INTRODUCTION

Eleneo Academy is a space for exchange, in-depth study and training in the energy sector. We organise one half-hour webinar per month: it’s a short format, which forces us to get straight to the point, knowing that our listeners’ diaries are full. Our aim is to make subjects that are often perceived as complex more accessible, by striking the right balance between simplicity and technicality. As you know, Eleneo is a consulting and software house company addressing a diverse target audience, made up of large energy consumers on the one hand and suppliers and producers on the other. Our webinars are therefore aimed at both categories of professionals and are access free.

Before we start, please note that you can ask questions throughout the webinar using the tab at the bottom right of your screen. We will try to answer them either in writing during the presentation or orally afterwards. We also welcome your comments and feedback on the Eleneo Academy format and the topics chosen: if there are any topics you would like us to cover in future sessions, please feel free to send us an email at contact@eleneo.fr

THE WHOLESALE ENERGY MARKETS : WHERE ENERGY PRICES ARE SHAPED

Let’s reveal today’s topic: wholesale energy markets. Why this topic? For two main reasons. First of all, because these markets play a fundamental role in ensuring a balance between energy supply and demand: it is precisely on the wholesale markets that prices are formed. Secondly, because the way they operate has a decisive impact on the activity and strategies of the players present on the energy markets, whether they are suppliers, producers or consumers. We will therefore do our best to explain how these markets work, who the players are and what products are traded on them.

THE WHOLESALEMARKET : OTC Vs EXCHANGES

Let’s start with a definition: the wholesale market refers to the market where electricity or natural gas is traded, i.e. bought and sold, before being delivered to end customers via the network. These are therefore virtual places where sellers and buyers meet to negotiate energy quantities. At this stage, it is very important to distinguish the two channels through which these sales or purchase transactions are carried out.

The first is over-the-counter: two counterparties may decide to exchange energy quantities in a bilateral negotiation, during which they define the prices and contractual conditions. For the management of these bilateral exchanges, the energy sector has adopted contractual standards aimed at harmonising practices and clauses: the most widely used are EFET contracts, framework contracts designed to facilitate over-the-counter trading by defining a precise and standard framework.

Wholesale market negotiations can also take place on energy exchanges, which are trading platforms where energy buyers and sellers can carry out transactions within a specific, regulated framework.

MAIN POWER & GAS EUROPEAN EXCHANGES

Before explaining how an energy exchange works, let’s start by identifying the main existing exchanges in Europe.

For electricity, we must mention EPEX SPOT and NORD POOL, which have almost pan-European coverage. Both platforms are active on the spot and intraday markets. EPEX SPOT is part of the German group EEX, which is the leading player in Europe in the sale and purchase of gas and electricity, both spot and futures. In the slide we also illustrate OMIE, which is active on the Iberian peninsula, and GME – Gestore Mercati Energetici – in Italy.

In gas too, we find two leading operators: the German EEX again, which, as you can see on this map, allows trading on its exchange of the main European indexes, and ICE, an American company with a global presence and an activity covering a very rich list of assets, from biofuels to agricultural commodities, from coal to gas. Its exchange dedicated to the sale and purchase of gas and electricity is called ICE ENDEX.

HOW DO ENERGY EXCHANGES WORK ?

Let’s get to the heart of the matter: how do these energy exchanges work?

Like any market, they are places of exchange between buyers and sellers, the members of the market. These members can connect to a platform and submit orders to buy or sell quantities. These orders are recorded in books, called order books: these are lists of buy or sell orders organised by price level. Algorithms are then used to match buy and sell orders (the matching process). Orders that do not match remain open as long as they do not find a corresponding order: the quantity of open orders present at a given time for a given product define the ‘depth of the market’. This is a very important concept: the deeper a market, the simpler and faster it will be to carry out a transaction, and the less the price of its securities will be impacted by individual transactions, even if they involve large volumes. This is a useful indicator for understanding where the market is heading: a high volume of open buy orders can indicate strong demand, and therefore a potentially bullish trend, and vice versa.

In a liquid market, characterised by numerous participants and a high number of transactions, the buying and selling prices will converge towards a clearing price, which is the price at which a transaction can be executed. We can also see the clearing price as the point of intersection between the demand curve and the supply curve: in fact, with a price that is too low, we risk having a surplus of demand and, conversely, at a high price, it will be supply that is in excess. The clearing price is therefore the equilibrium price between supply and demand, which consequently allows the maximisation of the quantities exchanged.

THE ROLE OF CLEARING HOUSES IN ENERGY EXCHANGES

When talking about how exchanges work, there is another aspect that is essential to present: the presence of clearing houses. What are they for?

In wholesale markets, the exchange of high volumes of energy leads to significant financial exposures between counterparties. We all know that in the context of over-the-counter trading, it is essential to assess the credit risk of counterparties. Moreover, negotiating to mitigate the credit risk of the counterparty, i.e. the risk that it will not be able to pay on the due date, is always time-consuming and can be a valid reason for scuppering an agreement.

