Losing their hedge: why so many UK energy suppliers went bust

Hedging strategies were powerless to protect firms from runaway energy price rises

Lancashire-based PFP Energy supplied gas and electricity to 85,000 domestic and non-domestic customers in the UK. Its 2020 annual report trumpeted its “sophisticated hedging programme” – the kind that should have helped the firm ride out bumps in wholesale energy markets.

On September 7, 2021, PFP Energy went bust. It was one of 21 UK energy providers to have shut up shop since the start of the year amid soaring prices for natural gas.

Adrian Leaker was managing director at PFP Energy until January, now working as a consultant. He explains that the company’s hedging strategy failed when customers shifted from fixed to variable rate contracts after energy prices shot past the UK regulator’s price cap.

Most of the company’s customers were on fixed tariffs, Leaker says. When it came time to renew contracts, the firm would estimate each client’s energy usage, and purchase forwards that covered roughly 95% of the estimated 12 months’ worth of gas and electricity.

“Every month some customers will roll off a fixed price contract and we only hedged them when they came to the end of the contract. So, we knew how many customers would renew, or we had an idea, so we’d hedge when it came to renewal,” says Leaker.

But during August and September wholesale gas and electricity prices rocketed by more than 250%. Suppliers were forced to hike their uncapped fixed tariffs, making them an unattractive option for renewing customers. Instead, customers switched to variable contracts, which were subject to a price cap set by the regulator, Ofgem.

PFP Energy did hedge its variable contracts out to six months, which is how often the regulator reassesses the level of the cap. But once the wholesale price went through the level of the cap, it became impossible for the company to obtain hedges to lock in supply cheaper than the price it could charge customers. Insolvency was inevitable.

“As the wholesale energy price went up, we had more variable tariff volume than we’d anticipated,” Leaker says. “Those customers that you hadn’t anticipated being on a variable tariff, you wouldn’t be able to hedge those at the wholesale energy costs as dictated by the price cap,” he adds.

PFP is just one example of how UK energy suppliers were wrong-footed by the gas price surge this year and tipped into bankruptcy.

Risk.net has researched the most recent annual accounts of the 21 firms that have gone bust since the beginning of the year, along with some that are still trading. Eight of the 21 failed firms stated in their annual reports that they implemented some form of hedging strategy against rises in wholesale gas and electricity prices.

The reports don’t go into much detail, or give sizes of programmes or hedges on their books. But speaking to industry consultants and former employees, the hedging programmes were derailed by a variety of factors: some to do with market structure, others to do with inadequate business models.

 

A number of smaller suppliers are believed to have hedged only a small proportion of their exposures, due to the cost of doing so in a highly competitive market, lack of availability of suitable hedges or because of restrictive supply agreements.

Some, like Pure Planet, largely relied on the fact that they only offered variable plans, so they should always be able to pass on the wholesale price rises to customers – that is, until prices hit the cap. Bulb also operates under this business model.

This has led to questions for Ofgem, which is responsible for setting the cap. Critics suggest the watchdog should have done more to monitor the risks that energy suppliers were taking – particularly smaller companies. They suggest the regulatory framework may need reform, to encourage fair competition without disadvantaging providers.

An Ofgem spokesperson said via email: “There has been an unprecedented increase in global gas prices which is unfortunately putting financial pressure on all energy suppliers, including those who have hedged their demand. Our number one priority is protecting customers and the price cap is doing that for millions of households this winter.”

Up, up and away

Gas prices have risen markedly in the past year. The benchmark price in the UK, officially known as the National Balancing Point daily day-ahead price, rose from 36 pence per therm in November 2020 to a peak of 277p on October 5, before retracing to 165p by November 2.

Ofgem caps how much energy suppliers can charge customers on variable tariffs, a level which is reviewed every April and October. The cap for the period spanning April to October 2021 equates to a price of around 46.89p per therm, according to Aurora Energy Research. But by April 1, UK spot gas prices were already at 50p per therm. The price of gas forwards for October delivery were at 30.2p on March 24, but this had risen to 52.2p on April 15. That meant using forwards to hedge against the gas price rise was no longer economically sensible as it would lock in a loss: providers would be paying for supply at a higher rate than they could charge to the customer.

The cap for the following period covering October 2021 to April 2022 equated to 67.41p per therm according to Aurora, but on October 1 – the first day of this period – the spot price was 199p, nearly triple the level of the cap.

 

 

Most focus in the press has been on the effect of gas prices on households, but in the UK gas is also the major fuel for electricity generation, responsible for 40.2% of the gigawatts generated on average over the past year, according to the National Grid. This figure can rise in times when there is little wind to power turbines, which was the case for parts of September this year.

