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Financialization of electricity market
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.
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.