European energy outlook

2008 was a rollercoaster year for Europe's energy markets. Roderick Bruce interviews trading CEOs and other senior executives to see how they envisage Europe's gas & power markets developing in the year ahead

Untitled Document

Some important strides were made in European gas & power markets in 2008, but the financial turmoil has slowed progress and hit liquidity. Next year Europe's energy markets face some key challenges, top industry executives say.

While exchanges and market infrastructure became increasingly integrated in 2008, cross-border trading remains difficult, and the ultimate goal of a transparent, competitive European market remains some way off. The credit crunch has not only reduced risk appetite but also trust between counterparties, emphasising the important role that clearing will play in the year ahead. Excessive regulation could also be an unwanted side effect of market turmoil.

Solving the problems in Europe's energy markets is no easy task, but there is broad consensus - and newfound urgency - among senior figures that now is the best possible time to push forward with the European Commission's vision for a competitive energy market, in order to restore and maintain liquidity that is currently trickling away.

The senior executives charged with addressing these issues and leading the wholesale markets forward are perhaps more introspective than usual at the start of the year, with a global recession looming. "The pace at which things have happened in the market this year has been surprising - the clock seems to have been ticking so much faster, and things that you thought impossible two or three weeks ago suddenly happened," says Jonas Abrahamsson, chief financial officer at E.ON Energy Trading. "That in itself prompts every organisation to revisit the way they work."

Powering ahead

2008 began with a wave of cross-border mergers and co-operation among Europe's energy exchanges. France's Powernext announced it would merge its power spot and futures operation with Germany's EEX, Nord Pool sold off its derivatives business to Nasdaq OMX, while Slovenia's Borzen announced an initiative with Eurex to link the Slovenian and Serbian power markets. In September, APX Group bought its exchange compatriot Endex to create Europe's largest gas exchange.

This rationalisation of exchanges has been welcomed by traders. "We need to find a way to simplify, standardise and harmonise exchange and clearing platforms across Europe," says Essent Trading CEO Paymon Aliabadi. "We want to have a pan-European energy spot and futures exchange, and pan-European grid access, and the two need to be harmonised."

Consolidated exchanges also offer a more economical trading environment by cutting margin calls, thus helping to offset the cost of clearing, which is being turned to more frequently in this constrained credit environment. "Exchange consolidation is likely to happen as traders really don't want a lot of margin calls; they need to consolidate or develop a system of netting between them," says John Evans, business development director at interdealer broker Spectron. "Either way, we need pressure from the users who want to protect their cashflows."

Cross-border interconnection between power grids has also been making progress, as the trilateral coupling (TLC) between France, Belgium and the Netherlands marked two years of successful operation in November. The three day-ahead prices on Powernext, Belpex and APX were identical 65% of the time on average, with this likely to increase to 70% in the third year according to Belpex. Denmark and Germany's day-ahead markets were also coupled in September, although the project was suspended temporarily after exchange prices did not correspond to the direction of flows across the interconnector.

In the Iberian Peninsula, the joint power futures market linking Spain and Portugal, OMIP, has also made progress, with volumes in the first three quarters of 2008 rising by 205% compared with the same period in 2007. "The power business across Europe has been favourable and slowly growing," says Bill Winget, CEO of RBS Sempra Energy Europe. "The Spanish power exchange in particular is pleasing, and liquidity has grown there."

Italy's November launch of physical forwards and financial futures exchanges bodes well for similar liquidity growth there. "The Italian market is surely much more competitive than a few years ago, when our spot exchange was launched," says Massimo Quaglini, CEO of Edison Trading. "The launch of forward power markets is a real milestone for Italy."

Winget has a generally positive outlook on Europe's power market, citing the continued opening of the central and eastern European markets such as Hungary, Czech Republic and Poland. "Yes, there are barriers to entry in these countries, but they exist in many western European countries too," he says.

As continental power markets move forward, the UK has lagged behind, with a market dominated by six vertically integrated utilities, a number set to fall further after EDF's purchase of British Energy in September. "Consolidation among vertically-integrated utilities in the UK can set us back in terms of advancing deregulation, as there just aren't enough independent players in the market," says Alexandra Merz, head of EMEA energy marketing at JP Morgan.

