European power: Iberian market slow to develop

Market analysts have pinpointed the Iberian power market as one to watch due to recent increased participation from banks, hedge funds and utilities. However, some European energy companies are still highly critical of the market’s structure and regulatory framework. Katie Holliday reports

The Iberian electricity market has experienced a resurgence in liquidity in recent years as increasing number of counterparties are starting to rejoin this market.

Investment banks, hedge funds and major European utilities have started to participate, after a period of extremely low volumes on both the spot and forward markets, prompted by the impacts of the global recession. Volumes have grown from 5.0 terawatts in 2006, the launch year of the Iberian power derivatives exchange and clearing house OMIP, to 31.4 terawatts in 2009. Over-the-counter (OTC) clearing volumes have grown from 0.1 terawatts to 19.9 terawatts over the same period.

Iberian power market analysts say now is the time for foreign participants to get involved, but other European players have voiced frustration over the logistics of gaining a presence on this market. A crucial bugbear is the Spanish regulatory landscape, and the recently announced wholesale review of the electricity sector has added further uncertainty for participants. But if market distortions can be ironed out and some regulatory certainty can be eventually provided, Iberia could become far more attractive to foreign participants.

“The market has evolved a lot in terms of liquidity and counterparties and it’s much better than the situation five years ago,” says Ignacio Soneira Garcia, director general of Spanish energy company EGL. “Volumes are increasing a lot, now the size of the OTC and futures markets is comparable to the physical volumes and we hope that this trend continues.”

However, despite this evident improvement, many participants complain that current liquidity levels, although increasing, are not sufficiently high to encourage enough producers and consumers to become more involved in hedging.

“Liquidity is increasing, but it’s still not enough,” says Jose Antonio Garcia, manager of energy risk at international consultancy firm Deloitte’s Madrid office. “Many people are complaining about this. A lot of our clients, mainly medium-sized players, find it difficult to make hedges quickly enough to be effective. But we expect liquidity to reach acceptable levels in three to five years. The market is moving in the right direction,” he says.

Peter Krembel, head of power, carbon and cross-commodity trading at German utility RWE, also believes liquidity levels to be unsatisfactory. “If you look at the levels of the Spanish electricity exchange (OMIP) swaps – yes they are rising but overall volumes in comparison to Germany, the Nordic market or even Holland or France, are practically non-existent. I would not even call it a true marketplace,” he says.

The Iberian electricity market traded 393 terawatt hours (TWh) on both the exchange and OTC markets in 2009, while Germany traded 4,248 TWh and the Nordic market traded 2,412 TWh by comparison, according to publicly available company estimates.

“It’s highly frustrating to operate in a market when everyone is claiming that the market is developing well and getting better and better but the reality is completely adverse,” adds Krembel.

The Iberian Electricity Market (Mibel) was born in 2004, the result of a collaboration between the Spanish and Portuguese governments. The initiative aimed to provide a single reference price for both regions and allow all participants free access to the market. Their combined volumes put the newly formed market on a par with Italy, but much like Italy, the region’s slowly developed and constantly evolving regulatory landscape has put it at a disadvantage in terms of attracting foreign participation.

In fact, regulatory uncertainty has recently prompted credit ratings agency Moody’s to downgrade the Spanish electricity sector. In its report on the issue, Moody’s says that the regulatory landscape in Spain has been particularly challenging in recent years due to the build-up of large tariff deficits – the amount of money that the electricity system owes the electricity companies – due to insufficient price increases.

Although designed to keep electricity prices down, these artificial tariffs have provided a barrier to liquidity development in the Iberian power market according to EGL’s Garcia. “There is a real need for stability in the legal framework. Any change that may affect the forward market must be thought through before its implementation, as there may be important financial implications for many different players in a market. Instead of setting artificial tariffs for small producers and for consumers everything should be based on market mechanisms,” he adds.

Jorge Simão, board member at OMIP agrees that regulated tariffs do not favour liquidity. “Artificial tariffs are a form of administrative hedge that compete with the derivatives markets,” Simão says.

“Regulatory hurdles are a huge entrance barrier and the whole regulatory set up in Iberia is flawed,” says RWE’s Krembel. “It really is one of the least continually developed marketplaces I’ve seen and the weakest in Western Europe. There is a huge gap between the ambitions and what has been achieved so far.”

Changing the goal posts

Iberia’s constantly evolving regulatory landscape is a recurring complaint from market participants and the unpredictable nature of the Iberian power market regulation is damaging its potential for liquidity development.

“Every time you have a political, regulatory intervention, you have a jolt to the market – it either suddenly goes up or down and it’s always a shock for market participants. After a period of abandonment, trading dries up completely and then people tiptoe again into it,” says Krembel.

According to Jaime Roman, head of risk management at Spanish utility Endesa, the constantly changing regulation means participants are unable to foresee changes to power market trading regulation: “Any regulatory change that is not forecasted or somehow described in advance will have an impact on the market. It will change the view of the traders in the market,” he says.

In addition to artificial tariffs, another current bugbear for participants is the Spanish government’s planned coal decree, which aims to establish incentives for coal generation. The structure of this decree could potentially have implications for power market participants, but uncertainty over the details of the decree and its date of issuance is a concern for market participants.

Marian De La Peña Cadenato, head of origination for front and middle office at Spanish natural gas and electricity company Gas Natural Fenosa, pinpoints the coal decree as a key concern. “We don’t know what it is going to be, when or even how it will be developed,” she says. “This impacts the market, because it is difficult to plan ahead. From a trader’s point of view, we don’t like this intervention in the market and the risk of excluding other sources of power generation.”

