Siân Williams casts light on this fragmented and complex commodity market and asks if consolidation is on the cards – and what has been keeping it for so long.
Power is an inherently regional product which is driven by local fundamentals. Different regions are subject not only to different weather patterns and industrial cycles, and therefore varied supply and demand, but also to different generation types, which means that changes in the price of fuels have stronger effects on some countries’ power prices than on others.
Each European member state also has different infrastructures for distributing power, which makes contract fungibility across borders much trickier.
So, it is understandable that the number of power exchanges in Europe is so high. But even if contracts are not fungible, that is not to say that consolidation cannot take place.
Tom Sargent, director of power and emissions trading at Eon, expects consolidation to be driven by exchanges as a reaction to market developments. He says that: “
Luke Jemmett, GFI’s product manager, commodities, believes that consolidation may be possible as more trading starts to take place at the longer end of the curve. “For longer-term products, people start thinking about efficiencies from cross-margining,” he says. “We may start to see consolidation of exchanges and less fragmentation amongst the clearing houses.”
“I think there is room for consolidation on the longer end of the curve,” he adds.
Sargent says that: “From our perspective it's frustrating to a certain degree that many initiatives take so long to complete, such as the Central and Western European market coupling project. There's also a shift from bottom-up initiatives to a more top-down approach, which could cause even more delays. It's vital that we keep the momentum going on these projects. However, we do also see the need for top-down guidance to ensure that we are able to deliver a common European market.”
Not everyone agrees that consolidation is necessary to make markets more efficient. One concern is that it could lead to liquidity pools for similar contracts, such as contracts based on the same country’s power, being concentrated on different exchanges. This would mean that large market participants could lose some of the benefits of cross-margining efficiencies.
“The model so far – one exchange per country – seems to focus liquidity in the right place,” says Matt Petzny, director, global commodities group at JP Morgan.
But consolidation in another area – clearing – could be much more advantageous. European Commodity Clearing (ECC), for example, provides clearing services for APX-Endex, CEGH Gas Exchange of Wiener Börse, EEX, Epex Spot, HUPX and Powernext.
Stuck in an OTC world?
Indeed, increased cleared volume is a more realistic target for exchanges because such a large proportion of power derivatives are executed over-the-counter. This is partly down to the market’s fragmented nature and partly down to the nature of most of the counterparties, who tend to be large utility companies with excellent credit ratings, which are known to one another due to the fact that the number of trading parties is smaller than in other markets.
“Most of the liquidity is still in OTC physical
Many attribute this to market fragmentation and to the fact that power trading between countries is limited by both the physical infrastructure and political reasons.
“The European market is, to some extent, an emerging market,” says Jemmett. “The EU directive was the catalyst to opening up the markets, and in many ways it then becomes a question of timetable. Some member states have opened up their market very quickly, for example Germany and the UK.”
But the market is slowly evolving and an increasing proportion of contracts are being centrally cleared.
Petzny says that: “The move to clear more contracts is definitely what we are seeing. Larger volumes are being cleared.”
Asked whether he could envisage the market ever becoming predominantly cleared, Tom Sargent said that: “We expect to continue to see different approaches for different products, but there will likely be more central clearing.”
But this is likely to take time. Clive Furness, managing director of derivatives consultancy Contango Markets, says: “Power is the most stubborn of energy commodities to go cleared.”
Market forces are not the only thing that will determine this shift. The European Commission issued proposals on September 15 to mandate clearing for standardised derivatives. The vital question is how regulators will decide upon what is standardised and what proportion of the contracts in this market will fall under this category.
Sargent says that: “Most OTC power derivatives traded will be considered to be standardised.”
At this stage, it is difficult to determine the extent to which this would affect the power derivatives market. There would be an exemption from the clearing obligation for non-financial companies whose trading fell below a threshold, though there are no details as to what this would be. On one hand, it may not affect any of the industrial players if the threshold is high enough. But given that financial companies will be subject to the rules, it could have a number of consequences.
