Modelling Electricity Spot and Futures Price

8/11/2019 Modelling Electricity Spot and Futures Price

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UNIVERSITY OF SPLIT

FACULTY OF ELECTRICAL ENGINEERING,

MECHANICAL ENGINEERING AND NAVAL

ARCHITECTURE

MASTER THESIS

MODELLING ELECTRICITY SPOT

AND FUTURES PRICE

Boris ikoti

Split, September 2014.


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UNIVERSITY OF S P L I T

FACULTY OF ELECTRICAL ENGINEERING,

MECHANICAL ENGINEERING AND NAVAL ARCHITECTURE

Field of study: Electrical Engineering

Study programme: Power systems

Programme number: 232

Academic year: 2013./2014.

Name and surname: Boris ikoti

Student number: 639-2012

THESIS ASSIGNMENT

Headline: MODELLING ELECTRICITY SPOT AND FUTURES PRICE

Assignment: Describe various models, market structures and functionality of power

exchanges using several exchanges in Europe as a reference. It is also

necessary to describe the derivatives market and the manner of functioning of

market products such as options and futures contracts. Single out one exchange

in Europe and make a detailed description and conduct a basic statistical

analysis of prices in last 10 years. Conduct spot price simulations using

simplified stochastic processes and illustrate a basic protection against risk

using futures contracts.

Application date: 03. March 2014.

Thesis submission deadline: 15. September 2014.

Thesis submission: 01. September 2014.

President

Thesis defence committee Mentor:

Associate professor, Goran Petrovi, Ph.D. Associate professor, Ranko Goi, Ph.D.


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TABLE OF CONTENTS

1.

INTRODUCTION ............................................................................................................. 1

2.

ELECTRICITY MARKET LIBERALIZATION ......................................................... 2

2.1. Liberalisation process .................................................................................................. 3

2.2. Conditions for reform ................................................................................................ 10

2.3. Measures of liberalisation and deregulation .............................................................. 13

3.

ELECTRICITY MARKETS ......................................................................................... 15

3.1. Market Structures for electricity ................................................................................ 16

3.1.1. Pool model .......................................................................................................... 17

3.1.2. Power exchange ................................................................................................. 18

3.2. European power exchanges ....................................................................................... 23

3.3. European Energy ExchangeEEX ........................................................................... 27

3.4. Spot market ................................................................................................................ 29

3.5. Derivatives market ..................................................................................................... 48

3.5.1. Futures contracts ................................................................................................ 49

3.5.2. Forward contracts .............................................................................................. 57

3.5.3.

Option contracts ................................................................................................. 57

4.

MARKET SIMULATION MODELS ........................................................................... 62

4.1. Stochastic spot price modelling ................................................................................. 63

4.1.1. Basic statistical analysis ....................................................................................66

4.1.2. Brownian motion ................................................................................................ 70

4.1.3. Parameter estimation ......................................................................................... 73

4.1.4. Mean reverting processes ...................................................................................76

4.1.5. Jump diffusion processes ....................................................................................82

4.2. Derivatives modelling ................................................................................................ 84

4.2.1. Modelling futures contracts ............................................................................... 85

4.2.2. Modelling options ............................................................................................... 90

4.2.3. Economic application of simulation models ...................................................... 98

5.

CONCLUSION ............................................................................................................. 107

REFERENCES ..................................................................................................................... 109

SUMMARY ........................................................................................................................... 110


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1.

INTRODUCTION

The electricity industry has undergone big structural changes over the last two decades.

Traditionally, electricity companies were regulated or state-owned monopolies governing thegeneration, transmission, distribution and retail of electricity. In this regulated setting, power

prices changed rarely and did so in a deterministic way. As a result of this restructuring,

prices are now set by the fundamental powers of supply and demand.

In these new, liberalized electricity markets, national and international parties have joined

the formerly exclusive group of market participants, creating new risks as well as new

opportunities for utility companies, distributors and consumers alike. Electricity wholesale

markets are now the centres of an increasing amount of trading activity in spot contacts

(short-term delivery of electricity). Because of the large price risk involved in trading spot

contracts and the wish to hedge (price) risk in general, other contingent claims such as futures,

forwards and options have been introduced to the electricity market.

Thesis is split into two parts. First part, which includes the second and third chapter, lists

basic steps of electricity markets liberalization process, explains various types of markets,

lists the majority of European power exchanges and explains the structure of spot and

derivatives market. Combining electricity trade of a large part of continental Europe,

European Energy ExchangeEEX was used as a referent power exchange.

Second part, which includes the fourth chapter, reviews simulation models used to model

spot prices and explains models used to evaluate the price of futures contracts and option

premiums. Several economic applications of simulation models are mentioned, both for

business analysis and hedging. Historical prices from EEX exchange are used as a reference,

specifically spot and futures prices and option premiums with delivery in Germany/Austria.

During spot price simulations only stochastic processes were analysed. To simulate the

movement of futures prices two distinct approaches were mentioned. One of which is a direct

linking of the futures price with spot price and the other a separate and independent modelling

of the futures price. Options are written on futures contracts and their premiums are

determined by the characteristics and price movements of futures contracts and they were

modelled using a well known Black 76 formula.


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2.

ELECTRICITY MARKET LIBERALIZATION

The current reform in the global electricity supply industry (ESI) is often presented as

being a sudden change. Whilst it is certainly true that there are, in any one country, stepchanges of rules, regulations, laws and structures, that are commonly associated with a

timetable of deadlines, they are in practice part of a continuum in which major structural

changes took about ten years to agree, and ten years to implement and settle down.

At high level, the reasons for reform are the growing belief, based partly on experiences to

date, that by market orientation, the industry can be more efficient.

Having begun as liberalised free enterprise in the 1880s, and fallen into municipal, federal

hands over the next few decades, the liberalisation experiment began in 1970s with a partial

opening of the generation sector to new entrants from whom the utilities were required to buy,

and continued in the 1980s with the beginning of consumer choice. The 1990s saw the

beginnings of competitive electricity markets with the growth of pool models, and the year

2000 saw the first bilateral physical market with the New Electricity Trading Arrangements

(NETA) in England and Wales.

Change was then rapid with the proliferation of market opening and power exchanges

across the world, and development of the market models for capacity, location and

environmental factors.

The journey has been broadly consistent in most countries and has been characterised by

many elements, such as reform, liberalisation, deregulation, re-regulation, third party access,

privatisation and unbundling. Many of these elements are now complete in many countries

and at this point, the countries are considering the virtues and drawbacks of the new model,

and in some places taking the market model to new levels of technical complexity.

The challenge has been to open the market to competition in a measured and controlled

manner such that each stage can be viewed in retrospect with regard to intended and

unintended impacts. In doing so, there is the recognition that networks have a strong tendency

to being natural monopolies, and hence that liberalisation and deregulation must begin with

power generation and supply.

If there is common ownership of networks and generation, or networks and supply, or both

(as there is in a national monopoly), there is conflict of interest, so that the incumbent isincentivised to raise the entry barrier and excessively charge the new entrants. Hence, new


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entrants need to be guaranteed free and fair access to power generation or consumption. This

is by no means simple, even with the best will of the incumbents because the operation of

power generation and of the transmission grid is optimised as a single entity.

Hence to allow competition, it is first necessary to restructure the national monopolies intovertically de-integrated (unbundled) form, and for there to be some form of commercial

arrangement between the unbundled tiers so that this arrangement can be followed by the new

entrants.

There are essentially three components to liberalisation in the ESI:

Reduction of the role of the state, in terms of ownership, command and control,

prescriptive solutions and direct cross subsidy.

Creation and enhancement of competition by deregulation, vertical de-integration

(unbundling), horizontal de-integration (divestment) and regulated third party access.