To avoid this type of obstacle and not to hinder the fluidity of exchanges or the confidence of operators, each exchange has clearing houses. These are credit institutions and banks, which, when a transaction is carried out, become the sole counterpart of the buyer and the seller: in other words, the central counterpart becomes the sole seller of each buyer and the sole buyer of each seller. It effectively assumes the credit risk of each transaction. To manage this risk, the clearing house requires its members to provide collateral, i.e. a guarantee that can be used in the event of default. In addition to this collateral, there are margin calls, which became quite famous during the energy crises of 2022 and 2023. Margin calls cover variations in the exposure of each counterparty following changes in market prices.

After obtaining the necessary guarantees from both counterparties, the central counterparty makes the payment to the seller and at the same time arranges for the transfer of the corresponding security to the buyer.

The role of clearing houses is therefore essential to the proper functioning of energy exchanges: by neutralising the credit risk of counterparties, they allow for greater agility and stability in the markets.

SPOT, FUTURE and FORWARD PRODUCTS

When discussing wholesale markets, it seems necessary to dwell for a moment on the distinction between spot and futures products.

Moreover, in most cases, the stock exchanges do not allow for the trading of both types of products and specialise, so to speak, in one of the two. One example above all is the EPEX SPOT exchange, which, as its name suggests, allows for the exchange of spot or intraday products.

What is a spot product? These are products that allow the exchange of physical quantities of electricity or gas shortly before their delivery. They therefore play a fundamental role in guaranteeing the balance between energy supply and demand in a market. On spot exchanges, we usually find two types of markets:

• The day-ahead market

  as its name suggests, day-ahead market refers to trading for the following day. It is organised around a daily auction during which purchase and sales orders are entered for each hour of the day. The intersection of orders, as seen earlier, gives rise to a clearing price, which is the price at which counterparties will have to sell or buy. This price, on an electricity spot exchange, is supposed to essentially reflect the variable costs of energy production: the principle of price setting will be the merit order, i.e. an order of priority depending on the marginal cost of production of each means of production.

• Intraday markets

  Intraday market allow positions to be adjusted as close to real time as possible, with a system of buy and sell orders that are continuously matched, 24 hours a day. The transaction is then executed as soon as two orders entered into the platform coincide. Trading is possible until a few minutes before delivery, with matching carried out on a first-come, first-served basis, so the best prices are served first (i.e. the highest purchase prices and the lowest sale prices). The products available are generally for 15, 30 or 60 minutes.

Then we have futures: these are derivatives, which represent a firm commitment to deliver an underlying asset at a future date, according to conditions set from the outset.

There are two main types of futures:

• Futures, which are standardised products traded on organised markets, such as a stock exchange.
• Forwards, which are concluded over the counter, directly between two counterparties, outside organised markets.

Futures offer more liquidity and transparency.

Forwards, on the other hand, are more flexible, but involve more counterparty risk.

MAIN ENERGY WHOLESALE MARKET PARTICIPANTS

Let us now move on to identifying the main players involved in the energy exchanges. In general, we will find the same categories of participants on the exchanges where spot products are traded and on the exchanges for derivatives. What differs is possibly their concentration.

Producers and suppliers use both the futures markets, to hedge in the medium to long term, and the spot markets, to adjust and optimise their positions in the short term. Other players such as traders, large consumers and banks also operate on both types of market. Aggregators are probably the only category found solely on the spot markets, as their role is to adjust volumes in real time and to value them in the short term.

Going into a little more detail, on the right-hand side of the slide we have broken down by category the number of members of the two main European exchanges: on the one hand, EPEX SPOT, Europe’s leading exchange for spot products, and on the bottom, ICE ENDEX, an exchange for futures products, particularly for gas (here we have limited our analysis to transactions carried out on the TTF).

The data emerging from the two pie charts is that, in both cases, if we add up the trading companies and the banks, we find almost three quarters of the total number of participants. Traders are predominant on the spot market, while on a long-term derivatives market we find more investment funds.

PARTICIPANTS HEDGING PRICE RISK OR SPECULATING ON THE ENERGY MARKETS

By analysing this data, we believe we can say that these different categories of participants can be divided into two main groups:

• On one hand, there are players who carry out hedging operations, such as suppliers, producers or industrial customers. Depending on their positions, these players will look for derivative products on futures markets that will enable them to close out open positions in the opposite direction. In this way, an industrial customer, who is inherently short because their production activity requires an energy input, will want to hedge a portion of their price risk with futures products. In the same way, but in the opposite direction, a producer will hedge a portion or all of the price risk related to the valuation of their production by selling futures products.
• On the other hand, speculators: players who look for opportunities to sell long positions at a higher price than the purchase price and vice versa. This category includes investment funds and some trading houses: as seen in the previous slide, they represent the vast majority of market participants. The choices of these players are often dictated by the need to anticipate market trends, trying to interpret events that affect the psychology of the markets. The risk of this approach is that it can produce price oscillations in the markets that are not justified by a corresponding evolution of the fundamentals: we then have episodes of volatility.