However, encouraging signs emerged in late-2008, with the Futures and Options Association project to increase market liquidity finally choosing Nasdaq OMX and Nord Pool Spot to build a spot and derivatives market in November, and APX Group holding the UK's first day-ahead auction in December.

Empty pipeline

In contrast to the UK power market's struggles, the National Balancing Point (NBP) remains the most liquid gas hub in Europe. "The UK is a bright spot and a favourable place to trade gas," says Winget. "However, the continental markets are opening at a glacial pace, although Germany has continued to thaw. We've grown our business there through the E.ON Ruhrgas capacity auctions."

The auctions, which are part of a gas release programme agreed with German regulators as a condition of E.ON's takeover of Ruhrgas, freed some of Ruhrgas' long-term volumes to competitors. Germany's gas market continued to open to competition in 2008, and the October 2007 merger of three gas zones increased liquidity on the NetConnect Germany (previously EGT) hub, Germany's largest, which now takes over 60% of market volumes, though the churn rate remains relatively low, at 1.5 times physical consumption.

Competition has also increased in Spain, where the process of removing regulated prices for industrial and domestic consumers was finalised in July. A new capacity allocation methodology in interconnections was also established, with open subscription and open seasons, to allocate capacity at the border with France. "All the changes needed to reach such a level of harmonisation have been done in Spanish regulation, with no support from the French," says a senior executive at Spain's Gas Natural.

Progress elsewhere remains minimal, with markets such as Italy and France still dominated by incumbent players, and the latter also blighted by regulated energy prices. The Gas Natural executive says the company is not satisfied with the level of interconnection and available capacity in Europe. "We consider that the main obstacle for energy trade is the lack of available capacity at cross-border points," says the executive. "Interconnections are essential for the integration of the national markets and they are a major step for the final objective of creating a well-functioning internal energy market."

Peter Bishton, head of power, gas & emissions trading at Cargill, says that when he set up the business eight years ago he expected gas to quickly follow electricity into the liberalised fold - but it has failed to happen.

Bishton says lessons can be learned from the US market, where Cargill is a significant end-user. "When I visit our US gas team, I know that discussions on fundamentals are about supply and demand - they're not about transport and access restrictions to the grid system," says Bishton. "Trading natural gas in the US is about fundamentals, and not about playing cat-and-mouse with an incumbent intent on making life difficult by creating artificial bottlenecks through interruptible contracts."

Subprime hits energy

Following the financial crisis that began to hammer global markets and financial institutions in September, liquidity in the energy markets has dipped. A positive effect of the financial intuitions and hedge funds coming into the energy markets was their risk appetite, and they helped to increase the level of liquidity and competition by challenging the incumbent players.

"I'm concerned that everybody is becoming risk averse, and a lot of liquidity and product innovation that was coming into the market has taken a step back," says Essent's Aliabadi. "That's not good for the industry or the market. Ultimately if we stop trusting each other then we are all contributing to driving liquidity away, creating a scenario where the industry will be dominated by the old-fashioned incumbents."

It's not just financial players reviewing their appetite for trading, however. Utilities and trading companies are also re-assessing their risks. "Companies across the board are pulling in their horns a bit and reviewing their risk profile downwards," says Winget.

With significantly higher credit risk inherent in the trading system, traders have migrated to exchanges or cleared deals, which in turn raises collateral requirements for margin calls. "As traders post more collateral, costs increase, so you will probably see bid offer spreads increase as a result," says Philippe Vedrenne, managing director at Gaselys. "Some might argue that OTC clearing is putting us more at risk in terms of cashflow, so we should sit down with our CFO to see if he'd prefer to manage cash or counterparty risk. They're likely to be more comfortable, especially at the big market-makers, to move towards OTC clearing."

However, under current cash constraints in the market, some feel that costs of exchange trading and OTC clearing may be prohibitive even for larger players. "Given that credit risk has generally increased, some asset-backed players may be more inclined to accept market risk on their books and trade less," says Peter Kreuzberg, chief commercial officer at RWE Supply & Trading.