The structure of the market has also come under fire. A unique feature of the Iberian power market is its mandatory pool system, which requires all physical market participants to ‘pool’ their output, which is then dispatched according to demand. Some market analysts believe this system is a deterrent to foreign participation.

“Under the mandatory pool trading concept, you are completely disadvantaged as a trader or a non-incumbent. To operate physically you have to apply for a local licence and the rules of which are complex and subject to change,” says Krembel.

But recent changes to Spain’s electricity regulation are helping to increase transparency and liquidity in the power forward market. Most of the tariffs for customers have now been removed, and market mechanisms have been set for the calculation of the remaining tariffs (last-resource tariffs – see below) which are set through auctions.

In Portugal, the government recently announced the end of regulated tariffs for non-domestic consumers to be implemented from 2011, which will help build the market,” Simão adds.

But Bill Gebhardt, the head of electricity trading at European investment bank Deutsche Bank, says these particular regulations have recently been adapted to aid entry for non-domestic participants on the Iberian market.

“Previously, the rules governing access to the physical electricity market largely differed from the regulation applicable in the majority of Western European countries. This limited the presence of foreign dealers in the physical market by requiring a fully capitalised local entity. Those rules, however, have recently been amended,” says Gebhardt.

Now that entrance to the market has been made easier, financial players, such as Deutsche Bank, alongside hedge funds, have began to show more interest.

Gas Natural Fenosa’s Cadenato believes this to be a strong sign of progress. “We have seen some counterparties return to the market after leaving a few years ago. Entering the physical market as a foreign trader used to be a longer process, but now it has been speeded up. In the futures market there are also some new entrants, including hedge funds and London banks that are coming into the market – it’s really interesting to see how the market is gradually getting bigger and better,” she says.

Deutsche Bank’s Gebhardt points out that the combination of regulatory uncertainty and volatile pricing has increased demand for hedging. “Increasing levels of volatility and uncertainty have pushed producers and consumers to look for hedging solutions in the market and financial players are well positioned to provide refined hedges for sophisticated needs,” he says.

However, the biggest liquidity resides in the hedging contracts for a maximum of one year ahead and liquidity is yet to develop further out along the curve. “It’s difficult to have a picture in mind of more than one year ahead because of the changes that impact the wholesale market,” says Gas Natural Fenosa’s Cadenato. “It would be helpful to have more activity further out along the curve, but people are reluctant to use these contracts because of the uncertainty,” she adds.

On a more positive note, high levels of transparency in the Iberian power markets remain a strong selling point. “That is one advantage the Spanish market has over its European counterparts,” says Cadenato. “The market publishes a lot of information – you can access all the information on the generation of all the power facilities in the country – this is one of our biggest positives,” she adds.

OMIP’s Simão agrees: “Recent enquiries carried on within the European Regulators’ Group for Electricity and Gas (ERGEG)’s regional initiatives lead to the conclusion that the Iberian market may be included in the group of the most transparent markets in Europe. Effectively, relevant data needed by market players is published in a very transparent way by system and market operators acting in Iberia,” Simão says.

Looking forward, market analysts’ outlook for the Iberian electricity market appears generally positive, despite frustrations over regulation and structural issues.

The increased interest from external participants is seen as positive, but a simplification of the rules and a demonstration of stability of energy policy from the government will be essential if the market is to reach its full potential. The outcome of the forthcoming wholesale energy review will be pivotal.

“We are confident that the governing party and the opposition party will reach a decision that will ensure the more efficient operation of the market,” Endesa’s Roman.

“They need to put distortions out of the system. It’s the same for the French market. If you want to increase confidence in the marketplace, you need to get the distortion out. There is a lot of interest in this market but the overriding nature of the regulation is off-putting,” says RWE’s Krembel.

EGL’s Garcia agrees: “Over the past year, we are seeing less and less surprises. I hope there are no more big changes that will affect the forward market. But it is surely a positive sign if the incumbents, who previously were not very active in this market are now publicly talking about hedging their production in the OTC forward markets,” he says.

According to OMIP’s Simão, a planned integration between the spot market operator, OMEL, with OMIP, to build a common body called OMI, will add significant efficiency gains for market agents. “We are very optimistic about the future. Activity trends together with the launch of state-of-the-art trading and clearing IT platforms makes us expect that our sustained growth will continue,” he adds.

Deutsche Bank’s Gebhardt agrees. “We expect the market to continue evolving in the coming years. As the rules and market infrastructure become more in line with the rest of Europe, we expect to see liquidity growth in both the OTC and exchange-based markets."

The ‘Last-Resort Tariff’ explained

The regulatory framework for the Spanish electricity sector was profoundly changed with the introduction of the Last-Resort Supply Tariff on July 1, 2009. It applies to consumers that contract capacity equal to or less than 10 kilowatt hours (KWh) of power – usually residential or small business consumers.

If they do not choose another supply option, they are automatically supplied power at a set price by last-resort suppliers such as Iberdrola, Endesa, Gas Natural Fenosa, Hidrocantábrico Energía and E.On España. Low-voltage customers have the option of contracting their electricity supply on the free market but this rarely happens.

So the participation of other competitors, only applies to customers that contract over 10 KWh of power, which usually applies only to the commercial side of the market.

Currently, high electricity prices have deterred foreign participants from entering the Iberian markets but market conditions to encourage the participation of other traders for contracted power supplies above 10 KWh are being developed, such as electricity auctions and the establishment of a futures market.

Source: Juan María Román Gonçalves, assurance partner at international advisory firm Ernst & Young’s Bilbao office