Enel is one of 70 energy companies in Italy that could end up needing a state-guaranteed credit line, as derivative hedges blow out. Which is likely to place even further pressure on the finances of Europe’s most indebted large economy.
One of the last things former European Central Bank Chairman Mario Draghi did before resigning as prime minister of Italy in July was to devise a credit scheme to shield large Italian energy companies from the economic fallout of the proxy war in Ukraine and Europe’s subsequent sanctions against Russia. Under the plan, the country’s trade-credit insurer Sace would provide guarantees for around 70% of the total amount of fresh debt extended.
That plan is now in the implementation phase. Italy’s biggest lenders, UniCredit SpA and Intesa Sanpaolo SpA, are expected to contribute €5 billion a piece to the emergency credit line, while state-backed Cassa Depositi e Prestiti SpA and two other banks, Banco BPM SpA and BPER Banca SpA, are likely to add €2 billion each. Technically speaking, it is an 18-month “revolving credit” line, meaning the money will be withdrawn as needed. Much of that money, like the emergency business loans disbursed by Italian banks during the coronavirus crisis, will be state guaranteed.
Enel apparently needs the credit line to cover derivative risks linked to spiking energy prices. Just as we recently saw in the UK’s gilt market, derivatives are doing exactly what they did in the GFC: magnifying risk and extending contagion.
An EU-Wide Problem
Significant sums of state-guaranteed credit have already been extended by European governments to energy companies, in order to prevent them from defaulting on their derivatives contracts. As NC reported in early September, this could cause a Lehman-like unravelling of the derivatives markets, with companies facing as much as €1.5 trillion in margin calls. To keep that from happening, Sweden and Finland have already provided guarantees worth €33 billion.
In July, Germany gave the national energy giant Uniper, owned by the Finnish company Fortum, a €15 billion loan, only for the firm to hit the rails once again in September. In the end, Berlin took over 99% of the company, at an additional cost of €30 billion. As Germany’s biggest importer of gas, Uniper was hit particularly hard by the vastly reduced flows of gas arriving from Russia. But its problems actually began before Russia’s invasion of Ukraine, with souring derivatives hedges largely to blame. In January this year Uniper was forced to borrow €10 billion from its Finnish parent group, Fortum, to meet margin calls following a surge in European gas and electricity prices in 2021.
As Yves has previously noted, it will take time before we know whether the liquidity problems at energy companies are the result of sensible hedges gone bad, stupid hedges gone bad, and speculation gone bad. It is quite normal for electricity producers like Enel to place shorts on the energy market as a hedge, as the FT explains:
The companies like to de-risk their power sales to households and businesses by taking short positions in futures markets before selling the physical electricity. That way if power prices fall, any losses on the contract will be mitigated by gains from the short position, and if prices rise the additional profit made on the physical delivery should cover the cost of the short.
Under current market rules, anyone taking a short position in futures markets is required to post additional collateral — or margin — to the exchange if the price of the underlying asset rises. In normal times, this is accepted trading practice but in recent months the soaring price of electricity has meant the collateral requirements for utilities that have hedged their power sales — often months or years in advance — have ballooned.
Interestingly, Enel’s derivative plays appear to have extended far beyond the energy futures markets. In 2021, it partnered with French lender Credit Agricole in establishing the first Sustainability-Linked Forex derivative programme. As a 2017 piece in ISDA Quarterly lays out, the company uses derivatives for a number of reasons, across a variety of asset classes, including interest rates, FX and commodities.
“We remain substantially stable in terms of our derivatives use. Derivatives are a sufficiently elastic product to keep us aligned with underlying risks, despite the challenges in the market,” said Fabio Casinelli, Enel’s head of treasury and capital markets. “Derivatives are a real support, a simple tool that absolutely helps us to manage financial risk and support.”
Five years later, that simple tool has created a $16 billion liquidity shortfall for Enel.
First Come, First Served
The fact that Enel is likely to be first in line for the state-guaranteed credit line is ironic given:
- Enel’s number-one shareholder is the Italian government, which owns 23% of its shares. In other words, the government is, to an extent, bailing itself out.