Increasing choice for consumers and participation in short and long term demand

management and responsibility to secure their energy.

From an industry perspective, some liberalisation objectives are:

Introduce competition in generation.

Introduce customer choice.

Deal with independent power producer and stranded cost issues.

Attract private investment.

Entrench universal service obligations.

Promote integration of the grid.

Reduce debt.

2.1.

Liberalisation process

We have noted that the ESI is highly complex due to the special nature of electricity and

that there is a very wide variation in key factors such as energy endowment and social model.

There is no one size fits all, and since no policy maker can unilaterally impose a new model

and design by committee is difficult.

Therefore the ESI takes incremental steps. This is shown in Figure 2-1.


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Figure 2-1. Planning small changes in a complex market [1]

Most countries are undertaking liberalisation in some form, and the starting point, pace and

scope varies in each country. There are several steps. The list below is in approximate order,

but this has been different in different places.

Corporatisation.

Unbundling.

Ring fence chosen sectors. For example, nuclear, hydro, grid;

Privatisation.

Forced divestment and fragmentation of incumbent utilities.

Deregulate.

Reregulate.

Further fragmentation.

Further unbundling and opening to competition.

Re-integration of some sectors and cross sector integration.

Re-consolidation

Horizontal integration with other industries.

Entry of financial institutions into the wholesale markets.

Pressure on retail deregulation.

Further deregulation of networks and metering.

Revise model.


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Unbundling is one of the foundations of ESI reform. It is the separation of the vertically

integrated industry sectors in such as manner as to facilitate competitive and non

discriminatory access of participants to means of operation and route to market for the

products or services. At the highest level, the industry divides neatly into the four sectors:

generation, high voltage transmission, low voltage distribution and supply.

Figure 2-2. The unbundled ESI model, showing the four main industry sectors [1]

It is clear, for example, that if a generator wishes to access the consumer market that

without unbundling, a vertically integrated participant could easily deny access to the delivery

of electricity.

There are different degrees of separation in the unbundling processes that should be

considered as stages.

Functional separation This involves the separation of the day to day business and

operation of the divisions. Whilst resources should be clearly allocated between the

divisions, there is no specific requirement for the inter business arrangements to be on

a commercial basis. For example, one could be a cost centre. However, the path is

clearly laid open for full separation, since cost centres can optimise and prioritise

effectively only if the services provided have clear monetary signals, thereby forcing

the profit motive, a profit centre approach and then standalone businesses.

Operational separation This involves separation of long term decisions, capital

expenditure and operation of the businesses. This is a natural progression from

functional separation, and the natural separation of board level decisions makes the

path for board level separation.


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Accounting separationThis involves the formal production of separate accounts for

the different parts of the business. Whilst this requirement may at first sight appear a

relatively straightforward one, involving capital expenditure, depreciation, core

operating budgets and some form of financial arrangement between the respective

divisions, the construction of full statutory accounts for each division actually sets a

clear path for full separation of the businesses since all resources must be accounted

for in one business or other, and all flows of commodity or service from one to another

should be treated as arms length arrangements on commercial terms. In practice,

journey from informal inter business arrangements to formal commercial

arrangements is a long one and hence there are many degrees of accounting

separation.

Legal separation The component companies are completely separate from a legal

perspective, although they could be ultimately owned, in whole or part, by the same

entity.

Ownership separationThis means no significant common ownership.

As a general rule, partial unbundling of generation is the first step, by allowing and

encouraging private new entrants. This can be regarded as stepwise deregulation. The next

major step is the separation of the high voltage grid from the other sectors. The unbundling of

supply from distribution is generally a late stage, and gradual deregulation of metering, and

networks at their boundaries and various support services continues after the main unbundling

is complete.

Corporatisation is a necessary precursor to unbundling because the unbundled sectors

cannot operate independently without being corporatized. Corporatisation is the process by

which a publicly owned company with a public service franchise and purpose starts to behave

like an investor owned company. This it self has many elements:

The requirement of each entity not to lose money, with no cross subsidy from one

entity to another. (Pareto optimality, applied within the firm).

Migration of some long term and high level responsibilities back to governments. For

example nuclear decommissioning.

Public service becoming a requirement rather than a purpose.

Preparation for unbundling by internal transfer pricing, and service level agreements.


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Increased independence from the fiscal and monetary structure of the nation. For

example, payment of taxes, payment for fuel.

End of requirement to create labour.

One of the first stages of corporatisation is by introducing formal arrangements between

the sectors that will be unbundling. This includes payments for goods and services. The

arrangement is shown in Figure 2-3. Each sector has cash inflow and goods and/or service

outflow. Consider initially a centrally managed economy. This is depicted in Figure 2-4. In

the extreme case for a closed economy with no money, then labour and natural resource

replaces the tax required to buy equipment.

Figure 2-3. Formal arrangements between unbundled sectors [1]

Figure 2-4. Arrangement for a centrally planned economy [1]


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Regardless of ownership, the state is the ultimate guarantor of ESI performance.

Accordingly, governments have been reluctant to relinquish control in some areas. The main

three areas are described below.

Nuclear power This has commonly remained under national control because it has

been considered that governments should be able to determine the amount of nuclear

power generation in the future, that nuclear decommissioning funds can only be

assured by public sector retention, that consolidation of nuclear power maximises

safety, and that overall public interest with respect to such a long term issue as nuclear

power can only be served by having national ownership and accountability through the

electorate.

Hydro powerThe case for public sector retention for existing large hydro plant forthe protection of public ownership of natural resources is not particularly compelling

in countries which have been happy to privatise fuel and mineral extraction. However,

the construction of large dams requires such significant trade offs between national

and local environment that sometimes the public interest can only be best served by

public ownership. The control of hydro dispatch is also highly useful for the system

operator. In addition, international aid, commercial loans and soft loans in relation to

large hydro schemes and the sheer size of the schemes often calls for a high degree of

state involvement.

National gridsNational grids are commonly retained because it was felt, with some

justification, that the grids form the focal point through which the industry is managed

in the short and long term. By maintaining control of the grid, there was de facto

control on every other sector, and by maintaining control of the grid, it was possible to

form a coordinated view of security of supply, and then facilitation of whatever

construction is required to alleviate this.

When state monopoly is corporatized, vertically unbundled and horizontally fragmented,

then component parts can be privatised, one at a time, or all together.

There are essentially three types of privatisation:

Widely distributed, in which the share price is set low and there is a per capita

allocation to the population.

Public offerings, in which investors (both strategic and institutional) buy the stock.

Trade sale, in which the whole organisation is sold to a single company.


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The privatisation process is a very sensitive one, since the ESI is seen as a national asset

and there is often a risk (perceived or actual) that the stock is sold at low prices to individuals

and companies with political connections.

The regulated sector is comprised of privately owned local monopolies, but has prices,revenues and/or profits regulated by government through the regulator. Deregulation is the

process by which parts of the regulated sector are opened to competition.

We have seen how the generation sector has generally been open to competition for a long

time, and even when the dominant incumbent generator is regulated, generation competition

is not usually classed as deregulation. Almost always, deregulation begins by a gradual

opening of the supply sector to competition, starting with the very largest consumers, with a

phased opening of the market to smaller and smaller consumers, and eventually residential

consumers.

The deregulation process leads to the existence of two distinct sectors the deregulated

sector which is open to competition, and the regulated sector which has regulated prices or

revenues. Regulation is applied to both sectors, but is more of a monitoring, guiding and

policing role in the deregulated sector than a price setting one. From a regulatory perspective,

the retail sector is the most important sector, since this is the interface between ESI and

consumer.

The presence of financial institutions should be regarded as a measure of success, of

market reform. Financial institutions can enter the industry in a number of ways including

strategic investment, loans, wholesale market trading and electricity supply. There have been

several circumstances in which creditors have acquired the assets of power companies as

collateral on default.

