Power Exchanges in Europe
by Darrell Delamaide
Article provided courtesy of Futures Industry Magazine, January/February 2009 Issue
European electricity exchanges are showing considerable resilience amid the global financial crisis and are on target to increase volume 10-12% this year. While hardly explosive, the steady growth in power trading comes even as some financial participants reduce their exposure in the power market. In fact, the crisis has had a silver lining, in that market participants are choosing to send more of their trades, including over-the-counter trades flowing through clearing houses in order to reduce their counterparty risk.
While new platforms continue to sprout up across the continent-“like mushrooms” according to one exchange CEO-the fact that several mergers and partnerships were announced last year heralds the consolidation of a fragmented market as exchanges seek to amass the liquidity that will attract global institutions, particularly from North America and Asia. At the same time, exchanges are diversifying their products and beefing up their distribution channels to further stimulate growth.
“It’s difficult to tell what impact the financial crisis has had,” says Bert den Ouden, chief executive officer of APX, the Amsterdam-based energy exchange. “At least we can say it has not been negative, and has probably been positive.”
Growth has continued at various rates across APX’s markets. APX was due to close on its acquisition of the European Energy Derivatives Exchange, also based in Amsterdam, by the end of the year, and the futures market was enjoying its best year ever. “There is a need for optimization on a daily basis,” den Ouden says, “and that need continues.”
While some financial institutions have pulled back from participating in APX, others have intensified their activity and new ones have joined, den Ouden says. Other exchanges and OTC market makers echo his remarks.
“The market hasn’t collapsed, much as you might have thought,” says Richard Frape, marketing director at Spectron Group in London. “There’s still a steady stream of inquiries from financial institutions. It’s not as if it dried up or they’re scared.”
Limited Impact from Lehman Bankruptcy
Lehman Brothers was not a big player in European power markets, so its collapse had less impact than in other types of derivatives trading, Frape notes.
Hans-Bernd Menzel, the chief executive officer of the European Energy Exchange, the main German exchange located in Leipzig, says the exchange’s clearing facility, European Commodity Clearing, was able to unwind the Lehman positions within 24 hours and even deliver a small sum to the bankruptcy receivers.
That kind of performance has made the clearing activities offered by exchanges look like something of a safe haven, Menzel says. “Today, clearing is really fashionable,” he says. “A year ago, that was just for academics. That time is past. When it’s raining, it’s good to have an umbrella.”
By substituting the clearinghouse as the counterparty, the exchanges reduce the risk exposure of participants, and not just for on-exchange trades. Most of the clearing houses also clear OTC trades. In fact, EEX’s clearinghouse has a balance of one-third on-exchange trades and two-thirds OTC trades-the proportion they have targeted and intend to maintain.
Market volume is growing, agrees John Cunningham, who trades energy contracts for BNP Paribas in London, and much of it, both exchange-traded and OTC, is going through clearing facilities. “It allows you to contain exposure, that’s the big driver.”
There is definitely a new caution in the air, says Geir Reigstad, who heads the Nord Pool derivatives and clearing business that was sold to Nasdaq OMX in October. While the volume of trading is growing, there is a change in the pattern. “People are being more careful,” Reigstad says. “They’re not doing one big trade, taking a large exposure, but making more small trades.”
There are other signs of added caution. More participants want to clear their trades through Nord Pool Clearing ASA. At the same time, however, some participants have withdrawn collateral from the clearing facility and reduced their credit lines as a way of reducing exposure. More business is migrating to the exchange, Reigstad feels, to benefit from the automatic clearing.
Appeal for Exchange-Traded Products
EEX’s Menzel, too, reports a growing appeal for exchange-traded products. “You get immediate access to 200 other trading parties,” he notes. “You have the anonymity of the trade and the uniform price as well.” Exchange trading has a leading role in price discovery for the German market, which includes Austria and Switzerland. By the same token, the large utilities in Germany continue to enjoy the confidence of other participants as counterparties in OTC trades, so that OTC remains an important component of the market.
