Both European and Swiss energy companies have made many headlines and sparked many political discussions over the past few quarters. The energy market is experiencing difficult conditions, with price levels and price fluctuations such as have never been seen before. After years of relatively low electricity prices and even falling demand at the beginning of the corona pandemic, prices on the European electricity and energy markets skyrocketed at the end of summer 2022.

Companies whose supply contracts have recently expired and which now have to procure energy at very short notice are suffering from costs that in some cases are many times higher than they were used to. On the other hand, companies which fixed the price of their electricity requirements based on a longer-term contract are being spared the turbulence for the time being.

If energy and electricity companies want to enable their customers to benefit from these kinds of medium-term price guarantees, they must in turn hedge against rising prices on the international futures markets. The price fluctuations (especially the price increases) on the futures markets must be balanced out by the energy companies, e.g. by using security deposits in the form of liquidity. The recent market turmoil, which could not reasonably have been predicted, is now putting a massive strain on the liquidity of energy companies in some cases, and is pushing their creditworthiness to the limits.

Guaranteeing the power supply

In Europe and Switzerland, governments are propping up energy companies with the declared aim of preventing a wave of insolvencies in the industry so as not to jeopardise the electricity supply. Specifically, the funds provided for the electricity supply industry by the Federal Council and the Swiss Parliament are to be regarded as a temporary credit guarantee. Nevertheless, these measures are understandably triggering controversy around the market positioning and risk management responsibilities of the companies in question. 

Even industry, which has been able to rely on relatively stable energy prices in recent years, is facing challenging times. It can be deduced from the current market situation that the cost of procuring electricity may become significantly more expensive in the next few years. Companies with larger energy requirements should review their procurement strategy or define a procurement strategy if they have not yet done so. In addition, energy price scenarios should be more closely integrated into the calculation of production margins.

Components and peculiarities of the electricity market

In Europe and Switzerland, governments are propping up energy companies with the declared aim of preventing a wave of insolvencies in the industry so as not to jeopardise the electricity supply. Specifically, the funds provided for the electricity supply industry by the Federal Council and the Swiss Parliament are to be regarded as a temporary credit guarantee. Nevertheless, these measures are understandably triggering controversy around the market positioning and risk management responsibilities of the companies in question. 

Even industry, which has been able to rely on relatively stable energy prices in recent years, is facing challenging times. It can be deduced from the current market situation that the cost of procuring electricity may become significantly more expensive in the next few years. Companies with larger energy requirements should review their procurement strategy or define a procurement strategy if they have not yet done so. In addition, energy price scenarios should be more closely integrated into the calculation of production margins.

Production 

Electricity can be generated in many ways. The main components in the European electricity mix are production from hydropower (flowing water and pumped storage plants), wind and solar energy, geothermal energy, nuclear energy and coal or gas combustion, the latter of which is sometimes also coupled with heat production. The different production plants each have specific characteristics in terms of primary energy, technical complexity and location, which ultimately determines the individual production costs. Electricity production in Europe is sensibly diversified in terms of different types of generation, both through regular production from run-of-river power plants or nuclear generation as well as flexible power plants such as gas-fired plants. In recent years, a shift away from fossil fuels as a primary energy source towards renewable energy has been promoted (Figure 1).

_{Figure 1: Electricity production in Europe (share of different energy types in percent)  (Source: Ember, Agora Energiewende )}

Consumption

While industry was responsible for 30 percent of total electricity consumption in Switzerland in 2021, the share accounted for by households was 35 percent and by service companies 26 percent. Transport consumes a good 8 per cent of Switzerland’s electricity. The Federal Government’s Energy Strategy 2050 envisages a significant reduction in per-capita energy consumption as well as overall electricity consumption, whereby the general substitution of fossil energy sources with renewable energies has the effect of increasing demand for electricity (e.g. electromobility). In Europe, a massive increase in demand for electricity is expected by 2050 (Figure 2).

_{Figure 2: Electricity demand in Europe will more than double by 2050, with wind energy meeting half of the demand (Source: WindEurope)}

Transport 

The production and consumption of electricity are neither spatially nor temporally synchronised. The electricity grid infrastructure connects the places where electricity is generated and consumed. In economic terms, the European electricity market can be regarded as a “coupled copper plate". Electricity prices are often the same from one country to the next, with price differences between countries essentially being determined by the costs of the transmission grids. This mechanism forms the basis for pricing on the wholesale marketplaces. 

Ultimately, however, it is the delivery that makes the difference. Electricity must be available in the right quantity at the right place and at the right time – always. Making sure that the generation and consumption of electricity match is an extremely dynamic process. Transmission network agencies coordinate this grid stability and can influence the generation capacity of local electricity production at short notice. Ensuring grid stability, which is ultimately determined not by economic properties but by physical properties, is an important task of the electricity companies that have access to or facilitate flexible production.  

