Virtual hubs and deep markets

EU regulatory body Acer has proposed several changes to the framework of forward markets and cross-border trading, aimed at boosting power market liquidity. Listen to a discussion on virtual hubs, financial transmission rights or “spread futures” and why the Nordic model may not be the best example to follow. And, would dividing the German power zone attract more investment into green energy and increase liquidity?

Host: Snjólfur Richard Sverrisson, Editor-in-Chief, Montel
Guest: Lion Hirth, Professor at Hertie School and Director at Neon Energy. 

Transcript

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 0:05

Hello listeners and welcome to the Montel Weekly Podcast, bring You Energy Matters in an informal setting. In today's pod, we return to the topic of market design, and in particular, the ways in which to optimize cross-border trading and hedging. What are virtual energy hubs are they needed, and how could they help liquidity in Ford electricity markets? What other proposals are on the table? And what is the role of TSOs? I'm Richard Sverrisson and joining me today is Lion Hirth professor of Energy policy at the Hertie School in Berlin and director of Neon Energy. A warm welcome to you, Lion.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 0:42

Hello. Glad to be here.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 0:43

Before we delve into the sort of nitty gritty and the more technical areas of wholesale market reform or proposals, how would you evaluate the current state of play in Europe's wholesale energy markets?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 0:54

I think by and large we are out of the crisis for a year now. I would date that. The end of the crisis actually to new years of last year. So I think it's now 14 month that we are out of the crisis. And it's surprisingly calm, right? I mean the, the PRI prices for both gas. And electricity and more lately, carbon also have fallen back very much from the peak levels in mid 2022 and are quite moderate and things are almost boring I would say.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 1:22

Absolutely. So in some countries like Spain, they're falling to 10 year lows, wholesale electricity prices, so. Do you think then you know, markets came outta this sort of very robust, they showed themselves to be stable and to deal with these kind of price shocks. So post, I was thinking post COVID, but also post energy crisis.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 1:39

I think yes and no. I think markets have worked pretty fine throughout the crisis and pretty much saved us in many ways. I think what. Didn't work so fine. Was society and policy responding to that? I think what's pretty, pretty clear now that the appetite for interventions into markets is high, larger than I expected. And the willingness to see prices and accept prices that might be beyond the ordinary. Is very limited, and I don't blame policymakers so much because they very much felt the pressure by their citizens and voters and the public. But I think the idea of having regulators and policymakers, for example, accepting scarcity prices. Seems to be a bit wilder than it used to be in my eyes.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 2:30

And do you think there are justified calls to change some of the markets, some of the market design in particular?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 2:36

I think market design is an ongoing project, right? We've been working on this for 20 years now. I wasn't there 20 years ago, but I joined on the way and people have. Thought about this for 40 or 50 years, since the 1980s and have started implementing this across Europe in the 1990s and two thousands. It's never a standstill, right? We've changed and improved and demanded many things on the way. If you think about how balancing markets on the very short term work today with Picasso and Mori and European harmonization, as opposed to just 10 years ago when everything was very much national and in fact Germany was split into four pretty much separate balancing areas. So things have changed and things should change, and there's a lot. Of more things to improve on. The margin, I think was what was a bit of a unnecessary detour, was that discussion about a radical change of kind of implementing a different way of pricing rules and kicking, essentially throwing marginal pricing out of the window and inventing something completely new that of course, no one did invent. Right. That was just a very strange discussion. And random fantasies. And in that sense, there is no need to change markets, but there's a lot of work that is ongoing and that should be ongoing on improving market design on the margin.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 3:50

Absolutely. So we had a, we've had a few diversions, but we are back on track. Then you'd say Lion in particular, I think we want to focus more on, on cross border trading in Fords and futures market. But before we get onto that topic, do you find that the Ford markets in electricity and gas are liquid enough at the moment? Is there enough liquidity in those markets?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 4:08