There are a number of measures of success for ESI reform. In the light of these we must

decide: if there has been sufficient market reform to achieve success and if the market has

reformed substantially, then how should we adjust the model to improve ESI performance in

delivering welfare, how to deliver further economic and environmental efficiency.

There are a number of areas to examine, including::

Priceswhat has been the effect of reform on prices, and what can be done?

Consolidationhow much is too much?

Demand management will market mechanisms eventually deliver this, or must a

prescriptive solution be applied?


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Datais the electricity meter flow data structure robust enough to recover from errors

and to handle events such as change of supplier, occupier, or meter?

Metering to facilitate demand management, should parts of the metering sector be

regulated or deregulated?

The macroeconomy how much do increasing prices resulting from environmental

limitations affect the economy?

The environmenttaxing externalities, or command and control.

Security of Supply assignation of responsibility or mechanisms for security of

supply.

Universal service.

Cross subsidy.

2.2. Conditions for reform

Early stage reform, such as corporatisation, and high level administrative unbundling,

provides quite different challenges to late stage reform, such as exposing elements of

transportation to competition and the development of wholesale derivative markets. To enter

each stage of reform, there are prerequisites in terms of will and capability.

Generation capacity The implementation model depends greatly on the current

generation capacity in relation to demand. If capacity is insufficient, then priority is

fair market access rather than competition in generation. If capacity is excessive, then

the divestment of ownership must provide current stability (possibly including vesting

arrangements for stranded assets), both for the dominant incumbent and the new

players, as well as a road map for both retirement and new build.

Investment environment This is enhanced by stability of laws and taxes, mature

local financial markets, freely traded currency, absence of hyperinflation and low

country risk.

Rationalised cross subsidies The cost of low consumer prices arising from industry

subsidy must be recovered by taxes, either from the subsidised consumers, or other

consumers. In this circumstance, new entrance is not possible, and the cross subsidy

system has to gradually unravelled.

The will to disaggregate the ESI from the national economy to some degree. The ESI

can be a haven for employment in both the ESI and in the fuel sector.


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A high voltage grid that is sufficiently present and reliable.

The ability to collect tariffs for electricity, supported by the laws, police and courts,

property access rights and disconnection rights.

Supportable universal service requirements.

Even in a fully privatised industry, the ESI is a collection of assets, existing property

rights, right to build, franchises and obligations that has an inbuilt legacy relationship between

private and public sectors that is de facto and informal as much as it is formal. These

relationships built up incrementally as the industry developed, with a few step changes such

as nationalisation and deregulation that in fact made relatively slight differences to this

collection. The state therefore retains an intimate connection with the running of the ESI.

The state is the ultimate guarantor even if companies in the industry fail. In developed

economies, this is particularly important in the consideration of security of supply. The state

has a remit to monitor the current and likely achievement of national and international policy

objectives that are affected by the ESI, and to intervene where the delivery falls short or can

be enhanced.

Electrification (connection of the population to the electrical infrastructure) is seen as an

essential development for welfare and economic growth. In the absence of a complete market

for emissions or equivalent, the state must manage aggregate welfare by economic or

prescriptive instruments.

The state performs numerous roles, for example:

The participation of the ESI in the fiscal structure of the macroeconomy.

The setting of policy.

Primary legislation (Acts of Parliament) to drive and control policy.

The conversion of direct taxes to indirect taxes.. The management of those parts of the ESI that remain under state control.

Consumer subsidy if the requirement for cross subsidy within the ESI is reduced.

Corporate cross subsidy by taxation and concessions.

Prices are not the only measure of the success of liberalisation, and that prices are but one

outcome of political model and industry structure. We can see in Figure 2-5. that there can be

a wide variety of electricity prices, depending on the degree of state subsidy, which itself is

dependent on the tax revenue (and welfare saving if unemployment is reduced) from the ESI.


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Indeed either the fully managed model or the open market model can in theory achieve low

prices when pursued to its logical conclusion.

Figure 2-5. The role of the ESI in the fiscal structure of the macroeconomy [1]

Regardless of ownership, the government has ultimate right of control. To the industry this

represents a moral hazard as well as a potential lifeline for ailing companies as wel l as

protection for consumers. The government is the de facto ultimate guarantor of the industry

performance in terms of the delivery of electricity to consumers.

Governments can and do retain substantial influence of nationalised and other private

companies. Such mechanisms include:

SharesFull or partial ownership, golden shares (a share with significant voting rights

but no significant economic value).

Legislation Primary legislation (Acts of Parliament), secondary legislation (the

detailed drafting of the Acts).

Taxes New taxes, windfall taxes, change in tax rates, tax breaks, categorisation of

tax liability.

LicencesGenerally determined by legislation, moratoria, as soft mechanisms such

as slowing down the on going series of permissions.

Rules and regulations.

Arbitrating and determining On disputes between different parties, and on

interpretation of laws and regulations.

Administration Slowing the operation of the company by means of enquiry and

general administration.


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Retained ownershipOf key sectors.

Discretionary enforcement of laws and regulations, and implicit connection between

ESI implementation of one policy and enforcement of a completely separate law or

regulation.

2.3. Measures of liberalisation and deregulation

Since liberalisation and deregulation is a global experiment, it is natural to wish to

compare the experiences across the world. There are many comparative indicators, some of

which are listed here.

Declared level of opening percentage market openness, pace of opening, import-

export extent, presence of international commercial agreements.

The planned year of full market opening.

Price level of transmission network usage separate tariffs for energy and transport,

within the country and with neighbouring countries.

The way the transmission network is allocated.

o Separated by ownership from other ESI sectors.

o Legally separated as a separate entity in which other participants in the ESI

may have a part ownership.

o Separated at the management level from other ESI sectors.

The way the market is regulated.

o Regulated third party access, controlled by an independent regulatory body.

o Negotiated third party access

The existence of the Balancing market.

The market share of the biggest / largest manufacturers.

European Commission Directorate General, Transport and Energy Energy

liberalisation indicators in Europe (2001) This considers the regulated and deregulated

sectors separately. In the deregulated sectors it considers matters such as development of

competition and development of the wholesale markets. In the regulated sectors it considers

matters such as access and interconnectivity of networks.

EU benchmarking studies These are published specifically in relation to the EU

Directives, but are quite general in nature, and include non EU countries such as Norway. Thefirst, second and third benchmarking reports were produced in 2001, 2003 and 2004, and


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focus on matters such as liberalisation timetables, roles of regulators, market monitoring,

network access and tariffs, as well as other issues such as treatment of congestion,

transmission investment, interconnection, cross border tariffs and balancing services.

Centre for the advancements of energy markets (CAEM) Retail Energy DeregulationIndicator (2001)This considers specifically the retail sector. It has 22 criteria, each with a

score of 1 to 100. Examples are:

Is there a detailed plan for customer choice?

How many customers can currently make a choice and how many have switched to

competitive suppliers?

Are there standard business practices and is competition in metering and billing

allowed?

Is generation deregulated and is there a vibrant wholesale market?

How are customers integrated into the programme? Are they informed about their

options? Is customer information disseminated to promote competition? Are

customers encouraged to shop in the competitive market?

Are utilities encouraged to offer new services and to cut costs for the transportation

services they provide?

Has the state commission adopted internal reforms to accommodate their new

responsibilities?

There are also a number of studies by consulting organisations, academic institutions and

international bodies, and best practice guides.


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Currently leading power exchange in Europe EEX (European Energy Exchange) combines

trade for delivery of electricity to large part of continental Europe. Market operator is a

private company EEX AG. With electricity other commodities and asset classes are traded as

well, such as: power derivatives, guarantees of origin, natural gas (spot and futures market),

emissions allowances and coal.

