This is the second in a series of three posts on what I see as the most important issues for the electricity market for the 2020s.  The first issue was disclosure in the gas market, which has as much impact on electricity as it has on gas, and is woefully inadequate.  The second issue, and the topic of this post, is the electricity hedge market:  how it is not working for new retailers and how it might be fixed.

By Greg Sise, 10 June 2019

Once upon a time, today’s electricity lines businesses (ELBs) existed as Electricity Supply Authorities (ESAs) and they had local networks and large retail customer bases, the consumers connected to their networks, and some also had generation.  They needed hedges to cover the spot price risk created by buying out of the spot market, at volatile and sometimes very high prices, to supply their customers at fixed prices.

At the time, Contact Energy and the Electricity Corporation of New Zealand (ECNZ) were the two big generator players in the market, but there were a large number of hedges traded between them, the ESAs and three buying groups (Pacific Energy, Energy Brokers and Powerbuy) set up by some of the ESAs.  There was even an electricity futures contract which traded actively on the New Zealand Futures and Options Exchange.

Then came the Electricity Industry Reform Act of 1998, also known as the Bradford reforms, requiring ESAs to choose between being a lines business or an energy business.  Almost all ESAs chose the former, and sold their retail customer lists to Contact Energy, Trustpower and the newly created “babies” of ECNZ; Genesis Energy, Mighty River Power (now Mercury NZ) and Meridian Energy.

At this point, sometime in the first half of 1999, the market became more or less fully vertically integrated, and the hedge market dried up overnight.  The electricity futures contract also stopped trading and was eventually discontinued.  A lack of liquidity and depth in the hedge market has been a perennial issue ever since.

In 2009 the ASX established new electricity futures contracts at Benmore and Otahuhu and later that year a technical advisory group was formed to assist with a Ministerial Review of electricity market performance;  it reported that “hedges play a crucial role in managing spot market risk, curbing market power in the spot market, providing signals and incentives for building new capacity and making demand-side investments, and facilitating entry by new retailers and generators.”

In 2010, as one of a raft of market reforms resulting from the Ministerial Review, the Electricity Authority was set up and it has worked over the years, along with the ASX, to promote liquidity in the key futures contracts.  The theory here is that a liquid futures market will provide (a) independent retailers and large consumers with a low-cost means of hedging price risk, (b) a means by which risk can be transferred to the parties best able to manage it, and (c) a forward curve indicative of future prices.

Arguably, it has succeeded with (b) above – risk can be transferred to other parties, and hopefully the party that can best manage the risk; but it has failed as a predictor of future prices, and it does not serve independent retailers and consumers well.  For a start, futures cannot be used to offset guarantees (known as prudential requirements) that retailers and consumers must meet if they buy direct from the spot market.

The chart shows the volume of contracts traded (in GWh), in the key quarterly baseload futures contracts, and how it has grown over time.  The total volume of contracts (known as open interest) is also shown.  After a few years of low growth, both volume and open interest have trended upward again.

Anyone wanting to use futures alone to hedge their risk over a longer period, is also faced with potentially large margin calls along the way, because futures prices move up or down with every up or downward movement in the spot price, regardless of whether or not today’s spot movements have any relevance to future years:  does the fact that it rained in the hydro lakes today have any bearing on spot prices in a year’s time?  If you believed the futures prices you would answer yes, but clearly in New Zealand the answer is an emphatic no!

The reforms of 2009/10 were aimed in large part at ensuring sufficient competition across the country, putting downward pressure on prices charged to consumers, and at spurring innovation in serving customers to give them a greater range of choices.  One indicator of competition working, would surely be an increasingly vibrant and sizeable independent retailer sector.  But since 2010 their market share has only risen to 8.5% of all customers, ignoring retailers that are owned by the four largest gentailers (Powershop and Energy Online, for example).  That’s a paltry 1% growth in market share per annum.

One of the biggest challenges for new independent retailers is to get hedges that are both reasonably priced and flexible enough to accommodate growth in customer numbers, the latter creating a growing exposure to spot price risk.

From our observations, the over the counter (OTC) market for standard hedges works fine, but only up to a point.  The OTC market is where parties wanting to hedge, approach each other, either directly or through a broker like Energy Link, for hedges known as contracts for differences (CFDs).  As long as the CFDs are fairly standard, and for fixed quantities, then they are typically available.

One of the success factors in a hedging strategy, is to buy well in advance, thus avoiding hedging during a period of market stress, when prices are high.  The Catch-22 for independent retailers that are trying to grow, however, is they don’t know well in advance what their spot exposure will be – maybe their growth will be on target, maybe it will be higher, and maybe it will be lower.

Independent retailers need hedging arrangements which are more flexible than are typically transacted in the OTC hedge market.

The Ministerial Review team pointed out, quite rightly, that there are advantages to vertical integration, including efficiencies in managing risk and lower cost of capital, but this must be balanced against the need for competition in generation and in retail:  competition keeps downward pressure on prices and it also spurs innovation and choice, both of which are good for consumers in the long run.

Getting the right balance between vertical integration and competition at the margin is the difficult part:  how big should “the margin” be for retail competition?  I suggest that 20% to 25% is a good target for truly independent retailers’ total market share, but at 1% growth in market share per annum this going to take a long time to achieve, and perhaps it won’t be at the current rate.

Getting the products available in the hedge market, for independent retailers in particular, is in my opinion the one essential ingredient to spurring growth in this sector.  A new hedge product which is more flexible in terms of volume, is the place to start in the OTC hedge market.