Forward market & NC FCA criteria explained.

Small & large bidding zones combined, is it possible?

An egg of Columbus satisfying both physical laws and competition

Heine Rønningen 01.10.2014

Why do we need a forward market?• Greed:

• Trading.• Risk taking with expected positive

return.• Fear:

• Hedging.• Offsetting risk stabilizing expected

return.

• Greed & Fear:• Order of the factors is important.• Fear comes first in a well functioning

market.• Market design must be based on

hedging needs.• Must be able to attract risk capital.

• Distribution of returns:

Risk takers expected return must be positive

Risk premium is kept at a decent level by competition

Hedging premium from generators

Hedging premium from consumption

Maximum return on risk capital

Additional market activity = Zero sum game

+

=

Different hedging needs in generation/ consumption could lead to high hedge premium

• Convenience yield/Natural backwardation: Insufficient short term supply / Insufficient long term demand

• Traders heaven RISK < RETURN: Too high hedge premium an indicator of inefficient market• Why is the free lunch rejected by risk takers?• Is it a competition issue?• Socializing trading by Introducing TR that cannot be

used for hedging (firmness etc.) => a step in the wrong direction.

• Hedgers heaven RISK > RETURN: Too low hedge premium:• Shake out of risk capital.• Socializing hedging by Introducing TR that reduces risk

too much => a step in the wrong direction.• What is high\low when it comes to risk premium? Is it

possible to find neutral KPI?• Different Bidding Zones cannot be outright compared.• Need adjustment for differences in natural volatility.

---Normalized marketprice, --- Actual Marketprice

High supply, low demand

Low supply, high demand

A inefficient market «needs» regulation• Need a clear understanding of the problem to select the right

tools for solving the problem:• What is “wrong”: no need for hedging, dominant market players,

small bidding zones, information unevenly distributed…..• How to intervene: selecting the right tool depending on the problem.• Reaching the objective: thresholds for ending market intervention.

• NC FCA regulates market intervention with a intention to improve market efficiency:• One single tool/instrument to solve all kinds of problems (TR).• Market intervention is default solution in all Bidding Zones.• Criteria for exemption in Article 35.• “No” criteria to continue intervention.

NC FCA requires hedging opportunities in all Bidding Zones• NC FCA criteria for TR exemption:

• Available and relevant hedging instruments:• Article 35 a: Relation between hedged item (generation or consumption) and hedging instrument.

Thresholds according to IAS39• Efficient pricing of hedging instruments:

• Article 35 b: Requirement for hedging cost (hedging instrument spread). Based on Richard Roll spread model.

• Nordic area: 12 Bidding Zones with efficiency requirements.• No need for efficient instrument pricing in all Zones if thresholds in Article 35 a is met

(e.g. Systemprice hedge could qualify).• Cannot expect to qualify for Article 35 a) under very wet/dry conditions

• => No market makers on EPAD is a step in direction of TR in the Nordic countries

• Value offset hedged item and hedging instrument must correlate:• Slope between 0,8-1,25• R-squared > 0,8

• Hedged item = generation/consumption:• Each hedged item belongs to 1 Bidding Zone.• No hedged item is x-border.• Dynamic BZ creates uncertainty.

• Hedging instrument = long term contracts:• Local Bidding Zone• Neighboring Bidding Zone• TR + Neighboring Bidding Zone• Systemprice (UCP)• EPAD + Systemprice (UCP)

NC FCA Article 35 a: IAS 39 criteria

NC FCA Article 35 b: Implicit spread• Richard Roll, Professor at UCLA• “A Simple Implicit Measure of the

Effective Bid-Ask Spread in an Efficient Market” in “The Journal of Finance, Vol. XXXIX. NO. 4, September 1984.”• The most quoted market efficiency

model based on market data only• Implicit spread = 2 x Square root

(Absolute value (Covariance (Short term change: Long term change)• Actual spread < Implicit spread

Ask

Bid

Spread requirement not too demanding. Last levels of efficiency must be reached on a voluntary basis

Small Bidding Zones and Competition

• Systemprice area consists of 12 Bidding Zones.• 12 Bidding Zones with

requirements for hedging opportunities could be a tuff challenge.• No market maker on Norwegian

EPADs at Nasdaq OMX.• Assumption of a physical rationale

for the 5 Bidding Zones in Norway.

How to improve competition?• National border serves as the only

fixed Bidding Zone border: --------• Fixed borders could also be

implemented internally in Norway.• One possible border could be south of

NO3: --------• If new fixed borders are implemented.

EPADs for larger areas could be quoted.• TSO will face the same degree of

freedom to change Bidding Zones. No reality change from current solution.

How to improve competition?• EPAD South = VWAP (NO1, NO2, NO5)• EPAD North = VWAP (NO3, NO4)• 5 BZ => 2 EPADs with improved

competition compared to individual zones.• Correlation EPAD South and NO1, NO2,

NO5 not perfect, but better than Systemprice.• 5 BZ still 5 BZ in DA/ID/IB.• EPAD North could be expanded to

include SE1 and SE2 + several other options

EPAD Sør

EPAD Nord

What if BZ changes across fixed borders?

• E.g. expanding NO5 north: --------• Under current rules: NO5 can be expanded.

No need for new BZ.• With new solution: a new BZ NO6 will be

implemented. Capacity between NO5 and NO6 can be set unlimited => NO5 and NO6 will be equal priced. Same result as if NO5 is expanded under current rules.

• EPAD South and EPAD North can be calculated under the new rules.

• EPAD North = VWAP (NO6,NO3,NO4)• The objective of improved competion and

better correlatation still valid, even for NO6

EPAD Sør

EPAD Nord

NO6

NO5

What is needed?• Solution requires no system changes for physical markets. • Solution is purely a commitment to keep some borders fixed.• Solution gives the opportunity to trade longer term contracts with reduced basis risk compared to

outright Systemprice and improved competition.• Fixed borders should be implemented with considerations to physical constraints (south of NO3 is

an example).• Gives the opportunity to quote «x-national border EPAD» based on generation mix or other =>

More attractive for both hedging and trading• Hydro EPAD (NOx, SE1, SE2)• Thermal EPAD (FI, DKx, SE4)• Same method can be used for PHELIX splitting• Physical or financial does not really matter. Last level of Congestion rent can be accounted for

seperatly.

Different physical and financial zones also applicable for continental Europe

PHELIX ELIX Systemprice

• Other markets have the same solutions (oil, gas, coal, freight) where the relation physical and financial structure is not 1:1.

Focus:• Avoid a polarized debate with bad compromises• Physical expansion of Bidding Zones to improve competition could lead to

costly countertrades or new unnecessary interconnectors.• Small Bidding Zones could lead to less competition => local monopoly.

• Create conditions for both physical and competition needs• Regulations can push the market in the right direction• Regulations can never take a deregulated market to a high efficiency level

• IEM includes competition as an instrument to reach the objective of a well-functioning market.