Dominic Whittome, consultant and ex-energy trader, regrets the loss of banks and other third parties from commodities and power trading
In November the Financial Times reported that Barclays was winding down its energy – largely oil and gas – trading business, which had revenues of about £100 million a year. It is part of a longer-term plan to exit commodities trading. But for the wholesale gas and power markets, energy merchants and investment banks have played a significant in providing market liquidity, especially out on the forward curve.
The forward market represents perhaps the only true ‘marker price’ an industrial buyer has to go on. Manipulate this market or, more to the point, allow a market to become so illiquid that it essentially manipulates itself – by sending distorted incentives to traders, making the curve even more illiquid – and volatility and opaque pricing will replace efficient supply and demand-reflective pricing. This also leads to greater volatility and high-risk premiums that are embedded into the price of power purchase agreements (PPAs). The same distortions can undermine market liquidity, leading to further market exit and making the cycle self-reinforcing.
This is why the market exit of investment banks is not good news for utilities, industrial buyers or households.
European and national legislation has piled layer upon layer of compliance cost on to energy-trading desks across the merchant banking industry. That extra burden, coupled with – certainly until very recently – low prices, has rendered many energy trading desks at financial institutions ‘non-commercial’ in the eyes of internal restructurers. Consequently, the banks concerned have quietly wound down or withdrawn their energy-trading operations altogether, and with it the liquidity-providing role they had to play.
To be fair, no single piece of legislation is solely to blame. But EMIR, the EU European Market Infrastructure Regulation (which covers all counter trades, defines them very broadly and considers all of them as derivative contracts) can arguably be said to be the straw that broke the camel’s back.
In theory, EU Regulation 648/2012 should have enhanced stability, transparency and efficiency in the forward gas and electricity purchasing – in EU eyes, ‘derivative’ – markets. But the new cost burdens that EMIR has imposed on the banks (the utilities too) has led to a significant reduction in long-standing trading by the energy merchants, merchant banks and some of the major utilities.
It has caused liquidity to contract, which may have led to a market efficiency situation in energy that is precisely the opposite of what – for all its good intentions – EMIR had set out to avoid.
The finer details of EMIR and other primary legislation, including the EU Market in Financial Instruments Directives (MiFID I and MiFiD 2), are too wide and complex to condense here. However, the de facto prohibition of cross-commodity clearing is widely thought to have curtailed the commercial viability of forward gas and power desks at financial institutions.
For example, merchant banks can no longer benefit from the operational efficiencies they once enjoyed by way of cross-netting positions across different commodities desks funneled through a single account, with profits and losses successively and efficiently offset against one another.
The practice also introduced economies of scale to the wider operation.
In the past a merchant bank could centralise and net-out trades across, say, gas, power, bullion, foreign exchange or interest rate swaps through one internally-offsetting account, forthwith it has to re-establish separate desks – each with separate books, reporting and accountability – to meet EMIR’s technical standards for the format and frequency of trade reports to trade repositories.
In the aftermath of the financial crisis, which is still with us, it was generally accepted that stringent legislation was required. Equally, so was more circumspect policing of trading managers and the individual traders reporting to them in an organisation. This extra regulation sounds fine and some would say it was not before time, but considering its long-term impact on liquidity, which has yet to be ascertained, and on forward gas and electricity prices, the questions for UK energy buyers are more likley to be, “For us, was it worth it?” or “Have we thrown the baby out with the bathwater?”
We can’t answer this yet. But let’s take a look at the market. Calendar gas and power prices rose about 20% in the last three months of 2016. The higher prices and notably higher market volatility will undoubtedly drive up renewal prices for industrial gas and electricity buyers as the April 17 round approaches.
To be fair, there are underlying supply and demand factors that would at least partially explain recent price rises. And given the spectacular power price gyrations we have seen very recently, one could equally make the case that it was surprising that the forward curve had not moved more, if it was supposed to be this inefficient and jumpy.
But as fellow former traders will testify, never be fooled by a headline price. The screen just gives you the cost – not the volume behind it. Forward prices can change significantly in the blink of an eye, especially once any ‘feeler price’ is executed.
No-one, no formula, and no machine can say how the market would have turned out had EMIR, MiFID and other legislation not been introduced. It is hard to see how the exit of merchant banks and other players who bring liquidity and competition to the wholesale market will help the interests of energy utilities or consumers in the long term. The only winners will be the incumbents and market participants that are still in the market, now each with a greater slice of the remaining marketplace to themselves.
First published in the February 2017 issue of New Power Report
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