- A few weeks ago, Enel published an op-ed in Italy’s foremost business newspaper, Il Sole 24, calling on the government to provide €20-30 billion of emergency credit assistance to Italy’s energy sector. According to a recent piece in Il Fatto Quotidiano, Enel argued the money was mostly needed to support struggling smaller utility companies that otherwise will not be able to cope with the mounting margin calls on derivatives contracts.
Yet just a few weeks later, it is Enel itself that is hitting the government up for a large chunk of that money. Anonymous sources told Reuters the government has already agreed in principle to grant state guarantees for the credit line. That money is needed to prevent margin calls from putting Enel’s business plans in jeopardy.
But Enel also has other problems. Its net debt (the amount of debt that would remain after it had paid off as much debt as possible with its liquid assets) is extremely high, at around €62 billion, while the value of its shares has fallen over 40% in value since January 1 — significantly more than most of its European peers. It is now trying to pay down its debt by selling off assets, including its entire business operations in Russia.
In the line behind Enel, some 70 other energy companies are at risk of default, according to the national federation of Italian utilities Utilitalia. In other words, the crisis has barely begun. As Yves noted in her preamble to the cross-posted article, “Lehman Event” Looms For Europe As Energy Companies Face $1.5 Trillion in Margin Calls,” the energy derivatives blowup has the potential to be a systemic crisis, which is why European governments will do everything within their powers to save the companies (and by extension, financial institutions) affected.
As Yves noted, because the energy-related crisis will hit first, as we are already seeing, the energy sector (and its financial counterparties) will be first in line to receive rescue money. As such, it will compete with and take precedence over the funding of real economy bailouts.
That is bad news for a real economy like Italy’s, which boasts Europe’s second largest industrial base. Many businesses only managed to weather the lockdowns of 2020-21 by taking on huge amounts of debt, which they now have to pay off. Yet that is becoming harder and harder as the price of energy and most everything else soars.
Italian companies are heavily dependent not just on debt but also gas (for their electricity), much of which used to come from Russia. Soaring energy prices mean companies are expected to pay €110 billion more in 2022 than they did before the pandemic, according to a report from the business association Confindustria. Crucially, more than half of that money (€55.6 billion) is due in the period September to December.
The head of Cofindustria, Carlo Bonomi, appealed for an aid package to protect Italy’s economy from surging energy costs. “Without industry, there is no Italy,” he said, adding: “I am more concerned now than I was at the start of the pandemic.”
Outgoing Prime Minister Mario Draghi’s government already spent €66 billion trying to insulate families and businesses from the energy crisis. But according to Bonomia, at least €40 billion of additional funds is needed.
All the while, the price of debt, for companies, households and the government, continues to surge, as the ECB begins to hike interest rates, in a desperate (and almost certainly forlorn) bid to tame inflation, and as the yields on 10-year Italian bonds hover around the 4.8% mark, their highest level since 2013. This time last year, they were under 1%. The average yield in European corporate bond markets also hit its highest level in a decade earlier this week, according to an index of investment-grade company debt.
If some of that debt begins unravelling as more and more companies enter default, European governments could find themselves in a spot of bother. This is because they have underwritten a large part of that debt. According to the UK-based bear market expert Russell Napier, “out of all the new bank loans issued in Germany [since February 2020], 40% are guaranteed by the government. In France, it’s 70% of all news loans, and in Italy it’s over 100%, because they migrate old maturing credit to new, government-guaranteed-schemes.”
In the case of Italy, it doesn’t end there. Over the past five years or so, Italian banks, with help from Wall Street’s finest, have been slicing, dicing, and repackaging non-performing financial assets, such as loans, residential or commercial mortgages, or other sometimes uncollateralized Italian “sofferenze” (bad debt) into asset-backed instruments which could then be sold to yield-starved investors all over the world. And a large part of that debt is also guaranteed by the Italian state, which means that when the firms that bought the debt begin discovering that it is unrecoverable, the Italian government will be left holding the tab.