Firstly, it would likely increase clearing as it would force financial players’ volume to be put through clearing houses, which could set a trend for others. It could also, some argue, reduce volume in standardised contracts for players who have few positions in the power market and so would not benefit as much as others from netting.
Sargent says that: “We see a risk that liquidity will be lower as it will be more expensive to trade for some market participants.”
The market, which is heavily dominated by utilities, has some appeal to financial participants who are looking to diversify their portfolio into commodities. But they are concerned that the market is insufficiently liquid for them.
One source says: “Markets here are specific to various European countries. By nature, fewer people are looking at power.”
Liquidity levels differ greatly from country to country, due in part to the varying degrees to which power markets are liberated. Germany is perceived by many as having one of the most liquid power derivative markets in Europe. EEX’s volume is trending upwards and 64,500 contracts were traded on it in September 2010, of which 49,700 were based on Phelix power, the country’s most liquid underlying power contract.
But many regional markets are now stuck in the vicious circle that hampers derivative markets – insufficient liquidity to attract more traders but an insufficient number of traders to improve liquidity.
Jemmett says that “a few banks” are involved in the markets at the moment and that he expects growth in the number of financial participants. “As markets become more liquid and cleared options become available, we will start to see hedge funds,” he says.
Sargent agrees. “We agree that liquidity should be higher. It's lower than we'd like and we've definitely seen a fall in far end liquidity. This appears to be driven by market forces – the fundamental market context, the availability of risk capital, and risk return of products and markets. This is not a market maker problem, but more a broader consequence of economic and financial drivers. It's not just an issue for the exchanges either. They provide the platform, but the market must have the desire for products.”
He adds that: “Bid-offer spreads have closed over time, but widened again at the far end in some markets.”
Hans-Bernd Menzel, EEX’s chief executive, thinks that the way of getting more liquidity isn’t necessarily to get more players, but to get existing players to execute more trades. The question, he says, is how to get them to trade more. He doesn’t believe that reducing transaction fees will help, but thinks good technology is the way to achieve this.
One benchmark – or many?
It is likely to be a long time before power markets benefit from the increased flows that are moving into commodities. The problem with a lack of fungibility between power contracts in different countries is that it is much harder to create benchmarks. A benchmark price in the UK, for example, would not be a suitable proxy for Norwegian power.
One market source does not believe that it would be possible to create a couple of pan-European benchmarks. “I don’t think you can do that. It’s a very physical market. Each of the regions has specific fundamentals that drive them,” he says.
Jemmett agrees. “With electricity, you have to consider the physical infrastructure,” he says.
Furness disagrees and thinks that it could be possible to create several benchmarks – but that the contracts would have to be carefully designed.
“Power is standardisable enough,” he says. “The challenge for the power market is to create a well-defined and stable product. Some index products in the power market don’t have integrity.” He adds that cash-settled contracts will be necessary if the market wants more participation from hedge funds who do not want to be associated with physical delivery.
He believes that the market needs a physical power price for every country now and that in the future it may be possible to have two or thee benchmarks across Europe.
He says that although absolute convergence is not possible, different prices will begin to move in a similar sort of way.
Sargent is also more optimistic about the idea of cross-border benchmarks. “We expect to see a number of benchmarks that are relevant to market conditions. Over time it may be possible to have benchmarks that cover wider market areas,” says Sargent.
N2EX hopes to boost liquidity
In the UK market, a utility-driven initiative has been launched to try to boost liquidity. N2Ex is a joint venture between Nord Pool Spot and Nasdaq OMX Commodities. It was the result of a request for proposal by the Futures and Options Association to create a new trading venue that would provide more liquidity to the market.
The exchange opened for business in January 2010 and first launched trading on its spot market. It plans to launch a futures platform in the autumn of 2010. Many players are taking a “wait and see” approach to the exchange at the moment.
“We’re supportive of seeing a cleared forward curve,” Jemmett says. “The most important thing is seeing a robust spot market leading to the creation of a credible index price.”
Asked if he believes N2EX will work, Petzny says: “It depends on how many people join in. Endex, ICE, never kicked off.” He says that he doesn’t have a problem with it “as long as it doesn’t fragment the market any further”.