Managing Threat of Contagion in UK Energy Markets
December 08, 2022
Managing Threat of Contagion in UK Energy MarketsDownloads
How governments, energy firms and traders in the United Kingdom respond to the energy crisis in the coming months will impact the energy industry’s future and, by extension, the UK economy.
In the run-up to the 2008 global financial crisis, a steady drip of bankruptcies, failed mergers and other bad news eventually gave way to market contagion that forced national governments to bail out individual companies — and in some cases entire industries — virtually overnight.1
Today, parallels can be seen in European energy markets. Factors including the post-COVID economic recovery coupled with Russia’s invasion of Ukraine have led to skyrocketing energy prices and uncertain physical supply, which in turn is spurring high inflation and tepid economic growth. As a result, unease about another market contagion is rising.2
That unease is particularly acute within the UK, where certain issues began rattling the energy markets long before current events. Prior to 2021, some suppliers did not hedge their exposure. While this decision allowed them to gain rapid share in relatively benign markets, it also caused them trouble when prices began to rise. Poorly hedged suppliers whose tariffs were capped by regulators could no longer service customers, resulting in the collapse of more than 30 suppliers since the beginning of 2021.3
Against this backdrop, the war in Ukraine and its associated sanctions have compounded an already delicate situation by pushing up energy prices for consumers4 and squeezing liquidity for energy firms.5
To combat rapidly rising cost-of-living expenses and mitigate the possibility of market contagion, the UK government recently instituted additional pricing supports and other consumer-friendly measures to reduce further uncertainty. A new Energy Prices Bill, introduced in September 2022, is designed to limit monthly costs for both consumers and businesses.6 Similarly, the Energy Markets Financing Scheme would theoretically prevent a 2008-like liquidity squeeze for suppliers by providing them access to a pool of capital.7
However, both bills, while essential for addressing short-term issues, do little to reform the fundamentals that are contributing to the current situation.8 And it’s unlikely that the UK economy will be out of the woods anytime soon. With these factors in mind, here are actions that corporations, energy firms and traders should consider to weather the current crisis while building a more stable and robust operating model for the future.
Prepare to Hedge
All businesses crave stability. But UK energy firms are unlikely to find much of it anytime soon. Will energy prices continue at their current high levels? And if so, for how long? These questions will probably remain unanswered for some time, so company leaders must prepare for a variety of scenarios to deal with the uncertainty.
A comprehensive hedging program is one important step companies can take to help manage future risks. Hedging is especially important for energy companies and energy-intensive industries since energy prices drive their overall profitability. Although the practice is not a cure-all (e.g., it does not prevent the risk of production outages due to energy rationing, which is a real possibility this winter), hedging does provide for stable cashflows beyond the immediate crisis.
In market contagion, the collapse of one trading firm creates a domino effect that spreads to other firms, as it did in 2008 throughout the mortgage and insurance markets.9 Given the interconnectedness of today’s global economy, contagion within the energy market is a real threat because credit risk is shared across businesses and industries alike. If one company defaults, others are likely to follow.
Collateral is one way to manage such risk. But it doesn’t come without a consequence: Today’s high and volatile market prices are forcing energy traders to provide unprecedented amounts of collateral, which is straining an already challenging liquidity situation.10
Two primary lessons from the 2008 financial crisis can be applied here. First, to mitigate the possibility of contagion, it is essential for energy firms to create stability by managing liquidity and trading positions, as well as instilling stakeholder support by developing a contingency plan to ensure directors can continue to trade in the event of contagion.
Second, ensuring an ongoing dialogue among energy traders and government officials and regulators to help weather the storm in the short term is a must.
Like the 2008 financial crash, one unavoidable byproduct of the current UK crisis may be reduced competition. In fact, some energy suppliers are already refusing new customers and are winding down their existing hedge portfolios, suggesting they might soon be closing their doors.11
A second parallel is an increasing push to cleared trading. After the financial crisis, a fear of further market contagion drove derivatives to be centrally cleared; i.e., trading needed to be backed with collateral.12 A similar development seems likely in the energy markets. Although this requirement might lower the chance of future contagion, it would also reduce liquidity for hedging. And less liquidity would impact further investments and slow down the energy transition.
These developments will have a fundamental, long-term impact on the energy sector overall, resulting in consolidation, not unlike the rash of tie-ups among U.S. mortgage originators in the aftermath of the 2008 financial crisis.
A Silver Lining?
While the UK government is willing to combat the current liquidity crunch by pumping billions of pounds into the economy, such support mechanisms cannot last forever. Energy traders who emerge from this immediate crisis intact should be prepared for tighter regulation, enhanced collateral requirements and a heightened focus on risk management.
It may be far too early in the current crisis to find the silver lining. But there is collective hope that the severity will finally bring long-needed reforms to the UK energy markets that will enable a more robust industry to emerge.
1: “2008-2009 Global Financial Crisis,” Corporate Finance Institute (November 4, 2022), https://corporatefinanceinstitute.com/resources/economics/2008-2009-global-financial-crisis/
2: “Britain’s Market Rout Stokes Contagion Fears Around the Globe,” Reuters (September 28, 2022), https://www.reuters.com/markets/europe/global-markets-britain-contagion-pix-graphic-2022-09-28/
3: “Failed UK Energy Suppliers Update,” Forbes (February 18, 2022), https://www.forbes.com/uk/advisor/energy/failed-uk-energy-suppliers-update/
4: “What’s Next for Oil and Gas Prices as Sanctions on Russia Intensify,” J.P. Morgan (March 10, 2022), https://www.jpmorgan.com/insights/research/oil-gas-energy-prices
5: “EU countries seek solutions to soaring energy prices due to Ukraine crisis,” France24 (September 9, 2022), https://www.france24.com/en/europe/20220909-eu-countries-seek-solutions-to-soaring-energy-prices-due-to-ukraine-crisis
6: “Government introduces new Energy Prices Bill to ensure vital support gets to British consumers this winter,” Gov.UK (October 11, 2022), https://www.gov.uk/government/news/government-introduces-new-energy-prices-bill-to-ensure-vital-support-gets-to-british-consumers-this-winter
7: “Energy Markets Financing Scheme (EMFS),” Bank of England (last updated November 14, 2022), https://www.bankofengland.co.uk/markets/energy-markets-financing-scheme
8: “UK Scraps Energy Bill Price Freeze After This Winter,” Bloomberg News (October 17, 2022), https://www.bloomberg.com/news/articles/2022-10-17/uk-government-scraps-energy-bill-price-freeze-after-this-winter?utm_source=google&utm_medium=bd&cmpId=google.
9: “Britain’s Market Rout Stokes Contagion Fears Around the Globe,” Reuters (September 28, 2022), https://www.reuters.com/markets/europe/global-markets-britain-contagion-pix-graphic-2022-09-28/
10: “Launch of the Energy Markets Finance Scheme,” Gov.Uk (last updated November 3, 2022), https://www.gov.uk/government/news/launch-of-the-energy-markets-finance-scheme
11: “Energy security trumps the climate? London’s biggest IPO of the year is an oil company,” CNN (November 9, 2022), https://www.cnn.com/2022/11/09/investing/ithaca-energy-ipo-uk
12: “Central clearing: trends and current issues,” BIS Quarterly Review (December 2015), https://www.bis.org/publ/qtrpdf/r_qt1512g.pdf
© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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December 08, 2022
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