Snjólfur Richard Sverrisson: 0:05

Hello listeners, and welcome to the Montel Weekly Podcast, bringing you energy matters in an informal setting. In today's pod, we return to the topic of market design, and in particular, the ways in which to optimise cross border trading and hedging. What are virtual energy hubs? Are they needed? And how could they help liquidity in forward electricity markets? What other proposals are on the table? And what is the role of TSOs? I'm Richard Sverson and joining me today is Leon Hurt, um, Professor of Energy Policy at the Hurti School in Berlin and Director of Neon Energy. A warm welcome to you, Leon. Hello, I'm glad to be here. Before we delve into the sort of nitty gritty and the more technical areas of wholesale market reform or proposals, how would you evaluate the current state of play in Europe's wholesale energy markets?

Lion Hirth: 0:55

I think by and large, um, We are out of the crisis for a year now. I would, I would date that the end of the crisis actually to kind of new years of last year. So I think it's now 14 months that we are out of the crisis and it's surprisingly calm. Right. I mean, the, the, the prices for both gas go down. And, and electricity and more lately carbon also have fallen back very much from the, from the peak levels in mid 2022 and are quite moderate and things are almost boring, I would say.

Snjólfur Richard Sverrisson: 1:27

Absolutely. So, I mean, in some countries like Spain, they're falling to 10 year lows wholesale, uh, uh, electricity prices. So. Do you think then, um, you know, markets came out of this sort of very robust, they showed themselves to be stable and to deal with these kind of price shocks. So post, I was thinking post COVID, but also post energy crisis. I

Lion Hirth: 1:46

think yes and no. I think markets have worked pretty fine during the crisis and pretty much saved us in many ways. I think what didn't work so fine was Society and policy responding to that, I think what's pretty clear now that the appetite for interventions into markets is high, larger than I expected, and the willingness to to see prices and accept prices that might be beyond the ordinary, uh, is very limited. And I don't blame policymakers so much because they, they very much felt the pressure by their citizens and voters and, and, and the public. Um, but, um, I, I think the idea of having regulators and policymakers, for example, accepting scarcity prices seems to be, a bit wider than it used to be in my eyes.

Snjólfur Richard Sverrisson: 2:39

And do you think there are justified calls to change some of the markets and the market design in particular?

Lion Hirth: 2:46

I think my market design is an ongoing project, right? We've been working on this for 20 years now. I mean, I wasn't there 20 years ago, but I joined on the way and people have thought about this for 40 or 50 years since the 1980s and have started implementing this across Europe in the 1990s and 2000s. And. It's never a standstill, right? We've, we've changed and improved and, and amended many things on the way. I mean, if you think about how balancing markets on the very short term broke today with Picasso and Mali and European harmonization, as opposed to just 10 years ago, when everything was very much national. And in fact, Germany was split into four pretty much separate balancing areas. So things, things have changed and things should change. And there's a lot What more things to improve on the margin, I think was what was a bit of a unnecessary detour was that discussion about a radical change of kind of implementing a different way of pricing rules and kicking, essentially throwing marginal pricing out of the window and inventing something completely new that of course no one did invent, right? That was just a very strange discussion, uh, and, and, and sort of random fantasies. And in the, in that sense, there is no need to change markets. But there is a lot of work that is ongoing and that should be ongoing on improving market design on the margin.

Snjólfur Richard Sverrisson: 4:06

Absolutely. So we had a, we've had a few diversions, but we're back on track then you'd say Leon. Um, I mean, in particular, I think we want to focus more on, on, on cross border trading, uh, in forwards and futures market. But, but before we get onto that topic, do you, do you find that the forward markets in, Electricity and gas are liquid enough at the moment. Is there enough liquidity in those, in

Lion Hirth: 4:26

those markets? I think from a, from a company that would like to hedge from a generator perspective or a load serving entity perspective, I think there can never be enough liquidity, right? The more is always the better here. You want to, you want to buy and sell, you want to have deep markets, you want to buy and sell whatever volumes you, you, you want at any point in time. Um, Uh, and of course we have the issue that many European forward markets are relatively short, have short horizons, right? I mean, we're talking about liquid markets one, two, three years into the future. And this is of course falling short dramatically, the investment horizon of, of any asset, right? Even batteries you can't hedge, uh, but certainly not generation assets. Um, and that will be, of course, something. That we ultimately would like, right? Ideally, you would hedge your investment, um, at the point of FID on, on liquid forward markets, but that's very, very far from where we are on the other hand. I think we do have a forward markets that are much more liquid than in many other places of the world. We have a, we have a de facto German physical hub that serves for hedging purposes for most European companies across the continent that has a churn rate of maybe eight or so. And that's pretty nice for the, for the frontier. No,