Consequently, when gas becomes dearer so does electricity. The benchmark for UK power, known as the day-ahead mid-price for baseload electricity, increased from £68.5 per megawatt hour (MWh) at the start of the year to a peak of £540 on September 13, before coming back down to £168 by November 2.

According to Aurora, the cap for electricity in April was set at around £60 per MWh. On April 1, the price was at £57.8, but five days later was beyond £60, where it remained. Baseload forwards for Q4 2021 were at £54 on March 22 but hopped up to £68.4 on April 20, meaning locking in a rate below the cap was impossible.

The cap set for the following period spanning October 2021 to April 2022 was set at around £82 per MWh according to Aurora, and on October 4 – the first day of this new period – the price was more than double the cap level, at £178.

 

For the larger suppliers in the so-called big six, such as EDF and British Gas, their significant balance sheet and working capital reserves help them to weather the storm while the market stays elevated. But for those outside the big six, this isn’t always the case.

Bulb Energy is a top 10 supplier with 1.7 million customers, but the firm has been in talks with competitors to secure its future. The company offers only variable tariffs, which means in normal times it can simply pass on any wholesale market rises to its customers directly.

A Bulb spokesperson says the company covers its energy needs using a mixture of power purchase agreements – which allow it to buy energy from renewable electricity generators and green gas producers – and on the wholesale market.

It is understood that Bulb has a rolling hedging strategy that goes out beyond three months, to help mitigate risk in gas and electricity markets.

According to Leaker, variable tariffs cannot always update as fast as the market price moves. Energy suppliers are required to give customers notice of rising variable tariffs – in Bulb’s case the notice period is 30 days. So when wholesale gas prices were rising rapidly earlier in the year, some firms may have been caught having to sell gas cheaper than they were buying it, even before the cap came into play.

Too much too soon

For some companies, runaway energy prices may also have combined fatally with runaway growth. Green Supplier Limited opened its doors in 2019 and, by September 2021, had signed up more than a quarter of a million customers as it pursued a strategy of rapid expansion.

Green’s hedging strategy was similar to many other small suppliers. For both gas and electricity, the firm would hedge using forward contracts for the duration of the fixed tariff contracts, says former chief operating officer, Steven Redmayne. For its variable contracts, it would aim to hedge 100% of its near-term customer consumption forecasts for a couple of months via forwards, which would be scaled back to 75% or 60% for the following six months.

The problem with fast customer growth was that the firm didn’t know how much gas and electricity to purchase ahead of time. Had it bought a year’s worth of energy for its existing customer base in November 2020, that wouldn’t have even covered half of its needs in November 2021. With the firm’s hedging strategy always a step behind the growth in its customer base, the crunch point came when the energy price rose beyond the cap. At this stage, hedging was no longer practical.

“If you look at the likes of British Gas, you know your customer base and you know what it’s going to be with a relatively high degree of certainty in a year’s time,” says Redmayne.

According to Leaker, there may have been some firms that were willing to hedge more, but were unable to. He says this can occur when suppliers are locked into energy supply contracts like Bulb, or Pure Planet, which had a gas supply agreement with BP.

According to Leaker, these agreements give the smaller retail energy suppliers a credit line to conduct hedges that they might not get elsewhere. But the agreements can also lock in the supplier, forcing it to conduct all hedges with that same counterparty. So, as the gas price rose, he says it’s possible that some suppliers hit their credit limits but were unable to go elsewhere to top up their hedges.

Electricity hedging is a particular challenge for smaller firms, and is believed to have been a big contributor to their troubles – especially with the demise of an Ofgem-backed programme designed to get the big six to provide hedges to smaller energy suppliers (see box: Secure and promote).

Customers’ electricity consumption tends to converge at peaks throughout the day which don’t typically match the blocks of energy that are traded, meaning it can be tricky to hedge effectively.

To mitigate the risk of being unhedged at peak times, a firm might overbuy a forward contract and sell off what it doesn’t need in what’s known as the imbalance market, says Chris Regan, a former head of EDF Energy’s trading and operations, and current product director at Brady Technologies.

“Imagine if [a supplier’s] overall average demand from customers was 100 units. They might actually buy 120 units, so that they were close to the balance in the peak, but had too much power in the off peak,” says Regan.

Firms can underhedge electricity and top up on the imbalance market, but that comes at a cost that can only usually be borne by the largest players, says Green’s Redmayne. That means there should in theory be a steady stream of smaller firms looking to sell off unused electricity in the imbalance market, which can be lucrative when the prices rise. Brady says that if smaller firms were hedging prudently, they might have made enough selling in the imbalance market to stay afloat.

