Liquidity in the Iberian power market has been on the rise thanks to market coupling and a move away from fixed tariffs, but uncertainty around government intervention and a lack of interconnection with the rest of Europe remain huge obstacles to achieving a fully mature market, finds Gillian Carr
Trading volumes in the Iberian market – incorporating the Spanish and Portuguese electricity markets – have been growing steadily over the past five years, but a number of hurdles still stand in the way of a fully functioning market and could stymie future progress, some participants fear.
Since 2006 the market has attracted increasing numbers of participants and a rise in both over-the-counter and exchange-traded volumes as end-users move away from fixed tariffs. This move has been driven by the Spanish government’s withdrawal of subsidies as it attempts to cut the unsustainable debt it owes to utilities. Market coupling between the two countries has also increased trade. However, significant obstacles continue to impair market efficiency. First, although there has been a move away from fixed tariffs, there are still structural issues tying some companies into using these ‘last-resort’ pricing schemes. Secondly, there is a great deal of regulatory uncertainty, especially surrounding government subsidies for renewables, which make up over a third of production. Thirdly, a lack of physical interconnection with the rest of Europe presents problems and is hindering Iberia’s participation in the unified European electricity market. And fourthly, wider economic woes within the countries have meant that potential improvements to the electricity market might have a longer timeline as Spain and Portugal wrestle with reducing debt loads.
Some are more optimistic than others on the market’s progress and potential.
“We’ve seen a steady increase in liquidity in the Spanish market over the past few years and this has definitely attracted the attention of some new players,” says Dirk Maes, lead on power trading for E.on Energy Trading (EET) in Cologne, Germany. “I’d say the market is developing positively and, with a few exceptions, is on the right track. It certainly helps that the Spanish market is a mainly financial one and doesn’t require any physical scheduling, making it much easier for new participants to get up and running,” he adds.
The Iberian market is organised into a pool structure consisting of the coupled electricity markets of Spain and Portugal, together known as Mibel, with a financial futures market (OMIP) and a spot exchange (Omel) and two clearing houses, Meff Power and OmiClear. Currently, the greatest volumes are found within OTC rather than exchange-traded contracts. In 2011, trading on-exchange decreased 13% compared to the previous year and bilateral contracts increased, according to data from the country’s energy regulator Comisión Nacional de Energía (CNE). However, these numbers are reflected across Europe, which saw trading volumes fall across the major seven1 power markets by 12% in 2011, according to European market research firm Prospex Research.
Liquidity on the Spanish futures market is more or less one-to-one with the physical market, which traded 258 terawatt hours (TWh) in 2010. In comparison, churn rates in the German and UK markets are 7.0 and 3.4 respectively. Short-term liquidity in Spain is considered fairly healthy but achieving longer-dated trades can be problematic.
“There are pretty good volumes in the short term – day ahead, week ahead, up to a month ahead are pretty decent volumes but when we go into the longer term, it’s always harder,” says Alberto Gonzalez, power trading manager at Spanish utility Iberdrola. “There’s a lack of long-term traders.”
Spain still lags far behind the German reference market in terms of liquidity and the variety of products available. The only liquid product currently traded is continuous base load, with some players occasionally trying to close a peak-load deal.
Nevertheless, trading volumes have been picking up. In terms of volume and liquidity so far in 2012, the volume of exchange-traded volumes has increased by nearly 35% versus the same period last year, with the most popular products appearing to be month-ahead and quarter-ahead, according to data from interdealer broker Tullett Prebon.
“The entrance of new clearing houses in the market has facilitated the participation of small members, such as small producers and hedge funds, increasing the liquidity and making the market more attractive to foreign companies,” says Patricia Lopez, analyst at Tullett Prebon’s Madrid office.
There are now 51 participants from both the US and eight European countries currently transacting on OMIP and its clearing house, OmiClear, with participation moving gradually further along the curve in terms of trades. There have been yearly increases in the number of market participants since 2009.
Much of this has been due to an increase in counterparties coming to the market thanks to a change in the mentality of the consumers and producers, says Ignacio Soneira Garcia, managing director of EGL Energía Iberia. “We see our customers now are much more keen on hedging their production with either base-load instruments or more sophisticated instruments,” he says. “So certainly there are more customers going to the market, either directly or by hedging their consumption or their production and that’s certainly bringing more liquidity to the market.”