However, the increasing complexity of the grid also opens up opportunities for industry if it can dynamically adjust its consumption. Although this flexibility has often not been exploited in the past, structured consumption can make a substantial contribution to reducing production costs during times of high energy costs such as we are seeing now. 

Storage

Oil or gas-based energy is typically stored in tanks for future consumption, but electricity is different. Storing electricity is subject to physical and technical limitations. Hydrological storage makes a substantial contribution. The Alpine and Nordic countries are considered perfect for this because of their geography, which makes it possible to build water reservoirs with the associated pumping stations and generators. Storage capacities are diversified, and short-term and long-term storage can compensate for seasonal fluctuations in generation and consumption.  

Trade

Trade markets are an indispensable part of the ecosystem. These platforms allow producers and consumers to set prices transparently. This pricing is also made possible by market participants who primarily hedge the financial market price risk, such as investment banks or hedge funds. Therefore, it is also extremely important for the purely physical market participants, meaning both producers and consumers, to correctly assess the dynamics of the market.

Generation costs vs. market price – here and now

The cost of generating electricity varies depending on the technology; run-of-river power plants produce electricity at relatively low cost whereas gas-fired power plants are cost-intensive. Nevertheless, it makes sense for different technologies to be provided to generate electricity. The different types of technology offer different levels of availability, which is essential for stabilising the transmission grid at short notice. 

As a result, the electricity market is supplied in such a way that a bid price for generation and consumption is determined for each hour in a spot auction. This pricing process follows an established procedure. "Merit order auctions" are used to define a uniform market price irrespective of generation costs.

Therefore, it makes economic sense but above all physical sense to invest in flexible and somewhat expensive power plants to ensure that grid stability is maintained. The loss of significant production volumes from run-of-river or nuclear production also explains why gas-fired power plants are currently often the production technology which determines the price in the “merit order”. Accordingly, high gas prices are partly responsible for the rise in electricity prices.  

Generation costs vs. market price – the futures market ensures calculability

Entering into forward contracts allows producers and consumers to fix prices now to purchase and sell electricity that will not be delivered until some point in the future. Because production and consumption must always be in harmony, the electricity market also has a structured forward price curve. This correlates with daily, weekly and seasonal demand. In principle this structure is easy to predict, but it also comes with market uncertainty. For example, the supply of wind, solar or hydro energy is influenced by the weather. This can lead to periods of increased volatility or even price spikes. 

_{Figure 3: Historical price development for the reference price Germany with annual delivery 2023 (Source: EEX)} 

As part of a responsible risk management system, energy companies use various hedging instruments to stabilise electricity prices or hedge their future earnings. These hedging contracts enable price risks to be managed and future profit margins to be secured. However, using these derivatives also comes with considerable challenges. Unrealised losses on listed hedging transactions must be backed by collateral (usually in the form of cash deposits).

A simple example: an electricity producer with a single plant has production costs of CHF 100 per MW/h. On the electricity exchange, the company sells future electricity production for CHF 200 per MW/h and has therefore fixed a gross margin of CHF 100 per MW/h. If the market price subsequently rises to CHF 600 per MW/h, the company must deposit the unrealised loss on the hedge of CHF 400 per MW/h as collateral. Even though the company is profitable from a business point of view with its gross margin, the high market prices lead to a temporarily heavy burden – to the point of being an overload – on the liquidity reserve of the electricity producer. This means that large price fluctuations require strong liquidity and capital management.   

Accounting aspects

From an accounting perspective, market turbulence also leads to major challenges. The strong increase in market prices leads to an rise in the economic value of the electricity production plants. In accounting, however, these assets are not valued at market value but at historical acquisition cost minus the necessary operating depreciation. On the other hand, hedging transactions on the energy exchange must be accounted for at market value. The market value of these transactions is negative when prices rise (see example above), and leads to a reported loss in the financial statements. Accordingly, although the electricity producer has a very profitable company from a medium-term perspective, in the short term it has to report losses in its annual accounts.

This “accounting mismatch” can best be (partially) eliminated by applying hedge accounting. Whether this is possible, and to what extent, depends largely on the structure of the hedging transactions and which accounting standard is applied. In principle, hedge accounting can be applied under the Swiss Code of Obligations, Swiss GAAP FER and IFRS. Under IFRS, hedge accounting leads to the elimination of volatility in the income statement. However, the effect remains visible in equity. Accordingly, this is of limited help for companies that have to comply with equity covenants. In certain cases, however, Swiss GAAP FER and OR allow for negative effects to be completely eliminated in the income statement and in equity.