Snjólfur Richard Sverrisson: 5:42

absolutely. But we're seeing with the hedging strategy of some big utilities is changing. Some of them pulling back from, from, from, um, from selling three years in advance as they may have used to due to, you know, the volatility of prices, the volatility of or the intermittency issues with renewable generation. Do you, how do you see

Lion Hirth: 6:01

that? I'm not so sure if the intermittency issue is, is a main thing here, right? So I, I'm trying to tell people that if you want to hedge, this is a price insurance decision, right? You want to insure yourself against price risk. And that's, that's very different from selling the output that you're physically going to produce. And that's very much deep in the, in the mind of both producers, generators, and. Um, and consumers as well as policymakers and regulators. So, so people tend to tell me, we can't use baseload futures to hedge our wind park because we're not producing baseload. And my response would be, yes, you're not producing baseload, but that still means a baseload future is a very reasonable hedge, certainly. Much, much better than no hedge at all, right? Because the wind output, the capture price that you're going to earn is highly correlated with the base price on timescales of a year or two. Um, so I think that's not the main driver here. I think the main driver for changes in hedging strategy Um, has been, um, certainly some of the policy interventions, but maybe more profoundly the margining requirements during the crisis where it was just the amount of cash that sums, though I pretty much, every firm had to deposit was just, had reached numbers that, that were too high even for the deepest pockets. And it's very sensible for firms to respond by this, by adjusting their, their, their their risk position and, and reducing exposure to margin calls and, and maybe move, move more to, to forwards that are non cleared and, and hopefully go back to cleared futures, um, over time.

Snjólfur Richard Sverrisson: 7:32

Yeah. No, I mean, it's very interesting. And it'd be interesting to see, You know, in company results and what happens over the coming months, um, as we've, as you say, as we've moved out of the energy crisis and return to some, some level of normality again, in terms of, um, energy prices and EU NG regulatory body, AESA, has called for Regional virtual hubs to improve forward power liquidity. Can you explain what a virtual hub is and how it would work?

Lion Hirth: 8:02

Maybe let's start with a bit of the context before we dive into this. I know virtual hubs on everyone's mind and was was was a prominent part of the market reform discussion in Brussels over the last couple of months. But the proposal that ACS made is actually much more. Much broader and much more far reaching, and also older than the discussion so acer I think it was in june 2022 has published a policy paper that i think My reading is that it's kind of preparing the ground for reform of the um, Uh of the guideline that's regulating these long term cross border Contracts. Um, and they've, um, suggested to do all kinds of reforms, for example, um, having these, um, transmission rights, these long term transition rights being auctioned off more frequently and at longer maturities and changing their derivative types instead of options, having spread futures and installing a virtual hub that, so that's just like, like, I think we should think of this as one of the pieces. Of the reform agenda that Acer has, has pushed forward. So what is a virtual hub? A virtual hub is a different price index that serves as the underlying asset of forward prices. So today across the continent, if you sign a forward contract. A financial future or forward in denominated in Germany or France. It's the German spot price or the French spot price, respectively, that is used to settle the contract. That's different in the Nordic region, right? If you buy a future on the system price, it's the system price that serves as the underlying. So that's the underlying asset. That's, that's used to settle the future. And the system price is a virtual hub. So a virtual hub is a new definition of an underlying that is serving and to settle forwards and future contracts.

Snjólfur Richard Sverrisson: 9:55

Um, and why introduce that in the continent? I mean, the experience so far in the Nordic regions has suggested that it hasn't always, it's not always, um, the, the, the most feasible solution for, for many market participants. Why then go and introduce a similar one on the continent where, where the markets seem to function quite, quite well?