The Nasdaq OMX acquisition of the international business at Nord Pool-Nord Pool ASA continues to operate the underlying electricity market and hold the exchange license-and the APX acquisition of Endex are part of the ongoing consolidation in the European market. In addition, Germany’s EEX has embarked on a wide-ranging “partnership” with Powernext in France that stops short of merger, but effectively links the electricity markets in the two biggest economies in Europe.
Initially, the two exchanges will combine their clearing operations. Then they are establishing a 50-50 joint venture based in Paris to trade spot contracts for both France and Germany and an 80-20 venture in Leipzig-EEX is the dominant shareholder in this unit-for the derivatives business.
The Powernext partnership, says Menzel, is an “extremely ambitious project” for EEX, and is the main focus for the exchange’s growth as the two partners must start to deliver on the benefits from their cooperation. EEX is also closely allied with Eurex, the largest European futures exchange. Eurex owns around 37% of EEX and supplies the Leipzig exchange with the technology for its trading platform.
There are other forms of cooperation that gradually are stitching together the fragmented European market. EEX and Endex, for instance, prior to their current merger or partnership projects, had entered into cross-margining between their clearing facilities. “This creates a considerable offset when it comes to margin calls,” Menzel notes, and can effectively save 1 billion euros on 2.5 billion euros in margin requirements.
At APX, den Ouden talks of “market couplings” that his exchange is using as a way of extending auctions of gas and transportation capacity across a network that eventually will embrace the Benelux countries-Netherlands, Belgium, and Luxembourg-and Germany and France. Ultimately, he says, a series of regional coupling networks like this can take part in a Europe-wide umbrella network, as prices and terms converge.
While this primarily affects the spot market, it will benefit futures as well, den Ouden says. “It improves the spot market and makes those contracts a better basis for derivatives,” he explains. “It reduces the volatility of the spot market indices enormously.”
Even while this consolidation is taking place, though, new platforms are being formed to respond to needs in local and regional markets as the concept gradually takes hold in different European countries. “Each government has to do significant work to support the exchanges,” says Nasdaq OMX’s Reigstad. “Local exchanges are getting responsibility for their local markets. They are sprouting like mushrooms across Europe.” One of the latest initiatives is IDEX, an Italian market based in Milan. Operated by Borsa Italiana, IDEX began trading its first contracts in November. “Power trading on the derivatives side is regional because there are so many local factors,” explains Ben Tait, a director at Prospex, a U.K.-based research firm that conducts an annual survey of European power markets. These factors range from local fuel prices to national regulations to weather. Italy could clearly benefit from an exchange, Tait feels, because it has the highest wholesale prices in Europe. It’s difficult for pan-European traders outside the country to get a feel for the system there.
Fragmented Markets: Time for Consolidation?
Menzel estimates there are 30-some platforms trading spot or futures energy contracts in Europe. “There must be consolidation sooner or later,” he says. “The time of a local one-product commodity market will come to an end, unless there is protectionism.” He says Europe could end up with two, three, four or five big groups, depending on how business develops.
For one thing, these markets must improve their liquidity if they are to attract more investors. Nord Pool historically has been the leader in this department because the Nordic countries started earlier, in 1992, with their liberalization of power markets. “Other markets have not reached the same degree of liberalization,” says Reigstad. “There are too many big players in these markets.”
Market participants see obstacles in this regard in the two biggest economies on the continent, Germany and France, though Germany (including Austria and Switzerland) has by far the deepest potential market for power. Because of the big utilities there, the bulk of German trading takes place over the counter. In France, both gas and electricity are a state-owned monopoly.
BNP Paribas’ Cunningham is sanguine about the prospects. “There is a great deal of overlap as a number of venues are trying to compete,” he says. But this has competitive benefits for market participants. “It’s really a decision about which platform has an edge,” he says. “Ultimately, the golden rule is that markets will decide.”
