Non-contestable consumers suffered $3b hedging losses

The previous blog "Demystifying electricity cost" covered a description of the vesting contracts and its purpose. There are very serious ramifications of these vesting contracts, one of which is its impact on consumers which I shall elaborate in this blog.First, a revisit on how tariff is determined and how vesting contract differences are embeded in the computation. 

1. The regulated tariff is for SP to bill non-contestable consumers (consumers who are not yet qualified to switch to retailers AND those who qualify but still purchase through SP).

2. EMA (Electricity Market Authority) determines the quantity of demand load to be vested quarterly. The VCL (Vesting Quantity Level) is the % of aggregate demand load to be vested. This comprises the LNG Vested Qty, the Balance Allocated Qty, and the Tender Vesting Quantity. The TDQ is a % of non-contestable load within the VCL. Finally, the MSSL Unvested Quantity is the balance of  non-contestable load not covered within the VCL. 

3. For illustration, the Q3 tariff is being prepared. The tendered price for the Tender Vesting Contracts and MSSL Unvested Tender Contracts of Q3 are obtained. These vesting quantities are in respect of non-contestable loads.

4. SP computes the price of the vesting contracts for the LNG Vesting Qty and Balance Allocated Qty  using the LRMC (Long Run Marginal Cost) model of a hypothetical efficient CCGT plant. The portion that is applicable to non-contestable load is obtained.

5. The tendered price and the computed price in (3) and (4) are weighted in respect of non-contestable load. This is the average vesting price for Q3 which is, for example 27.00 cts/kWh.

6. Vesting contracts are 'contracts for difference' between gencos (as sellers) and SP (as buyer). The parties settle with each other half-hourly for loads dispatched based on the difference between the strike price of the vesting contracts and the relevant gencos' nodal prices. If vesting price is lower, gencos pay SP the difference, and vice-versa. SP recovers from or distributes to non-contestable consumers, this difference. To do this, the adjusting debits/credits are worked into the tariff by adjusting the weighted average vesting price of 27.00 cts/kWh for Q3. However, since Q3 data are not yet available, this adjustment is done on a stagatime basis. The Q3 adjustment is based on the lasf 1/2 month of Q1 + the first 2-1/2 month of Q2 (mid-Mar to mid-June). 

7. The USEP or Uniform Singapore Electricity Price is the weighted average of all nodal prices.  SP buys from the Wholesale Electricity Market at spot prices, which is the USEP + some admin fees.  For the adjustment period from mid-Mar to mid-June, the USEP is higher than the vesting price. It means SP has been a net payor to gencos in respect of the vesting contracts. The amount that SP has paid out that is attributable to the non-contestable load needs to be recovered from the non-contestable consumers in Q3 in the tariff. Hence from the Q3 vesting price of 27.00 cts/kWh, the tariff is adjusted upwards to, for example, 28.50 cts/kWh.

8. Note that the adjusting debits/credits attributable to contestable loads is settled between SP and retailers, other direct market participants, and contestable consumers who buy at pool with SP, via monthly invoicing.


The benefits and cost of hedging:

The purpose of vesting contracts is to mitigate the capability of gencos to exercise market power.  They are in effect, financial hedging instruments. As such, there are benefits and cost for the hedge depending on how the actual cost of electricity turns out. 

From 2004 up to about 2012, the vesting price and the USEP were roughly evening out. Then from 2013 onwards, vesting price has been way above USEP every quarter. This means from 2013 onwards, it has been a one way ticket with SP paying out huge sums of cash to gencos for the vesting contract differences. Industry experts estimate that for the 5 years 2013-2018, more than S$3 billion has been paid out. 

So who's footing the bill:

As the MSSL, SP is the sole counter-party to all gencos for these vesting contracts. SP does not assume any risk, and all benefits and costs of the vesting contracts are passed on to consumers.

The benefits and cost of vesting contracts are split between the contestable and non-contestable loads. The non-contestable load is fully vested, so the vesting contract difference is first fully apportioned to it. The balance is attributable to the contestable load. 

The total demand load is split into :-

(a) Non-contestable load - comprising of those consumers who are not qualified to switch to retail AND consumers who are qualified to switch but remain as SP customers.
(b) Contestable load - comprising of consumers who have switched to retailers, other direct market participants (big consumers who buy direct from the wholesale market) , and consumers who buy at the pool through SP. 

Which group of consumers then, are bearing the major part of the S$3 billion+ hedging cost from 2013-2018? This depends on the Vesting Contract Level (VCL). In 2004 when Vesting Contract mechanism was introduced, the 3 biggest gencos controlled 87% of generation market, the VCL was set at 65%. The VCL was gradually rolled back as genco market composition changes. The 3 big gencos market share is now only 57% and VCL is now 25%. The gradual reduction of the VCL also coincides with the rolling out of the open market which reduces the non-contestable load as more consumers switch to retail market. The overall effect is that between 2013-2018 the hedging cost is practically almost fully attributable to the non-contestable load.

So the many consumers that I have come across who did not wish to switch to the retail market because they are too busy, their bill is too small to bother, it is not their priority, they are happy with current services, etc, etc, and the others who are not yet qualified to switch, these are the consumers who are footing the S$3 billion+ hedging cost. To add insult to injury, they have also paid out more than S$210 million GST in respect of these hedging cost.

The morality and equity of hedging cost:

A regulated pricing mechanism in the electricity business  with a bias or faulty methodology, has the capability to make massive transfer of wealth from consumers to investors. The estimated hedging cost of S$3 billion+ from 2013-2018 is massive. This is certainly not sustainable, nor equitable to non-contestable consumers.

With the domestic (residential) market opening up by stages, non-contestable load is expected to get smaller. Assuming the trend of vesting prices being higher than USEP continues, and assuming the VCL  remains at 25% of total demand load, there will need  to be an equitable redistribution of the huge hedging cost to all consumers, both non-contestable and contestable. It is not clear how retailers can negotiate this looming problem in respect of their existing consumers with contracts locked up. 

Where hedging is done with financial instruments that are market driven, transparency is ascertained. You win some, you loose some, but in the long run, it probably evens out. But if you have a loosing streak for 5 years, it perhaps point to some weakness in the methodology. In the case of these LNG Vesting and Balance Vesting contracts, the strike price is a regulated one, derived from very complicated formulation and parameters set subjectively. When the vesting price relationship to the USEP make a pronounced change as in 2013-2018, an explanation is in order. Something has changed significantly and we need to know what it is. So what happened in 2013? Were there some changes to the parameter settings for the LRMC model, or has there been some structural change in the market?

This is a politically hot potato best kept under wraps for the average moms and pops will have difficulty understanding it, except walking away with a sense that they have been short-changed. However, it is not a situation brought about by incompetency. Market driven electricity systems are highly complex, fluid and dynamic, and the NEMS (National Electricity Market of Singapore), like most other countries', is continually evolving. The electricity crisis in California in 2000 showed ill-planned concepts in the system can have a devastating effect. We are nowhere like California, but there currently exists in NEMS serious problems that require policy or regulatory intervention. This S$3 billion+ vesting cost is one of them. Next few blogs will explore more.

Coming up next :
Ramifications of vesting contracts - continued