Lion Hirth: 10:17

That's a good question. I think Acer is pointing to the Nordic region as Almost as a blueprint, um, in, in many ways, um, and I understand because a lot of the decision that, that the Nordic region has taken make a lot of sense to me. So theoretically that's a very reasonable role model, but empirically it's not in the sense that you've seen, uh, of course, Nordic forward liquidity, like truly collapsing over the last 10 years. Right. It's, I mean, it's not, has not disappeared, but it moved from a very liquid market to something that's. not very liquid anymore. So empirically it's, it's, um, it's maybe more a red flag than, than, than a clear role model. On the other hand, the idea of virtual hubs, the idea of having a somehow defined price index underlying future markets is something that's Very much established and very successfully used for many, many years across the United States, right? In the U S where we have locational marginal pricing. Um, there's very few forward markets established on locational on nodal prices. They almost exclusively based on price averages across a broad, broader area across multiple nodes. And that is nothing else than a virtual hub. So it's not that we've only have sort of bad examples or. Poor performing virtual hubs. We also have very, very well performing and, and, and, and long living virtual hubs outside Europe.

Snjólfur Richard Sverrisson: 11:47

Do we need such hubs than in Europe? I mean, in the French and German markets.

Lion Hirth: 11:51

So we've, we've thought about this quite a bit and to, to us, it's not entirely clear. Um, I think. There is a bit of a sentiment among some, maybe also some in Brussels and Ljubljana that the current setup is perceived to be unfair because Germans have all this nice liquidity and the others are left in the, in the rain. And I think that perception is a misinterpretation of how markets are used because it's of course daily business of generation firms in Belgium and Austria and Hungary and France. Thank you very Uh, and load serving entities in Denmark and in Italy to use the German forward market as a hedge again, because hedging is not about selling or buying electricity is about insuring against price risk and being insured against the German price risk is a pretty good insurance against the Hungarian or Austrian price ever because these markets are highly correlated in their, in their forward prices. So proxy hedging in a vert. is very common. And it's not that only German firms use the German forward market, quite the opposite firms across across the continent benefit from that liquidity. So I don't see the current setup as being kind of unfair towards other bidding zones. And, and hence, from that perspective, I don't think there's a need to act urgently.

Snjólfur Richard Sverrisson: 13:16

And of course, there's also a correlation here. With the discussion about splitting the German market zone as well, isn't that what do you think the German zone should be

Lion Hirth: 13:28

split? I think this is not just a correlation. There's there's some causality here. So, um, my own personal opinion, and I don't make many friends here in Germany with that has has for a long time being that split of the German bidding zone is Is would be very helpful and necessary and, uh, and would be very beneficial to us and our neighbors. But maybe let's not dive into that discussion too much, but I do think the virtual hub question and the buildings on split are linked in the following way. If the German bidding zone were to remain, let's say for the next 10 years, if he, if he, if he were sure the German bidding zone would stay as is for the next 10 years, my gut feeling is we don't need a virtual hub because we can continue to use the physical hub. And it's very doubtful that a virtual hub would be performed better than a German market. So there's, I think a pretty good risk that even if we introduce a virtual hub, it would stay Void and, and would be little use and maybe even sort of split some liquidity and we would end up being worse off by having, having a less liquid, like lacking a unique liquid, big, physical or virtual. But if you believe the German bidding zone is going to be split sometime in the 2020s or so, in let's say five or seven smaller bidding zones, if that would happen, It's much less clear that any of these bidding zone could support a big liquid physical hub, because there's no kind of natural big bidding zone anymore in the middle of the continent that could kind of attract all that liquidity. And if we would lose that without a replacement, that would be an awful outcome. Then we would all be left in the rain. So in that situation, I would personally, as sort of my gut feeling tells me, We should have a virtual hub up and running in, in, in, in sort of being prepared for that situation because then, then we need it. And that's, of course, when we enter politics, right? Then you find people who, who are arguing in favor of a virtual hub, not because they really like a virtual hub, but because they want to prepare, prepare for a potential bidding zone splits. And then there's also others who, who argue against a virtual hub, not because they don't like it, but just, they want to pretend, uh, or they want to prevent, uh, the German bidding cell to be split. So then, then it's sort of nasty and deep politics, uh, uh, very much.

Snjólfur Richard Sverrisson: 15:57

I'm about to say that gets very, very political there. I mean, you also touched upon some of the other, uh, changes that Acer has called for some of the proposals anyway, um, in detail. Um, and, you know, for example, you know, there are. So changes on how grid operators sell long term transmission rights to help improve market liquidity. How does it work now and how would it then change under these proposals?

