Problems with too much competition and efficiency maximisation - natural gas market edition

I have blogged earlier highlighting the problems with excessive competition and efficiency maximisation. This post draws attention to the problems with competition and efficiency maximisation in the natural gas sector.

The recent rise in natural gas prices have roiled utility companies in Western Europe. Seven British energy suppliers with 1.5 million consumers have gone under and more are under deep stress. The situation while a concern is not as bad in the continent.

UK, in particular, has seen intense competition in the energy market, with over 70 suppliers. They compete to outbid each other by offering low prices and attractive terms to consumers. While the suppliers have accused the regulators of unviable price caps at a time of soaring natural gas prices, the government has blamed the suppliers for bad business practices and poor hedging strategies. In any case, the episode once again underscores the perils with unfettered competition in any market. 

Izabella Kaminska (HT: Ananth) has a very good article that highlights the main issues. Liberalisation ushered in competition,

By 2017, such efforts had successfully driven consumer prices down relative to wholesale costs by increasing competition in the UK market from the incumbent Big Six players to as many as 70 organisations. Many of these new providers were happy to gain market share by undercutting rivals and offering below-cost deals to consumers. Many were also asset-light businesses that did not have infrastructure of their own, giving them another big advantage. Others were less attuned to hedging their market-based exposures than more experienced operators.

But competition came with a race to the bottom in prices and created associated systemic costs,

It made investing in critical infrastructure incredibly unappealing for any player still managing legacy assets. It was on the back of such market conditions that one of the UK’s largest natgas suppliers, Centrica, decided to close its Rough natural gas storage facility — the biggest in the country — in 2017. The facility was coming to the natural end of its life anyway, and would have needed a significant investment to modernise and revive it. But also, the chances of ever achieving a return on that investment were becoming increasingly negligible — especially in the context of ESG trends that risked making the underlying asset become stranded in the long term too. As a result, a vital reserve mechanism that had helped the UK stockpile gas in the summer for release in the winter months for many decades — smoothing supply and demand price shocks shocks in the process — was permanently lost. While many worried this could expose the UK to serious systemic shortages in the event of colder-than-expected weather, those defending the decision argued the UK could always turn to wholesale LNG and continental spot markets to ship in additional supplies when needed. Nobody, however, expected that the natgas wholesale markets themselves might get squeezed to the current extent.

Suppliers bet on Management 101 concepts of flexibility and efficiency maximisation, which reduced resilience and generated its own negative externalities and attendant risks on the system,

For the most part, price spikes in the natgas market operate much like the surge pricing dynamics you see balancing the market for taxis on the Uber app. Just how spikey those prices get, however, is directly correlated to how inclined service providers are to hold expensive standby reserves (that might never be needed) directly themselves, or to commit to longer-term supply contracts. Much like with Uber, which benefits from not being tied to long-term employment contracts with its drivers, most of the time there is a market incentive to run as lean a natgas operation as you can. That means avoiding expensive hedges, contracts or storage facilities as best you can -- and taking market-based risks -- so the savings can be passed on to consumers directly.

The problems faced by the natural gas market also points to the problems with excessive pursuit of efficiency,  

Commodity producers like British Gas saw fit to separate their retail operations from their production ones. But while stripping the retail operation to its bare minimum is great for maximising utility and reducing costs, it introduces the same sort of risks that apply to undercapitalised banks, or those that rely excessively on short-term funding to finance their long-term lending operations. If and when the wholesale market seizes up, such operators have no reserve or production of their own to fall back on, and require bailouts to continue operations. This risk runs especially high in wholesale markets that are exposed to structural chokepoints on the supply side — something that differs greatly to the market for taxi drivers, which has much lower barriers to entry and can easily cultivate new supply.

In 2007, when wholesale markets unexpectedly froze up due to the credit crunch, Northern Rock’s over-dependence on short-term funding markets meant there were no reserves at the bank to fall back on. After failing to get third-party investment or a government bailout, the bank was forced into insolvency. This situation is analogous to what the British natgas system is facing now. Except, unlike what happened with funding markets, it’s not something that can be fixed by simply throwing central bank money at the problem. The choke points are a function of real supply issues. Since bailouts can’t magically engineer more natural gas, the only thing they can do is transfer the high cost of sourcing natgas for critical industry to the government balance sheet instead of the private one. Such a transfer, however, inevitably comes at the cost of other national spending commitments.

The consequence of all this is socialisation of private losses, 

The bailouts being discussed for industrial CO2 suppliers in Britain, thus, amount more to the nationalisation of a giant naked short natgas position than anything resembling a resolution. If the crunch were to deepen due to a particularly cold winter, the nation state of Britain would risk being exposed like any other player caught short in a rising market. The regrettable takeaway of the situation is that the low prices consumers experienced as a result of market liberalisation may have been largely illusory. They will have come at the cost of investments capable of making the system more resilient which, it turns out, were worth paying up for when times are good.

