Defaults and “failing” Parties 31 October 2006

Any views expressed in the Paper are the views and conclusions of the author and shall not be attributed to the author’s employer or any body or person who may be referred to in the Paper whether expressly or by implication.

2

WHERE ELEXON FITS INOffice of Gas &

Electricity Marketing Authority (Ofgem)

The Regulator

ELEXONThe Balancing &

Settlement Company

National GridThe System Operator

Electricity Industry(e.g generators, suppliers)

Consumers(e.g. domestic, industry)

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ROLE OF ELEXON

• ELEXON administers the wholesale electricity balancing and settlement arrangements in Great Britain.

• This mainly affects:-– Great Britain’s electricity users (c. 28 million

customers)– The industry electricity companies that

generate (i.e. produce) and supply electricity.

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ROLE OF ELEXON (cont.)

• As part of its role:– ELEXON manages and enforces the

Balancing & Settlement Code.– ELEXON runs the day to day

settlement of wholesale electricity balance and imbalance.

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– ELEXON’s systems capture data on electricity generated and supplied in Britain.

– ELEXON manages the process for modifying the Code. Modifications can be raised by industry Parties.

ROLE OF ELEXON (cont.)

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– ELEXON manages and advises Code bodies e.g. BSC Panel, Trading Disputes Committee and Performance Assurance Board.

– ELEXON manages the “assurance processes” which ensures that Parties are complying with performance standards set out in Code.

– As part of assurance, Parties are (for e.g):-• Audited• Given guidance• Issues are escalated to Performance Assurance Board.

– Assurance is important to ensure the accuracy of settlement and for the protection of customers and competition.

ROLE OF ELEXON (cont.)

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HOW DOES THE BALANCING AND SETTLEMENT PROCESS WORK?

– Generators “notify” ELEXON’s systems of how much electricity they will produce in each half hour and suppliers “notify” how much electricity they will “take”.

– Any difference (whether more or less) between how much a generator or a supplier has notified are dealt with through ELEXON’s systems.

– Similarly if a Party does not notify but produces or “takes” electricity, the “imbalance” will be dealt with through ELEXON’s systems.

– The prices for imbalance are calculated in accordance with a formula set out in the Code, but are basically the consequence of the market price.

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GENERAL SITUATION – THE FACTS

• Since October 2003 energy prices have risen rapidly. • Ofgem estimates that over winter 2004/5 consumers paid £5.2

billion more for gas and electricity than they had the previous year.

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GENERAL SITUATION – THE REASONS

• There has been an unprecedented increase in the wholesale price of gas paid by UK suppliers.

• Gas is used to produce 40% of UK electricity, and so the price of electricity has also rocketed.

• A number of reasons have been put forward for the rise in wholesale price of gas. For e.g:-– gas supplies from the North Sea have declined faster than

expected, although there are still significant reserves.– There is a greater reliance on imports.– the price of oil has soared in recent years and, with the price of

gas in Continental Europe still linked to oil, this has had a knock-on effect on the price of gas in the UK.

– imported storage capacity in the UK has been said to be inadequate and not able to offset declining North Sea production.

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GENERAL SITUATION – INCREASE IN PRICES

For Example• Chemicals Industry – Consumes c. 22% of the energy

used by UK manufacturing industry. Sector has experienced price rises of c. 70% for gas and 60% for electricity over the last c. 2 years.

• Construction Products – gas bills rise by up to 80% and electricity bills rise by up to 60% over the last c. 2 years.

• Retailers – average rise of 40-50% over the last 12 months.

• Domestic users – gas bills increased by 38% and electricity by 30% since October 2003.

Figures from Energywatch

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GENERAL SITUATION – However…

Ofgem has stated that:-• Despite rising prices, domestic bills are

still among the most competitive in Europe.

• Business customers – while now facing higher energy prices, most will have paid less for energy over the past 14 years than European counterparts.

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GENERAL SITUATION - COMPETITION

The position of Ofgem:

• Effective Competition in both wholesale and retail markets is important to protect the interests of consumers – Ofgem’s Corporate Strategy and Plan 2006-2011.

• Competitive markets will, over time, provide more, innovation, better services and lower prices than prescriptive regulation – Ofgem’s Corporate Strategy and Plan 2006-2011.

• Ofgem is working with the European Commission, other national regulators and competition authorities to promote full and effective liberalisation of European energy markets.

• Ofgem’s approach is that security of supply is maintained by promoting effective competition in wholesale and retail energy markets, and by network monopolies having the right incentives to invest.

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GENERAL SITUATION - COMPETITION• The Department for Trade and Industry has a target to

“Ensure that the UK ranks in the top 3 most competitive energy markets in the EU and G7 in each year”.

• Energywatch has stated that the UK Government, Regulators and the European Commission must ensure that the wholesale gas market is open, competitive and transparent.

• Energywatch is concerned that fundamental characteristics of the UK and wider European markets inflict artificially high prices on UK customers. Energywatch wants more competitive wholesale gas markets.

