There have been 12 bankruptcies in the U.K. power and gas supply segment year-to-date; nine of these failures have occurred in the month of September. Some market commentators believe there may be as few as 10 suppliers left by the end of the year compared to 52 suppliers in Q1 2021, before the spike in commodity prices. Although perhaps surprising to some, this trend is unrelated to the recent petrol shortages, but rather, another indication of energy stress.
It’s hard to analytically put a price on a non-income-producing asset. In theory, oil, gas and power prices should form around the variable production cost of the highest-cost producer whose output is needed to satisfy demand. In reality, and in the short run in particular, violent price swings do occur. Today, one-year forward baseload power prices have more than doubled in most major European power markets, while coal, CO2 and Dutch gas prices are up 112%, 94% and 200%, respectively, in 2021.
This is bad news for unhedged U.K. energy suppliers, which typically sell the majority of power and gas forward at regulated fixed prices. These unhedged participants are usually smaller, lower-credit-quality companies. Due to collateral requirements in long-term procurement contracts, the cost of hedging is too high for small balance-sheet-constrained operators—which either need to pay upfront cash payments or post collateral, making full hedges uneconomical. In a nutshell, fixed tariffs (fixed revenue) combined with an unhedged procurement position means a spike in gas and power prices translates into significant losses. We estimate the net liabilities from a lack of hedging will likely run into the billions of £ (about £500 per 1 million accounts without hedging).
The current situation is a reminder as to why an investment grade rating is crucial to the supplier’s business model. A strong balance sheet limits hedging costs—as a higher rating typically means lower upfront collateral requirements, allowing hedges to be implemented profitably. Furthermore, well-hedged suppliers (typically larger incumbents) are getting net new customers for free as the regulator needs to allocate the customer base from the defaulted operator under the supplier-of-last-resort regime. Given an otherwise fixed cost base (mostly IT systems and support staff), operating leverage tends to be meaningful—thus, more customers are generally earnings-accretive. Therefore, paradoxically, large investment-grade-rated incumbents will likely emerge as winners in a more consolidated U.K. energy retail market.