ForTheDoers Blog

Why is electricity traded on exchanges?

Juha Ruokonen 31 August 2022, 16:35

Electricity trading

A power exchange is a trading platform where electricity producers and electricity consumers meet. There are two types of power exchanges. In power exchanges specialised in physical trading, electricity producers and consumers trade with the aim of the physical delivery of electricity from the producer to the consumer. The aim of derivative exchanges, meanwhile, is to offer companies ways to hedge electricity price-related risks.

Nord Pool exchange offers trading in tomorrow’s electricity supply

The majority of the electricity consumed in Nordic countries is bought and sold through the Nord Pool power exchange. Nord Pool is where the trading of physical electricity happens and where the electricity market’s daily prices, i.e. the so-called spot prices, are formed. The power exchange aims to find the lowest possible market price for each hour to meet demand. The spot price varies hour by hour based on supply and demand, and trading takes place each day of the year for the next day’s electricity production. Simplified, it could be said that the electricity purchased today from Nord Pool will come out of the wall socket tomorrow. Electricity retailers handle Nord Pool trading on behalf of households and small companies.

A derivatives exchange trades on future output

Many electricity producers and consumers value predictability and foreseeability in electricity prices and in risks related to trading. Consumers who have entered into a fixed-rate, fixed-term electricity agreement know the price of the electricity for the agreement period and thus are able to estimate the amount of their future electricity bills. Industrial companies, meanwhile, aim to secure the availability and prices of their raw materials, energy and other production inputs in advance so that they can price their end product and plan their production. It would be impossible for an electricity producer to plan its investments if it only knew tomorrow’s cash flow.

In a derivatives exchange, the trading focuses on the coming months and years – even as far as five years into the future. The most significant derivatives exchange in Nordics is the NASDAQ Commodities exchange. Derivatives markets are also called futures or financial markets. In a derivatives contract, the parties agree on the delivery of a certain amount of electricity at a certain price for a certain period of time. A derivatives transaction doesn’t typically involve the transfer of any physical product – just money.

A derivatives exchange offers transparency about the markets’ price level

There are multiple benefits to trading on an exchange. When the platform has many participants at the same time (sellers and buyers), finding the market price is efficient. Exchange trading is a continuous auction, with both sellers and buyers making bids. The exchange publishes the bids submitted and the prices of the completed transactions. This increases transparency and makes it easier for the participants to form an understanding of the current price level for different periods in the future. At the end of the day, the exchange publishes the day’s closing price, which companies use to put a bookkeeping value on the electricity derivatives they have purchased.

The most significant challenges of exchange trading are the financial requirements and reporting. Joining an exchange requires having enough capital (cash and/or collateral) right from the start as well as the ability to manage daily reporting and financial transactions. For this reason, direct members of the exchange tend to be major companies, banks and service companies specialised in exchange trading.

A derivatives exchange aims to minimise counterparty risks – collateral is key

Exchanges are designed to be low-risk marketplaces and to streamline trading between buyers and sellers. In particular, exchanges aim to manage counterparty risks, i.e. to ensure that each participant is able to meet its obligations as agreed. One of the ways exchanges do this is by requiring various types of collateral and/or guarantees from the participants.

Even to start trading on an exchange, cash (collateral, margining) must be transferred to a clearing account defined by the exchange. As transactions are concluded, companies have to transfer additional collateral on a daily basis to meet the current collateral requirements. Collateral requirements consist of several different components (initial margin, variation margin, etc.), and a big part of them change along with changes in the market price. What’s noteworthy about this is that even if the company doesn’t trade more, an increase or decrease in market prices will increase or decrease the collateral requirements. For example, if a seller has sold at a low price and the market prices rise, the seller must transfer more collateral to the exchange. When prices drop, the collateral is returned to the seller. Upon delivery of the products sold, the collateral related to the sale in question is returned in its entirety.

This may sound laborious and complicated, and it is. So why do companies go through all the trouble? There’s a very straightforward explanation: with collateral requirements, the trading risks are low. The purpose of the collateral is to compensate other parties for expenses incurred in the event that a member of the exchange is unable to meet its obligations, for example due to a bankruptcy. Collateral could perhaps be compared to a security deposit for a rental unit. It is given to the landlord in case the tenant is unable to pay the rent or causes damage to the property. If the tenant keeps the apartment in good condition and pays the rent as agreed, they will get the security deposit back at the end of the lease.

High electricity prices raise collateral requirements

The sharp rise in energy commodity prices over the past year (Figure 1) has increased the collateral requirements for exchange trading. Electricity sellers and buyers are hedging, i.e. selling and buying their future production and consumption years in advance, and these transactions were already in place before the price increases we are now experiencing. For these transactions, companies must transfer collateral (money) to the exchange to match the current price level. The collateral requirements have risen to astronomical levels and have led to the indirect costs of exchange trading (tying up money in collateral) causing financing or liquidity challenges for companies.

Power futures

Figure 1. Nordic power futures prices have risen sharply this year. Source: Nasdaq Commodities, Bloomberg.

Power exchanges have a place also in the future

When I took a course on the fundamentals of environmental economics, I learned that efficient markets are the key to maximising the social welfare of society. The electricity market is no exception. Nord Pool aims to find the lowest price for each hour and derivatives trading allows companies to manage price risk effectively. Today’s exceptional market situation has highlighted the challenges of collateral requirements for exchanges in particular, and the market and legislation must be further developed on the basis of the lessons learned. Companies’ trading needs will not disappear – power exchanges will continue to have an important role also in the future.

Juha Ruokonen

Juha Ruokonen

Communications Manager, Trading and Asset Optimisation (TAO)