In the meantime, the exchanges continue to add products to play to their respective strengths. Nasdaq OMX Commodities is promoting carbon emission contracts, based both on European Union Allowances (EUAs) in the Emissions Trading Scheme and Certified Emission Reduction units (CERs) provided in the Kyoto Protocol, as a potential global product, using Nasdaq OMX’s international distribution muscle to reach for investors in Asia and North America.
EEX also aims to offer a range of carbon emission and energy products to complement the power products. “It’s important to offer all these things because of the strong interdependency among them,” says Menzel.
EEX also has a partnership with Eurex under which its emissions futures and options are listed on the Eurex platform and available for trading by Eurex members. That partnership, which kicked off in December 2007, has given a big boost to EEX volumes in those products, and the two exchanges are mulling the idea of expanding this to include EEX’s power products.
APX’s den Ouden sees his exchange developing its natural gas products, based on the large proportion of gas-fired electricity generation in its two major markets, the Netherlands and U.K. “We are currently the strongest European gas exchange and you can expect us to become a leading gas exchange” globally, he says. Gas lends itself more easily to becoming a global product and that makes it easier to consolidate market share, he adds.
But Menzel sees power itself as a product with global reach. “Power will become a global brand with pan-European prices,” he says, “even if it is impossible to transport.”
Fresh Start for U.K. Power Market
The U.K. has been largely left behind in the drive to develop power trading in recent years as the market has moved ahead in continental Europe, but that’s about to change. Two of the big players in European trading are mounting efforts to bring spot and derivatives trading to the British market.
Nasdaq OMX Commodities, which acquired the international business of the Nord Pool group in October, was picked in November by the U.K.’s Futures and Options Association to set up an exchange for spot and derivatives trading. Nasdaq OMX, which is partnering with the Nord Pool spot power market, beat out more than 10 competitors in the FOA tender, which had dragged out for some 18 months as mergers and acquisitions kept realigning potential bidders. Nasdaq OMX hopes to have the exchange operating by next summer with initially 20 to 30 participants.
The FOA initiative is aimed at bringing transparency, centralization and robust reference pricing to the wholesale U.K. power markets, with the provision of a central clearing service being one of the key ingredients. Market participants have noted for some time that the U.K. market needs increased liquidity and greater participation to facilitate risk management and smooth out volatility.
The combination of Nord Pool’s long experience in operating a power exchange and the muscle provided by Nasdaq OMX won the unanimous approval of the FOA panel reviewing the bids. “We are delighted that the process has concluded with a recommendation of the services of one of the largest energy exchange groups in the world,” said Paul Beynon, the head of U.K. power trading at RWE and the head of the review board. “It will enable the enhancement of services and products on offer and give the U.K. energy wholesale markets a proper structure for growth.”
Not to be deterred, APX of the Netherlands, one of the competing exchanges that lost out in the FOA tender, went ahead with its plans to mount a day-ahead auction, holding the first one on Dec. 2. The auction drew 18 participants and transacted a volume of 2,300 MWh.
APX already has a strong presence in the highly liquid U.K. gas market and sees the power auction, which it believes will provide a transparent reference price for derivatives, as a step toward integrating power and gas trading in the U.K.
The latest steps hope to revive a market that dried up after the collapse of Enron. “The U.K. was a very good market, but suffered thanks to Enron, Duke and Williams,” says Ben Tait, a director at Prospex, a U.K.-based energy research firm. The European exchanges, with their expertise and resources, may be able to overcome that legacy of the past.-Darrell Delamaide
Darrell Delamaide is a freelance journalist based in Washington, D.C. He has written about finance for 30 years and has contributed articles to publications such as Barron’s, Bloomberg, Euromoney, Institutional Investor and International Herald Tribune. He also has written two non-fiction books-one on the Third World debt crisis in the 1980s and another on post-Cold War Europe.
