Land of opportunity

Liberalization of the European energy markets over the past few years has brought both challenges and opportunities for players in the market, and one opportunity to arise is energy trading. PEi takes a look at one utility embracing competition in Europe, and how trading has become a useful tool as the barriers to competition slowly fall.

Siân Green,

Senior Editor

On 19 February this year, the EC directive on electricity market liberalization became effective, requiring the member states of the European Union to implement minimum measures to open their markets. Now, all member states, bar Greece and Ireland, have met these requirements, and liberalization is underway.

The directive includes requirements for network access, transmission system unbundling and the implementation of new generation capacity. Each member state`s electricity market should now be 26 per cent open, with customers with an annual consumption of over 40 GWh able to choose their supplier. Ireland and Greece were granted extensions to the 19 February deadline.

By 2003, Europe`s electricity markets will be 33 per cent open, and further liberalization could be implemented by a 2006 deadline, pending the agreement of the Council of Ministers. The EU`s aim is to create a single European market – for both gas and electricity – and to promote competition.

But in spite of these minimum requirements, the pace of reform across Europe has varied and there is a general north-south divide. The northern countries, such as Sweden and the UK, made a head start in liberalizing their markets whereas countries further south, including Greece, Italy and France, have been notably slow. In Sweden, Finland Germany and the UK, all consumers will be able to choose their electricity supplier by the end of 1999. Norway, although not an EU member state, is also advanced in its liberalization measures.

Although some countries in Europe began opening their markets as early as 1990 (UK) and 1991 (Norway), competition in the market has been largely driven by the EU directive. Competition has created a new environment in the market and has had a notable impact on utilities, which have re-oriented themselves considerably in the face of competitive pressure. Many utilities have developed new business areas in order to seize opportunities outside their home territories. One of these business areas has been trading.

As a result of competition, pools, spot markets and exchanges catering specifically for the electricity market have emerged in the UK, Scandinavia, Spain and the Netherlands. Other countries, such as Italy and Germany, are discussing trading developments. As these operations evolve they are becoming gradually more sophisticated, and have become an efficient and cost-effective tool for buying and selling power within a region.

One European utility to have ventured into energy trading is Eastern Group, a UK-based integrated gas and electricity utility formed during the restructuring of the UK electricity market in 1990. Its core operations in the UK centre around its retail arm and it is active in the UK pool where it manages the output from its gas- and coal-fired generating capacity. Over the past two years, it has focused on building up its operations in Europe.

Eastern`s trading unit, Eastern Power and Energy Trading (EPET), trades approximately 160 TWh of electricity and 5 billion therms of gas per year. The trading operation is a central part of Eastern Group`s overall strategy for building its business outside the UK, a strategy which it embarked on in 1997.

Humble beginnings

Eastern`s first move outside the UK began on 4 November, 1997, when EPET became the first British company to trade electricity on Nord Pool, the Norwegian and Scandinavian power exchange. Initially trading from its Ipswich head office, it soon opened an office in Stockholm, Sweden.

Nord Pool was created in 1993 as the world`s first international commodity exchange for electricity and as of 1 March 1999, had 265 participants from Norway, Sweden, Finland, Denmark, the UK and Germany. It is 50 per cent owned by Svenska Kraftnät, the Swedish national grid, and 50 per cent by Norway`s Statnett. It has developed rapidly, trading physical (spot) and financial (futures and options) contracts.

Eastern is one of the major players in the UK market, and in the mid-1990s was quick to recognise the opportunities developing in Europe as a result of deregulation. In particular, it saw the Scandinavian markets as a good place in which to gain its first foothold due to the rapid market liberalization that was taking place in Norway and Sweden. According to Mark Haslett, Eastern`s head of portfolio strategy, “It was clear to us that the European market was liberalizing, and obviously the Scandinavian market was somewhat ahead of the rest of Europe.”

Eastern`s strategy for Scandinavia was to gradually build a strong portfolio of products, but realised that in spite of a strong track record in the UK, it had a steep learning curve ahead of it. The company decided that its first step would be to begin trading on Nord Pool. According to Haslett, it believed that trading would help it understand an electricity market very different to that in the UK. “Trading [on Nord Pool] was not an end game in itself,” said Haslett, “but it got us into the market and understanding its values. It was therefore part of the learning exercise.”

Understanding the differences between the UK and Scandinavian markets was an important part of Eastern`s success. The UK is dominated by thermal plant while Scandinavia is dominated by hydropower plant, and the two markets therefore operate very differently. According to Haslett, the Scandinavian electricity market operates very much like the UK gas market as the hydropower plants allow the capacity for energy storage. “Obviously the characteristics of the Scan- dinavian markets are very different as they are dominated by hydro- power assets,” said Haslett. “Understanding these similarities and differences was part of that learning curve.”

Eastern was quick to learn, however. By the end of April 1998 it had closed a deal to acquire a 55-year lease on two hydropower plants in Norway – Svartisen and Kobbelv, and in June 1998 announced a 50-50 retail and trading joint venture with Swedish energy company Lunds Energi.

Under the hydropower leasing deal, EPET has acquired the rights to an 89 per cent share of 210 MW of the two plants` combined 650 MW output. Lunds Energi is responsible for the remainder of the output from the hydro plants. Lunds Energi itself currently retails around 1.5 to 2 TWh of power per year in Sweden.

The move to begin trading on Nord Pool therefore allowed Eastern to gain a foothold in the Scandinavian market and acquire new products. “We are building a portfolio of positions in the Scandinavian market,” said Haslett. He added: “It is a relatively easy aim to achieve. You just need a license [to trade] and then you can move on after you have begun to understand the market; this is what Eastern has done.”

