able to trade without consistently spilling significant quantities back into the market at times of low demand. For those too small to meet this granularity and with no generation of their own, the only alternative is exposure to cash-out prices. The combination of these factors means smaller suppliers cannot usually access wholesale product to sell on competitively. These circumstances place them at a competitive disadvantage to integrated players even without high and volatile prices. But pricing developments over recent years have significantly impaired the small player s ability to survive in the market because they cannot hedge their positions. Requirements to maintain constant trading operations and to manage their imbalance position (which is an embedded effect of the supply business) also impose disproportionate costs relative to the larger players; a large player s economies of scale is a small player s unavoidable cost of doing business. 4.2 Cash-out Another key dynamic at play is exposure to high and penal prices for uncontracted quantities, or cashout. Given these cash-out prices reflect short-run costs of balancing the system often from premium, flexible sources of energy, the costs are systematically higher than contract prices, especially as demand 3

4 rises. So if a party cannot get contract cover, it will have to cut back demand, which is not logical or often possible, or face greater imbalance exposure and the higher prices associated with this. Ofgem has carried out significant work since November 2006 against the background of various change proposals to electricity cash-out, but none of which have as yet been accepted. In fact despite a recognition that significant defects exist under the existing rulebook, change is not likely before June 2009 at the earliest and probably not before mid Analysis produced by the regulator shows unambiguously that high and volatile cash-out prices are not cost-reflective (they are heavily polluted by system costs), create unnecessary risk through the supply chain and artificially inflate prices to the detriment of customers. In all, the penalty presently seen by the small supplier community on a conservative basis arising from cashout is to the order of 1mn per annum on those suppliers who do not have generation according to one small supplier (and Ofgem has quoted figures consistent with this). This is a significant amount in the context of a low margin business. Cash-out reform is essential and over-due. Identified solutions to relieving price pollution are already available. However, if cash-out reform is not to occur promptly, action could be required to mitigate inflated cash-out prices this winter. In a low liquidity, high imbalance risk environment players with surpluses are reluctant to offer these until it is clear they do not require them, and then the inclination is to sell to physical players backed by assets. Where pure suppliers can obtain quantities, some large players are applying draconian credit terms and it is quite normal for counter-parties to seek full payment for energy upfront. 4.3 Vertical integration unconstrained needs checks and balances The abolition of the Pool and the reform of the wholesale trading arrangements were premised on breaking up the club because its members could set market prices. The introduction of greater transparency into the market, to enable traded commodity markets to develop was a key driver of the Neta reforms. But paradoxically the successor trading arrangements have actively incentivised vertical integration to the extent that most activity in the electricity market is now off market between related entities. All the scale players in the electricity market with the exception of Centrica remain broadly in balance, especially when long-term purchase deals are factored in. And the commercial imperative to stay in the market is now for balanced growth, given the incentives at the heart of the Neta bilateral contractual model. As a consequence market rules are compounding pressures for increased vertical integration. Debates on these matters has increased of recent and are beginning to be better understood, especially through the current Berr committee inquiry into the power market. However GB participants cannot expect early resolution of the structural barriers to competition in energy across Europe. This means that policy makers must exercise what influence they can on local factors over the short term if prospects of a level playing field are to be improved. But at the same time the pressures towards vertical integration and scale in the UK markets are not relenting, increasing the challenges. Forum members believe that policy makers need to specifically address what new mechanisms or corrective steps might be needed to enable smaller players to compete both on generation and supply sides of the industry on a much more level playing field because the market model and rules as they have been developed disadvantage them unfairly. 4.4 Other matters There are other issues that members of the Forum are concerned about (again to different degrees). They include: excessive reliance on cost reflectivity principles in design and development of market rules in a sector where participants have different abilities to adapt and respond to such rules (cash-out being the prime example); over-collateralisation and double counting of credit arrangements within the market; 4

