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: "[More] consolidation
would be beneficial for exchanges operating power day-ahead and
intra-day markets and we'd like to see a European algorithm for
day-ahead and a European intra-day capacity platform.
We’re not sure we see a great deal of
consolidation on futures exchanges, but it's clear that a small
number will always be present. We expect that market forces and
opportunity will result in natural development over time."
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
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
"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
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 [uncleared]
contracts," says Jemmett. "In the UK there is not yet a great
deal of clearing, although this may change if projects such as
N2EX and APX gain traction."
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
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
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
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
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
One source says: "Markets here are specific to various
European countries. By nature, fewer people are looking at
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
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
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