Increased electricity and gas prices are causing trouble for companies and driving up inflation
The European electricity market remains in turmoil, but the record prices are not only keeping consumers on tenterhooks. Dr. Volker Schmidt, Senior Portfolio Manager at Ethenea Independent Investors S.A., analyses the corporate bond market and its mechanisms using two European companies as examples – Uniper from Germany and EDF from France.
At the beginning of the year, the German power utility Uniper had just secured EUR 10 billion in additional credit lines to meet due and future margin payments (provision of collateral). Margin payments are more familiar from hedge funds and banks, and are associated with speculation. “But speculation and hedging are also commonplace in electricity trading,” says Schmidt.
Uniper is an electricity producer that primarily sells its electricity to wholesalers. In order to hedge against fluctuations in the market price, and to have a reliable basis for calculation, Uniper uses forward contracts and, in this way, already secures the sales price for future electricity production today. “However, the dramatic increase in electricity prices means that Uniper would have been able to achieve much higher prices without these forward contracts. At the same time, the value of the hedges has become very negative and Uniper’s counterparties can now demand collateral from Uniper in order to be hedged in the event of the company defaulting. In fact, Uniper’s loss on the hedge is the counterparty’s gain,” explains Dr. Volker Schmidt.
Although the losses on the hedge would be partially offset by higher revenue when the electricity is sold by the buyers, it is not very reassuring that a company suddenly needs EUR 10 billion in additional collateral. “The major risk for Uniper at the moment is that its customers will default and ultimately be unable to pay the high electricity costs,” says Schmidt.
Credit rating downgrade
According to Dr. Volker Schmidt, the problem is different for EDF. “The French government has decided to cap EDF’s sales prices, due to high inflation and increasing energy prices. Therefore, EDF expects a reduction in its EBITDA (earnings before interest, taxes, depreciation and amortisation) for 2022 of around EUR 10 billion.”
The three major rating agencies have either threatened or have even already implemented a credit rating downgrade, says the Portfolio Manager. “Lower ratings mean higher refinancing costs, a lower investment capacity, and ultimately higher electricity prices. As this situation is no longer viable, we also expect the French state, which is not only the majority shareholder of EDF with 80% but also caused EDF’s difficulties by intervening in the market to fight inflation, to cushion the measures.
“The Russian invasion of Ukraine has caused energy and electricity costs in Europe to explode once more, as Russia is an important supplier of oil, gas, and coal. In addition, the sanctions make doing business with Russia even more difficult and the number of companies that are voluntarily refraining from doing business with the country is also increasing,” says Volker Schmidt. The most recent announcements about a halt to Russian gas deliveries suggest that the end of the price increases is still a long way off. The example of Uniper illustrates once more how difficult the current situation is. “The majority owner of Uniper, the Finnish Fortum, is also an important electricity producer in Russia, but many companies are now no longer allowed to trade with Russia and Russian companies,” the expert reports.
Bankruptcies
Apart from these and other prominent examples, some smaller market participants have already gone out of business, he says. “Many low-cost electricity suppliers in Germany and England, but also in other countries, have either stopped supplying their customers or have gone bankrupt. They were not able to cushion the higher prices of the electricity producers,” Schmidt reports.
This demonstrates the need for caution in the utility sector, which has long been considered relatively stable. It is therefore advisable for investors to check very carefully whether the company is an electricity producer, a network operator or a wholesaler that ultimately sells the electricity to end consumers. In some cases, companies are active in two of the areas mentioned. The network operators, which are often state-owned, are in the most comfortable situation. They receive a fixed transmission fee from the state for the expansion, modernisation, and operation of the networks. As a monopoly, they do not have to fear competition and only need to make sure that they collect their fees from their customers in a timely manner.
Schmidt puts into perspective the assumption that, in view of the current high electricity prices, electricity producers should also be in a comfortable position: “The last few months have shown that the situation is not easy for them either. Unexpected effects from hedging transactions and government intervention are causing uncertainty. In addition, Russia’s increasing isolation is having an impact on their day-to-day business, because the number of counterparties in Russia with whom they still want - or are allowed - to do business has drastically reduced.”
As a result, gas and coal-fired electricity producers are facing significant price increases for raw materials. On the other hand, renewable energy producers depend on sufficient water levels and wind strength, which have also become more uncertain due to climate change, he says. “For the wholesalers who do business directly with end customers, the market is just starting to settle down. The smaller companies that have defaulted so far were not present in the bond markets,” the Portfolio Manager says.
Safe haven investments
“Central banks are faced with the dilemma of inflation rising faster than expected due to energy costs, which will not only be reflected at the petrol pumps but also in all areas of life in the medium term, due to the increase in the cost of supply chains. Energy costs will be hard to fight with interest rate hikes, even though it is the mandate of central banks to prevent inflation from getting out of hand,” says the bond expert.
Ethenea expects that the Federal Reserve will definitely raise its Fed funds rate several times this year and that the ECB may follow suit towards the end of the year. The development of long-term interest rates is unclear. “On the one hand, inflation should ensure rising yields, on the other hand, sovereign bonds are currently in particularly high demand as a safe haven in light of the war in Ukraine. And recently even recession fears have emerged. Here, too, we remain cautious and are keeping the duration in our bond portfolios low. At Ethenea, we remain cautious and very selective in our bond investments, particularly in the utilities sector,” says Schmidt.