I think from a company that would like to hedge from a generator perspective or a load serving entity perspective, I think there can never be enough liquidity, right? The Moore is always the better here. You wanna buy and sell, you wanna have deep markets, you wanna buy and sell whatever volumes you want at any point in time. And of course we have the issue that many European forward markets are relatively short, have short horizons, right? We are talking about liquid markets. 1, 2, 3. Years into the future, and this is of course, falling short dramatically the investment horizon of any asset. Even batteries you can't hedge. But certainly not generational assets. And that will be of course something that we ultimately would like, right? Ideally you would hedge your investment at the point of FID on liquid forward markets, but that's very, very far from where we are. On the other hand. I think we do have a forward markets that are much more liquid than in many other places of the world. We have a de facto German physical hub that serves for hedging purposes for most European companies across the continent that has a churn rate of maybe eight or so, and that's pretty nice for the frontier.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 5:15

No absolutely. But we're seeing with the hedging strategy of some big utilities is changing. Some are pulling back from from selling three years in advance as they may have used to due to, the volatility prices, the volatility of, or the intermittency issues with renewable generation. Do you? How do you see that?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 5:32

I'm not so sure if the intermittency issue is a main thing here. Right. So I'm trying to tell people that if you wanna hedge, this is a price insurance decision, right? You wanna insure yourself against price risk. And that's very different from selling the output that you're physically gonna produce. And that's very much deep in the mind of both producers, generators, and and consumers as well as policy makers and regulators. So people tend to tell me. We can't use base lot futures to hedge our wind park because we're not producing baseload. And I, my response would be, yes, you're not producing base lot, but that still means a base lot. Future is a very reasonable hedge. Certainly much better than no hedge at all, right? Because the wind output, the capture price that you're gonna earn is highly correlated with the base price on timescales of a year or two. So I think that's not the main driver here. I think the main driver for changes in hedging strategy. Has been certainly some of the policy interventions, but maybe more profoundly the margining requirements during the crisis where it was just the amount of cash that sums pretty much every firm had to deposit was just, had reached numbers that, that were too high, even for the deepest pockets. And it's very sensible for firms to respond by this, by adjusting their risk position and reducing exposure to margin calls and maybe. Move more to forwards that are non-clear and hopefully go back to cleared futures over time.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 6:54

Yeah, no, I mean it's very interesting and it'd be interesting to see, in incomp results and what happens over the coming months. As we've, as you've say, as we've moved out of the entry crisis and return to some level of normality again in terms of energy prices and EUNG regulatory body, Acer has called firm. Regional virtual hubs to improve forward power liquidity. Can you explain what a virtual hub is and how it would work?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 7:22

Maybe le let's start with a bit of the context before we dive into this. I know virtual hubs on everyone's mind and was prominent part of the mark of reform discussion in Brussels over the last couple of months. But the proposal that a has made is actually much more. Much broader, much more far reaching and also older than the discussion. So Aser, I think it was in June, 2022, has published a policy paper that I think my reading is that it's preparing the ground for reform of the of the guideline that's regulating these long-term cross-border contracts. And they've suggested to do all kind of reforms. For example having these transmission rights, these long-term transmission rights being auctioned off more frequently and at longer maturities and changing their derivative types instead of options, having spread futures and installing a virtual hub. That's that's just, it's like I think we should think of this as one of the. Pieces of the reform agenda that ASA has pushed forward. So what is a virtual hub? A virtual hub is a different price index that serves as the underlying asset of forward prices. So today, across the continent, if you sign a forward contract. Financial future or forward in denominated in Germany or France. It's the German spot price or the French spot price respectively that is used to settle the contract. That's different in the Nordic region, right? If you buy a future on the system price, it's the system price that serves as the underlying, so that's the underlying asset that's used to settle the future. And the system price is a virtual hub. So a virtual hub is a new definition of an underlying. That is serving to settle forwards in future contracts.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 9:04

And why introduce that in the continent? The experience so far in the Nordic region has suggested that it hasn't always, it's not always the most feasible solution for many market participants. Why then go and introduce a similar one on the continent where the market seemed to function quite well?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 9:21