3.1.

Market Structures for electricity

At the beginning of electricity market liberalization, previously monopolistic model is

transformed in order to achieve a wholesale market at first and later a complete power

exchange market. In order to reach a wholesale model, market is usually transformed into a

single buyer model, and the retention period on this simple model depends on many factors

within the country where the market is transformed. Single buyer model is characterised by

the fact that producers only have one buyer to whom they can sell. This model is a natural

step in the liberalization process, before moving to a wholesale model.

Basic characteristics of a wholesale model can be summarized as follows:

Partially open market with a limited number of consumers, defined mostly by

the size of annual consumption, while other consumers are in the public service,

that is, they are supplied by one supplierprovider of public service.

Manufacturers independently contract delivery method and price of electricity to

eligible consumers. Small consumers are supplied by the tariff system defined

and approved by an independent regulatory body.

Transition to a wholesale model requires significant transition costs and and

additional costs of administration access to and use of the transmission and

distribution network.

Electricity price of risk (production cost, market price) are transferred mainly to

producers and consumers, as opposed to a non-market system where risk is

exclusively on consumers.

In relation to monopoly system, wholesale model reduces political influence,

though not entirely. The basic premise for this is certainly a well-defined legal

framework and technical regulation of electricity market.


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Wholesale model is always a precursor model of the open market (retail

competition) in which all consumers are allowed to have a free choice of their

electricity supplier.

Basic versions of the wholesale model, based on how the electricity market is organised,

are bilateral model, pool model, and their various blends. In purely bilateral electricity market

it is assumed that market mechanisms, based on bilateral agreements between manufacturers

and trading companies, will lead to real market prices of electricity.

In all liberalized markets of Europe the goal is to achieve a fully liberalised power

exchange. The exception is the United Kingdom (England and Wales) where market is

dominated by a pool model. The following chapter explains the pool market model, while in

section 3.1.2. focus is on power exchanges, showing the way how the market develops to a

exchange model and comparing it with previous market models.

3.1.1. Pool model

In the pool model all producers submit their offer stacks into the pool, which produces

stacks and then sends dispatch instructions. The pool itself is purely an administrative entity

and takes no risks. The basic variants of a pool model are:

Mandatory pool, generation is only allowed through the pool.

Voluntary pool, generators can participate in the pool, or the buyer and seller can

request dispatch to meet a bilateral contract between them.

Pool system has been accepted by most Anglo-Saxon countries, predominant is the second

option (voluntary pool). Mandatory pool poses many questions over the years related to

market efficiency. In the UK (England and Wales) mandatory pool was in the 90s regularly

referred as an exemplary example of an organised electricity market. It was abolished and a

new system based on the model of a bilateral market was introduced NETA (New

Electricity Trading Arrangements).

Protection from variations in market prices is realized through short-term and long-term

financial bilateral contracts (futures and forward contracts), but usually based on CFD

principle ("Contract for difference").

A contract for difference (CFD) is a financial transaction between two parties who do not

necessarily have anything to do with the ESI. There is no explicit connection between the

CFD market and the system operator, and there is generally no market operator. With no


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explicit connection to the market, the system operator is not obliged to making changes to the

index, and this gives basis risk to CFD participants. The transaction is in the form of a fixed

for floating swap which are common in the financial markets. The transaction is as shown in

Figure 3-1. The price F is fixed, whereas the price PPP is floating until the agreed

indexation date is reached. This can be understood by regarding the swap as two separate

energy contracts. One is the sale of physical energy at a fixed price and the other is a purchase

of physical energy at a floating price.

Figure 3-1. CFD as two separate energy contracts. Q is the energy volume in MWh

The usefulness for generators and consumers/suppliers is shown in Figure 3-2. The

generator A, if dispatched, receives the PPP from the system operator, and this serves as an

index. Supplier B pays an uplift on PPP to pay for transmission, distribution and other

services. The net result is that B always pays a net price of Q(F+uplift) and hence retains norisk to PPP. The risk to change in uplift is called basis risk. A, if dispatched, receives a

revenue of Q

F and hence is insulated from changes to PPP, provided that PPP exceeds the

offer price into the pool.

Figure 3-2. The net result of participation in the pool and transaction of a CFD

3.1.2. Power exchange

We have noted that with the exception of the change from bundled centrally managed

(effectively a communist model) to unbundled centrally managed, that each structural step in

the development of the ESI market is relatively slight. The growth of power exchanges is theslightest of all, but finally bridges the gap between electricity is a intractably complex product


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for true competitive wholesale trading, to markets tradable by financial counterparties such as

commodity traders, funds, investment banks and actively hedging consumers.

Since not only do definitions of entities vary widely from country to country but from

model to model we use stylised definitions for the purpose of these figures:

MOMarket operator. Financial reconciliation only;

SBSingle Buyer. Economic optimiser;

SOSystem Operator. Managing the physical system from a starting point of physical

notifications;

PX Power Exchange Introducing agent, financial clearing house, physical

notification agent;

PNPhysical notificationAgreed volume submitted to system operator.

In the simplest pool with no demand side participation, Generators submit offer stacks to

SB, who constructs a trial schedule using consumption history and submits this to SO, which

then manages the imbalance with positive and negative reserve and capacity contracts. A

financial power exchange, not integrated with the MO, can operate effectively for contracts

for difference in this environment since there is an effective market index. In the absence of

the pool index the non integrated PX is vulnerable to index basis, definition, change of

definition and illiquidity.

Figure 3-3. Pool. No demand side participation [1]

With the addition of mandatory demand side participation (no bid no energy), SB no longer

estimates demand. Commercial mechanisms for demand imbalance are required. Figure 3-4.


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Figure 3-4. Pool model with mandatory demand side participation [1]

In the bilateral model, participants trade with each other instead of the single buyer. Since

the bilateral contract is effectively a PN promise, then reconciliation is required with the

market operator.

Figure 3-5. Bilateral mechanism [1]

The simplest power exchange is simply an introducing function between participants. This

part can be played by brokerage companies which need not have more resource than one

person with one telephone.


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Figure 3-6. Power exchange, just acting as a broker [1]

A formal power exchange (the standard interpretation of the term), acts as counterparty,

and must therefore reconcile trades.

Figure 3-7. Power exchange, acting as financial counterparty [1]

An integrated power exchange (the most advanced model, figure 3-8.) submits

notifications in relation to the net position from trades executed. If bilateral trades (not shown

below) are required to be posted or crossed on the exchange, then the exchange is very

similar to the single buyer but is driven to reflect market conditions rather than proprietary

estimates. In France for example, bilateral trades are submitted directly to SO (RTE, an

administrative division of Electricit de France) and trades with Powernext are submitted to

SO by Powernext.


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Figure 3-8. Power exchange, integrated with system operation [1]

The basic commodity is the same in all cases a hourly (or other period) electricity

notification commitment to the system operator. Power exchanges can differ widely in their

details:

Counterparty visibilityWhilst it is technically possible for counterparties to identify

each other in some exchange models, the standard arrangement is that contracts are

anonymous.

Auction mechanismThe exchanges generally hold an array of bids and offers from

participants, that form the production and demand stacks. This can be published in full

(with anonymity) or just the most recent trade, the highest bid and the lowest offer.

Credit arrangements The exchange requires capital to maintain a very high credit

rating, which is generally (but need not necessarily be) provided by participants.

Trades also require initial margin and variation margin. Margin requires complex

algorithms for electricity.

Licence restrictionsAn exchange may be limited by rules beyond the exchange. For

example, while a generation or supply license may not be required, registration with a

financial regulator may be.

LocationLiquidity is concentrated by trading at exchange hubs. Clearly, pricing is of

postage stamp form within a hub. Exchanges can trade several locations at the same

time, including locations in neighbouring markets.

