Market Risk

Retailer risk

Electricity retailers are primarily exposed to financial risk via energy price volatility on the wholesale electricity market. They are permanently assessing the balance between paying higher prices for fixed quantities at guaranteed prices versus the-precisely-required quantity at the time it is needed at the volatile market price. While wholesale prices are cheaper on the average over the long term, retailers have to ensure that their cash flow can accommodate short-term price hikes.

Furthermore, while this is the 'highly visible' risk of electricity retailing, there is also the 'slow haemorrhage' risk of possessing too much guaranteed offtake and not being able to place it with customers at prices that cover costs. In this case, the excess quantity is 'spilled' to the wholesale market at the volatile price, which will in general (on the average over the long term) be lower than the purchase price.

While the retailer can lower its prices to win more customers, it can then find itself having deliberately contracted to lose money, albeit less money, over the medium term - and will have yielded the opportunity to spill its surplus during times of elevated prices.

The "Varanus Island" experience

The Varanus Island experience demonstrates both the risk borne by 'unhedged' retailers and an important product adjunct that retailers can provide to their customers, in the form of stable prices in the face of adversity on the power system.

The Varanus Island 'experience' occurred in the winter of 2008 when the State's gas supply was reduced by around one third, resulting in very high wholesale electricity market energy prices for a few months. Strictly speaking the high prices and the duration for which they occurred were aggravated by additional 'double-contingency' events beyond the immediate gas supply failure, but the 'experience' refers to the energy price profile at that time, which is shown in the following graphs taken from the Economic Regulation Authority (in which the prices need to be divided by 10 to convert to c/kWh).

Average peak and off-peak trading interval STEM clearing prices, 2006 to 2011
Source: ERA 2015 Wholesale Electricity Market Report to the Minister for Energy pdf 6.2MB

Generator risk

Though it might seem 'counter-intuitive', baseload generators often facea considerable risk in the wholesale market. In order to finance the power station, the generator has to contract its production with an offtaker of high credit standing - which, because of its credit standing can demand very best price on a high production quantity. Depending on the nature of the contract, when the generator requires maintenance, it stops producing energy and has to instead buy from the market the missing energy and deliver that instead. Ironically, because it is a baseload generator (very efficient and cheap), its absence from the Balancing Merit Order can cause an increase in the price that it has to pay. On top of this, if the maintenance is “forced”, the generator has to refund capacity payments received from the IMO, perhaps at penalty rates depending on the circumstances.

Prudential default risk

One of the abstract risks faced in the market are those related to credit support of the institutions that underwrite the prudential requirements of the market participants. Specifically, market participants may meet their prudential requirements by lodging either cash (in effect of a prepayment) or a bank guarantee underwritten by a financial institution of sufficient credit rating. In the event of a bank guarantee being used and the financial institution having its credit rating downgraded sufficiently, the market participant has to replace the bank guarantee within 1 business day, or it will trigger a 'suspension event' regardless that the participant and the market might otherwise be enjoying 'business as usual'.