Twenty-two years ago this month, the collapse of Enron sent shockwaves across various segments of the global financial industry. The accounting scandal which saw Enron, an energy trading company, collapse and thus default on its book of energy market trades left those on the other side of the trade with significant credit risk. This was the first domino to fall that led to centralised clearing for US energy markets, as market participants sought the safety net offered by clearing houses. What we see now is an US energy market whereby most of the trading in derivatives involves cleared futures on an exchange.
Across the pond in Europe and we have a completely different picture altogether. With a seismic event, in the form of an Eastern European war, hitting the energy markets so drastically over the past two years, it’s a miracle we haven’t seen more energy trading companies collapse under the strain. While governments stepped in to rescue, this does not change the fact that one or two firms were right on the brink. The market generally understood that major disaster was not far away, and this subsequently has put a greater focus on credit risk.
Overall, exposures of EU entities to energy derivatives markets totalled around €1.1 trillion (£950bn) in February 2023, with natural gas and power derivatives representing 60% of the gross notional amounts (Source: ESMA paper on EU Energy Derivatives Markets: Structure and Risks). This is a staggeringly large market, second to FX for bilateral volumes, which means there is a high amount of credit risk. This raises the question – is it time European energy markets shifted from a bi-lateral to a cleared world?
No crisis, regardless of how big the knock-on-effect is, will change the fact that energy trading firms prefer to use OTC derivatives for specific risk management needs tailored to their physical operations. The reality is that central clearing does not always support all the products or structures required by energy traders. At the moment, with European energy markets as volatile as they are, listed derivatives mean posting high amounts of margin which would be far too costly for most firms. This is why the majority of the market stills prefers to maintain flexibility by using bilateral OTC contracts. In fact, certain firms have even managed to net down exposure in clearing and replaced it with additional bi-lateral exposure which does not require initial margin to be posted.
Therefore, with clear evidence to suggest that energy trading will remain bilateral for the foreseeable future, attentions must now turn to how credit risk can be managed as and when the next unexpected event materialises. A handful of banks aside, the market is still not subject to any capital requirements, yet it is still very much exposed to credit risk which, if not managed correctly, could lead to numerous defaults.
“The sheer size of the bilateral energy trading market means there are still significant credit risks that need to be managed, and effective credit risk management is crucial for energy trading firms to ensure the continuity of their trading activities.”
From ongoing credit assessments, to stronger risk mitigation measures and continual credit monitoring to minimise the impact of counterparty defaults, energy trading firms now need to manage their bi-lateral exposure in a way that is a reliable alternative to clearing but without the costs of posting margin. This is why, since the volatility has calmed somewhat, we have seen more firms turn to tools that enable their bi-lateral credit exposures to be managed down on a relatively continuous basis by offsetting exposures on a multilateral basis.
While certain energy trading firms may not be worried about credit risk due to having collateral agreements in place with major counterparties, this does not alter the fact that they are still exposed if there are any significant changes in market prices due to unforeseen events, such as the recent threat of strike at an two of Chevron’s Australian LNG plants which sent the price of the Dutch TTF hub soaring 10% in a day.
Moves to reduce credit risk are especially important right now given the structural instabilities in energy markets today, caused by a number of factors, including an unreliable supply of gas and the transition to greener more sustainable alternatives. Ultimately, if energy trading is to remain bi-lateral, then no stone can be left unturned when it comes to managing credit risk exposures across the different counterparties. The Enron collapse might seem like a distant memory, but the fallout 22 years ago is still a good lesson to manage credit risk carefully.