competition and entry in the gb electricity retail market.pdf - Frontier ...

January 2011 | Frontier Economics 17
therefore be exposed to the risk of price volatility over time and will therefore
have to allocate scarce capital to cover this risk, with an associated cost.
It is therefore likely that the levels of liquidity seen in the GB market will
constitute an entry barrier to non-vertically integrated new entrants, particularly
those who may be capital constrained (e.g. smaller participants). However, as we
discuss in Chapter 3 below, Ofgem’s latest update on liquidity 21 shows that there
are positive signs that liquidity may be increasing in the areas that are important
to small suppliers.
2.2.2 Credit risk
Any party selling a commodity will wish to understand the creditworthiness of
their counterparty to manage their risk in the event of a default. To manage this
risk, purchasers may be required to post some form of collateral. Equally, the
terms on which sales are made may vary according to the creditworthiness of the
purchaser, with less creditworthy counterparties being charged a premium to
reflect credit risk. This is a sensible and efficient response to dealing with the risk
of default. 22
Further, to cover the potential liabilities of the market as a whole arising from a
party who is unable to settle their imbalance liabilities, market participants are
required to post further collateral under the Balancing & Settlement Code. The
level of collateral is linked to their estimated imbalance exposure over time (i.e. a
function of forecast consumption and notified net purchase contracts).
Requirements for collateral may represent a barrier to entry in two ways:
if the amount of collateral or the price premium is above that which
would be found in a highly competitive market (relevant only for
bilateral contracts), it will reduce expected margins; and
even if the level of collateral were that which could be expected in a
competitive market, credit risk arrangements may make it difficult for
poorly capitalised players to enter the market.
While posting collateral has a cost for any potential entrant, it is most likely to be
a material barrier for smaller, less well capitalised players that do not have a credit
rating.
21 “Liquidity in the GB power market: Update”, Ofgem (3 December 2010).
22 It is energy customers that ultimately pick up the costs associated with default, so it is correct that
the market is designed in a way that minimises such risks.
Barriers to entry