Firstly, a utility company must also try to manage the Ofgem cap. Their spot customers’ supply price is a risk too. You may ask, if they buy spot and sell spot, then surely, they are ‘back-to-back' with no market price risk? However, this is not the case as Ofgem’s unit price cap does not allow the utility company to pass on any large seasonal spot price increases.
Secondarily, UK power and gas suppliers need to hedge as they sell a long-term fixed price to a customer. The hedge will protect against adverse changes in prices, particularly from rising prices. The utility company must arrange an equivalent long-term fixed-price purchase (the ‘hedge’ against the customer’s fixed price) to ensure the supplier can 1) honour their customer contract and 2) remain profitable. The alternative of not hedging in a rising market means the business will become unprofitable and potentially fail if prices move in an extreme way. So far this is simple vanilla power and gas risk management. But it is important to note that it is not that simple because retail customers can pay a small 30 GBP exit fee that allows a customer to terminate an ‘underwater’ fixed price deal. Should this event occur, then the customer is effectively leaving a hedged supplier ‘high and dry', because termination is only ever likely to happen when market prices are lower than the fixed price. This implies the utility company has a conditional exotic option embedded into the supply contract, which it must ‘manage’ with a dynamic real-time set of risk assumptions using an adapted Black-Scholes algorithm and some serious trading-savvy to boot - not so easy!
As it stands now, the UK utility companies are operating in a very tricky space, with more volatility and more risk, even if hedged. They can lose money if prices rise or drop quickly. As is the case of the last two years of extreme price swings. And indeed, customers generally want to fix and budget big spends such as utility bills.
To better understand a UK utility company’s embedded gas and power market risk, they must analyze their risk as a complex combination of spot, long term pricing contracts, customer retention periods, new customer inflows, the Ofgem cap, complex statistics and option theory, and a particularly strong acumen for trade timing.
Onyx can help. We have been remarkably successful in dynamic trading and hedging in the energy market space and have a qualified team dedicated to reviewing and aiding complex portfolio risk management for any player.
Forbes recently ran a detailed article reviewing the UK supplier situation and impact on households and Ofgem, you can find it here.
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