That's a good question. I think Aser is pointing to the Nordic region as almost as a blueprint in, in many ways. And I understand because a lot of the decision that, that the Nordic region has taken make a lot of sense to me. So theoretically that's a very reasonable role model, but empirically it's not in the sense that we've seen. Of course Nordic forward liquidity, like truly collapsing over the last 10 years, right? It's, it's not, has not disappeared, but it moved from a very liquid market to something that's not very liquid anymore. So empirically it's it's maybe more a red flag than a clear role model. On the other hand, the idea of virtual hubs, the idea of having a somehow defined price index underlying future markets is something that's very much established and very successfully used for many years across the United States, right? In the US where we have locational marginal pricing there's very few forward markets established on locational, on nodal prices. They're almost exclusively based on. Price averages across a broad area across multiple nodes. And that is nothing else than a virtual hub. So it's not that we've only have bad examples or poor performing virtual hubs. We also have very well performing and long living virtual hubs out outside Europe.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 10:41

But do we need such hubs then in Europe, I mean in the French and German markets?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 10:47

So we've thought about this quite a bit and to, to us it's not entirely clear. I think there is a bit of a sentiment among some, maybe also some in Brussels and Luana. That the current setup is perceived to be unfair because Germans have all this nice liquidity and the others are left in the rain. And I think that perception is a misinterpretation of how markets are used because it's, of course, daily business of generation firms in Belgium and Austria and Hungary and France and load serving entities in Denmark and Italy. To use the German forward market as a hedge. Again, because hedging is not about selling or buying electricity, it's about insuring against price risk. And being insured against the German price risk is a pretty good insurance against the Hungarian or Austrian press ever because these markets are highly correlated in their forward prices. So proxy, hedging in a word is very common. And it's not that only German firms use the German forward market, quite the opposite. Firms across the continent benefit from that liquidity. So I don't see the current setup as being unfair towards other bidding zones. And hence from that perspective, I don't think there's a need to act urgently.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 12:05

And of course there's also a correlation here. With the discussion about splitting the German market zone as well, isn't that, do, what do you think the German zone should be split?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 12:16

I think this is not just a correlation. There's some causality here. Okay, sure. My own personal opinion, and I don't make many friends here in Germany with that has for a long time been that a split of the German bidding zone is, would be very helpful and necessary and and would be very beneficial to us and our neighbors. But maybe let's not dive into that discussion too much. But I do think the virtual hub question and the bids zone split are linked in the following way. If the German bids zone. Where to remain, let's say for the next 10 years. If he were sure the German bidding zone would stay as is for the next 10 years. My gut feeling is we don't need a virtual hub because we can continue to use the physical hub, and it's very doubtful that a virtual hub would be performed better than a German market. So there's, I think, a pretty good risk that even if we introduce a virtual hub, it would stay. Void and would be little use and maybe even split some liquidity and be, would end up being worse off by having a less liquid lack, lacking a unique liquid big hub physically or virtual. But if you believe the German bidding salon is going to be split sometime in the 2020s or so in, let's say five or seven smaller biding zones. If that would happen, it's much less clear that any of these bidding zone could support a big liquid physical hub because there's no kind of natural, big bidding zone anymore in the middle of the continent that could kind of attract all that liquidity. And if we would lose that without a replacement, that would be an awful outcome. Then we would all be left in the rain. So in that situation, I would personally, as my gut fitting, tells me. We should have a virtual up hub up and running in, in sort of being prepared for that situation because then we need it. And that's of course where we enter politics. Right? Then you find people who are arguing in favor of a virtual hub. Not because they really like a virtual hub, but because they wanna prepare for a potential bidding zone split. And then there's also others who, who argue against the virtual hub, not because they don't like it, but just they wanna pretend or they wanna prevent the German bidding zone to be split. So then. Then it's nasty and deep politics. Exactly. Very much