Keith Martin, director of front office at Gazprom Marketing & Trading, disagrees. "People know the advantage of using the forward market to hedge, but who you trade with is going to be one of the key decisions you make," he says. "We've been approached by a lot more counterparties who want to do physical deals directly with the source of supply. We're inundated on the legal side with counterparties wanting to sign up with a company who has a long-term presence in the market."

Kreuzberg points out that proprietary players may be less willing to offer risk capital to the market, further reducing liquidity. "The situation may be exacerbated by a recession, with cheap commodities reducing absolute volatility in the system, making people even less inclined to trade."

Lessons from the crunch

The liquidity drain is concerning, and major market players are being called on to rise to the challenge and implement solutions to ease the effects of the credit crunch. "Some of the more traditional players like Essent, RWE, E.ON, and EDF need to work together to put the right protocols in place and go back to business, and fill the liquidity vacuum until the financial markets stabilise," says Essent's Aliabadi.

While the energy markets were robust in the face of Lehman Brothers' default, some executives feel that the clearing system can still be improved. "In the current crisis some intermediaries turned out to be the biggest risk takers," says Kreuzberg. There is still a lot of credit risk inherent in most clearing frameworks, putting initial margin - that non-clearing members would post with clearing members - at risk. All of a sudden they were closer to default."

Kreuzberg says that there is a lot of close-out risk in the system, even when traders transact with each other on fully secured margin agreements. "Every now and then traders appear to have large exposures against each other, and these would be very difficult to replicate in the event of a default," he says. "The way to avoid that would be a clearing-based, or multilaterally agreed system to allow the market to reduce close-out risk through triangular ring trades to systematically offset positions."

RWE Supply & Trading carried out such bilaterally or trilaterally-agreed ring trades to reduce close-out risk, and Kreuzberg says that clearing houses and software companies could work together to provide a platform for such netting trades.

Aliabadi agrees cross-product netting agreements have removed some credit uncertainty, as have the implementation of credit support annexes (CSAs). "More traditional players now appreciate the principal of CSAs and reducing exposure with counterparts on a regular basis," he says.

Despite trouble among US energy companies like Constellation Energy and Reliant Energy, European utilities have remained robust - thanks, in part, to their often vertical structure and market power. "Vertical integration means that such energy companies are relatively well-capitalised," says JP Morgan's Merz.

Non asset-backed trading houses have also remained strong, and many have learned lessons from Enron's demise. RBS Sempra Energy's Winget points out that when he joined to lead its European business in 2001, there were 12 US merchant energy traders in Europe. After Enron's collapse, only Sempra and Koch remained. "We were robust then, as now, because we don't have long-dated, illiquid positions," says Winget. "Generally most of our positions are 18 months to two years out."

Ultimately, a balanced approach to trading and credit risk management should allow balance sheets to remain healthy while hedging physical exposures. "Overall, the decrease in liquidity has not been to the extent that we feared," says E.ON's Abrahamsson. "All fundamental players need to find a balance to support liquidity, given that the ultimate way of minimising credit risk is not managing your commodity risk, which is clearly not a good response."

Regulatory threat

Abrahamsson says market turmoil raises the spectre of increased regulation. "There's a risk that a reaction to the financial crisis may be a desire to over-regulate, which would be counterproductive in the long term," he says.

Energy traders were already unnerved in 2008 by an initiative by French regulator CRE that obliged gas traders to report data on all transactions concluded in 2007 on yearly and seasonal 2008 and 2009 contracts. That, combined with an overwhelmingly negative response from traders to a draft report from the Committee of European Securities Regulators (CESR) and the European Regulators Group for Electricity and Gas (ERGEG) on record keeping and pre/post trade transparency, has increased worries of the implementation of onerous data reporting obligations that breach confidentiality.

Transaction data reporting may well be attacking the issue from the wrong direction. "The ERGEG approach to transparency is from the wrong end," says RWE's Kreuzberg. "Where transparency needs to be improved first is on the supply and demand side." He wants to see published plant data, such as context information on outages, interconnector availability and demand load all made available to traders.