Live trading or day aheadWhilst exchanges are best suited for live trading, they can

operate in batch mode in a pool-like manner. This is essentially a pool model with


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demand side participation. Since pool markets produce high quality indexes (i.e. with

high concentration of indices), then the index is amenable for exchange traded

financial contracts for difference.

Index construction and publication Indexes can be published and could be for

example, the closing trade, a weighted average of trades near the close, an average of

unaccepted bids and offers, etc.

Financial derivative contractsFor example European options cashed out against the

index, average rate options, multi-commodity options, time spread options

3.2. European power exchanges

The European Energy Exchange EEX is an electronic exchange based in Leipzig, for

trading electricity and related products. Since its inception in 2002, EEX has evolved from a

local to the current leading European power exchange. It is made up of several companies that

establish international partnerships and thus a wider network to trade energy products. Market

operator is a private company EEX AG. EEX is analysed in detail in chapter 3.3. (and

chapters 3.4 and 3.5.).

Figure 3-9. Main trading area on EEX [2]


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Nord Pool market, the electricity market of the Scandinavian and Baltic countries, founded

in 1993, is currently the largest spot market in Europe. Spot Market ("Nord Pool Spot") is

organized through trade on day-ahead and intra-day markets. In 2013, the spot market

recorded a trade of 493 TWh. Of the total electricity consumption of Scandinavian and Baltic

countries, 84% is purchased on the Nord Pool Spot market in 2013. Until recently there was

no derivatives market, but Nord Pool Spot in cooperation with the company "NASDAQ OMX

Commodities" created a market in financial derivatives based on prices from the spot market.

Figure 3-10. Nord Pool market [4]

IPEX (Italian Power Exchange) is the Italian electricity market established in 2004. With

the goal of Italian market liberalization, competition was created in the spot market. The

volume of trade is not nearly as big as on EEX or Nord Pool markets, but it is constantly

growing with a steady increase in market participants.

Powernext is the French electricity exchange, founded in 2001, which offers trading on the

spot market and the derivatives market. Spot market is organized by "EPEX SPOT" and

derivatives markets is organized via the "EEX Power Derivatives." Market operator is a

private company Powernext SA, which shares ownership with EEX AG in EPEX SPOT, and

has a 20% stake in the "EEX Power Derivatives."


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APX is a transparent electricity market of Great Britain, the Netherlands and Belgium,

which offers trading on the spot market. In cooperation with the European Commission in

2004, APX has launched a triple market coupling connecting the French, Belgian and Dutch

spot market. Market coupling of the specified countries implies joint bids for sale and

purchase on the spot market, taking into account the network transmission capacity of these

countries.

Figure 3-11. APX electricity market [5]

Belpex is the Belgian electricity exchange established in 2006 that offers trading on the

spot market. An important feature of this exchange is associated trade of electricity on a day-

ahead spot market with two neighbouring exchanges, APX Exchange in The Netherlands and

Powernext exchange in France. The correlation between the prices on these exchanges is 90%

which is the highest recorded market coupling of electricity exchanges. Belpex SA, the

operator of Belpex Stock Exchange, is 100 % owned by the APX exchange.

Endex ("European Energy Derivatives Exchange") is the Dutch electricity market

established in 2002 with headquarters in Amsterdam, which offers only trade of futures


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contracts of electricity. Participants of Endex exchange are manufacturers, distribution

companies, financial institutions, industrial consumers, "hedge" funds, asset managers, etc.

Omie is the operator of the Spanish spot market, and OMEL is the system operator

responsible for the functionality of the network and consumer supply security. Trade ofSpanish futures contracts is lead by Portuguese company MIBEL. An important factor in the

Spanish electricity market is lack of transmission capacity between Iberian Peninsula and the

rest of continental Europe. Market coupling with the Spanish market would not have

satisfactory results until the completion of additional transmission network facilities which

would increase transmission capacity with the rest of Europe.

EXAA is the Austrian electricity market established in 2002. The number of market

participants has increased from the initial 10 to 74 participants from 15 countries. EXAA only

offers trading on the spot market on a daily basis.

PXE (Power Exchange Central Europe) is a power exchange of Czech Republic, Slovakia

and Hungary established in July 2007. PXE offers trading on spot and futures markets.

Trading financial futures is possible only for Czech Republic delivery area.

Towarowa Gieda Energia or Polish Power Exchange POLPX is Poland's Energy Market,

founded in 2000, which offers trading on the spot market and futures market of electricity.

Due to the lack of liquidity in the futures market, futures trading in Poland Stock Exchange

was discontinued in June 2006 and was reinstated in 2008.

Figure 3-12. Average prices for first 17 days of NWE market coupling project [6]


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With constant strive for connecting the electricity markets, on February 4, 2014, began a

project to connect the north-western European markets - NWE (North-Western European

Price Coupling). The largest four spot markets in Europe: EPEX SPOT, Nord Pool Spot, APX

and Belpex and 13 system operators from France to Finland, successfully launched market

coupling of the day-ahead spot market. Figure 3-12. presents the average realized prices on

the spot market for different areas of delivery, in the period from 5 February to 21 February

2014. With this project Denmark, a country that is located between two largest spot markets

in Europe, achieved the best results, and the lowest price of electricity ( 28.64 for 1 MWh).

3.3.

European Energy ExchangeEEX

As previously mentioned, the EEX AG is made up of several companies that establish

international partnerships and thus a wider network for trading energy products. Figure 3-13.

shows EEX Group and EEX AG shares in individual companies.

EEX Group

EPEX SPOT SE

50%

EEX Power

Derivatives GmbH

80%

European

Commodity Clearing

AG

98.5%

European Energy Exchange AG EEX AG

EGEX European Gas

Exchange GmbH

100%

Global

Environmental

Exchange GmbH

100%

Cleartrade Exchange

Pte Ltd.

52%

European

Commodity Clearing

Luxembourg

100%

Figure 3-13. EEX group [7]

For trading electricity, the most important three companies are:

EPEX SPOT SE Operator of electricity spot market "EPEX SPOT". Ownership is

divided between companies EEX AG and Powernext SA. There are spot markets for

France, Germany / Austria and Switzerland.

EEX Power Derivatves GmbH Operator of futures market for Germany/Austria

(Phelix Futures), France and Italy, and options market for Phelix futures. Operator of


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physical futures market for France, Netherlands and Belgium. It is possible to register

a base load futures contract for Switzerland, Spain, Romania and Nord Pool market.

European Commodity Clearing (ECC) AG Banking company owned by EEX AG

that offers execution of all financial and physical transactions on EEX. Guarantees the

payment and delivery of electricity to all market participants. It offers registration of

bilateral agreements on the exchange.

Figure 3-14. EEX trading participants by country [3]

Physical futures contracts at expiry are realized through physical delivery of electricity.

Financial futures contracts at expiry are realized through financial compensation between the

price at expiration and the price at which the contract was concluded, and can be implemented

as a physical futures contract through the spot market. The total volume of trade with power

derivatives on the EEX exchange in 2013 was 1,264 TWh, while the spot market recorded a

trade volume of 346 TWh [3]. For comparison, the Nord Pool spot market recorded a trade

volume of 493 TWh in 2013. Power derivatives and the number of market participants is whatmakes EEX the current leading power exchange in Europe.


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Figure 3-15. Greater trading area on EEX [2]

In following chapters, the structure of both spot and derivatives market (futures and option

contracts) is explained. As a reference market EEX was chosen, because it has the greatest

potential for expansion, due to well-structured derivatives market, a growing number of

market participants and a stable growth of trade volume.

3.4. Spot market

Financial spot markets and spot commodity markets are generally well-organized markets

in which goods and money are delivered immediately after the transaction on the exchange.

Due to high transaction costs, the spot market typically offers only standardized products for

trade in goods.

