Peter Styles is Chairman of the Electricity Committee at EFET, the European Federation of Energy Traders. This opinion was first published in the EFET Annual Newsletter.
Why are measures of market liquidity so important to traders, yet so mistrusted or misapprehended by policymakers and bureaucrats?
To a trader the presence of good liquidity in a market signifies an important reassurance that he is not alone, that he will be able to find a counterparty when he needs to adjust his position, that the bid to offer price spread will be manageable and that the reference or index price used in that market is credible.
To the consumer, naive policymaker or distrustful regulator, liquidity may suggest an indication of speculative interest and “unnecessary” churning of positions. He may expect that a healthy commodity market is simply one where all trades are physical and each contracted quantity is bought or sold at the wholesale level “once and for all”.
But such an expectation defies both economic and commercial logic. Indeed strong liquidity is the very best evidence of a robust wholesale market in a commodity (such as electricity or gas), and a robust wholesale market in turn is the very best guarantor of efficiently selected and correctly priced sources of supply for consumers.
In more sophisticated academic, business and indeed government circles, the need for adjustments of trading portfolios and the utility of derivative instruments are rather widely accepted. As we have seen in recent years, however, even when the functioning of markets in this manner becomes accepted, public mistrust may migrate away from concerns with market mechanisms as such, towards nuanced worries about market abuse, excessive risk taking and lack of credit control. You may be sure that EFET is working hard on these topics.
So what are the prospects for continued or even improved liquidity in European energy markets? Let us first put to one side crude oil, refined petroleum and LPG products and coal. These product markets exhibit a geography which is not restricted to Europe and do not significantly differ in character within Europe as between countries and regions. They also tend to be naturally deep or liquid because of the fungible nature of the underlying commodities. Increasingly the same can be said of LNG.
One caveat in relation to coal is that some (overseas) sources and some (European) delivery points can be thinly traded and can accordingly cause worries about a price index attached to the corresponding physical location.
In the natural gas sector hopes of better liquidity hinge on:
- Release of ever greater quantities, until now tied up in long-term, oil-indexed import contracts, into the spot market (assuming the conditions of the long-term contracts are adjusted)
- Continued reform of entry/ exit, capacity booking and physical hub arrangements, so that shorter-term deals and backflow trades become easier to conclude
- Resumption of an increase in overall demand, related partly to macroeconomic recovery and partly to substitution of coal and nuclear power generation sources
For the electricity sector the picture is cloudier. On the one hand, wholesale power markets are long established and competition seems to be strong in countries such as Germany, Britain, and the Nordic area. Day-ahead price coupling should in theory bring the benefits of market depth and competition in these countries into neighbouring regions.
On the other hand, participation of some types of trades on the financial side of these markets is threatened by tougher regulation of derivative transactions and by new compulsory clearing arrangements. In addition, several financial institutions are seriously reviewing how well any physical commodity trading fits their overall business model.
Meanwhile a dramatic growth in output from renewable sources, notably wind and solar, in several countries where support mechanisms are not market-based is effectively removing substantial volumes of must-run base-load power from the wholesale market.
The intermittency of such sources in turn leads to calls for generation capacity remuneration mechanisms to be put in place or extended. And those mechanisms would in their own right deprive the market in electricity as a commodity of a portion of the cash accruing to generators, which is its lifeblood.
One thing is sure: liquidity will continue to be an axiomatic indicator of the health of our European energy market. We know why we need it and what may happen when it is absent. As energy traders we try to take care when explaining to outsiders what liquidity is, the extent to which it may be threatened, and why it is so important. If you think we are not doing a good job in this respect, let us know!