UK energy companies are like macho banks circa 2007
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A government concerned with giving consumers more choice. A chain of operators with aggressive business practices. A sleepy regulator who failed to challenge these operators. And then a big market shock. We may be back in 2007, when Northern Rock – and a host of other macho banks – collapsed, ushering in a global financial crisis.
However, it is 2021 and the uproar has shifted to the European energy market, with UK consumers once again on the brink of crisis. Haven’t we learned anything?
The answer is no. There are striking parallels between the UK banking market circa 2007 and today’s electricity market, which has been rocked by an energy crisis that has the potential to cause economic and political chaos. Yet no one had apparently realized that another toxic time bomb had been built from very similar ingredients in a very different industry.
First, a story in a jar. Northern Rock failed after a period of rapid growth, during which it supercharged what banking industry jargon calls “maturity transformation.” Any bank relies on this ability to borrow short term (traditionally through customer deposits) and to lend long term (typically through 25 year mortgages). But for many of those UK lenders that collapsed in 2007/8 (including HBOS, Bradford & Bingley, Alliance & Leicester), this mismatch had been taken to extremes.
Northern Rock had amassed over £ 100 billion in loans, increasing fivefold in a decade. When the bank was unable to replace its vast swath of short-term funding, collapse was inevitable. Banks around the world have experienced similar pressures. The UK, however, had a particular concentration of aggressive mid-sized banks.
Compare that with the UK energy market in its recent incarnation. Dozens of small operators have crammed into a highly competitive market. Many relied on exploiting a “maturity mismatch” between buying on the spot energy market and the long-term prices at which they were locking their customers. But when those spot prices soared, they suddenly racked up millions of pounds in losses every day.
Hedging for this risk has been a rarity for many energy market challengers. This could be due to a desire to maximize the hike in time. Or it could simply be that it is not possible for small traders to use an obvious hedging technique – buy in high volume at convenient times.
This raises important questions about governance and risk controls. Weak bank boards, poor risk management processes and insufficiently strong risk management committees have enabled the balance sheets of Northern Rock, HBOS et al. to develop in an unsustainable manner. British energy pushers appear to have had the same shortcomings.
And the role of regulation in all of this? The UK energy market is commonly referred to as ‘highly regulated’. This is true in the sense that consumer pricing is framed via price caps.
But Ofgem looks a lot like the former UK regulator, the Financial Services Authority. He did not give much thought to “prudential” risk, that is, to the safety and soundness of individual companies or of the system as a whole. Had he done so, he would not have allowed companies to operate at aggressive prices and without hedging supply costs. Strict regulation of bank liquidity and capital is now the norm in the banking sector; before 2008, this was not the case.
The regulatory administration of business failures also has parallels. So far, at least, the energy companies that have collapsed have been relatively small and are emerging as bigger rivals with potential government backing.
In 2007/8, policymakers used a similar technique to deal with disasters, persuading seemingly stronger banks to take control of struggling rivals. This happened most dramatically when a faltering HBOS was rescued by Lloyds with government encouragement and an antitrust waiver granted for crisis reasons. This attempt to avoid a state bailout not only failed (enlarged Lloyds itself had to be rescued within months), but it also created a giant bank with a quarter of the bank’s UK market share. Retail. This made all previous and subsequent rhetoric about the importance of competition absurd.
This same dynamic is currently playing out in British energy. Of the 70 companies operating earlier this year, experts now predict less than 10 will survive, all with larger market shares. If stronger governance and regulation was deserved before, it certainly will be now.