Analysis: UK power back end hedging falls while front curve volumes rise

Low electricity prices are making UK utilities sell power forward for delivery over the next quarter rather than lock in margins years ahead, market sources say.

The market has seen a structural shift with a quarter-on-quarter increase in near curve transaction volume, against a decline on the back end, ICIS data shows.

This is down to utilities changing how they hedge their future margins by selling the power they produce and buying the coal, natural gas and emissions contracts they need for production, industry sources say.

They attribute it to the fact electricity prices are so low there is little point locking them in, while at the same time reforms to the carbon market could change whether it is more profitable to run heavily emitting coal-fired plants or relatively clean gas-fired plants.

“The decline in forward hedging can mostly be put down to the poor performance in prices. It’s all very weak out there, so there is less incentive to hedge,” said one trader, adding that prices have reached such a point over the last three months, that it is significantly dented back-end hedging.

Summer ’16 and Winter ’16 volumes are down approximately 30% each since the beginning of the year, while Summer ’17 and Winter ’17 transactions are down 35% each, according to data obtained by ICIS.

It is no coincidence that prices have fallen in this period, with the Winter ’16 dropping from £48.75/MWh at the start of January to £47.05 in the third week of May. “Traders are likely to lay in hedging if the market rallies. This inherently keeps a cap on prices, so the market tends to remain depressed,” said another market source.

The upward revision of expectations of the extent of solar generation capacity build out before the cut in the UK renewables obligation subsidy on 1 April resulted in power contracts for summer delivery shedding value. Over the first quarter, Summer ’16 prices fell from £44.80/MWh to £42.50/MWh.

“Going forward, prices will be more sensitive to weather – especially solar and wind on the supply side,” said one trader. “The market would rather hedge on the near curve where forecasts and in turn price visibility, is better.”

Sources say that rebalancing portfolios in the short term based on weather forecasts and subsequent fluctuations in supply and demand of power has boosted front curve trading. Weather sentiment is “increasingly echoing across the front quarter” according to a trader, and ICIS trade data shows front quarter volumes rising 25% year-on-year in 2015.

Plant economics

Some traders are also concerned over the uncertainty over changes in environmental policy and how it will impact their generation portfolio.

“Forward spark spread and dark spread exposure is hard to judge, because the economics of burning coal versus gas might change with new policies,” said the first trader, giving a possible reason for the drop in long-dated contract volumes.

Uncertainty how EU states will backload carbon credits increases the political risk of trading power.

This risk is difficult to mitigate and the risk-reward profile of trading on the back end of the curve is diminished, perpetuating a decline in volumes.

The hike in the UK carbon price support (CPS) has narrowed the gap between clean dark and spark spreads, rough measures for assessing the profitability of coal and gas fired power plants. This has made the competitiveness of coal-fired generation increasingly sensitive to changes in prices in the carbon market.

Financial regulation

Financial regulatory reform is also denting forward hedging. Under the EU’s new markets in financial instruments directive (MiFID II), companies would be required to hold more cash to back up trading.

“The expected increase in capital requirements is making some of the medium sized players wary of tying up capital in margining back end contracts,” suggested a market source.

After 2016, firms with hedge positions that continue to be marked to market will be subject to threshold tests and increased capital requirements. The increase in regulation is starting to “squeeze firms’ balance sheets and it is having a slight effect on hedging decisions,” the source added. surya.kanegaonkar@icis.com