Blame game

In the meantime, the flurry of energy supplier failures has sparked a bout of finger-pointing, with many scrutinising the action – or perhaps inaction – of Ofgem.

“Every energy supplier in the UK has to provide data to Ofgem on a monthly basis and it picked up since the start of Covid, where financial information and reporting on all key metrics was given,” says Redmayne. “What has Ofgem done with that data for a year and a half I would ask, and the answer is nothing at all.”

Some have suggested that Ofgem’s primary responsibility towards customers resulted in an ultra-competitive market that drove many providers to offer loss-making tariffs. With prices and margins squeezed, smaller suppliers struggled to source the extra cash to hedge more fully.

“What Ofgem should have done years ago, is set some gross margin targets, and said ‘if you can operate below those gross margins, you have to prove you can do it and why that isn’t predatory pricing’,” says Leaker.

The regulator’s former chairman, Dermot Nolan, who left the position in early 2020, told the Financial Times in September that with hindsight stronger licensing requirements from Ofgem may have been necessary.

Some suggest Ofgem could have run stress-tests to examine whether suppliers’ hedging strategies would be able to withstand a volatile market. The regulator could also have required firms to hold cash reserves, but Regan says this would have made the market unattractive with already low returns.

Redmayne suggests an Ofgem-managed cap on what wholesalers can charge suppliers for energy would incentivise generators to ensure sufficient supply levels.

“Because [energy generators] know there’s going to be spikes in the future, they’re holding off for as long as possible until they come in and charge thousands of pounds a megawatt hour. They are generating so little energy for such a high price, when if they put a cap on there, they would generate more but at a reasonable price,” says Redmayne.

While there may be questions raised about Ofgem’s role, George Karalis, managing director of debt and derivatives advisory at consultancy Evercore, says the responsibility ultimately lies with the suppliers themselves.

“Ofgem has always been very transparent on what the price regulatory framework is and it’s for people that are operating in that business to manage the risk around it,” he says.

Secure and promote

Leading up to 2014, Ofgem became concerned that smaller suppliers were unable to obtain effective hedges for their electricity exposures. As the largest six suppliers owned a 98% market share of retail electricity and gas markets, and most owned their own power stations, Ofgem believed that smaller firms which were reliant on buying electricity from the larger market players didn’t have adequate access to trading with the larger firms, and were struggling to hedge their wholesale electricity needs.

So the regulator launched what it called the “Secure and Promote Market Making Obligation”. The scheme required the big six firms – Centrica, EDF Energy, E.on, Npower, Scottish Power and SSE – to post bid/ask spreads for peakload and baseload hedging products during two-hour long windows of the day, with the later window being aligned to peak activity in the gas market.

To participate, smaller suppliers were required to meet the credit terms of the big six if they wished to trade.

But despite Ofgem’s efforts, Chris Regan at Brady Technologies says only a few smaller suppliers ever traded on the platform.

“None of the smaller suppliers wanted to access the wholesale market and pay their market fees to hedge. Instead, it was traders, the financial firms, the asset aggregators and the big six that were all trading with one another,” says the trader.

“There was a big push on for the big six to offer favourable credit terms so smaller suppliers could hedge forward. We were all basically offering credit more favourably than is prudent to small suppliers just to reduce the regulatory risk of essentially Ofgem coming in and saying you’re not being helpful.”

Ofgem did not respond to questions on the secure and promote programme.

After a steady decline of mandated market-makers, Ofgem suspended the scheme in 2019.

Steven Redmayne, formerly of Green, says that if the scheme was still in existence it may have helped smaller suppliers by providing access to the markets to hedge, but in itself it would not have stopped firms from going under.

Renewed threat

Another pressure point for many UK energy suppliers is the Renewables Obligation. This requires firms to acquire a proportion of the electricity they supply from renewable sources, through the purchase of renewable obligation certificates (ROCs). If a firm doesn’t obtain the correct number of ROCs, perhaps because they can’t afford it at the time, they must pay the equivalent amount into a buyout fund. This fund is divided among suppliers who have met their ROC obligations.

But if firms can’t afford to pay their required amounts into the buyout fund, the shortfall has to be met by mutualising it across the other energy suppliers, once it goes above a threshold – creating another cost for suppliers.

“That’s why you see a lot of companies going bust at this moment in time because they haven’t got the money to do the ROC buyout,” says Leaker.

The Renewables Obligation is settled every five months with an additional two months for firms to pay late fees, so Leaker says there could still be even more firms that find themselves in difficulty in the coming weeks as they struggle to pay their RO fees.

Correction, November 4, 2021: An earlier version of the article stated that Bulb had asked the UK government for a bailout. A spokesperson for Bulb denied this was the case. We have changed the article accordingly.

Editing by Alex Krohn