Prof. Michael Kraus,
College of Technology and Design, Mannheim University of Applied Sciences
While electricity spot and futures exchanges have been late to develop in Germany, it is a crucial market in the evolution of a pan-European energy system. The race is on between Frankfurt and Leipzig to develop a dominant and liquid exchange.
The wholesale electricity trading market is fast becoming the hub of competition in the European electricity industry. It will be home to futures, swaps, options and weather derivatives, and is where the major German and European players will come face to face with one another: generators, wholesalers and major industrial consumers, as well as the regional and municipal electricity distributors.
Deregulation in Europe has encouraged the development of electricity exchanges.
The electricity spot and futures exchanges, which are relatively late in developing in Germany, are institutions pertaining to the wholesale market. The size, heterogeneity and geographical location of the German electricity market all favour electricity exchange development there. But there are also electricity exchanges in neighbouring markets, such as the Netherlands and Scandinavia, which means that development of the German electricity exchange itself is subject to competition. For example, the Amsterdam Power Exchange (APX), which has been holding daily double-sided portfolio auctions for spot contracts since last year, would like to set up a trading platform in Germany as well. And the Scandinavian electricity exchange NordPool is seeking to gain a presence on the German spot and futures markets through a partnership with German exchange initiators.
For a long time, efforts have been made to set up an electricity exchange which is tailored to the German market and which does justice to its requirements and peculiarities – it is a market which is set right at the crossroads of Europe and which has the largest number of power stations, and so has important implications for energy trading development in Europe. Independently of one another, financial institutions, state governments, the securities exchange in Düsseldorf, the futures market in Hanover and Deutsche Börse AG all initiated separate electricity exchange projects.
Even in these early stages, these initiatives were in competition in terms of finding the most suitable location for the exchange. The projects did not originate from the players in the electricity market as much as the politicians and, above all, the banks and stock exchange operators, whose interests and skills naturally lie in stock and futures trading and the provision of system services such as settlement and clearing.
Only the Leipzig initiative showed any interest in a spot market at an early stage, although it did suffer as a result of the lignite protection clause in the new energy legislation restricting electricity trading in the former East German states.
There are discussions underway between London and Frankfurt to establish a ‘global’ European exchange.
Last year, a project group was formed from within the finance and energy industries in order to amalgamate the various exchange initiatives. There was no time to waste – as exchange developments elsewhere were moving on apace and Germany could not afford to lose out – so the group drew up a profile of requirements for an electricity exchange, on which basis the panel favoured the Deutsche Börse AG in Frankfurt. The fact that the New York Mercantile Exchange (Nymex) was originally available as a product development partner in Frankfurt must have played a role in this decision.
Despite the fact that the vote had gone Frankfurt’s way, the Leipzig initiative continued undeterred with its plans to set up a spot exchange. This is set to open in May this year in the form of a daily double-sided auction for spot contracts, initially without block trading features. A futures market is due to follow nine months later. The Leipzig Power Exchange (LPX) was founded in conjunction with the Scandinavian exchange operator NordPool. The Sächsische Landesbank and the Scandinavian electricity exchange both hold a 25 per cent stake, and several east German states also have holdings in the company. Up to one fifth of the electricity turned over in Germany should be traded on the Leipzig spot market. The model is similar to the Scandinavian one in that only one power contract will be traded for both German trading zones, and pricing will be on a zone basis in the event of bottlenecks in the transmission grid.
The wholesale market in Europe cannot be further developed until rules on cross-border transmission are properly established
Over the last year, the Frankfurt initiative has expanded into a joint German and Swiss project – EEX, the European Energy Exchange. The pan-European trading platform will be based on the electronic trading system of the Eurex futures market, and market players will be able to access it through Internet browsers as well as a separate communication line provided by Deutsche Börse. It was to take the form of a futures market without market makers and with continuous trading for electricity futures, an open limit order book and physical delivery, but EEX has now said that it will operate an integrated spot and futures market. The spot market will begin this summer and the hedge market in the fourth quarter this year. In the longer term, the plan is to accommodate additional products, such as oil or natural gas.
EEX is owned by German and international energy and finance industries, who hold 52 per cent, and Eurex and its partners, who hold 48 per cent. Before the end of this year, EEX is due to open and trade four contracts, one monthly contract for the north and and one for the south trading zone, for peak and base load power each. Last autumn, EEX announced it was to set up a spot market, too, for which it was bringing together a working group consisting of market players and transmission grid operators.
A head start
Supply and demand bid curves
With initially two exchanges out there, there will be several spot markets in competition with one another. The European exchanges are working on the assumption of a consolidation of the national exchanges in the medium term; therefore the coexistence of different national electricity exchanges is not an option. This poses a question with respect to the spot market as to whether it should be LPX, EEX or German APX, or a joint international venture right from the beginning.
