The start of the year saw the return of the energy markets to the popular press, the tabloids, as the California crisis turns energy into a human-interest story by virtue of the rolling blackouts. But, as with any “foreign” news item the UK tabloids try and draw a parallel with their domestic market and the UK newspapers believe they have found one – the UK electricity market. But there is no such correlation between the California and UK electricity markets, and any suggestion that the UK risks suffering in a similar manner to California – which some journalists have suggested – is simply irresponsible. Indeed the recent chaos in California, and the realisation that the majority of the US electricity market is dysfunctional, has tended to promote Europe as a role model market for electricity deregulation and market competition. Compared with California, any other electricity market is almost certainly a more positive role model.
It is important to identify why the UK electricity market will not follow in the footsteps of California. In the California electricity market the crisis is primarily due to three factors: a lack of generating capacity; the inability of utilities to contract ahead which leaves them exposed to the volatile spot market; and the prevention of utilities being able to pass on higher prices to consumers due to the absence of deregulation on the supply side. By comparison, the UK market has 30 per cent excess generation capacity, it encourages long-term contracts, and it has deregulation of supply.
California is yesterday’s story, but by virtue of its economic size it will continue to be tomorrow’s headlines. The continuing micro-examination of why the market failed, who was to blame, how the problem can be fixed, and whether it will impact beyond California will likely undermine confidence in California, and possibly US electricity deregulation, for some time. Interestingly, the UK is facing a similar confidence issue, albeit for totally different reasons. And in common with California the issue dogging the UK market is also yesterday’s story making tomorrow’s headlines: the New Electricity Trading Arrangements.
Since the turn of the year the UK electricity market has been in limbo. From mid-December until the end of January there was practically no trading of EFA (electricity forward agreements) contracts beyond the end of March, the date at which the summer season commences and when NETA is intended to be introduced. The trading impasse had a knock-on impact on those industrial and commercial companies that buy forward electricity in the April annual rounds. For these companies the contract negotiations cannot commence without an indication of forward prices on which to base annual contract supply prices. But without any forward trading the forward curve has been opaque, delaying contract negotiations, which can account for up to 30 per cent of this market sector’s annual capacity requirement.
The cause of the trading impasse was the lack of agreement on how the EFA contract should transition to a post-NETA grid trade master agreement (GTMA). Although not involved in the trading developments, UK regulator Ofgem had indicated its preference for the transmission element of the GTMA to be split 55/45 between buyers and generators. But the generators, in particular Innogy and British Energy, felt that the buyers should be liable for all the transmission element of the new GTMA contracts. The result, at the start of the new year, was a trading standoff.
Since these developments a number of “solutions” have been suggested with the most popular being a “Schedule 5” contract with the counterparts deciding whether to include transmission (Schedule 5 On) or not include transmission (Schedule 5 Off). The transmission element in these Schedule 5 On contracts would be determined from day-ahead price indices derived from reporting companies (such as Platt’s). Although not perfect, it provides an indicative level of transmission costs and appears to have garnered some support in the market. Following a meeting convened on 31 January to gain consensus on GTMA and Schedule 5 a number of transactions have taken place, mainly with Schedule 5 On, although market liquidity will take a few weeks to build back.
But not all are happy with Schedule 5 and the market is likely to be split into two tiers as a result. The concerns about Schedule 5, mainly expressed by trading companies, are that it will limit the development of market liquidity and will deter the entry of new financial participants into the market, which traditionally inject new liquidity and transparency. Underlying this concern is that fact that GTMA’s are physical contracts whilst the EFA contracts are financial, and transitioning from a financial to a physical contract runs the risk of reducing market liquidity.
A counter proposal to Schedule 5 is a titled agreement (financial) contract, which would serve as a transition contract, bring in new financial participants and ensure that market liquidity was maintained before moving on to a physical or Schedule 5 contract.
There is market logic behind both the financial and physical contract options, and both are viable. In the short term the development of a two-tier market is unlikely to hamper the market. It actually has some precedent in the UK gas market, which has its own two-tier market with trading on either NBP or Beach prices. In the longer-term the pricing will converge, assisted by the development of futures and other financial over-the-counter products.
For the above to be implemented will require NETA to go live, and at the time of writing the regulator’s preferred date of 27 March is still not certain. Although Ofgem has confirmed it has started its last testing phase on schedule it cannot, or will not, commit to its preferred date. And if Ofgem has no apparent confidence in meeting its preferred date why should the market? California and the UK may have different electricity market structures and performance levels. And the UK is unlikely to ever follow California into utility bankruptcy and blackouts. But both do share one common factor: a lack of confidence in the deregulation of their markets.