Electricity spot market is not organized as a market with delivery immediately after

transaction. Due to the impossibility of storing electricity, instant delivery is possible only in

exceptional circumstances. Therefore, spot electricity market can be divided into two distinctmarkets: the day-ahead spot market and intraday spot market.


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Trade at the day ahead spot market is organized on power exchanges under the principle of

equalization of supply and demand for each hour of the following day. The offer comes from

the surplus production that can not be sold in the long term. It is similar to the demand, as in

the case of unforeseen loads and demand, traders and large consumers can purchase additional

electricity on the spot market. In some cases, the manufacturer buys electricity because it can

not fulfil its contractual obligations or if the market price is lower than the costs of production

units.

Trading products on the day ahead spot market has been standardized and market rules are

the same for all market participants, buyers and sellers, which makes the market operator

neutral during execution of transactions. Except various delivery periods of electricity, on the

spot market base load (electricity supply throughout the next day) and peak load (deliveryduring peak loads in a day, depending on the market) are traded. The competition between

producers, traders, speculators and large industrial consumers is achieved when the

submission of tenders for the purchase and sale are delivered to the exchange.

Figure 3-16. Offers for buy/sell of one participant at the day-ahead auction

Each offer contains the quantity and a minimum/maximum price at which a market

participant is willing to sell/buy electricity. Immediately after the expiration of the time for

sending bids, exchange operator from all of the offers received, forms a supply and demand

curve and publishes a determined price for each hour of the following day. Only offers for

sale that are lower than the determined price and offers to buy that are above the determined

price will be executed, and all of them will be matched at the determined price. This process

is called a uniformly valued auction. Figure 3-16. shows offers to buy/sell electricity maid by

MWh

EUR/MWh

100

80

60

40

20

10 20 30 40 50

Offers to sell

Offers to buy


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one participant of the market for a specific delivery period. Each participant of the market

must send their offers.

Intraday market is a market for continuous trade and quick delivery of electricity. A trader

can access the market when, for whatever reason, there is an immediate lack of power/energythat should be delivered. This situation demands a quick solution and intraday market serves

for that purpose. Prices in this market are significantly higher than on the day-ahead spot

market and mainly electricity blocks of one hour are traded.

EPEX SPOT covers the spot market in Germany, Austria, France and Switzerland with

headquarters in Paris and offices in Leipzig, Bern and Vienna. The market was created in

2008 by merging companies, and related spot markets, Powernext SA from France and EEX

AG from Germany. EPEX SPOT currently has 222 registered participants. The total trade

volume recorded in 2013 was 346 TWh, while in Germany/Austria 265.5 TWh was recorded.

Compared with consumption in Germany, which in 2013 amounted to 596 TWh, 40% of total

electricity consumption in Germany was bought on the spot market. EPEX SPOT market is

organized as a day-ahead spot market and intra-day spot market.

EUR/MWh

300

200

-100

0

100

6000 7000 8000 9000 10000

Offers to sell

Offers to buy

MWh

DMP

DMV

Figure 3-17. Summarized offers to buy/sell at a determined market price and volume


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Day-Ahead spot market is organized through uniform auctions at which all market

participants send their offers to buy/sell. After the tenders are received and auction expires,

EPEX SPOT summarizes all offers, and after equalization of supply and demand publishes

the determined market price (DMP) and determined market volume (DMV) for a specific

delivery period. An example is shown in Figure 3-17.

Delivery periods for a particular hour, blocks of several continues hours, base load, peak

load and supplies for the weekend are all separately traded or determined from a shorter

delivery period. Auctions are held every day and end at noon for Germany/Austria and French

area, while in Switzerland ends an hour earlier, and the results are published soon after

(usually 15 minutes after).

Figure 3-18. Prices for each hour on the Germany/Austria spot market from 2000. to 2014.

Offers to buy/sell contain up to 256 combinations of price/quantity of MWh for delivery in

one hour of the following day, while prices for 1 MWh must be in the range from -500

/MWh to 3000 /MWh. Minimal trading increment for delivery quantity is 0.1 MW, and

minimal trading increment for the price is 0.1 /MWh. EPEX SPOT is the first power

exchange which introduced negative rates in 2008, starting with the day-ahead spot market in

Germany/Austria. Negative prices are not a theoretical concept. The buyer on the spot market

receives electricity, and if the price is negative, receives money as well. Figure 3-18. shows


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prices from the day-ahead spot market in Germany/Austria for each hour of delivery from the

creation of EEX spot market in Germany, from 15 June 2000. to 27 June 2014.

Market prices move in line with demand and supply of electricity, which is determined by

several factors such as climatic conditions, seasonal factors and consumer behaviour. Pricesare falling in the case of low demand, and falling into negative territory when inflexible

consumer can not be quickly and cost-effectively turned off and back on. Negative price

signals producers to reduce production and to compare the costs of turning the power plant off

and back on later with costs of selling electricity at the negative price. Renewable energy

sources (wind and solar power) also contribute to the decline in market prices in the case of

low demand, because of their rights of first purchase and production dependence on hardly

predictable external factors (wind and solar).

Figure 3-19. German delivery zones with their transmission system operators (TSOs) [8]

Location of delivery and trade of electricity on the spot market is defined by zones of

transmission system operators. When sending offers to an auction zone of delivery must be

specified in the offer. In France there is only one zone of delivery under the control of the

French system operator "RTE". In Switzerland, there is also only one zone of delivery under

the control of the Swiss system operato "Swissgrid". In Germany, there are 4 different zones

with 4 separate transmission system operators: Amprion GmbH, Tennet TSO GmbH, 50Hertz


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Transmission GmbH and TransnetBW GmbH. Austria has only one zone of delivery with

TSO Austrian Power Grid. These 5 delivery zones in Germany/Austria form a single zone for

the formation of the final price on the auction, or the same price for all zones.

Trade with blocks of electricity is based on a combination of several hours of delivery.Offers must be sent to auction where the quantity of delivery does not have to be the same for

each hour of delivery within the block. Offer/transaction of the entire block will be executed

on the exchange for all specified hours of delivery in the original tender or it will not be

executed. Trade of particular hours of delivery has a higher priority than a trade of block, as

the price of blocks is based on the determined prices for delivery periods of one hour. Block

price offer is compared with the realized volume-weighted average market prices of hourly

delivery periods contained in the block. On that basis it is determined whether the blocktransaction will be executed or not.

Table 3.1. Standard block offers and prices in Germany/Austria, 2014. [9]

23. June 24. June 25. June 26. June 27. June 28. June 29. June

Monday Tuesday Wednesday Thursday Friday Saturday Sunday

Middle Night

(01-04) 23.14 29.1 28.71 29.57 29.77 30.28 25.78

Early Morning

(05-08) 28.57 34.48 33.79 34.56 33.68 28.05 21.78

Late Morning

(09-12) 35.03 50.6 44.87 45 44.2 32.17 28.96

Early Afternoon

(13-16) 36.25 43.75 40.11 41.44 37.56 29.67 28.54

Rush Hour

(17-20) 44.01 41.11 40.94 46.1 38.83 33.52 29.64

Off-Peak 2

(21-24) 40.17 39.04 38.92 41.7 38.85 34.68 33.33

Night

(01-06) 22.77 28.88 28.42 29.18 29.4 29.22 24.72

Off-Peak 1

(01-08) 25.86 31.79 31.25 32.06 31.72 29.17 23.78

Business

(09-16) 35.64 47.18 42.49 43.22 40.88 30.92 28.75

Off-Peak

(01-08 & 21-24) 30.63 34.21 33.8 35.27 34.1 31 26.96

Morning

(07-10) 35.11 44.68 42.32 43.25 41.83 30.67 23.7

High Noon

(11-14) 35.34 49.45 42.93 43.06 41.69 31.37 30.67

Afternoon

(15-18) 38.46 40.36 39.31 42.17 35.8 29.75 27.29

Evening

(19-24) 42.74 40.18 40.1 44.07 39.64 35.16 32.86

Sun Peak

(11-16) 35.81 46.62 41.68 42.36 39.51 30.44 29.52

Blok prices


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On the intraday spot market, introduced in 2006, electricity is traded continuously up to 45

minutes (Germany and France, while in Austria and Switzerland, 75 minutes) before delivery.