He attributes this change to the gradual acceptance by consumers and producers of an increasingly liberalised electricity market. While the move towards liberalising the market began in the 1990s for Spain and Portugal, regulated tariffs remained an option for certain end-users and sectors.
“I think there has been a clear trend towards a sophistication of the habits of the consumers,” says Soneira. “A few years ago, it was very unusual that a consumer purchased their energy on an index price, they always wanted a fixed-price for one year, which was the regulated tariff. But tariffs are disappearing and consumers are changing their minds and are more aware of the different possibilities the market can bring and are willing to go to an index price or hedge their consumption with a futures market or different combinations.”
He adds that it is similar for the producers – as tariffs are phased out, they are more aware of the risks that they have. “With the difference in prices and the volatility that we’ve seen in prices during the past years, it has made them more likely to go to the market to hedge their production.”
Market coupling
While much of the liquidity in the Iberian market is centred around Spain, the Mibel market coupling project between Spain and Portugal, launched in 2006, has meant that the Portuguese market has been opened up to a larger pool of market participants and provides an additional area of pricing and liquidity. “The liquidity is centred on the Spanish price but Portugal creates another area of price that you can trade and we can trade the spread as well,” says Nuno Fonseca, vice-president, Spanish power trading at Citigroup. “The Spanish price and the Portuguese price have been more or less coupled most of the time.” While prices are often coupled, there are periods of significant deviations of pricing that present risks for retailers/producers and so there is interest in hedging for those periods.
In recent months there has been some decoupling, with Portuguese prices hovering above Spanish prices due to a dry year in terms of hydroelectric capacity. Also, because Portuguese production is smaller, once the border is full, it can easily lead to higher prices. But this only happens for short periods of time, says Fonseca. “Most of the time the markets are coupled. The capacity between both countries is quite big and so there is not extensive demand to trade the Portuguese price. We have even seen some Portuguese utilities basing their hedging strategies on the Spanish forward market.”
Other market participants agree that the two markets converging has had a net benefit for both markets. “It’s been a very close market where the correlation is large and it offers the possibility of obtaining positions in Portugal without eyeing too much risk on the positions. Because if you are well informed about the Spanish market and you know how it works, then you know there will also be correlation in the Portuguese market,” says Raul Fernandez, Iberian power trader at investment bank JP Morgan. “I think the success on the participation is very high and I think this is the result of a very clear and transparent sort of coupling market between the two markets.”
Each year the degree of congestion in the Portuguese-Spanish interconnection has been getting lower and lower. In 2010, congestion occurred around only 20% of the time, compared with 80% of the time in 2007, according annual reports by the Spanish and Portuguese regulators to the European Commission.
Remaining obstacles
One of the worries that remains though is government intervention in the markets. “The huge regulatory intervention that this market suffers is, I think, one of the big hurdles for new entrants who are unsure about what to do or whether to enter the market or not,” says Iberdrola’s Gonzalez.
The biggest issue around government intervention at the moment is Spain’s ‘tariff deficit’, which currently stands at €24 billion ($31.4 billion). The deficit has accumulated over the past decade and is owed to the main Spanish utilities who sold power to consumers at a discounted price under the real cost of generation, due to the government’s regulated price tariffs. Since the utilities were required by law to sell at these prices, the real burden of the debt is owed by the Spanish government.
As a way to pay down the deficit, the government announced that Spanish retail prices will be raised by 5–7% starting from April 1, which will pay back €3.1 billion ($4.1 billion) of the tariff already accrued and will prevent the utilities’ debt from growing larger, slowly beginning to correct the market to accurately reflect the nominal price of electricity generation.
Another decision taken by the Spanish government was around the ‘special regime’, which is the renewable portion of Spain’s production. According to data from Spanish transmission system operator REE, generation from renewables made up 34.5% of Spain’s 270TW power consumption in 2011 and a similar percentage is found in Portugal’s production mix. With a larger percentage of renewables making up the share of electricity production than most European countries, both the Spanish and Portuguese markets are often described as being driven more by fundamentals than market technicals. Most traders in these markets will not only consult financial indicators and supply/demand ratios but also weather reports and plant production reports, says Citigroup’s Fonseca.
