The power of one

Is a single electricity trading reference price essential to achieving the liquidity to which the British market aspires? Trevor Loveday reports.

The torpid trading of electricity in the UK is a concern. Lack of participants means less-competitive wholesale prices, which baulk new entrants and raise costs for consumers. Churn in the UK is put at about three, compared with nine in other European markets. Churn, in this context, is the number of times a clip of power is traded before it its consumed, and it is therefore a good measure of liquidity.

A paucity of trading on exchanges could lie behind the lack of liquidity in Britain’s power market. The UK market favours bilateral, over the counter (OTC) trades, while other European energy companies trade much more of their power on exchanges. Significantly greater liquidity in European markets is seen as a product of the greater transparency in exchange trading. “It has been argued that exchanges offer transparency and this generates more robust reference prices that are more readily trusted by market participants,” says Ofgem.

In the light of a government commitment to address the liquidity issue, Nord Pool Spot, in collaboration with Nasdaq OMX Commodities (NOMX) unveiled its N2EX exchange in January 2010. It launched with a day-ahead auction alongside a day-ahead prompt market. Some of the drive for that was to head off regulatory intervention. “Clearly the market felt better developing its own solution rather than relying on the government to intervene,” says Nord Pool’s director of European integration Hans Randen.

Energy regulator Ofgem, in its objectives for the British market, includes “a robust reference price generated along the curve – for near and longer term products”. NOMX last year launched power futures contracts benchmarked against a day-ahead index price produced by N2EX’s auction. Randen explains: “The purpose of the day-ahead index price is to form the base for a suite of futures contracts – up to two years out benchmarked on the day-ahead price.”

But he argues that a single reference price is needed for the entire market – not solely the futures market – to instil confidence. Indeed, he asserts that a single reference price – founded on an auction-based market – is an essential ingredient to achieving the liquidity to which the British market aspires. “The UK lacks transparency. Compare it with the Nordic market where there was a single index from scratch. It’s much more liquid and transparent.”

Crucially, exchange-based trading presents less of a hurdle for new entrants, according to Randen. There is complexity inherent in bilateral trades – particularly the need to hold, for all other counterparties, grid trade master agreements, which set out terms for settling each deal and delivering the power.

He comments: “Non-exchange bilateral trading costs time and money. The exchange removes that – you just sign the exchange’s terms and conditions. It takes away issues around trading – you can make financial trades – which are key to new participants and supports the physical market with liquidity and volumes and building liquidity in the forward curve.”

And a single reference price adds still greater simplicity, he says: “Multiple sources of price information creates risk. A single price clarifies.”

Reference prices abound in the UK day-ahead market. Providers include London Energy Brokers’ Association, N2EX, Platts and ICIS Heren. But none have the confidence of the market as truly reflecting the market price. According to Randen, the high number of reference prices leaves market entrants “caught in the headlights of diversity”.

However, diversity may have its benefits, according to Clive Furness, managing director of commodity consultancy Contango Markets, and development officer for the Futures and Options Association’s Power Trading Forum. “I don’t think having different indices is bad at all. In fact, I think it keeps the market on its toes and keeps the market thinking about the basis on which trades take place,” he says.

But aren’t multiple indices inherently complex? “I’m not sure I buy that argument,” says Furness. Taking a broader perspective beyond power markets, he says there can be a place for multiple indices used by all players in the marketplace – such as equities – as long as they are based on purely commercial grounds.

However, what is available in the market appears not to be doing the job. “I don’t feel that historically we have had adequate robust indices,” says Furness. “By robust, I mean it has to be auditable, replicable and it must be transparent to everybody.” He emphasises that markets must be left to choose on the form of indexation, and the Futures and Options Association has no preference.

“I think the way it is likely to happen is: you get a number of indices that are considered to be robust by the marketplace and there will be one that becomes more favoured for centralised trading than the others because that’s the way markets are. It’s already started to an extent – that’s the lesson from other markets,” he says.

Exchange trading is growing in the UK. N2EX’s trading platform is offering the sub-1MW clips that small new entrants need to hedge against customer acquisitions and so on, and which are rarely available at favourable prices through the OTC market. And the 2011 opening of the BrtiNed interconnector between the UK and the Netherlands awakened APX-Endex’s dormant day-ahead auction.

More recently, Danish power-trading company Neas Energy unveiled plans to extend its trading on the N2EX in the UK. Senior vice president Soren Petersen said Neas’ greater transparency from increased auctioning was allowing new players in to boost liquidity.

Meanwhile, market reform at home and changes on the horizon in the European Union will add to the pressure on Britain to rethink its power trading approach, Randen believes. The North West Europe commitment will link Britain with EU neighbours possibly by 2013. “With market coupling in the EU to instigate flow, you need a single index,” says Randen. “When the North West commitment happens, we will see a single index.”

So there is growth in UK exchange trading but it is not impressive. And it is not taking the market into the sort of churn rates that create the liquidity enjoyed in the rest of the EU. If the missing element is confidence, a sound index may be what is needed to tip the balance. Choice in price index has not galvanized confidence, but it is fair to say that we are in early days in terms of exchange trading. In time, the market may gravitate towards a single trusted index as a commercially driven development. And the prevailing regulatory wind from EU market integration, and to some extent Electricity Market Reform, is taking the UK into single index territory.

Meanwhile, as Ofgem fires off warnings of an impending threat to security of supply, the need for price signals that prompt investment in generation could not be more urgent. Liquidity is clearly part of the solution, but as yet there is little sign that the UK market will change its ways any time soon.

Trevor Loveday is a freelance journalist

This article first appeared in Utility Week’s print edition of 19th October 2012.

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