Emergence of financial markets for electricity: a European perspective

Abstract

Deregulation directed at European energy markets is proceeding, although the speed often may seem slow. Real changes are coming in the development of physical and especially financial markets for electricity. Electricity deregulation started in individual countries, notably the United Kingdom and Norway, and the Norwegian effort spread to the rest of the Nordic region before the Union's 1996 Electricity Directive started to have a real impact. Electricity deregulation is a complicated process, involving breaking up of generation monopolies, unbundling of generation and transmission, consumer choice of suppliers through local distributors, and eventually perhaps the establishment of a power pool, where physical as well as financial contracts are traded. The deregulation process now has gone far enough to reap some experiences. The original UK deregulation model, which focused mainly on breaking up the generation monopoly, proved somewhat inefficient because it didn’t offer real consumer choices and opened for inefficient gaming strategies among producers. This experience has pushed the United Kingdom in the direction of the Nordic model. Norwegian deregulation is peculiar in the sense that new entry to generation is highly restricted. On the other hand, Norway — now with the entire Nordic region — has developed a quite advanced and quite well-functioning electricity trading pool, with widespread financial trading and good liquidity. Part of the success of the Nordic model comes having a high-quality spot price which can be used as a benchmark for the pricing of financial contracts. Another possible source of success is the high proportion of hydropower, for which production volumes can be adjusted quickly and outages and price spikes thus avoided. The Swiss experience further underscores the importance of a spot-price benchmark, because the extensive Swiss physical trade has allowed a growing volume of contract trade even in the absence of deregulation. From these experiences we propose four factors we believe to be instrumental in creating healthy financial power markets. The choice of pool model, including spot, adjustment and forward markets, will make or break liquidity. A price index is essential for ensuring transparency. Standardized, simple derivative contracts make trading easier and more attractive. Finally, the underlying physical system is important: a hydro-based system is easy to adjust, while a thermal system will have problems with security of supply. Although the process is slow, deregulation is likely to change the European electricity market in profound ways. We see the effects mostly as beneficial. Deregulation will improve efficiency in generation, will improve transparency for better consumer choices, and allow the emergence of efficient financial trade in electricity. If deregulation is all that's done, the environmental effects may be adverse because lower prices encourage greater consumption and hence emissions. Coupled with a sensible environmental policy, we believe deregulated markets can minimize the costs of environmental protection.