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UK ENERGY CONSUMPTION

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UK ENERGY CONSUMPTIONSector Electricity use, GWh

(2004)Percentage

Industry 117,149 34.45%

Transport 8,034 2.36%

Domestic 115,526 33.97%

Public Administration

20,924 6.15%

Commercial 74,215 21.83%

Agricultural 4,194 1.23%

Total 340,043 100%Source: Digest of UK Energy Statistics 2005

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GAS DIVERSITY

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ELECTRICITY DIVERSITY

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ELECTRICITY – SYSTEM RELIABILITY

• Britain has one of the most reliable energy supplies in the world.• Last year, the electricity transmission network was 99.9997 per

cent reliable. • Power cuts on the local electricity networks have fallen 16 per cent

since 2002.

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IN DIFFICULT TRADING TIMES – PARTY MAY SUFFER FINANCIAL DIFFICULTY

• It may not be able to pay the Trading Charges etc it owes to ELEXON.

• It may not be able to “take” or produce the electricity it has “notified” – thereby incurring further imbalance Trading Charges.

• Parties have c. 29 days to pay Trading Charges after the date the Charge is incurred.

• It takes this long to establish the quantities of energy produced or “taken” and thus to determine the Trading Charges due for the relevant day.

• Accordingly at each point in time a Party may have debts which it has incurred over the previous 29 days.

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HOW DOES THE CODE PROTECT INDUSTRY AGAINST PARTY FINANCIAL FAILURE

• The Code does not give complete protection to Parties.

• It reflects a balance between protection against risk and the need for business and operational flexibility.

• PROTECTION GIVEN by the Code includes:-– “Credit Cover” – Trading Parties must lodge cash or

letters of credit with ELEXON.– Ability of BSC Panel to take steps against a “failing”

Party.

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CREDIT COVER• Credit Cover is calculated using a complex formula based on

the relevant Party’s pattern of trading.• The formula tries to ensure that a Party does not over the 29

days accumulate debt in excess of its Credit Cover.• Credit Cover is monitored on a 24 hour basis.• If a Party accumulates debt in excess of its Credit Cover, it

will be in Credit Cover default.• Parties are given a short period to remedy Credit Cover

default. If they do not, industry is informed of the Credit Cover default.

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MAIN TYPES OF MONETARY DEFAULT UNDER THE CODE

• Credit Cover default.

• Failure to pay Trading Charges on date required by the Code.

• Failure to pay ELEXON charges for administering the Code on date required by the Code.

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WHAT HAPPENS IF A PARTY IS IN DEFAULT

Credit Default• ELEXON informs all Parties that a Party is in Credit Cover default.• Party’s “notifications” are rejected if they would increase the Party’s debt.• If a Party is in Credit Cover default for a specified period or repeatedly

goes into Credit Cover default ELEXON convenes BSC Panel which considers the action to be taken.

Payment Default• If a Party is in payment default, ELEXON convenes BSC Panel to consider

action. • ELEXON may use the Credit Cover which has been lodged. N.B The Credit

Cover may not be sufficient to pay out the whole of the debt.Insolvency• If a Party is insolvent, ELEXON convenes BSC Panel to consider action.

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MAIN ACTION PANEL CAN TAKE• Notify all other Parties.• Suspend the Party’s right to submit notifications

and dis-apply notifications already submitted.• With Ofgem’s prior approval, suspend the

Party’s right to register further metering systems (i.e. take on more customers).

• With Ofgem’s prior approval, require apparatus to be “de-energised” (i.e. disconnect customers).

• Expel the Defaulting Party from the Code (i.e. effectively stop a Party trading legally).

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EFFECT OF PANEL ACTION

• In most cases (particularly where the Defaulting Party is a generator producing electricity) these measures will be enough to stop the situation getting worse (i.e. stop further debt being incurred).

• The steps will (in most cases) stop a Trading Party continuing to trade or continuing to trade in a way which will incur or increase debt under the Code.

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DIFFICULTY

• However, a difficulty may arise if a Supplier keeps trading despite being unable to pay its Trading Charges and/or despite being legally insolvent.

• While the Panel, with Ofgem’s prior approval, can order the de-energisation of the apparatus (i.e. disconnect customers), this approval is unlikely to be given.

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SOLUTION • Step 1 – Ofgem revokes the Supplier’s licence – it can no

longer lawfully trade.• Step 2 – Ofgem appoints a “replacement Supplier” to take

over the “failing Supplier’s” customers.• Step 3 – ELEXON operates the process whereby the

“replacement Supplier” takes over the customers.• However, it make take a while (sometimes days) before

Ofgem is entitled to revoke the licence.• In the meantime the Supplier continues to trade, thereby

incurring Trading Charges which it cannot pay and probably does not have sufficient Credit Cover in place to cover.

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WHAT HAPPENS TO UNPAID TRADING & OTHER CHARGES?

• They are “smeared” across the other Parties.• Parties pay in proportion to their trading volumes

over the relevant period.• Parties to date have been satisfied to take the

risk of Party failure and balance it against the flexible arrangements of the Code in relation to Credit Cover etc.

• Parties to date accept the risk that the Code (and Credit Cover) does not provide complete protection.