UNDERSTANDING A PRICE PROVIDER SCREEN : HOW TO CONSULT IT?

It is important not to confuse energy exchanges with price providers. The former, as we have seen, is a market place that centralises negotiations and guarantees the rules of the game. The second, the price provider in turn, such as Montel, Icis, Argus, is limited to providing market data. It therefore retransmits the prices published by the exchanges. We thought it might be interesting in the context of this session to look again at the information present on the screen of a price provider. Here we have selected gas quotations, TTF CAL 2026 – 2027 and 2028 published by ICE in the Benelux.

After the product side, we move on to two fundamental columns: the BID and the ASK. The first, the offer, indicates the purchase price and in particular the highest price at which a buyer is willing to buy. The ASK, the demand, on the other hand, represents the selling price and in particular the lowest price at which a seller is willing to sell. So which price should we look at? It depends on our positions: if we are long, and therefore wish to sell, we should refer to the BID price, because we are looking for buyers and in particular the price at which they are willing to buy my position. Conversely, if I need to buy volumes, so I have a short position, I will look at the ASK, because I am looking for sellers and I want to know the price at which they are willing to sell the product I need. Next to each of the two columns, we find the quantities of assets available for purchase or sale at the price indicated on the screen, in this case 5 MW for sale and 10 for purchase.

Then we have indicators that can help the user understand how the market is evolving: the opening price (OPEN), the highest (HIGH) and lowest (LOW) prices reached during the trading session, as well as the LAST, the last price at which a transaction was made.

Next come the measurement of the variation in the price compared to the closing price in absolute value and in percentage and the quantities traded during the last transaction (VL) and traded during the current trading day (VA).

Last but not least, the settlement price of the product, i.e. the price at which the previous day’s trading session closed. The calculation of this price follows very specific rules, which are defined by the various stock exchanges.

LIQUIDITY AND WHOLESALE MARKETS : THE BID – ASK SPREAD

As we are dealing with wholesale markets, we feel it is important to spend a few minutes on a key concept for the proper functioning of these exchanges, namely liquidity.

First of all, a definition: the liquidity of a market represents the ability to buy or sell the assets listed on it quickly without these transactions having a major impact on prices or transaction costs. A high level of liquidity indicates that the price accurately reflects the evolution of the fundamentals of supply and demand for the underlying product.

The more transactions we have on a product, the more we can imagine that supply and demand will have the opportunity to come together to provide a price representative of the state of the market.

How can we measure the liquidity of a product? The difference between the bid price and the ask price can be an excellent indicator. This spread effectively shows us the distance between the purchase price and the sale price. A narrow bid-ask spread generally indicates a liquid market. This means that buyers and sellers are close in terms of price, which reflects strong market activity and increased competition between participants. Consequently, it will be easy to buy or sell an asset without having to accept a significant discount in relation to the market price. Conversely, a high bid-ask spread can indicate weak competition for a given product; this may mean, for example, that there are fewer market participants or that demand for the asset is lower.

In the graph on the side, for moderately liquid products such as a CAL 2026 baseload in France, we can see how this spread is wide in the morning when the markets open and narrows as the hours pass and transactions are executed.

LIQUIDITY AND WHOLESALE MARKETS : THE CHURN RATE

The second indicator for the liquidity of a product is the churn rate, which measures the number of times an energy unit is traded before being consumed. So, the more times an electron or gas molecule is traded before being delivered, the higher the number of transactions, and therefore the liquidity of the derivative product. Typically, to give an idea, we can say that a churn rate of less than 10 indicates illiquid markets.

How is it calculated? It’s simple: we divide the total volumes traded by the consumed volumes of the product. In the example on the right, we have retrieved the net churn rate of the TTF, NBP, PEG and PSV over the period 2021–2023. It emerges that the TTF is decidedly more liquid than any other European index hub, and is out of all proportion to the UK’s PSV, PEG or NBP. We can also see that liquidity on the European gas market increased significantly between 2022 and 2023 with the gradual end of the energy crisis.

CONCLUSION

We are coming to the end of our presentation: we hope we have provided clear explanations and thus enabled you to expand your knowledge of wholesale energy markets.

A few conclusions before moving on to questions:

• First of all, we feel it is important to emphasise that wholesale markets are institutions necessary for the proper functioning of the energy market, as they enable trading at competitive prices, securing counterparties and ensuring quotes in line with the state of supply and demand, if liquidity is sufficient.
• On the other hand, and this will probably seem even more obvious to you after our presentation, these markets remain fragile institutions. Fragile why? Because the number of participants is limited and, as we have seen, most of them do not use them to hedge their price risk but to speculate. Prices are therefore potentially manipulable, which can generate excessive levels of volatility.
• The markets therefore have a strong need for regulation: this is the objective of organisations such as ACER, national regulators or European directives such as REMIT or MIFID, which must guarantee the transparency necessary for these institutions to continue to perform the function for which they were created.