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Financialization of electricity market
Write by Alexis Gléron september 2024
Message from the author: 'It’s been a while since I last wrote an in-depth article without a clear marketing purpose. I took advantage of the summer to engage in this exercise once again. Even more unusually, I will also produce an English translation of this article because I believe it has international relevance.
The crude oil market has gradually become more financialized over the past few decades. It has evolved from a collection of regional markets dominated by physical actors and contracts to a global market where most transactions are financial. By 2024, any individual investor can bet on the price of oil through an app on their phone (via futures or, more often, ETFs). Crude oil, once a physical commodity, has become a financial asset. For every "physical" barrel of crude oil, 20 to 30 "paper" barrels are traded. As a direct consequence, the price of a barrel has become increasingly correlated with movements in other financial assets.
Today's electricity markets closely resemble the oil market 40 years ago. Most participants are physical actors (producers, suppliers, consumers, etc.), and many contracts are for physical delivery (although this has evolved in recent years). The various markets are limited in size and illiquid.
Is this a bad thing? Why should your dentist be able to bet on the price of CAL 2027? Electricity is a basic necessity; shouldn’t it be beyond the reach of banks and hedge funds? Well, that’s precisely the somewhat controversial theme of this article.
We will explore why electricity markets need to become more financialized and why this financialization is a key factor in the energy transition.
Liquidity and completeness
Let’s begin this first part with two important definitions.
Liquidity refers to the ability of market participants to execute transactions quickly and at low cost. It is usually measured at a given moment, through various indicators such as the volume of transactions completed, the difference between the best bid and ask prices (bid-ask spread), or the depth of the order book.
A complete market is one where participants can hedge all their risks. If you are exposed to the risk of electricity prices rising in winter 2029, in a complete market, you are able to buy a contract (forward, futures, etc.) that allows you to hedge that risk by locking in that price today. Similarly, if you produce solar electricity only in the middle of the day and want to protect yourself from price drops during those particular hours, in a complete market you can do so.
Electricity markets sorely lack these two characteristics, which are closely linked. Low liquidity is concentrated on a few standard contracts, such as baseload, with relatively near-term maturity. Even on these, the transaction costs are very high compared to other assets. If we compare with oil, it can be traded several years in advance and benefits from numerous optional products (which exist in electricity but are largely illiquid).
However, discussions and reforms around the European electricity market have largely ignored these two major dysfunctions.
During the 2021-2022 crisis, the electricity market was literally paralyzed by a lack of liquidity, preventing participants from hedging and sustaining "delusional" prices disconnected from physical fundamentals. If we look at this period in particular, the presence of financial actors "shorting" the forward markets and hoping to profit from a price drop would have greatly improved the situation.
Conversely, in 2024, prices during solar hours literally collapsed, with producers and aggregators mainly unable to hedge all their volumes in the long term due to a lack of appropriate financial products.
At the heart of better liquidity is, of course, a transparent market supported by a diversity of physical actors, which is still not the case in many European countries. But this will not be enough to provide a level of liquidity and completeness similar to that of oil; the presence of financial actors is also required.
Financialization and Energy Transition: A major issue
Let’s first establish a basic observation: the energy transition needs long-term liquid and transparent prices. The electricity markets as they exist today do not offer these guarantees, which greatly hinders the financing of the infrastructure needed for the transition.
Take the example of renewable energy producers. Most of these producers need long-term price commitments to ensure the profitability of their projects. However, without robust and liquid forward markets, these producers often find themselves relying exclusively on Power Purchase Agreements (PPAs), which, while effective, are difficult to scale sufficiently.
It is essential to have long-term market prices to adequately finance renewable infrastructure. This need is even more critical as we approach the end of subsidies for many renewable technologies in Europe.
On the consumer side, the same need exists. To finance the electrification of their processes, they need to lock in the profitability of their investments and, therefore, know the long-term cost of their electricity. Signing PPAs, whether renewable or nuclear, is part of the solution, but the volumes from these contracts are generally indexed to the availability of the underlying plants. This represents a risk for the consumer and therefore a significant barrier to adoption.
The imperative need for new financial instruments
The creation of new forms of financial contracts, beyond the current baseload and peakload futures/forwards, better suited to the specifics of energy transition assets, is a necessity.
This includes more sophisticated derivatives (solar profile, options, etc.) and long-term hedging instruments that would allow participants to protect themselves against price fluctuations over longer time horizons.
For these new contracts to emerge, a greater diversity of actors, with heterogeneous needs and risk preferences, must be able to participate in the electricity markets.
No magic recipe, but necessary advances
Unlike oil, which is a global commodity transportable by ship and whose market is worldwide, electricity is inherently a more local good, limited by the length of physical interconnections. This local nature has historically limited the number of participants in the market. However, this situation is changing rapidly with the emergence of many small producers and suppliers, particularly in Europe. This diversification of actors must be supported by a market infrastructure that allows them to access advanced financial instruments tailored to their specific needs.
There is no magic recipe to solve the complex challenges described above. The evolution towards more liquid and complete markets is not only desirable but essential to ensure the success of the energy transition. The increased presence of financial actors in these markets may seem controversial, but it is a key factor in bringing the necessary liquidity for their proper functioning. This financialization, if properly regulated, can thus play a crucial role in developing a sustainable and resilient energy system.
Additional Remarks
Some might worry about seeing inexperienced investors, like your dentist, betting on electricity prices. However, it is important to remember that these investors are already taking risks on other equally exotic and volatile products, such as cryptocurrencies or complex derivatives. They might as well bring some liquidity to markets whose proper functioning is vital for our energy future.
Moreover, it is striking to note that an individual investor who puts 100 euros into an ETF or a digital token often benefits from better technological tools and more precise data than an SME that spends 1 million euros on electricity annually. This asymmetry reveals the lag in electricity markets and the inefficiencies that this can cause.