And it encompasses many parts of the American version of modern capitalism, 

What the situation further reflects is that we as a society seem to have learned very little from historic crises bearing similar fundamentals, among them the 2008 global financial crisis, the Enron crisis of 2001 and, yes, even the great Egyptian famine of scripture. More worryingly, it indicates that while we were focused on making the financial system more resilient, we were inadvertently inducing fragility elsewhere. Notably, in the world of physical goods and services, through increased dependencies on just-in-time supply chains, wholesale markets and competition.

The pandemic induced shipping disruptions and factory closures have exposed the chinks in the just-in-time management strategies of companies, most famously in the semiconductor chip shortages which have very adversely impacted the automobiles industry. Indian readers would be familiar with the dismal outcomes from unfettered competition in the domestic airline and telecom markets. 

There is a lesson here for infrastructure regulators. Their objective function currently seeks to protect the interests of consumers and producers/suppliers by balancing affordability with cost-recovery and reasonable profits. Into that objective function, it's now required to add a systemic resilience cost which should get distributed across all stakeholders. 

In unbundled industries like utilities, the resilience cost would have to be apportioned across generation, transmission and distribution, supply, and consumers. This questions the rationale behind the idea of completely deregulated market in supply. The ideas of efficiency enhancing supply competition and consumer surplus are just that, illusory ideas. They are not free lunches but leave a cost behind for others to pick up. The inevitable race to the bottom at the consumer side of the market in a regulated business merely transfers costs and risks upstream. When the upstream side is unable to bear those costs, they settle on to the tax payers. Bailouts follow. 

If one borrows the principles of Econ 101, the costs have to be internalised by those generating them. In other words, supply competition and lower prices have to happen within a regulatory framework which internalises the resilience cost. 

As Kaminska's analogy with financial markets show, the resilience cost may be relevant for all consumer facing businesses which involve an upstream production side which houses significant risks. 

Update 1 (08.10.2021)

From The Economist,

The origins of the mess lie in the 1980s and 1990s, when privatisation created an oligopolistic energy market dominated by the “Big Six”, which paid their shareholders juicy dividends and their bosses fat salaries. The government responded to anger over high energy bills with further liberalisation, which created a fragmented market. Some of the new entrants were innovative, such as Bulb, which offers consumption-tracking apps, and Octopus, which discourages consumption when demand is high with dynamic pricing. But most were thinly capitalised and produced no energy, merely buying it on global wholesale markets and selling it on. Some paid little attention to ensuring continuity of supply or hedging against price fluctuations. 

Such me-too operations were always vulnerable to a demand squeeze. But the risks rose in 2017 with the closure of a big gas-storage facility, which left Britain able to store just 2% of its annual demand. Other big gas importers, by contrast, can store 20-30%. And the risks rose further in 2019, when the government capped consumer prices in response to continued grumbles about high energy bills. The perfect storm came this summer. As pandemic restrictions eased, global demand for energy rose. Gas supply in Russia, a big producer, was disrupted, and unusually calm weather stilled British wind turbines. In August Ofgem, the industry regulator, said that from October the price cap would rise by 12%. But since then the wholesale price of gas paid by British energy firms has risen by more than 70%. The result is that British energy firms are tied into contracts to supply gas to households at far less than they must pay to get it.

This is an explainer in The Economist on rising natural gas prices. 

Bloomberg compares the episode to Evergrande,

The foundations of this extraordinary crisis were a lack of financial resiliency, light-touch regulation and unsustainable pricing practices that left the industry unprepared for its Black Swan moment... This tale of inadequate capital buffers and “moral hazard” will be familiar to students of previous crises. And its resolution will be similar too: a bonfire of the energy suppliers, in which the small fry are consumed by better capitalized entities. Big suppliers will get even bigger. Injecting more competition into a market once dominated by the “Big 6” energy companies like British Gas (owned by Centrica Plc) and EDF Energy (Electricite de France SA) was well intended and achieved some success. The market share of legacy suppliers has dropped to around 70% and new entrants helped spur innovations in clean-power tariffs, online services and smart-meters, aiding energy efficiency and the decarbonization drive. Providers were forced to become more efficient and, at least in some cases, customer service improved. Perhaps there’s such a thing as too much competition.

The new entrants expanded rapidly because it was their best hope of generating cash. As we’ve seen in the airline industry and now with Chinese property developer Evergrande, getting customers to pay in advance is a cheap source of funding. The energy suppliers held up to 1.4 billion pounds ($1.9 billion) of excess customer cash, or around 65 pounds per household, Ofgem estimated in March, and they weren’t required to ringfence that money... Customers aren’t blameless here. Assisted by price comparison websites, they opted for the cheapest tariff, rather than prioritize the supplier’s financial resiliency. Under Britain’s “Supplier of Last resort” system, customer credit balances are protected if the provider collapses. So consumers couldn’t really lose.