More small and medium energy suppliers will go bust because they fail to grasp the basics of risk management. For some, the problem is more fundamental, according to Gary Huish, director at Energy Potential, a consultancy that specialises in energy risk management.
He suggests they step back and define what they do.
“Many are not particularly clear if they are a service driven company whose product happens to be energy or a risk taking enterprise – and that is a recipe for disaster,” says Huish.
Selling energy, he suggests, “is not like flogging baked beans”.
“Extracting value from wholesale energy markets is challenging, even for experienced traders,” says Huish, who spent years in trading and risk management, most recently as head of commodity risk for Morgan Stanley.
“In a banking business model the core ‘franchise’ skills are all about accurately pricing the risks, adding a fair margin to the customer, and quickly trading away the risks,” says Huish. “This ‘locks in’ margin, leaving the institution with as near a risk-less revenue stream as possible.”
That is exactly the model that new supply companies should replicate, he advises. The problem is, many are not.
“Smaller players are implicitly speculating on wholesale prices, selling fixed-price tariffs and hoping that when they deliver their energy, spot pricing levels will allow them to make a profit,” says Huish.
When prices are falling, that strategy seems smart. “But markets always revert,” says Huish. When they do, suppliers can quickly find themselves with “serious ‘out of the money’ liabilities that they are never going to recover from their tariffs”.
This is why Huish thinks there is a market for the firm’s services. In simple terms, it “helps companies develop a clear business model based around risk control, while providing pricing models and processes that accurately value risk” alongside “hedging strategies to de-risk their exposures”, he explains.
Armed with the right tools, Huish says suppliers can focus on customer acquisition, service and billing. If they want to actively manage some risk, “our models make it very clear how much risk is consistent with the business model”.
Without those tools, new entrants lacking sufficient energy trading expertise, “are setting themselves up for a very bumpy ride, with a significant risk of failure”, he warns.
Shift or bust
Managing an energy company “is quite tricky,” says Huish, “even if you strip out all the changes” currently redefining the market.
The risks are myriad: “fuel price volatility, seasonal patterns, weather risks, not to mention the massive influx of green power that has disrupted conventional pricing mechanisms,” he explains. “You have to condense that into a competitive tariff for the year ahead. That is difficult.”
Huish believes ignorance of those fundamentals contributed to the failure of small suppliers seen in recent months. He thinks more will go under, with rising wholesale prices piling on the pressure.
Even well resourced challenger and municipal energy suppliers have had to implement double-digit price rises in recent months.
“From April to October [prices] have almost doubled. If you are not properly hedging risk, energy purchasing costs can be much higher than sales revenues. Cash reserves can be consumed very quickly” says Huish.
“Typical retail margins are just a few per cent of total supply costs, so there is little scope to get pricing and hedging wrong. The UK pricing environment has been extremely challenging even for the most experienced energy traders.”
Do, or do not
Suppliers have to decide if they are a risk management business, or a marketing business, suggests Huish.
“If it is the latter, the focus should be customer acquisition and service, with risks passed the through to a third party. You will have to pay that third party to take on those risks, leaving a reduced – but secured – residual profit. Hoping the risks will manage themselves is fool’s gold. You might get lucky – you can never discount luck – but over the long run your business model will almost certainly fail,” he says
“Either you actively manage against a clear strategy, or pay someone else to do it. There is no middle ground.”
Key considerations for local authority energy suppliers
Local authorities (LAs) continue to consider launching energy companies. Energy Potential works with LAs involved in energy. As such, Huish is limited in what he can disclose. But he says while councils have deeper pockets, the same risks apply. So what are the key steps to consider?
Stage one is “have a clear strategy,” says Huish.
“Never underestimate the power of good planning. A transparent, agreed trading strategy will provide a solid foundation for risk management decisions”.
Stage two is “have timely, risk reflective pricing”.
“Many supply companies produce a tariff and may hold it open for weeks or even months. Timing risk between tariff creation and customer acquisition is very real, and can lead to customers being effectively loss-leaders. Gaining customers is important,” Huish says, but so is avoiding losses.
Stage three is to “measure your risks accurately and hedge quickly and efficiently” leaving “residual risks that – even if things go badly – do not materially compromise the business”.
Huish thinks local authorities “are absolutely trying to do the right thing”. But, if they are going the whole hog with supply licenses, must be crystal clear about the challenges posed by energy markets.
“An undefined trading approach is a recipe for disaster.”