But aside from giving the company the chance to understand the market and the value of goods traded on it, trading is an effective risk management tool that allows Eastern to manage its growing portfolio. As Haslett explained, Eastern sees itself as a portfolio risk management company rather than a trading company: “Eastern does a lot of trading, yet the core of that business is not trading but risk management.”

A European aim

Since its initial foray into Scandinavia, Eastern has applied a similar strategy in other parts of Europe. The company`s aim is to build a flexible pan-European energy portfolio throughout the gas and electricity supply chains, and has offices and operations in Germany, the Netherlands, Spain, Poland and Italy, to name a few. “We are already a European business, but what we need to do is have a focus throughout continental Europe,” said Haslett.

Eastern freely admits that in spite of eight years of operating in the deregulated UK market, it has little experience of overseas markets. The company therefore believes that the most effective way of achieving its aim is through partnerships and joint ventures. It feels that partnerships with local companies will help to level the playing field as it tries to build value for both itself and its partners. “What we are trying to do is combine the skills that we have built over the last eight years and our knowledge of how markets work with the local knowledge and skills base,” said Haslett.

Eastern has now established joint ventures and partnerships, some of which involve trading, in several countries:

• A controlling interest in Teplarny Brno, a district heating company in the Czech Republic, and a stake in SME, a Czech distribution company

• An industrial and commercial gas retail joint venture – Compass Energy – in the Netherlands with Energie Noord West

• An energy retail and trading joint venture with Lunds Energi

• An energy trading joint venture with Spanish electricity company Hidroelectrica del Cantabrico.

Spain is one of the rapidly liberalizing countries in Europe, and in December 1998 Eastern announced that it had secured an international strategic alliance with utility Hidroelectrica del Cantabrico. Eastern bought a five per cent share holding in Hidro for £54 million to cement the relationship, which is designed to help Eastern capture energy trading and risk management opportunities in the Iberian region. “Spain is one of the key markets in Europe,” said Haslett, “the intent is to become a major player there.”

Eastern is now actively trading in Spain, Europe`s fifth largest electricity market, and also in Portugal. Because of the speed of deregulation, Eastern sees many opportunities developing in this market despite the criticisms of those who believe that the larger utilities still have too much market power. Haslett acknowledges that this could inhibit liquidity developing in the market, but said: “These things take time; at least we are there.”

The relative isolation of the Iberian grid from the rest of Europe highlights one of the barriers to the European electricity truly becoming a single market with cross border trading. There is currently a single 700 MW electricity interconnection between Spain and France, 550 MW of which is taken up by a long term contract. Opportunities for cross border trading are therefore limited, a factor that is evident across many parts of Europe.

Crossing the borders

Although the EU is aiming to achieve a single market for energy products throughout Europe with its directives, at this early stage of deregulation, there are still 15 separate markets rather than one. Electricity trading is playing a major part in increasing liquidity, and is widening the scope of the national markets, but the four pools and exchanges remain separate. A single market is thus several years away.

Another barrier to the development of trading in Europe is the issue of cross-border tariffs which vary considerably from country to country in terms of rate and structure. To develop a more liquid environment these tariffs will need to be standardized, a goal that the EU is attempting to reach by a 2002 deadline. According to Haslett, the debate on cross-border tariffs is beginning to reach a consensus. However, he believes that providing the solution is practical and workable, it can be constantly improved. “Whatever solution is found, you need to make it work,” says Haslett. “Then it will evolve.”

The varying pace of deregulation between different countries is also an issue, and together with cross border tariff issues, is preventing the convergence of electricity prices in Europe. The large electricity consumers are acutely aware of this factor as they begin to shop around, and because of this, they are themselves creating pressure for the markets to become more liquid.

Eastern is naturally aware of these problems, but seems prepared to wait for the market to evolve. “The issues are not easy,” says Haslett. He asks: “How do you go from 15 separate markets to one single one?” Eastern`s approach is to treat the European market as if it were unified; it believes that this approach brings value. “Trying to treat the whole area as one portfolio adds value, because ultimately it will be one market,” said Haslett, “it`s a mindset.”

Nevertheless, Haslett believes that it will be at least five to ten years before the European market has reached the stage where the natural gas markets are in the US at the moment, i.e. there are a number of separate markets but it is possible to trade between them.

New opportunities

As the trading markets in Europe develop and become more sophisticated, further opportunities have arisen in this arena such as emissions trading and weather derivatives. Eastern sees little point in trading pure weather derivatives – electricity and natural gas contracts already have a certain element of the weather embedded in them. They are only practical if the market for them is sufficiently liquid and there is enough customer demand, according to Haslett.

“If you are trading electricity or natural gas, you are, whether you like it or not, trading weather,” says Haslett. “Whether you want to trade pure weather derivatives or not would depend on the market conditions – we would be happy to trade this if there were customer demand for it. We are about risk management, not just trading, and if weather derivatives help us do that then we would be happy to trade in these kinds of products.”

When it comes to emissions trading, however, Eastern is much more enthusiastic. Haslett says that the company would definitely become involved in this if it went ahead in Europe as it would be an effective and useful risk management tool. “The SO2 experience in the [USA] has shown that you can do it,” said Haslett.

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Figure 1. Eastern was attracted to Scandinavia by its advanced liberalization measures

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Figure 2. Characteristics of the Scandinavian power market

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Figure 3. Quantity of power traded on Nord Pool, 1993-1998, TWh

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Figure 5. The European electricity market consists of four separate electricity pools and exchanges