You are here: Aarhus BSS Does the electricity sector risk its own “financial crisis”?

Does the electricity sector risk its own “financial crisis”?



Does the electricity sector risk its own “financial crisis”?

Electricity companies are getting larger and larger, they consolidate and expand across borders. However, is it even an option for society to let electricity companies go bankrupt if their businesses fail despite their many efforts? Or have the companies become so essential for society that they are in fact “too big to fail” as was the case with certain banks after the financial crisis?  New research from Aarhus BSS raises this question and sounds the alarm.

09.01.2019 | MICHAEL SCHRØDER

PHOTO: Colourbox/Knud Erik Christensen

So far, we have avoided any major catastrophes. But it has happened once and it can happen again. That large areas are temporarily covered in darkness due to the failure of an electricity company to deliver the power that is so essential to the functioning of society.

It happened in California in the beginning of this century where the state experienced an unfortunate combination of increasing demand, power shortages, a liberalised wholesale market and fixed retail prices. As a result, the two distribution companies  electricity in California were brought to the brink of bankruptcy as they were forced to buy electricity from suppliers in the northwestern US on the unregulated market and sell it to consumers at fixed prices. Since supplies were also uncertain due to an exceptionally cold winter in the northwestern US, several Californian citizens experienced more and more blackouts.

The state of California had to intervene and bail out the companies. In August 2001, the state of California had spent USD 10 billion on buying electricity and had sold it to the distribution companies at a fixed price of just USD 3 billion.

The companies were saved, but Californian taxpayers are still paying off the USD 7 billion bill.

Too big to fail?

“Things might have been done differently, but apparently it was never an option to let the two companies go bankrupt as this would have resulted in large scale 

disruptions of California's electricity supply,” says Professor Erik Reimer Larsen from the Department of Management at Aarhus BSS.

In the scientific journal Energy Policy, Reimer Larsen and his colleagues Ann van Ackere from the Université de Lausanne in Switzerland and Sebastian Osorio from Potsdam Institute for Climate Impact Research in Germany pose the question ”Can electricity companies be too big to fail?”: They do so in an article of the same name.

And the answer is apparently yes. Or rather: if you fail to keep a watchful eye on the electricity sector, you risk allowing the electricity companies to grow to a size that makes them essential to the functioning of society. This means that you have to keep them alive even though they are not profitable. And this is a dangerous development, says Reimer Larsen, who refers to events in the financial sector before, during and after the financial crisis.

“If running an unprofitable business doesn’t have any consequences, you’re likely to take more chances and thus risk making the situation even worse,” says Reimer Larsen.

Shrinking profits

According to Reimer Larsen, the problem is that the large electricity-generation companies are simply not making enough money to pay of the interest on the huge investments that the production of electricity requires.

In the UK, the total profit of the six largest electricity companies has been reduced by half from 2009 to 2016. Only one company has managed to increase its earnings during this period.

An obvious risk of this declining profitability is that the companies start to limit or postpone their investments in necessary maintenance in order to reduce costs. This increases the risk of sudden and unplanned blackouts caused by technical problems.

“The combination of size, not making any money and being able to take risky chances without any consequences is a dangerous cocktail. This became very evident in connection with the financial crisis. Here governments had to bail out the big banks that were on the brink of bankruptcy,” says Reimer Larsen.

Heed the warning signs

His point is that the same thing could happen in the electricity sector. He emphasises three particular signs that should make authorities and international organisations heed the warning signs.

1.      The electricity companies are generally getting larger and larger. One example is the Danish company Ørsted (formerly known as Dong), which has gone from being a regional oil company to becoming a dominant player in the national electricity market. In addition, electricity companies increasingly go from being regional or national to being international and in some cases even global. This consolidation and concentration of power may result in a situation where the failure of one or a small number of companies can create havoc in the entire sector.

2.      In many cases, it is hard to decipher who is actually regulating the electricity sector, and there is a lack of coordination between authorities. Where such regional (the US) or transnational (the EU) coordination does exist, the focus is on market access and environmental regulation, not on companies' long-term financial health.

3.      Many large electricity companies have failed to guard themselves from the rapid and large-scale introduction of subsidised renewable energy sources such as wind or solar energy. This has resulted in lower prices thus threatening the earnings of the large companies, whose electricity production is still based on nuclear power, gas or coal, and their investments in large power plants.

According to Reimer Larsen, the combination of these three elements constitutes a flashing warning sign that requires authorities to make some careful choices - with an overriding focus on safeguarding the security of supply.

“No government can quietly sit by while the lights are being turned off,” the authors state in the article.

To intervene - or not to intervene

However, regardless of which solution the authorities opt for - invention or no intervention - there are pros and cons.

If governments intervene and bail out the companies, it may result in a competitive imbalance in the market and in worst case, create a Domino effect which puts all other companies in jeopardy and in need of similar help.

If governments do not intervene, it may have even greater consequences and result in planned or random cases of blackout like those in California. This will not just lead to dissatisfaction among voters, but will also have a major derived effect on the economy. It is estimated that the cost of the California crisis was approximately USD 40 billion.

In addition, the trust in the entire sector will suffer, which would make it even more difficult to attract investors in the future.

An underlying risk of intervening is also that companies might be tempted to take risky economic chances if they - rightly or wrongly - believe that the state will intervene if things go wrong.

According to Reimer Larsen, this calls for consequences for the owners and not just for the taxpayers.

“Competent leadership is a necessity, and taking chances must have consequences,” says Reimer Larsen and points towards several Danish examples of local electricity tsars who have taken considerable chances.

Stricter monitoring

He emphasises several ways in which authorities may increase the monitoring of the electricity sector.

“First of all, it would be a good idea to increase the international regulation by taking a transnational look at the sector - e.g through the EU. In addition, the authorities should keep a close eye on the companies, their profitability and the possible pros and cons of mergers. Monitoring should be done on a long-term basis, and perhaps companies should be required to have a certain liquidity or equity capital. Or to be divided into smaller divisions. Finally, the emergence or new companies that are “too big to fail” should be prevented, says Reimer Larsen. He points to the Danish energy company Dong (now Ørsted) and the position that the company is gaining in the wind energy sector.

“It’s the same with electricity as with many other things: We don’t think about where it comes from and how. At least not until it’s not there. Then we think about it,” concludes Reimer Larsen.

PHOTO: Colourbox

Can Ørsted become too big to fail?

The largest developer of offshore wind farms is the Danish energy company Ørsted (formerly known as Dong), which has a global market share of 16 per cent followed by the German company E.ON with 9 per cent. In this rapidly growing market, Ørsted expects to double its capacity between 2016 and 2020. 

A market share of 16 per cent might seem like an acceptable level of market concentration. However, according to the researchers, you need to take into account the risk that comes with one company being dominant in a technology that is becoming increasingly important.

Offshore wind energy is on its way to becoming the most important source of renewable energy in Denmark. Today, Ørsted has a 50 per cent share (2015) of the total offshore wind energy in Denmark, but this still only constitutes a small part of the total Danish electricity production. Thus, this market share is not regarded as a problem.

However, when Ørsted is allowed to gain such a large market share in a rapidly growing industry such as wind energy, the situation may soon change: Ørsted can suddenly become a so-called "system-critical" institution*.

  In the future, the company’s profitability, which is currently ensured due to generous subsidies, can come under pressure as this state subsidy is increasingly being abolished.

*Term used since the financial crisis particularly to describe some of the major banks.