How to spot the next Leicester City-scale surprise in the energy market

Leicester City wins the Premier League. Donald Trump makes it to Republican Presidential nominee. The government introduces an extra Capacity Market auction.

The last few weeks have been full of surprises - or risk-materialisations as I call them.

Each one proves that shake-an-industry-to-its-core surprises do happen. And increasingly often in these unsettled times.

The problem is such against-the-odds surprises are unwelcome in business. They mean something hasn’t gone to plan. A risk – foreseen or not – has materialised.

But it’s every risk manager’s dream to:

  • (a) spot such an unlikely event’s potential early on and

  • (b) have a plan to act on as its likelihood moves from outlandish to obvious.

Imagine hedging against Leicester City’s triumph while the odds were still 5,000 to 1. Goosebumps all over.

The good news is there are few real surprises in the energy market. Although at times it might feel like changes arrive out of the blue, that is rarely the case. To the well-trained eye, there are normally signals.

So here's how to train your eye...

4 Steps to spotting and costing an early-stage risk

The question I am always asked by Energy Managers is "how can I spot the warning signals early on"? While the risk is still a twinkle in Atë's eye (the Ancient Greek's goddess of misfortune). Foresight is far more valuable than hindsight.

Take the much-discussed Capacity Market and the government’s ‘surprise’ decision to bring the mechanism forward one year to 2017/18. How could we have predicted that? And the cost?

Step 1. Identify the underlying risk

First, we have to identify the underlying risk. What is the government trying to solve by implementing the Capacity Market? Have they achieved it?

The Capacity Market is part of the government’s Electricity Market Reform. Its purpose is to ensure security of supply by procuring sufficient reliable capacity to meet demand.

The first generation auction ran in 2014 for 2018/19. It acquired nearly 50GW of generation at a cheaper-than-expected price of £19.40/KW. The next auction ran in 2015 secured £18.00/KW for 46GW in 2019/2020.

So it seemed peak demand for those years would be covered and below budget. The government had done well to treat the underlying risk.

Step 2. Check whether the underlying risk was effectively mitigated

During 2015 wholesale power prices fell 20% from the £45-£50/MWh range of the last 4 years.

Over the last few months, three events warned that the government might need to take further action.

  • In December 2015, National Grid established a Supplementary Balancing Reserve for 2016 to secure 3.6GW extra capacity. At least £122.4m will be spent on SBR during winter 2016/17.

  • On 25 February 2016, National Grid published data showing demand would exceed supply for 11 weeks of winter 2016/17 (although this had not counted the potential 3GW contributions from interconnectors nor the 3.6GW from the SBR, and National Grid played down fears of black outs)

  • In February, five more power stations announced they would close. And one - Fiddlers Ferry - had already secured contracts in the Capacity Market auctions.

So, had government achieved their target of securing supply security for 2017/18? Considering these events and lower power prices, you would say "no". Then we must ask what will the government do to ensure the answer is ‘yes’?

Step 3. If no, analyse the available options

There were two methods we knew the government could use to procure the supply quickly:

  • (a) Leave it to National Grid and the SBR.

  • (b) Or bring the Capacity Market forward.

There simply wouldn't be time to devise a whole new mechanism.

The Capacity Market looks preferable when we consider:

  • the previous Capacity Market auctions secured all target capacity at good value

  • following this route would show the government is taking action on energy security.

Step 4. Estimate the cost of likely options

What would a more urgent Capacity Market cost? Given this is the first time an auction will be run for 2017/18, it’s fair to assume it might look similar to the four-year-ahead auctions for 2018/19 and 2019/20. So we could use them as a basis to estimate the cost.

  • Winter 2018/19 = £19.40/kW x 49.3GW = £956m

  • Winter 2019/20 = £18.00/kW x 46.4GW = £835m

This money is recouped only from electricity used between 4 and 7 pm on winter weekdays. We estimate this 'chargeable volume' at about 11TWh. Dividing each figure by that gives us:

  • Winter 2018/19 = £87/MWh

  • Winter 2019/20 = £76/MWh

This cost is before the top-up capacity is costed in the year before delivery. This will increase the cost by the quantity of capacity required and the prevailing auction clearing price.

Our central forecast for both years rises to around £125/MWh after adding:

  • Inflation: applied because Capacity Market auction costs are always quoted in 2012 terms

  • the extra cost of the year-ahead auctions still to come.

But is simply extending the auction forward one year enough?

We know for some coal power stations, their future Capacity Market payments weren’t enough. In fact, Fiddlers Ferry closure announcement said their 2018/19 Capacity Market contract was not sufficiently valuable to incentivise them to stay open. They would rather pay £33m to exit their Capacity Market contract.

And so far, these auctions haven’t brought forward investment in new power generation.

So we could expect two things:

  • the mechanism will need to secure more attractive contracts for generators

  • new conditions to tie generators to their agreements with stronger penalties for leaving.

Taken altogether that gives us a forecast range for the new Capacity Market auction like this:

(Are you an EDF Energy customer? Log into our Market Insight portal for more non-energy cost analysis and forecasts)

How can I use this approach for other risks?

So here's my killer question for identifying and costing risks:

‘Is the market / mechanism / regulation achieving what it was designed to?’

I find it works for many energy risks not just regulatory ones. Because the process of answering this question forces us to understand what drives risks. From there it’s possible to explore ;scenarios and costs, and plan how to react if particular risks materialise.

Need help identifying and costing your energy risks?

You’ll have noticed identifying and sizing risks requires deep levels of expertise in the subject matter in question. When it comes to energy, most businesses don't have it in house. That's where our Risk Management Services can help. We give you access to wide-ranging energy expertise to help you identify and mitigate your business’s energy risks. Knowing is better.

Modern Energy Risk Management addresses all risks but prioritises high-impact risks over high-probability ones. Because they are normally unique to your business, physically interrupt operations, have longer lasting knock-on effects, and require immediate attention. So high-impact risks have a devastating impact on your business’s performance and your professional reputation. Most high probability risks don’t. That’s why we work through a process to:

  1. 1. identify every way that energy affects your business performance

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  3. 3. plan how to mitigate them in a way that suits your business and creates an opportunity wherever possible.