The answer will lie in the far-sightedness and tactical skills of the players in question which will enable them to decide which measures should be taken and which omitted to ensure that, at the time at which a possible merger is mooted, their market has the expertise, systems and market support to be sufficiently interesting to other parties and to bring synergies to bear within a jointly operated exchange.
The expertise is currently widely distributed. APX and NordPool already operate spot markets on different commercial trading systems and have skills and market support in their electricity markets, and even the support of German companies trading in the Netherlands or Scandinavia. What is important for market success in Germany is support from the relevant German and Swiss market players, and this is something EEX does have, plus it is currently building up its expertise in electricity trading. It has developed its own successful electronic trading systems which are currently being tailored to the requirements of electricity trading.
The willingness or necessity to undertake a joint approach will become apparent if and when one exchange implementation can be more rapid and can reach a critical level of liquidity earlier, which would therefore be detrimental to other exchanges. In this regard, time is on EEX’s side. It has been working on setting up the electricity futures exchange for months, thus creating the right conditions for the implementation of a spot market. It would be logical for the other players to take steps towards implementing an electricity exchange soon, and to back up these measures with concrete project teams, investment, information events and training sessions for traders. The absence of these measures can hardly provide adequate incentive for other parties to be interested in a joint operation.
The market will also put pressure on the exchange operators. The ‘Europeanization’ of equity capital in the electricity industry is highly advanced, and the major players are active in all the European electricity markets. This will eventually result in demand for a single power exchange with uniform rules and technologies and a single interface to operative trading. It has already happened in the Scandinavian market, and it will not be long before the continental market is also demanding a single power exchange. However, the wholesale market cannot be further developed across Europe as a whole until the rules on transmitting electricity across national borders are developed further.
For market operators, this pan-Europe level of development provides an opportunity to concentrate liquidity, which means higher turnover and reduced transaction costs, generating yet more liquidity. Strategic alliances between individual exchanges will not achieve this goal, the only step that will are mergers and especially unified trading, settlement and clearing systems.
There are currently discussions to establish a ‘global’ European exchange between London and Frankfurt. Deutsche Börse has said that if the two team up, it will drop the spot market ‘Xetra’ system in Frankfurt. What the implications would be for Frankfurt are unclear.
Internet markets will radically change the initiation, negotiation and processing of electricity transactions and will eliminate some elements of the value chain between power producers and end-consumers. In the financial markets, private market operators have increasingly emerged in recent years. These are known as ECNs (electronic communication networks), and are increasingly making their presence felt in the stock and derivatives markets.
ECNs are not exchanges in the strictest sense, and require neither a credit institute license nor any regulatory exchange permit. They take liquidity from traditional central exchanges such that their systems are more cost-effective and user-friendly, roughly relative to the trading periods, products or trading forms.
They are operated by banks, private companies and international information providers, such as Reuters, Bloomberg and Telerate, which have global networks stretching as far as the trading floors of the market players.
A few ECNs are now beginning to operate in the German electricity market. SAP has introduced an online exchange for electricity and other commodities under the name of industry-to-industry (i2i) and this can be integrated as a module into existing standard software packages.
The platform provides tenders, auctions and exchange trading as transaction models.
The broker company Energy & More is collecting electricity demand bids from German companies in order to negotiate better terms from domestic and international electricity suppliers. The cumulated demand is tendered on the Internet, and the producers respond with their asks.
NetStrom also provides an electronic marketplace, where spot transactions are carried out. Offers to buy and sell from a large number of energy suppliers, especially smaller municipal ones, can be accessed online. In the future, the transactions will be settled and cleared through a major German bank.
At this stage, it is only possible to draw up a sketch of how the German electricity exchange market will look in a few years’ time. If the situation in the finance markets can be approximately extrapolated to the electricity market, then the internet will not only mean that exchange operators will have to adjust to new forms of competition, notably in the spot market, but will also force them to develop a whole new understanding of business which goes beyond their traditional core activities. And in the same way as it would be wrong to assume that Internet-based trading platforms will be restricted to niche markets, operators of ECNs should not assume that the traditional exchange operators cannot adopt new, innovative approaches in order to face up to the competition.
It also goes without saying that the fierce competition in the electricity market will increase the pressure on the market players to act. Electricity suppliers cannot continue to operate with cost prices and secure margins. They need to find new purchasing and selling methods and, in doing so, need to consciously enter into risks.
The electricity exchange is the appropriate medium for this. Therefore it is crucial that all market players get to grips with the techniques and instruments associated with electricity trading and the operations of electricity exchanges, auctions and risk management, and implement appropriate dealer training as early as possible.