Renewable premiums accounted for nearly 40% – €6.6 billion ($8.6 billion) – of the costs generated within the Spanish electricity system in 2011 and are expected to rise further in 2012, according to data from the CNE. As a measure to counteract this, the government announced a freeze on further subsidies (which were mainly feed-in tariffs) for renewable energy projects starting from this year. This particularly affected the solar industry, which had expanded rapidly due to subsidies.
“If you make too many interventions, you end up paying for these sorts of things and it’s a problem,” says Gonzalez. “So we have the deficit, the solar energy issue and all these decisions affect the market in the end – and all these regulations have a lot to do with what’s going to happen in the market. It should be more transparent and easier for new entrants to enter to increase competition in the market.”
Another issue coming up on the horizon as well for Spain will be whether the country’s nuclear power plants will have an extended life or not, a decision that should be made within the next year.
Renewables
With over a third of power production in Spain and Portugal coming from renewable generation, participating in the market means adapting strategies from other markets centred around traditional fossil fuels. “The increasing number of renewables [sources] has caused higher volatility in the price of the pool and this volatility can also cause movements in the rest of the curve, especially during the first minutes of the pool coming out,” says Carmen Nunez, member of Tullett Prebon’s Madrid team.
With wind in the mix, there have been times when the generation has been oversupplied and traders have seen prices at zero. In the Spanish market, unlike the German market, a negative price isn’t possible, as a lower limit of 0.00 €/MWh has been set. “Our rules don’t allow for negative prices but of course, we’ve seen zeros several times and well, that’s something the traders have to live with,” says EGL’s Soneira. “With the number of wind producers we have in Spain, wind is one of the factors in order to be able to anticipate pool prices, so that’s something that everyone is aware of. We all have to work with a meteorologist and with good information about the prediction of wind production.”
Joining the EU market
The problem of wind volatility and oversupply could be mitigated with the move towards the EU goal of a single electricity market. However, the Iberian market is mainly cut off from the rest of Europe as a result of a lack of interconnectors with other countries. Currently there are a few interconnectors that link with France but trading volumes and capacity have been too low to produce much of a price convergence with the French market, as only 3% of available capacity has been used in the French-Iberian border.
“Almost all renewable energy has to be consumed domestically, as cross-border capacity with neighbouring power markets is limited, says EET’s Maes. There are plans to double the capacity of the interconnector between Spain and France but this will still only take overall capacity to 2,800MW. “Spain and Portugal can therefore be regarded as a power ‘island’ within Europe – although this property does make the market attractive for trading companies that are looking for ways to diversify their risks,” says Maes.
As the pan-European market coupling project moves forward, the Spanish transmission system operator and exchanges have been preparing to open up the market. Interconnectors are being built across the Pyrenees but at the moment, the current interconnections between Spain and France show significant congestion.
According to the CNE report, commercial capacity for the daily market in 2010 was 800MW for imports and 460MW for exports, although commercial trade did increase year-on-year. with the rest of Europe. The roadmap for the market coupling project looks to link the Iberian Mibel market with the central-western European (CWE) market sometime in 2012.
When the interconnection does end up coming into play, market participants anticipate that it will lead to a convergence in pricing. “If you look at the forward curve, the prices are pretty much flat – the Spanish calendar 2013 or 2014 [prices] are pretty much at the same levels as the German or French ones because the fuel-based structure of the market leads to similar prices,” says Citi’s Fonseca. He notes that if the interconnection is increased, as planned, conversions should happen on the real or spot price but that this is not likely to occur right away. “It will depend on the size of the border because it is also quite difficult to increase. It takes a long time just building the line and so I think this difference will still be there for some time. I don’t think the border capacity will increase to such an extreme level that it will imply a total convergence of prices.”
For the near future, most market players will be keeping an eye on the short-term threats – Spanish regulators and the governments of Spain and Portugal – and will hope that the market coupling project within the Iberian market continues pushing forward. “There are definitely plenty of opportunities for participants but there are also some regulatory risks,” says Maes. “However, there’s a long way to go before we see the sort of market maturity that’s present in other continental markets as it is something that will not be achieved by French market coupling alone.”
