Derek W. Bunn
London Business School
This issue of The Journal of Energy Markets provides three substantial contributions to energy market behavior from three different research perspectives: industrial organization, econometrics and trading.
In the issue’s first paper, “Gas market area mergers: when is bigger better?”, George Anstey, Marco Sch¨onborn and Philipp Hiemann analyze the way in which European governments introduced distinct gas market areas with specific entry–exit tariffs as part of the process of opening up the European gas market to competition. They observe that in practice, however, gas market areas abstract from the underlying physical realities of the network and do not necessarily signal the locational value of gas. This introduces a competitive distortion. The paper examines the welfare effects of expanding gas market areas and the circumstances in which a larger gas market area increases or reduces economic welfare. In general, more mature market areas that already rank highly in terms of competitiveness and liquidity stand to gain little from market area mergers, unlike less mature market areas, particularly when merging with a more mature market area. However, Anstey et al argue that merged market areas enjoy greater market power and could therefore allow more efficient Ramsey– Boiteux transport pricing in the face of decarbonization and the associated stranding risks for gas assets. Current European regulations do not seem to allow these pricing principles to be applied, but they would potentially offer important gains for transmission system operators and end users alike, and they might justify further market mergers where other benefits appear illusory.
The second paper in this issue presents a more econometric study on pricing in energy markets. In “On the contagion effect between crude oil and agricultural commodity markets: a dynamic conditional correlation and spectral analysis”, Christos Kallandranis, Dimitrios Dimitriou, Alexandros Tsioutsios, Ioannis Vlassas and Danai Diakodimitriou examine the volatility comovement between crude oil prices and key agricultural commodities for a series of shocks faced by the global economy. By using both a multivariate Baba–Engle–Kraft–Kroner generalized autoregressive conditional heteroscedasticity (BEKK-GARCH) model to estimate the volatile comovements and to detect possible contagion effects and a wavelet coherence analysis to test for time–frequency connectedness, the authors find positive correlation patterns between cocoa, corn and cotton prices and West Texas Intermediate oil price fluctuations. This correlation pattern is particularly evident during the global financial crisis, the eurozone sovereign debt crisis, the Covid-19 crisis and the Russo-Ukrainian War, which confirms the increased spillover during crisis periods. The paper’s findings indicate a pattern of contagion for all assets, which could be attributed to their common trade and financial characteristics, and this has important implications for portfolio managers, investors and government agencies.
Looking specifically at the microstructure of electricity prices in our third and final paper “On the potential of arbitrage trading on the German intraday power market”, Elisabeth Finhold, Till Heller and Neele Leithäuser present new results on the effectiveness of pair trading on the German intraday power market. This is a common risk-averse, heuristic trading strategy. However, due to myopic decision-making and a lack of foresight, it is apparent that the profit obtained is far from optimal. By comparing this strategy with the ex post optimal solution (ie, a strategy with perfect foresight), the authors show that, on a set of 15 selected days between 2020 and 2022, the predictive information can generate, on average, more than five times as much profit by excessively buying and selling the same contracts over a trading interval of five minutes. Another problem with pair trading in practice is the possibility of unbalanced auction wins. Finhold et al show that an unbiased loss of up to 10% has a negligible impact on the profit obtained, but they also demonstrate the value of frequent optimization updates by simulating strategies with only sporadic participation in the market. This work illustrates the detail required to elaborate profitable trading strategies in an increasingly efficient power market.
The authors investigate welfare effects of gas market area mergers and argue that merged market areas benefit from increased market power.
On the contagion effect between crude oil and agricultural commodity markets: a dynamic conditional correlation and spectral analysis
The authors present an empirical study concerning the volatility comovements between crude oil and agricultural commodities relative to global economic shocks such as Covid-19 and the Russo-Ukrainian war.
The authors compare ex post arbitrage trading with pair-trading on the German intraday power market and how each method may be optimised.