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7 September 2022

Is this the energy industry’s “Lehman moment”?

Energy suppliers and banks are in a pinch that looks a lot like 2008.

By Will Dunn

What is a “Lehman moment”? Generally speaking it’s the point at which one company’s disaster becomes everyone else’s problem, as happened in September 2008 when the losses Lehman Brothers had made by betting on America’s subprime mortgage market became insupportable. The investment bank filed for the biggest bankruptcy in corporate history, and panic spread like a disease through the global financial system.

The term has been applied in recent years to the car industry, the Chinese property sector and cryptocurrencies, and it’s not always apposite. In the case of the energy sector, however, there are disturbing parallels. The companies that generate and sell power in the UK and Europe – including Centrica, the UK’s biggest domestic energy provider – are suddenly scrambling for cash in a situation Finland’s minister for economic affairs described on Sunday as having “the ingredients for a Lehman Brothers of [the] energy industry”.

This is happening for reasons that may sound familiar: financial derivatives have been used to do something that looked very clever until, suddenly, it wasn’t. As with the 2008 crisis, the problem is rooted in some expensive bets on the future of a market and, as then, it is beginning to look as if the fallout will be everyone’s problem.

But wait a minute: why, at a time when energy prices are through the roof and companies are reporting record profits, would the energy industry want any more money?

“They don’t have a solvency problem, they have a liquidity problem,” says John Kemp, a senior energy market analyst at Reuters. Kemp explains that when traders, wholesalers and retailers in the energy market buy gas or electricity, they also buy financial instruments that help to take the risk out of changing prices.

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It works like this. Imagine you’re a greengrocer. You buy apples at wholesale prices and sell them for a bit more. Then, a local school says it would like you to deliver five boxes of apples a week for the next year, at an agreed price. Great, you have guaranteed income, but what if the price of apples rises? You’ll still have to deliver them to the school, and the price is locked in; you won’t make as much money. You might even make a loss. While you’re thinking about this problem, you wander into the betting shop. Oops – gambling is no way to secure your future income. Or… is it? What if you made a bet that the price of apples would rise? That way, if it does, you’ll make less profit on the apples you’re selling to the school but your winnings at the bookies will cover the difference. If the price of apples falls, you lose the bet but the price of doing so is covered by your higher profits. You’ve now hedged the risk out of supplying apples.

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Energy companies can insure themselves against uncertainty in a similar way, by taking short positions (bets against prices rising) on energy. However, two problems have emerged. First, the price of gas is now so high and volatile that these positions have become very expensive to take. Second, while customers might pay up in a few months’ time, the financial markets on which these positions are taken expect to be paid daily.

What this means is that companies which could wait three months to a year to be paid for energy they’ve supplied (at very high prices) are being asked by banks to cover their hedging losses (which are correspondingly high) right now.

In normal times, Kemp says, banks will “carry that loss for you. [They] will charge you interest – it’s like an overdraft. But if your losses continue to mount there’s going to come a point where the bank is not really that comfortable about continuing to increase your credit facility. They want you to actually put some more simple, cold, hard cash into the account.” It’s for this reason that Centrica, despite reporting a fivefold increase in operating profit for the first half of this year, is now reported to be asking banks for billions in extra credit to give it the liquidity it needs.

In 2008 Lehman had made extravagant bets on the durability of the American housing boom; it got into trouble when homeowners began posting their keys through the letterbox and walking away. The big problem for energy companies today is that they are also exposed to defaults: if hundreds of thousands of small businesses and domestic customers can’t (or won’t) pay their bills, the money that was supposed to cover the energy companies’ hedging losses might never turn up.

“How many households,” Kemp asks, “will simply prove unable to pay their bills?” If a sufficient mass of unpaid bills is allowed to build up, “that will trigger a series of defaults through the system, and ultimately that raises the question about do certain suppliers or generators fail – and if that becomes the case, who absorbs the losses? We’ve reached the point where a lot of the banks are saying ‘we really don’t want to do that; we want to pass that risk on to governments’.”

Even bigger than the risk of domestic energy defaults, Kemp says, is the risk from the UK’s 5.6 million small and medium-sized businesses, which have high energy use and face uncapped price rises of five times or more; one recent survey suggested 70 per cent of the country’s pubs could be unable to pay their bills. While domestic customers could have their payments spread or be moved to prepayment meters, businesses can become insolvent, “and then the debt becomes effectively irrecoverable”.

What this means is that whatever your position on the political merit of “handouts”, as Liz Truss described cost-of-living assistance last month, action to help those most at risk of default (people on lower incomes and small businesses) is essential to reduce the chances of, to use another phrase familiar from 2008, a “credit crunch” in the energy market. To fail to do so would be to introduce an even greater systemic risk.

[See also: The pound has fallen to a 37-year low against the dollar]