Continuous trading is available for Germany, Austria, France and Switzerland, with similar

rules and characteristics for all four markets. The most advanced is the German intraday spot

market which rules and characteristics are discussed below.

The minimum trade volume increment is 0.1 MW, with a minimum price increment of

0.01 /MWh and allowed price range from -9999 to 9999 . With standard hourly deliveries

of electricity and blocks for base load (from 1 to 24 hours) and peak (from 9 to 20 hours every

day) load, on the German intraday spot market even 15-minute delivery periods are traded.

Starting every day at 15 o'clock continuous trading for delivery the following day is

conducted in hourly, 15-minute or block deliveries up until 45 minutes before the delivery.Besides the standard blocks of delivery, market participants can create their own delivery

blocks consisting of several consecutive hours by choice.

Continuous trading is very different from an auction mechanism. Trading is mostly done

electronically. When sending a offer to buy/sell for a specific delivery period, price and

quantity of delivery must be specified and if there are other offers to sell/buy at that price and

with sufficient quantity, the transaction will be immediately or partially matched without any

price determination by the exchange. Almost always there is an immediate best open offer tosell ("ask") and buy ("bid") at which transactions can be matched. Trader may decide that he

does not want to buy at the current price and gives the order to buy at a lower price and waits

for his open order to be matched, and the same goes for the opposite. There are several types

of offers which can be sent to the exchange with different modes of execution. Offer types for

the German intraday market are:

Limit order Offer to buy/sell that can only be matched at the determined or better

price, depending on whether it is an offer to buy, then the better price is the lower one,

or offer to sell, then the better price is the higher one.

Market Sweep Order Offer to buy/sell seeking the best deal in a given zone of

delivery, but also in other areas and countries.

10th MW Orders Bids for buy/sell of an extremely small volume of delivery from

0.1 to 0.9 MW.

Methods of offer execution are:


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Immediate or cancel (IOC) The offer will be immediately matched when sent,

otherwise it will be cancelled.

Fill or Kill (FOK) Similar to the IOC with a difference that offer must be fully

matched at the determined or better price. There should be enough volume for the

offer to be fully matched, otherwise it will be cancelled.

All or None (AON) The offer will be received by the exchange and will be fully

matched at the given price or better, otherwise it remains as an pending offer on the

exchange until it is fully matched.

IcebergOne big offer which is divided into several smaller offers, usually with the

help of automated programs for the purpose of concealing the actual amount of the

offer, in this case the amount of MWh.

Figure 3-20. Prices on intraday spot market in Germany on June 24, 2014th

Prices on intraday spot market can fluctuate greatly depending on the needs for balancing

the delivery and other unpredictable factors. Figure 3-20. shows the highest, lowest and last

price of matched transactions for the supply of power by the hour in Germany on June 24. For

example, the delivery of electricity in a period 08-09 hours, the lowest matched price is below

30 /MWh, and the highest, is around 45 /MWh.


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Difference in matched prices of 15 /MWh for the same delivery hour, which is 50% with

respect to the lowest matched price, indicates high volatility on intraday spot market. Market

participants can take advantage of high volatility for the sale of contracted deliveries from the

day-ahead spot market at higher prices, if the delivery can be covered in a different way or if

it is a surplus. In the case of higher prices, producers can sell excess electricity which they

currently have available or if they failed to sell on the day-ahead spot market or bilaterally.

Market participants, traders or consumers who have unpredictable demand and/or did not

meet their needs to deliver from the day-ahead spot market or bilaterally, can access the

market and secure a sufficient amount of energy to deliver. Excessive demand is often on the

intraday spot market, and with it a higher price than on the day-ahead spot market for the

same delivery period. With the introduction of even shorter delivery period (15 minutes was

introduced in Germany and Switzerland) it is now more possible to better balance the

unpredictable demand and production from renewable energy sources, and therefore the

prices on the intraday spot market. In order to reduce price volatility in both spot markets and

increase the delivery quality of electricity, market coupling has been introduced.

Figure 3-21. Balancing price between areas with different supply/demand [10]

Connecting a day ahead spot market mostly works on an auction basis, taking into account

the transmission capacity between countries. In the lower price area the demand curve shiftsto the right, and in the area of higher prices supply curve also shifts to the right by the amount


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of transmission capacity between areas. The result is a balance between price areas. Figure 3-

21. shows an example of balancing prices between two day-ahead spot markets.

Market coupling of day-ahead spot markets on EPEX SPOT exchange is held every day

starting at 9:30 - 11:15 am. Delivery contracts of one hour are traded. Auction forms are:

EPEX SPOT France to Germanydelivery from France to Germany

EPEX SPOT Germany to Francedelivery from Germany to France

EPEX SPOT France to Belgiumdelivery from France to Belgium

EPEX SPOT Germany to Netherlandsdelivery from Germany to Netherlands

EPEX SPOT France to Spaindelivery from France to Spain

EPEX SPOT France to UKdelivery from France to UK

EPEX SPOT Germany to Denmarkdelivery from Germany to Denmark

Denmark to EPEX SPOT Germanydelivery from Denmark to Germany

Market coupling of intraday spot markets between EPEX SPOT markets/countries is based

on active and continuous linking offers to buy and sell, taking into account the transmission

capacity between countries. Without market coupling markets in Germany, the visible supply

and trade exists only between consumers, producers and retailers from the German delivery

area (local area). By connecting the German and French markets, continuous trading for the

German area has local offers and best offers to buy/sell from France and conversely, but only

if there is available transmission capacity between countries. The aim is to decrease price

differences between countries so there are no additional costs for the purchase/sale of

electricity, or for the transmission of electricity between countries. In trading on the exchange,

if both parties of the transaction are from the same delivery area, further delivery process is

relatively simple. In the case of trading between countries, it is necessary, at all times, to

amend the automatic transmission capacity between countries and an active communication

between TSO of the countries. In both cases, the registration of trade and delivery is regulated

by ECC AG (European Commodity Clearing) company.

The total trade volume of 16.3 TWh on intraday spot market in 2013 is considerably lower

then the trade volume on the day-ahead spot market (330 TWh). Hereinafter, day-ahead spot

market will be considered as spot market.

At the end of each auction on the spot market, certain prices for each hour are used for

indexes that represent the price for a period of delivery in a given area. For the

German/Austrian delivery area Phelix index is computed, as Phelix Base and Phelix Peak


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index. Phelix Day Base index represents the base load for one day and it is calculated as the

arithmetic average of all hourly prices (0-24) for delivery determined on the auction. Phelix

Day Peak index represents the peak load for one day and it is calculated as the arithmetic

average of the hourly prices for delivery from 8 to 20 hours determined on the auction. With

daily indices, there are also monthly indices, Phelix Base Month and Phelix Peak Month,

which are calculated as the arithmetic average of all daily Phelix indexes in the month. Figure

3-22. shows the Phelix Day Base index as the average hourly prices of each day from 2000 to

2014. Most other indices are calculated according to the similar or the same principle.

Figure 3-22. Phelix Day Base index from 2000. to 2014.

