Energy trading at the cross-roads

Power and gas exchanges in Europe multiply, but, experts say, we are nowhere near a mature, integrated European energy market as yet. Trading regulations need to be improved and harmonised and interconnections expanded. European Energy Review assesses the state of energy trading in Europe and interviews the ceo’s of NordPool and APX.

Sixteen years ago, in 1993, the first energy exchange, now known as NordPool, was set up in Europe – in the deregulated Norwegian market. Since then, some 20 new power and gas exchanges have been established throughout Europe, many of them in recent years. With the recent integration of the German and French power exchanges and the Dutch and UK gas exchanges, the energy trading sector seems to be entering a new phase of consolidation.

Most market watchers agree that liquid and transparent trading platforms are an indispensable feature of a well-functioning – integrated and competitive – European energy market. The rapid creation of new exchanges and their growing consolidation, seems to point to a healthy level of market activity and competition. However, appearances may deceive. In many markets, including France, Germany and even the UK, the “liquidity” of the exchanges remains highly limited. This means that in those countries only a small part of the total electricity produced is being traded on the exchanges. Most of it is bought and sold bilaterally, in the so-called over-the-counter (OTC) market. As Erik Saether, the ceo of Nord Pool Spot says elsewhere in this magazine: ‘If you take all the liquidity of all the power exchanges in Europe and add them together, it is still less than the liquidity in the Nordic market.’

European Power Exchanges

Nord Pool Spot is the biggest spot power exchange in Europe with a trading volume of 298 TWh (terrawatthours) in 2008. GME in Italy recorded a volume of 221 TWh (in 2007), Omel in Spain 195 TWh (also in 2007). The French-German combination EEX-Powernext recorded a volume of 198 TWh in 2008. APX NL and APX UK reached a combined volume of 36.3 TWh last year.

The Nordic market is one of the most liquid markets, as almost 69% of national consumption was traded on the Nord Pool Spot Exchange in 2007. The figure for Omel in Spain was even higher, over 75%. In Germany liquidity was only 21%, in France just 9%.

And that is not the only problem. As Pieter Veuger, energy trading specialist of PriceWaterhouseCoopers in Amsterdam points out, in many countries, energy trading regulations are inadequate and market transparency leaves much to be desired. Moreover, regulatory regimes differ widely among countries. The European Commission, Veuger says, is ‘still wrestling with this problem. Brussels keeps tightening regulation of the financial markets, but not of the physical markets. But in energy, the financial and physical sides are closely connected.’ As an example, Veuger points out that in many energy markets, unlike in financial markets, there are no rules against front-running, a practice by which a trader trades on his own account while taking advantage of advance knowledge of pending orders from his customers. As a result, Veuger says, many market players, such as banks and industrial users of energy, shun the exchanges. ‘They feel they do not get a level playing field. Even in Scandinavia big industries are still reluctant to participate in the power exchange.’

Another obstacle that stands in the way of a healthy international energy trade, experts say, is the limited interconnection between markets, particularly in electricity. There are two aspects to this. One is the existing physical interconnection (the cables) between countries, the other is how much of this capacity is available to be traded on the energy exchanges, a process called “market coupling”. Interconnection capacity as a percentage of installed generation capacity varies between less than 10% (e.g. in France,

‘What we are seeing is an accumulation of complex risks’
Italy, Spain, the UK) to in between 10 and 30% (in Germany, the Netherlands and the Nordic countries), and in rare cases over 30% (Belgium, Denmark). Market coupling is even more limited. The Nordic region and the French-Belgian-Dutch region are the only two as of now to enjoy market coupling. The French-Belgian-Dutch region will be expanded with Germany and Luxemburg next year. An attempt to couple the German and Danish markets failed last year for technical reasons but will be tried again later. Market coupling is a highly complex process, but it is an essential step in the further integration of energy markets in Europe. The couplings that have been made work very well: the markets show a high level of price convergence after having been connected.

The current economic crisis may have some positive effects for the energy exchanges. Bert den Ouden, ceo of APX Group, notes that ‘the credit crunch seems to have a positive effect on our trade volumes. Market parties apparently feel more of a need for someone to bear counterparty risks.’ Yet, seen from a wider perspective, the crisis will not make things easier for market players. As Den Ouden points out, ‘the energy sector is already confronted with huge regulatory risks and enormous bureaucratic obstacles. To these are now added great financial and economic uncertainties. This puts a heavy burden on the development of a healthy European energy market.’

Veuger is also concerned. ‘What we are seeing is an accumulation of complex risks. I am not sure whether energy companies are ready to deal with a systemic crisis such as occurred in the financial markets. They have learned a lot from the Enron crisis, but nobody knows where potential new risks may lie. The tools they use now are based on “value at risk” procedures. What you really need is a type of “war game scenarios” to be prepared for this.’
Prospects for power and gas trading, then, are highly uncertain. There only seems to be one certainty for the European energy market at this moment: the market model designed by Brussels will be severely tested in the coming years.