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 14:35

I'm about to say. That gets very political there. You also touched upon some of the other changes that Acer has called for some of the proposals anyway in detail. Now in, for example, there are so changes on how grid operators sell long-term transmission rights to help improve market liquidity. How does it work now and how would it then change under these proposals?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 14:59

So today, European owes are obliged by law, by European law to submit what's called long-term transmission rights. So they have established an entity that's called jail and they hold annual auctions and also monthly auctions where market participants and commodity trading houses can buy these LTRs fir. First of all, the term LTRs, I find a bit misleading because. It very much sounds what it historically was, physical transmission rights. But really this is not transmission rights. These are all financial derivatives, very much like forwards and futures. So if you ask me, we should actually drop the term because we, it's confusing to, to everyone because we all think of physical lines, but we should rather think of financial derivatives that help people to hedge. Against the price risk across bidding zones. So to hedge yourself against the risk that the Belgium price will be higher or lower than the German price or the Austrian price will be higher or lower than the German price. That's the purpose of these certificates, of these contracts.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 16:05

So it's a, so for companies who are active in both markets and want to, ensure themselves against any the price is moving in the opposite direction to which they want them to move in, if you like.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 16:14

That's one possibility. Another possibility is imagine you are a. A check based generator and you've sold German futures to hedge yourself, then you are exposed still to the price risk that the check prices might diverge from the German prices, and that remaining basis risk is something you would like to hedge using these cross border products. So the setup of today is that TSOs have to do this and the auction is off on that platform called jail. And they do this by selling options. So they're selling what's in the academic literature is called financial transmission, right Options, FTR options. So these are options on the spread between two electricity prices. So it's an option on the German French or the German Czech electricity price spreads on the hourly day. Head spreads. That's what they sell today. And indeed, and maybe let's talk about this briefly. In our view, the biggest proposal that AA has made in their policy paper two years ago is not even the virtual hub that has gained so much sort of attention, but it's a much more what seems to be a technical change, and that change is to change the type of derivative that's sold by TSOs from an FT R option to a so-called FTR obligation.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 17:30

So explain that. What, what does that, how does that change the whole system and then the practice of hedging that cross, cross border electricity?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 17:38

So an FTR obligation, that's another term that I don't find very useful because a financial transmission right obligation is a bit of a contradictory, right? Either. Either something is a right or it's an obligation, but having that's also an obligation is a bit confusing. I think the best to think about these contracts as being financial derivatives. That have an underlying, that's the spread between two bidding zones like ja, the German French spot spread, and an FDR obligation, the one that AA would like to see coming. It's nothing else than a future on that spread. So we call it a spread future because that's what it is. It's a future contract on that spread. By the way, these contracts are traded today under different names. Effectively what you can trade on ex what they call a spread products is very much the same contract, just that spread. Products are not issued by TSOs. They're traded among. Market parties and AA would like to make TSOs sell the same spread futures. And what you what's helpful to know about this, that it's a spread future is nothing else. It's exactly the same thing as a combination of two domestic futures. So if you sell a French German spread future, that's absolutely the same thing as selling a German future and buying a French future at the same time. So it's just a combination of two futures. It's a linked future, and you can see that if you trade on ex you can in, in the graphical user interface in the front end, you can buy or sell a spread future, but in the back end, in the system that's implemented as the simultaneous trade of two domestic futures of selling Germany and buying France at the same time.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 19:22

What does Acer or how would you suggest that these kind of contracts get sold in the future? Is there a certain you mentioned the joint allocation office, the J you mentioned exchanges. Would that continue that way? Or, there's also talk, as far as I understand of TSOs auctioning these contracts as well. So there's a greater role for the grid operators here is they're not.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 19:46