Market coupling has reduces volatility, as can be seen in Figures 3-18. and 3-22. Following

the introduction of negative prices in 2008, the number of price jumps on levels over 100

/MWh has decreased. With negative jumps becoming more rarer, the price has stabilized in

the last few years on levels between 30 and 50 /MWh. Figure 3-23. shows the frequency

histogram of Phelix Day Base index during the period from 2000 to 2014 with a sample of

5125 prices. The histogram would be approximately normally distributed according to the

Gaussian curve if there were no prices prior to 2009. Frequency histogram of the prices for

the period from 2009 to 2014 with a sample of 2000 prices is shown in Figure 3-24.


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Figure 3-23. Frequency histogram of Phelix Day Base index from 2000. to 2014.

Figure 3-24. Frequency histogram of Phelix Day Base index from 2009. to 2014.


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Phelix peak index should always be greater than Phelix base index because it is generally

higher average demand for electricity from 8 to 20 hours than the average demand throughout

the day. Appearance of the Phelix Day Peak frequency histogram is relatively the same as for

the Phelix base index.

Figure 3-25. Phelix Day Peak index from 2000. to 2014.

With the increasing construction of photovoltaic power plants in Germany and the current

installed capacity of 36 GW [11], during sunny days peak price is more often lower than the

base price of the index. Production capacity of renewable and conventional sources of

electricity is growing from year to year and currently equals 171 GW in Germany. An average

load of 50 to 70 GW, share of production from renewables equals 25.4% and 74.6% from

conventional sources. Increasing production capacity with insufficient increase in spending

and the right of pre-emption of photovoltaic power has changed the way electricity markets

function. Figure 3-26. shows the production from photovoltaic power plants in Germany in

one day, June 26, 2014. Figures 3-27. and 3-28. show the percentage price difference between

peak and base Phelix Day indexes. During the summer months, from May to October, there is

less difference between peak and base index, and on sunny days it is often that peak index is

lower than the base index. During winter months, the difference between indexes generally

ranges from 5 to 15 /MWh last 5 years, with occasional jumps above 20 /MWh.


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Figure 3-26. Production from photovoltaic power plants in Germany, 26 June 2014 [11]

Figure 3-27. Percentage price difference between peak and base Phelix day indexes


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Figure 3-28. Percentage price difference between peak and base day indexes last 6 years

Peak and base index and block prices of delivery only take into account average hourly

prices within a day, while the cost of hourly electricity supply can vary greatly depending on

the market situation. Figure 3-29. shows the average cost of hourly electricity supply on the

spot market for delivery in Germany/Austria in each year from 2002 to 2013. From 2002 to2009 price periodicity is revealed. Lowest price is at 4 am, followed by increase in price to

day high at noon, a slight decrease in the afternoon with the leap around 7-8 pm and further

drop of prices until midnight. From 2010 till today, price periodicity is the same as for the

previous year, but with a smaller price increase during the day due to larger production from

photovoltaic power plants than in previous years. The highest price is no longer during the

day, but at night at around 8 pm. For the period from 2011 to 2013, price at 8 pm was around

5 /MWh higher than the price at noon, while the 2010 price at noon and at 8 pm was

approximately the same. Figure 3-30. shows the average cost of hourly deliveries in the

period from 2002 to 2013, and separately for the period from 2002 to 2009 and from 2010 to

2013.


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Figure 3-29. Average prices of hourly deliveries per year


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Figure 3-30. Average prices of hourly deliveries

Prices also vary depending on whether it is a business or non-business day. Figure 3-31.

shows the average electricity price in Germany/Austria by days of the week for each year

from 2002 to 2013, and Figure 3-32. shows the average price per day of the week for period

from 2000 to 2014. Figure 3-33. represents the average hourly price by delivery days of the

week for 2013.


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Figure 3-31. Average price per day of the week


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3.5.

Derivatives market

Due to high volatility in the spot market, market participants are exposed to risks when

trading on the spot market. The most important are the price risk, counterparty risk and

volume risk (ex. lack of liquidity in the spot market). With long-term contracts, which until

recently were not present on most power exchanges, derivatives market provides market

participants ability to protect and manage their risks. Long-term contracts bind contract

parties to deliver electricity (the underlying), during a given period in the future (delivery

period), and are known as derivatives.

Derivative is a special type of contract that has a current value based on expected future

price movements of the underlying asset. Derivatives are traded for:

Hedging, risk management

Arbitrage

Speculation

Market participants, producers, traders and large consumers, are using derivatives to hedge

against risk. Futures contracts can be bought to hold a long position, or sold before bought to

hold a short position. For example, the short futures contract can be used as a protection

against falling electricity prices by fixing the price for delivery in the future (the futures

price). Arbitrageur exploits the difference between prices in different markets on the same

tradable asset class. For example, the simultaneous purchase of a contract for supply of

electricity out of the market (bilaterally) at a reduced price and selling futures contracts on the

market at a higher price. Speculators trade derivatives in order to achieve profit by taking on

the risk of future price movements, thus providing liquidity to other market participants.

Power exchanges use many types of derivatives, but the most common are:

Futures contracts

Forward contracts

Options

In addition to these there are many other derivatives, standardized and non-standardized.

For the purpose of describing the electricity exchange EEX only standardized derivatives of

EEX exchange are taken into account, while non-standardized derivatives, mostly bilateral,

are not taken into account.


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3.5.1. Futures contracts

A typical futures contract is a standardized, portable and binding contract to buy or sell a

specific amount of the underlying asset at a certain time in the future (the maturity of the

futures contract) at a specified contract price (futures price). Future contracts are used mainly

to reduce the risk future market prices by fixing the price to be paid/received for the delivery

of the underlying asset in the future. The risk for a buyer or a seller of a futures contract is the

same, because the amount of loss and gain of contract participants is the same (but opposite)

at any given time until expiry of the contract.

Expiries of futures contracts and the amount of supply of the underlying are standardized.

The only debatable aspect of the contract is the current price to be paid for the underlying at

some point in the future, or futures price. Contract Standardization is carried out in order to

facilitate trade in futures markets.

Future price at time t for delivery of the underlying asset, with the price on the spot market

S(t) and the expiration of the contract at time t, is expressed as f (t,T). Payment (P) of a

futures contract at expiration T is expressed as:

(3.1)

To avoid arbitrage, from relation above we see that the futures price agreed at the time T,

for the delivery of the underlying asset at the time T (instant delivery), must be equal to S(T).

Any other price would allow arbitration, by buying the cheaper and selling the other.

Having to pay the contracted futures price in given time in the future, there are no costs of

concluding the futures contract. However, due to market conditions, the value of futures

contracts change over time. For example suppose that the market participant has a long

position for delivery of the underlying asset in the future at a market price of 100, and thecurrent market value of the contract is 110 . If market participant sells the contract at the

current price, he will realize an immediate profit of 10 and will no longer have any liability

in connection with the delivery of the underlying asset in the future.

The value of each futures contract is recorded at the end of each trading day. This means

that financial positions are valued according to current market prices as shown in the previous

example. The difference between the price of the previous day and current prices are

continuously determined. Profit or loss of a position is added to or subtracted from the

account of a market participant. Since there is a risk involved when trading futures, exchanges


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are using margin accounts that guarantee that contracts will be respected. Margin is

determined by how much money you should have in your account when you trade futures

contracts and is usually only couple or more percent of the total futures price, and if the

position is in negative territory even more.

Trading futures contracts on exchanges is relatively straightforward and ultimate delivery

of the underlying asset rarely happens when the contract expires. Sellers and buyers usually

break commitments by exiting their positions prior to the expiration of the contract.

The above-described typical futures contracts differ greatly from futures contracts that are

traded on power exchanges. In a typical futures contract underlying asset is being bought/sold

and delivered in a given time in the future, or when the contract expires. Power futures

contract expiration and delivery do not match. Instead of a specific date of delivery, electri

Documents

Modelling Electricity Spot and Futures Price