The Impact of Sanctions Against Russia on European Wholesale Energy Markets
Can lessons be learnt from the global financial crisis?
August 03, 2022
Sanctions on Russia have deepened stress in European wholesale energy markets, increasing the risk of a liquidity crisis among energy traders that is jeopardising energy supplies.
As reported in our recent Resilience Barometer – Energy Sector Report 2022, 60% of energy companies believe the supply chain has been permanently disrupted by events in Eastern Europe. Sanctions, and the response to them, are a large part of that disruption.
In this article, we focus on the challenges for energy traders. Specifically, we explore steps that could be taken to lower the risk of market contagion, drawing lessons from the global financial crisis of 2008.
How might market contagion rise?
Russia’s invasion of Ukraine – as well as sanctions and countersanctions imposed since – has added to the stress in the European wholesale energy market, as uncertainty over physical supply pushed up market prices and volatilities. For example, the TTF month-ahead contract, a benchmark for prompt natural gas prices (i.e. prices for for delivery within the current calendar month) in Europe, trebled immediately following the outbreak of the war and has traded at high levels since. Consequently, energy traders’ liquidity and credit risks increased. A loss of confidence by market participants could lead to a serious risk not just of defaults by individual traders but also of market contagion. The latter risk arises because market participants are highly interconnected: energy traders buy and sell from one another in wholesale markets, either bilaterally through over-the-counter trades or on exchange. Due to this interconnectedness, the default of one trader would result in significant losses for its hedge counterparties and wider market participants. Especially in an already jittery market, one collapse could (without government intervention) trigger a series of defaults, comparable with that experienced by financial services firms during the 2008 global financial crisis.
Proactive intervention by stakeholders is needed
Financial and economic consequences from the current crisis appear unavoidable. For example, any failure to fulfil contractual obligations under energy supply contracts – be it due to force majeure, economic hardship or material adverse change – will inevitably lead to renegotiations, restructurings and, in some cases, litigation or arbitration.
The worst outcomes must be avoided at all costs. Widespread market contagion would not only jeopardise many businesses, but also put supplies to customers at risk.
Governments – along with financial and energy market regulators – need to act to protect the integrity of European energy markets. They must monitor the situation closely and provide fast and innovative solutions to protect vulnerable energy traders.
At the same time, regulators need to ensure that energy traders act responsibly, managing risks robustly and hedging their exposure. There is a risk that anticipated governmental intervention for “too big to fail” companies could lead to excessive risk-taking and complacency.
What should energy traders do?
Although energy traders cannot tackle the current situation unaided, there are two important internal actions they can take: create liquidity and maintain market stability.
Risk appetite and business strategy should be reviewed to prioritise the preservation of liquidity over trading profits; such reviews typically take the form of a medium-term financial restructuring plan. Such a plan will build the confidence of hedge counterparties, lenders, clearing providers, regulators and key staff.
As well as remaining within established market practice parameters, the restructuring plan needs to be capable of withstanding external energy market shocks including sanctions and countersanctions. Measures planned may entail any or all of sales, recapitalisations and solvent running-down of (parts of) the trading or retail books.
At the same time, it is paramount that preparations for a possible default are made to ensure that directors can continue to trade without the risk of being accused of wrongful trading. A detailed contingency plan should be worked up, given the huge execution risk associated with stressed financial restructuring.
The focus of the contingency plan, and the resources committed to it, need to be carefully balanced to ensure that the plan is executable without becoming the primary path.
Careful financial restructuring plans are especially valuable for energy traders, as solvent rundowns protect hedge positions and thus reduce market contagion risks. This is because equivalent legal frameworks to the UK’s Special Administration Regime (SAR) for energy retailers, which allow for continued execution of supply contracts, do not exist for energy traders.
Maintain market stability
Energy traders collectively should do all they can to prevent a default by any large energy trader, which would undermine market confidence and increase contagion risk.
They should initiate a dialogue with government and regulators and flag up any impending difficulties as early as possible. A good example of this has recently been seen in Germany, where Securing Energy for Europe (formerly Gazprom Germania) received $10bn of funding from state-owned development bank KfW to help satisfy its short-term liquidity needs.1 Similarly, Bulb Energy’s SAR has received significant funding, believed to be up to £3bn, from the UK government.2
Living with moving goalposts
Following these recommendations should go a long way towards establishing the market and protecting individual firms from disruption. However, the tightening of sanctions imposed on Russia continues to evoke countermeasures, such as Russia’s insistence on payments for natural gas in roubles. Energy traders and others need to be vigilant and keep checking that they and the market are protected.