Making this supply/demand data available would also prohibit trading by incumbent players on the basis of inside information gained through a lack of transparency. Kreuzberg says that collecting trade data should only be the third element in the transparency chain after transparent access regimes and supply/demand data. "If those three elements are attacked together then we can really make this market a better place, and attract more players and restore the liquidity that we'll lose from the financial crisis."

The carbon markets, which depend exclusively on policy and regulation to exist, have grown strongly in 2008 thanks to concerted efforts from regulators to define market structure and improve clarity on the post-2012 environment. "Despite the cliff at 2012, a lot of players have made markets and created liquidity," says Aliabadi.

"That's a signal to regulators: in order to bring confidence back to the wider energy markets you need to have as many participants and as much transparency as possible. The financial turmoil has created the opportunity for the EU to step back up and drive through a consistent set of protocols, and drive forward integration, co-operation and transparency in the gas, power and emissions markets."

Trading year-ahead

Markets are now sufficiently mature and robust to withstand a drop in liquidity. "There will be a dip in liquidity as people reassess their positions, but the depth of the market is much deeper than in 2002 post-Enron - there are more counterparties," says Gazprom's Martin. "We counted more than 300 trading counterparties across Europe - not including industrials - that want some sort of energy exposure."

The year ahead therefore looks more likely to be one of recovery rather than growth. The effect of a recession may also hit hard, however. "I'd be surprised if we see trading volumes recover next year, one would expect a downturn but you never know - lower energy prices can help credit lines stretch further, while reduced trading limits could increase churn," says Spectron's Evans.

E.ON's Abrahamsson adds: "We're seeing signs that confidence in the financial system is returning, but the big question is how long-lasting the recession will be. However, even if we have a recession for two or three years, it doesn't stop the markets moving towards more liquidity and transparency."

In the face of a recession, commodity price falls may cause supply constraints and major market players are likely to dash for the supply security of physical assets, according to some of the traders interviewed. "After the de-leveraging process that is going on now, the security of assets is a valuable aspect," says Edison's Quaglini.

JP Morgan, which holds several thousand megawatts of generating capacity in the US, is now looking to acquire European assets too. "There are numerous such opportunities in this environment, and we continue to look to grow our commodities business," says Merz.

The outlook for environmental markets, infrastructure and upstream investments is the most concerning aspect of the year ahead for many market participants. "The high price levels in markets was encouraging a lot of innovation in renewables investment, and you wonder if that's sustainable given the economic situation," says Aliabadi. "It will be interesting to see how committed the world is to pulling back on carbon emissions during a downturn compared to when times were good."

Key aspects of improving market efficiency, like building new pipelines and removing bottlenecks from transmission grids, may become more challenging. And a gap between supply and demand may emerge. "It's clear there is a growing demand for energy, and even if there's a recession I think demand will grow," says Martin. "But will we have the infrastructure in place to meet that demand?"

Ultimately, market development will be driven forward by a combination of the European Commission, national governments, regulators and private initiatives. Politicians will play a key role in ensuring that the spectre of resource nationalism - a tempting recourse in a downturn - is vanquished. "Liberalisation is out of the bottle and it's taking hold," says Martin. "How quickly it spreads will be determined by the EU and national governments. It will be interesting to see the effect of the recession on trading, but liberalisation will continue for sure."

The private sector may occasionally have to force the issue. "The final goal is an integrated market in Europe and sometimes, although the workers are willing, we're missing the architects," says Powernext CEO Jean-Francois Conil-Lacoste. "Sometimes we have to make the plans ourselves - the TLC is one example and the EEX/Powernext co-operation is another; these were all private initiatives. We need to use such cross-border initiatives to force a path through national protectionism."

Given the fundamentals of credit concerns, falling prices and global economic woes, 2009 will be another challenging year, but the way ahead for Europe's markets remains clear, according to Abrahamsson: "The vision of the European Commission is the right one. There's no way back on the road to liberalisation."