Lion Hirth: 16:28

So today European TCOs are obliged by law by European law are Um, to submit what's called long term transmission rights. So they have established an entity that's called jail and they holds annual auctions and also monthly auctions, uh, where market participants and commodity trading houses can buy these LTTRs. First of all, the term LTTR is, I find a bit misleading because, because it, it very much sounds what it historically was physical transmission rights, but really this is not transmission rights. These are all financial derivatives, very much like forwards and futures. So. If you ask me, we should actually drop the term because it's confusing to everyone. Um, because we all think of physical lines, but we should rather think of financial derivatives that help people to hedge against the price risk, uh, across bidding zones. So to hedge yourself against the. Risk that the Belgian price will be higher or lower than the German price or the Austrian price will be higher or lower than the German price. That's the purpose of these, of these certificates of these, uh, contracts. So for companies

Snjólfur Richard Sverrisson: 17:40

who are active in both markets and want to, you know, ensure themselves against any, the prices moving in, in the, in the opposite direction to which they want them to move in, if you like.

Lion Hirth: 17:50

That's one possibility. Another possibility is imagine you are a check based generator and you've sold German futures to hedge yourself, then you are exposed still to the price risk that the check prices might diverge from the German prices. And that remaining basis risk is something you would like to hedge using these. cross border products. So the setup of today is that TSOs have to do this and their option is off on that platform called Jail and they do this by selling options. So they're selling what's in the academic literature is called financial transmission right options, FTR options. Um, so these are options on the spread between two electricity prices. So it's an option on the German French or the German. Check. Electricity price spreads on the hourly day head spreads. That's what they sell today. And indeed, and maybe let's talk about this briefly. In our view, the biggest proposal that ASA has made in their policy paper two years ago It's not even the virtual hub that has gained so much sort of attention, but it's a much more what seems to be a technical change. And that change is to change the type of derivative that's sold by TSOs from an FTR option to a so called FTR obligation.

Snjólfur Richard Sverrisson: 19:10

So explain that. What is, what does that, how does, how does that change the whole system and, and the practice of, of, of hedging that cross, cross border electricity?

Lion Hirth: 19:20

So an FTR obligation, that's another term that I don't find very useful because a financial transmission right obligation is a bit of a contradictory, right? Either, either something is a right or it's an obligation, but having a right that's also an obligation is a bit confusing. I think the best to think about these, um, contracts as being financial derivatives that have an underlying, that's the spread between two bidding zones, like the German French spot spreads and that FDR obligation, the one that Asa would like to see coming. It's nothing, nothing else than a future on that spreads. So we call it a spread future because that's what it is. It's a future contract on that spreads. By the way, these contracts are traded today under different names. Um, effectively what you can trade on EX, what they call a spread products is, is very much the same contract. Just that spread products are not issued by TSOs. They are traded among. Market parties and ASA would like to, um, um, make TSOs sell the same spread futures. And what you, um, what's, what's helpful to know about this, that it's a spread future is nothing else. It's exactly the same thing as a combination of two domestic futures. So if you sell a French German spread future, that's absolutely the same thing. As selling a German future and buying a French future at the same time. So it's just a combination of two futures. It's a linked future. And you can, you can see that if you trade on yaks, um, you can set up in, in the, in the graphical user interface in the front end, you can buy or sell a spread future, but in the backend, in the system that's implemented as the simultaneous trade of two domestic futures of selling Germany. Okay. And buying friends at the same time,

Snjólfur Richard Sverrisson: 21:10

what does a so how would, how would you suggest that these kind of contracts get sold in the future? I mean, is there a certain, uh, you mentioned the joint allocation office, the jail? Um, you mentioned, um, exchanges. Would that continue that way? Or, or there's also talk, as far as I understand of, of, of TSOs auctioning these, these contracts as well. So there's a greater role for the grid operators here is they're not,

