There are many stages in the delivery of gas and electricity to consumers, and not all of them are physical.
Wholesale markets are where gas and power is sold and bought (traded) as a commodity by several different types of market participants:
- Electricity generators and gas producers who sell their energy output on the wholesale market.
- Suppliers who buy the energy they need to supply their customers from the wholesale market.
- Consumers, such as large industrial companies and other energy end-users, who consume the energy purchased on the wholesale market.
- Speculators, who are looking to profit from market moves in the underlying commodities.
Liquidity is a measure of market efficiency. In a liquid market, there are many buyers and sellers, meaning participants can easily trade a product without affecting the underlying wholesale price. The actions of a single sale should not cause a sharp swing in wholesale prices. As such, this makes it easier to discern the ‘true’ value of the commodity being sold, with trades averaging out at the prevailing wholesale price. However, when liquidity is low, there is limited visibility of what the price of the product should be. Ultimately, this means that buying or selling that product involves more risk, and potentially large swings in market value, as participants struggle to find the underlying commodity price.
There are three key factors in determining market liquidity: cost, volume, and time. In addition, each element of this trio has a number of measures behind it.
- Bid-offer spreads are the difference between the bid (to buy) and the offer (to sell) in the market for a particular contract. Liquid markets with a high degree of competition between many trading parties tend towards a narrow bid-offer spread.
- Transaction costs are the exchange and broker fees that can limit or encourage market access and activity. The higher the cost, the less likely there will be a trade, reducing liquidity.
- Volatility is an indication of how far the market moves over time. Typically, liquidity and volatility have an inverse relationship. In less volatile markets, participants have the confidence that the traded price represents true value. Whereas in more volatile markets there is less confidence in the underlying price of the product, so liquidity falls.
- Trading volumes – in the GB gas market, volumes are roughly split equally between traded exchange futures (for example Intercontinental Exchange (ICE)) and broker-facilitated over-the-counter (OTC) trades. The higher the volume being traded, the more liquid the market.
- Market depth is the ability to make large transactions without affecting the underlying wholesale price. This means in practice that there are enough market participants that no single player is a price setter.
- Churn rate refers to the number of times a unit of a commodity is traded before it is finally delivered. A high churn rate indicates a greater level of trading activity. This means that it is easy for market participants to trade and optimise their positions before final delivery.
- Number of participants in the market. The more different counterparties there are competing within the market, the greater the liquidity.
- The amount of time before delivery – liquidity increases as we move towards delivery while the longer dated contracts are less liquid.
- The amount of time between transactions, or the number of transactions within a time period. For the more liquid prompt contracts the time frames will be in minutes, while for the third and fourth power season this is more likely to be days or even weeks.
Liquidity in the wholesale gas market
The GB wholesale gas market is a mature, liquid market with a diverse range of sources and trading platforms available. Historically, the majority of trading has been conducted over-the-counter (OTC) through brokers, but in recent years gas trading has shifted towards exchange platforms.
Liquidity in the wholesale electricity market
Liquidity in the wholesale electricity market had been in a period of decline since 2001. The Energy Supply Probe in 2008 by Ofgem found that low liquidity in the electricity market was a concern. This was seen to be creating a barrier to new entry into supply markets and a source of competitive disadvantage for independent suppliers.
As a result, ’Secure and Promote’ was introduced to improve liquidity. This licence condition came into effect on 31 March 2014. The Secure and Promote licence condition has three liquidity objectives promoting:
- Availability of products that support hedging through Supplier Market Access (SMA) rules.
- Robust reference prices for forward products through Market Making Obligation (MMO).
- Near-term trading liquidity through a reporting requirement of day-ahead trading.
What is Market Making Obligation (MMO)?
The Secure and Promote changes introduced a ‘market making’ measure, currently requiring five of the UK’s largest utilities to post bids and offers on select wholesale electricity products during two daily, hour-long liquidity windows. In this way, there is a guarantee of product being available for trade. As such, power trading generally happens for an estimated 1 hour in the morning and 1 hour in the afternoon. The trading window starts at 10:30 in the morning and 15:30 in the afternoon. During the liquidity period these suppliers are mandated to post bid and offer prices with a maximum spread of 20p on the front two months, one quarter and four seasons. In times of extreme volatility the spread is allowed to be wider. The spreads are originally chosen to be similar to spreads in the National Balancing Point (NBP) gas – a virtual trading location for the trading of gas in the GB market.
Ofgem data has indicated that the changes under Secure and Promote have led to improved liquidity in the wholesale power market.
Extending the Market Making Obligation
Recently, Ofgem published a consultation considering extending the market-making obligation to more companies. Currently, only five of the UK’s largest utilities are required to post bids on select wholesale electricity products during the two liquidity windows.
Meanwhile, there have been calls for Ofgem to make changes to the licence over concerns that the obligation has adversely affected liquidity outside of the two market making windows. In such a situation, more market makers would mean even less trading outside of the windows. It has been argued that volume caps and fast market rules, which allow licensees to withdraw bids and offers on products if prices move more than 4% compared to the first trade in a window, are too inflexible. They do not limit the costs and risks to the market makers.
Additionally, independent UK electricity suppliers would like greater liquidity on forward block products beyond existing baseload and peakload offerings. If Ofgem decides changes to the Secure and Promote licence condition are required then a further consultation will be published in autumn 2017.
Electricity Balancing Reform impact on liquidity
Exchange traded volumes of day-ahead and within-day have remained broadly constant since the introduction of Secure and Promote, according to Ofgem. However, there have been more volatile day-ahead prices since 2015, which may reflect tighter margins in the market, greater uncertainty, and the effect of balancing market reforms introduced in November 2015. Changes to the cash-out mechanism have come into effect and, as a result, imbalance prices have become significantly more volatile. Sharper cash-out prices have increased the incentive for parties to hedge appropriately and have underlined the importance of liquidity along the curve, the regulator said.
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