5 problems with agency arrangements for key market services that are not discretionary and which are dominated by the agents retained by the Big Six; excessive market complexity, which has many manifestations; and persistent change in market rules (for instance, network charges) and regulatory policy (for instance, treatment of green tariffs), driven often by concerns about market efficiency and which tend to disregard competitive side-effects. 5. Possible remedies There are three basic solutions that should help tackle the distortions evident in the market. ESF members believe to varying degrees they are all necessary to the longer-term orderly functioning of UK energy markets and competition in them. At a high level they are: tackling competitive barriers and access limitations to the UK markets on the continent. These issues are complex and interlinked across a number of markets and jurisdictions. The prospects for early resolution of these matters are not good; taking active steps towards deepening liquidity in traded energy markets, but particularly the electricity market. It is unfortunate that an important Power Trading Forum initiative to pool liquidity and create an organised day-ahead financial market has stalled. We would also like to see a careful analysis by policy makers of a more open trading model perhaps one in which participants above a defined size made available for trade the power they produce, as advocated in more detail below; and last but not least, removing or neutralising urgently trading rules within the central BSC trading arrangements that in effect penalise smaller players because they create such strong incentives to balance as a response to risks the rules artificially create. These rules work in a way to artificially reward economies of scale and create a structural disadvantage to smaller players in the market because the current pricing mechanism feeds back inappropriate costs. A number of mechanisms may be available to redress some of the deficiencies identified in current operation of the market and to facilitate more equitable trading arrangements but without wide-ranging structural measures, and some of these are summarised at Box 4. Options that recur in discussions at ESF meetings are: mandatory trading (that is, requiring real transactions within a company group and not just quantity nominations which are then netted off), perhaps setting a regulatory rule that integrated players must make available a defined percentage of their base-load and peak generation portfolios to other parties; perhaps reintroducing the self-supply limit withdrawn in 2003 that was intended to stimulate market liquidity but which was withdrawn when as the regulator felt the markets were fully competitive; imposing a requirement on vertically integrated players to offer terms to third parties that are no worse than terms applied to within group customers; and/or regulatory ring-fencing of trades between affiliated businesses, though administering such an arrangement can admittedly be complex and resource intensive. These measures have associated with them differing degrees of compulsion and some are more radical than others. In the first instance we would wish to see players above a defined size (say three million customers) mandated to trade a defined element of their portfolio, combined with the requirement to offer terms to third parties. The quantities need not be large given the size of the small supplier community, and such arrangements could be overseen by Ofgem with a relatively light touch. In addition many of the members believe there is a need for: urgent reform of electricity cash-out ideally ahead of winter to eliminate system pollution of prices; 5

6 in the event this is not possible, creating a tolerance band that reflects the fundamental operational reality of the electricity system that independent players cannot ordinarily achieve contractual balance. There is a reasonable level of consensus among ESF members on these issues, though a small number of members do not consider reform of cash-out as a priority. Box 4 Potential remedies mandatory trading, perhaps setting a regulatory rule that integrated players must make available a defined percentage of their base-load and peak generation portfolios to other parties; reintroducing the self-supply limit withdrawn in 2003 that was intended to stimulate market liquidity; imposing a requirement on vertically integrated players to offer terms to third parties that are no worse than terms applied to within group customers; failing the above, regulatory ring-fencing of trades between affiliated businesses; urgent reform of electricity cash-out ideally ahead of winter to eliminate system pollution; alternatively, creating a tolerance band within which neutral cash-out prices would be applied. 6. Conclusion All the issues outlined above exercise individual smaller suppliers differently depending on their long-term business objectives and immediate priorities. Overall independent suppliers believe in the market why else would they participate and they know that it can be made to work better. While there is an inherent and legitimate advantage in economies of scale and scope, smaller suppliers believe that the market as it operates is materially impaired by restricted liquidity. And the strong incentives created by the central trading arrangements to greater integration is artificially and unfairly aggravating the disadvantages faced by independent supply. These circumstances place them at a competitive disadvantage to integrated players even without high and volatile prices. And the more complex the trading arrangements, the more significant this differential becomes. 6