Lion Hirth: 21:37

well, JAO is owned by the TSOs. So JAO is essentially a service entity, um, the joint allocation office for the TSOs. So the setup today is that. And I would assume, and I actually support the idea that that would continue, that we have separate auctions for these long term transmission rights. The alternative would be for TSOs to actually engage in continuous forward markets themselves, but regulated entities. Sort of doing actually trading on the market is a bit of a dangerous thing. As we've seen in the, in the energy crisis, it's, it's easy for proper traders to kind of make private benefit out of that situation. And then they might be not sort of being the best, the best position to do this. So having separate auctions makes sense if they must be conducted by Zhao. That's not entirely clear. It could also be someone else. So this, the Swedish transmission system operator, Svenska Kraftnet, has run similar auctions and they have commissioned a broker to do that on their behalf. Um, that's a possibility. Another way to look at this is, uh, European governments. Um, sell off their emission certificates, right? Their EUAs, and they ask someone to do that on their behalf. So it's not the German government that runs the auction. It's in that case, it's EX, uh, the energy exchange that does it on that behalf. They could also be a possible candidate, um, for, for running these LTTR auctions. So in my view, that's a service that should be tendered. And whoever does the auctioneer as, as, as the best service at the lowest price, uh, in my view, should do that job.

Snjólfur Richard Sverrisson: 23:17

Because if the TSOs were to do it directly themselves, that would obviously change their roles quite substantially in the market. And it's, um, this is very complex. As you said, they're not, they're not commodity trading houses. So maybe they, they shouldn't be, uh, in that role as well as guaranteeing security of supply.

Lion Hirth: 23:37

In a way, yes and no. So I, I look at them the same way. They shouldn't interfere with markets. They shouldn't change prices. They shouldn't trade. They shouldn't take positions. But if you emit LTTRs, and they've been doing this for at least a decade or so, you effectively do all that. You do engage in the market. You do take a position. You do affect prices. So every. FTR option that today German or European or any other TSO sells through these auctions are bought up by someone. And that might be a commodity trading house. It's not so much the, the small utilities is probably more a professionalized trading houses. And they buy these options. And what they usually do is They can either keep them on their books for speculation, they believe it's a good price, they'd like to keep the risk and they, um, they keep that on the books and hope to make a profit out of this, or at some point they start delta hedging that option, so they take a position, let's say they've bought a German Belgium FDR option. So they start taking positions on the German at the Belgium forward market. So maybe they sell German forwards and they buy Belgium forwards. And by doing so, of course, they will impact forward prices, right? If they do this in large volumes, they do shift, they, they, they do shift the forward premium. They introduce a shift in the prices. And effectively, if you take the whole chain and you look at this from the end to the, to the, from the beginning to the end, of course, TSOs, by setting these options did have an impact on prices and did shift the Belgium and the French and the, and the German forward price. So the, the view that TSOs shouldn't have any impact. do anything that will impact prices is just incompatible with the very notion that they should sell LTTRs. It's not just capacity, but they sell, you can't sell just capacity forward. You always have an impact on, on forward prices and forward markets.

Snjólfur Richard Sverrisson: 25:44

Absolutely. Fascinatingly on, I mean, just, just finally to say, okay, at the moment, they're just proposals there. You know, what would, what needs to happen for some of this to actually come into force? And how long do you expect that to take?

Lion Hirth: 25:59

So there is a bit of that reform in the legislative process for the electricity market reform that I'm not sure, but should be. Sort of done soon. There's been a compromise, uh, two months ago or just before Christmas actually. Um, but that's relatively soft language. So the, the virtual hub is mentioned, but it also needs to be an impact assessment first. Um, so the, the legislative track, uh, with the electricity market directive and regulation is, is one end. And then there's possibly a reform of the forward cash flow. Um, capacity allocation guideline of the FCA, one of the network codes that we have that, um, kind of establishes or prescribes how, when, and how much LTTRs, TSOs must issue. And that's pretty much it. probably where that reform would be implemented. I'm not a legal expert. I'm not a policymaking expert, but that's my guess. Um, and that could happen, um, or be formally started by the end of the week, uh, the end of the year, maybe, and, and, and come into force next year. Uh, but that's really a wide guess. I'm not, I'm not very much involved in these processes. I'm, my concern is mostly that, um, we very much understand what kind of reform we are taking. And my. reading from the discussion, following the debate and following the statements and following the arguments and workshops and stakeholder consultations is that even fundamental questions are still not well understood by everyone. And there's a lot of sort of a lot of loose ends that we should close before changing the law and changing the way the market is set up.

Snjólfur Richard Sverrisson: 27:48

So a lot of work that still needs to be done here. Leon, many thanks for joining. The Monzo Weekly

Lion Hirth: 27:54

Podcast. Leon. Thanks for having me.