JAO is owned by the tso, so JAO is essentially a service entity the Joint Allocation Office for the TSOs. So the setup today is that JAO kind of runs the auction on behalf of TSOs. And I would assume, and I actually support the idea that would continue, that we have separate auctions for these long-term transmission rights. The alternative would be for TSOs. To actually engage in continuous forward markets themselves, but regulated entities, doing, actually trading on the market is a bit of a dangerous thing. As we've seen in the energy crisis. It's easy for proper traders to make private benefit out of that situation and they might be not being the best position to do this. So having separate auctions back sense, if they must be conducted by j. That's not entirely clear. It could also be someone else. So this, the Swedish transmission system operator, Svenska Kraftnett, has run similar a auctions and they have commissioned a broker to do that on their behalf. That's a possibility. Another way to look at this is European governments. Sell off their emission certificates their uas, and they ask someone to do that on their behalf. So it's not the German government that runs the auction. It's in that case, it's ex the energy exchange that does it on that behalf. They could also be a possible candidate for running these LTTR auctions. In my view, that's a service that should be tendered and whoever does the auctioneer as the best service at the lowest price in my view should do that job.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 21:17

Because if the TSOs were to do it directly themselves, that would obviously change their roles quite substantially in the market. And it's this is very complex, as you said, they're not they're not commodity trading houses, so maybe they shouldn't be in that role as well as guaranteeing security of supply.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 21:34

In a way. Yes and no. So I look at them the same way. They shouldn't interfere with markets. They shouldn't change prices. They shouldn't trade, they shouldn't take positions. But if you emit ATTRs and they've been doing this for at least a decade or so, you effectively do all that. You do engage in the market. You do take a position, you do affect prices. So every FTR option that today, German or European or any other TSO sells through these auctions are bought up by someone. And that might be a commodity trading house. It's not so much the small utilities. It's probably more professionalized trading houses. And they buy these options and what they usually do is they can either keep them on their books for speculation, they believe it's a good price, they like to keep the risk, and they they keep that on the books and help to make a profit out of this. Or at some point they start Delta hedging that option. So they take a position, let's say they've bought a. German Belgium, FDR option. So they start taking positions on the German, at the Belgium forward market. So maybe they sell German forwards and they buy Belgium forwards. And by doing so, of course. They will impact forward prices, right? If they do this in large volumes, they do shift they, they do shift the forward premium. They introduce a shift in the prices. And effectively, if you take the whole chain, and if you look at this from the end to the be to the, from the beginning to the end of course, TSOs, by setting these options, did have an impact on prices and did shift the Belgium and the French and the German forward price. So the view that T owes. Shouldn't have, do anything that will impact prices. It's just incompatible with the very notion that they should sell LTRs. It's not just capacity, what they sell. You can't sell just capacity forward. You always have an impact. On forward prices and forward markets.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 23:36

Absolutely. No fascinating. Lion. Just finally to say, okay at the moment they're just proposals. They're, what would, what needs to happen for some of this to actually come into force and how long do you expect that to take?

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 23:49

So there is a bit of that reform in the legislative process for the electricity market reform that I'm not sure, but should be. Done soon. There's been a compromise two months ago or just before Christmas actually. But that's relatively soft language. So the virtual hub is mentioned, but there also needs to be an impact assessment first. So the legislative track with the electricity market. Directive and regulation is one end. And then there's possibly a reform of the forward capacity allocation guideline of the FCA one of the network codes that we have that establishes or prescribes how, when and how much L TTR TSO TSOs must issue. And that's probably where that reform would be implemented. I'm not a legal expert. I'm not a policymaking expert. That's my guess. And that could happen or be formally started by the end of the week the end of the year maybe and come into force next year. But that's really a wide guess. I'm not, I'm not very much involved in these processes. I'm, my concern is mostly that we very much understand what kind of reform we are taking and my. Reading from the discussion, following the debate and following the statements and following the arguments and workshops and stakeholder consultations, is that even fundamental questions are still not well understood by everyone. And there's a lot of, a lot of loose ends that we should close before changing the law and changing the way the market is set up.

Snjólfur Richard Sverrisson, Editor-in-Chief, Montel: 25:26

So a lot of work that still needs to be done here, Lion. Many thanks for joining the Montel Weekly podcast, Lion.

Lion Hirth, Professor at Hertie School and Director at Neon Energy: 25:33

Thanks for having me.