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R.I.P. Belgian energy sector?

By Benedict De Meulemeester

By Benedict De Meulemeester on 7/03/2012

Friday morning we woke up with an announcement that looked good at first sight. The Belgian government is pushing ahread with its plans (view our blog of 17/1) and freezes the energy prices. Important: this is only for residential consumers, not for companies (view * at the end of this blog). Apparently every adaptation of a variable price component in a residential energy contract will be forbidden. Shortly afterwards, I had someone on the phone working for the pricing department of a Belgian energy supplier. He confirmed my worst fears: this is a catastrophe for anyone in this country supplying gas or electricity. On top of this, the government has also decided that a residential consumer can cancel his/her contract at any point to sign a new one. As with the commentary of team managers after a footbal game, you have to be careful with such first reactions to such drastic changes in policy. But even after a weekend this still looks like an insane policy that might destroy the fragile Belgian energy market.

 The layman will think this is a great decision. Those devils-in-suits of the energy companies can no longer enrich themselves at the expense of Joe Sixpack. But if you are a little bit familiar with how energy companies operate, you will understand that ‘freezing energy prices’ isn’t something you can just do. In Belgium almost all alternative suppliers, the newcomers, buy their energy in a wholesale market. Prices in that market move up and down according to laws of supply and demand that the suppliers cannot influence. Compare this to the vegetable store around the corner. If the price of tomatoes on the wholesale auction markets goes up, the store can only adapt the price labels and apply the higher price. If the government would say, “no, the vegetable store cannot raise the tomato price as of now”, than this is good news for the consumer in the (very) short term. But in the not even so long term this would mean that many small vegetable stores will go broke and the competition will dissapear. There are two possibilities. Either we will have to line up for the rare tomatoes in the market like we know from communist countries (specialists in ordering prices top-down). Or the government will have to admit its mistake and the consumer will face a sudden rise in tomato prices.

 What will happen now to energy suppliers?

 Regarding freezing variable energy contracts, for example a gas contracts linked to the currently rising oil price. The supplier has a contract with a wholesale trader in which the price is linked in a similar way to the evolution of the market (oil in this case). If oil prices run up in the coming months, the suppliers will face rising costs without the possibility of raising their revenue. Consequence: losses. This opens an important legal question. In Belgium we have a law that forbids companies to sell with losses. Doesn’t the application of this freezing of energy prices mean that the government obliges energy companies to defect from this law?

 Energy suppliers can hedge away the problem of course. Hedging is a difficult word of course, but it comes down to the buying of oil futures to compensate for the losses on a frozen gas price. However, companies can never compensate 100%, the suppliers with whom I’ve spoken so far fear large losses. Moreover, if oil prices would fall again (do I have to remind that we are at an all-time high?), the government will obviously demand that gas prices fall along. The specialists know that this can be solved by selling back the hedges, but again, there will be timing and volume losses.

 The decision to give clients the possibility of cancelling contracts with immediate effect whenever they have found a lower price somewhere else, is even more disastrous. The fixed power price offered by a supplier, for example, is based on the price level of the underlying wholesale market (www.apxendex.com).  The lower fixed prices that we were offered in 2008 – 2009 for example, had nothing to do with energy companies slashing their margins. It was purely a consequence of the halving of the wholesale price for electricity in the wake of the financial crisis.

 To offer a fixed price, suppliers need to hedge. They will buy futures contracts. If the market falls, and clients cancel their contracts, suppliers are stuck with the expensive futures, the losses are totally on their account. In the energy market it is actually quite simple: fixed price – fixed term. If the term is not fixed, the supplier will need to incorporate a large risk premium to cover possible losses on the underlying futures transactions.

 Risk premiums, there we have it. Losses on the hedging of variable prices when the government decides to fix or unfix them. Losses on futures when clients cancel contracts. Energy suppliers have only one possible solution for these losses, and that is raising their tariffs by incorporating risk premiums. Meaning that you will get the same effect as when you freeze the price of tomatoes in vegetable stores. In the short term a large majority of Belgians will win money.  With the delayed averages in oil-indexed gas prices and the recent rise in oil prices, we are heading for an increase of the gas price. Thanks to the government the majority of Belgians that still buy oil-indexed gas (since they never took the trouble of looking at alternatives), will be saved from this certain price rise.  However, as soon as their current contracts end, the average Belgian will pay the bill. If there is an energy market left by then, it will be much more expensive.

 If there is an energy market left. Hence the irony. Politicians are always eager to blame GdF-Suez for all that goes wrong in the Belgian energy market. Well, the Belgian company that will suffer least from this measure will be that vilefied ex-Electrabel, now GdF-Suez. The profits that they make on the production of power will compensate the losses of retail sales. Just think about the example of the vegetable stores. If a big store sells tomatoes that it grows itself, it obviously has the best chances of surviving the retail price freeze. This measure will primarily affect the smaller suppliers, the ones that did all they can to organize some competition in the tough Belgian market. The smaller a supplier is, the larger the chance that he will not survive this price freeze.  The bit of competition that we had in our market, threatens to be wiped off the board by this measure.

 This government decision is based on a study by the Creg that concludes that prices in Belgium are more expensive than those in the surrounding countries. They come to this conclusion based on the analysis of one tariff out of the dozens offered in the market. An Electrabel tariff of which everyone in the sector knows that it isn’t the best, to the contrary. I made the V-test and rapidly found a power tariff that is more than 200 euros per year cheaper. If you read something like this, you wonder ‘Has the policy been adapted because of the study, or has the study been conducted because the governent wanted to change the policy’? But OK, if the government pushes ahead with this measure, the conclusion that Belgium has higher energy prices than surrounding countries will soon become truth.

 You start to ask yourself: ‘why don’t the people in those cabinets understand this’? They have academic degrees, some of them even in economics? They must understand that interfering in pricing in an open market is very dangerous? Well, I fear that they do understand this. I fear that this is a purely political decision, against all knowledge of what will happen. It is remarkable that minister Johan Vandelanotte of the Socialist Party is pushing this price freeze. The socialists in the government want to avoid that the automatic indexation of wages in Belgium is discussed, the automatic increase of salaries when inflation rises. Even a temporary suspension of indexation is taboo for red Belgium. If the index rises strongly, the socialists will have trouble holding on this. And what is the main reason for strong inflation in Belgium? The volatility of energy prices indeed. Freezing the energy prices looks like a desperate measure to calm down inflation. The collateral damage of this measure is the destruction of competition in the energy markets. Problems that are to be treated later, I guess?

 * Companies are not affeted by this measures. This means that they will not get the short term benefits. However, if the Belgian energy retail market collapses, this will have ramifications for the market of large consumers. In short: without advantages in the short term there are potentially large disadvantages in the long term.

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