Market design and the use of FTRs and CfDs

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1 THEMA Report ISBN no Market design and the use of FTRs and CfDs A report prepared for Energy Norway September 2011

2 CONTENT 1 SUMMARY AND CONCLUSIONS INTRODUCTION AIMING FOR AN EFFICIENT POWER MARKET Efficient forward markets are based on fundamental needs European requirements defining the target model Market timeframes and the Nordic learning curve POSSIBLE MARKET SOLUTIONS Two models for creating a local forward market Seven levels of maturity for the local markets Five models for a FXBM POSSIBLE DEVELOPMENT PATH TOWARDS TARGET MODEL Possible development path - FXBMs given seven levels of maturity Governance issues Nordic fit to development path Possible gaps between Nordic solution and target model Nordic region development path Page 2

3 1 SUMMARY AND CONCLUSIONS The forward cross-border market (FXBM) has to fit to the two local markets that are to be connected. Thus, there is no generic solution that is the best one for all interconnections. When an efficient day-ahead market (DAM) is lacking, the preferred solution would be a PTR w/uioli. When an efficient DAM is introduced, market players can no more trade directly across the borders since capacity is made available to the whole market and optimised in the implicit auction. But other needs and opportunities for forward XB trading will arise. First, if the owners of the interconnector want to hedge their congestion rent, they could sell FTRoptions some would prefer to call them a PTR w/uiosi, but also this contract would act as a financial derivative since the holder will always have the incentive to give all capacity to the DAM. Generators and consumers cannot use FTR-options to hedge their fundamental risk since they are not exposed to volatile congestion rents. Second, generators and consumers may have a need for swaps. If there is a system price in a given region (like in the Nordic), market players may need to swaps a forward on the system price to their local area price to this end they need CfDs. If there is no system price available, market players may need a swap between two local area prices. This will make them able to use the adjacent forward market for hedging purposes, improving competition and market efficiency. These contracts could be called FTR-obligations or CfDs. TSOs cannot use these contracts to hedge congestion rent since it just swaps one price for another. Finally, if two areas have liquid forward markets towards their local area price there is no need for a FXBM. Cross border risk could then be managed by buying one forward and selling the other. Market players in the Nordic region need CfDs between the system price and their local area price, since the liquid forwards are on the system price. The German PHELIX price has a similar role in Continental Europe since it serves as a proxy for prices in several other countries. Thus Continental European market players could also need to swaps PHELIX for their local area price. This creates an opportunity to create a standardised contract (CfD of FTR-obligation) for the combined region. The products could be traded on competing platforms from power exchanges and OTC. The liquid forward contracts on the PHELIX and on the Nordic system price can be used to manage cross-regional risk. TSOs could in addition want to hedge congestion rent by selling FTR-options, possibly promoting investments. This will be a one-off auction. A market for secondary trading is probably not needed or possible since the generators and consumers do not need this product to manage their fundamental risk. There is no need to create a market for FTR-options unless demanded by the TSOs. Page 3

4 2 INTRODUCTION This study suggests a development path towards target models for forward cross-border markets (FXBM) that is coordinated with the development of both Day-Ahead Markets (DAM) and local forward markets. It further suggests a development path for how the Nordic FXBM could integrate with the markets in Continental Europe. The target model has been defined through several European projects under the umbrella of the Florence Forum, hosted by the European Commission (DG Energy). The most recent description is given in the Framework Guidelines on Capacity Allocation and Congestion Management (FG on CACM) (FG-2011-E-002 of July 29 th 2011). It is important to note that we talk about the target model as one model. But the model itself consists of different market solutions that may all be efficient and work well together and in total represent the future target model. Thus, one could easily argue that there are several target models. When using the phrase target model we are referring to the group of market solutions described and recommended in the FG on CACM and to some extent the underlying work done by the Project Coordination Group (PCG) to Florence Forum. The target model is further described in chapter 3.2. In Chapter 3 we describe the basic purposes of the DAM, local forward markets and FXBM, what the target model may look like and the typical key requirements for the market design defined in EU-regulation and in various reports from key European projects on market integration. In Chapter 4 we explore alternative solutions for DAM, local forward markets and FXBM, combinations of these alternatives; governance issues and discus how these solutions may fit into the target model for European power markets. In Chapter 5 we describe a possible development path, following different levels of market maturity in the local DAM and forward markets, starting with the less mature markets and moving towards more efficient and harmonised markets in line with target model. We describe key governance issues related to achieving the target model. Finally, we discuss how the Nordic FXBM fits with the target model and how the Nordic FXBM could integrate with Continental European FXBMs. Page 4

5 3 AIMING FOR AN EFFICIENT POWER MARKET 3.1 Efficient forward markets are based on fundamental needs The overall target for the power system is to ensure efficient utilisation of the system (grid, generation, consumption) and ensure efficient investments and development of the system. To this end markets may serve as efficient tools, both for short term optimisation and by providing price signals for investments. Regulation is an alternative tool. Thus, it is important to note that the overall target is not to have liquid markets, but liquid markets, as well as regulation, are both alternative ways to reach the target. There are typically two sources of risk and uncertainty, creating challenges to the market players and a loss of social welfare. The first source is imperfections. Imperfections could stem from a lack of competition, lack of XB capacity, lack of cooperation and harmonisation or a lack of efficient market solutions (e.g. inefficient algorithms). The second source of uncertainty and risk are market-related fundamental uncertainties such as the future cost of power generation, the future power demand, political priorities and the availability of generation from wind, solar and hydro. Markets can help market players manage the fundamental uncertainties, and to some extent also to overcome or limit some of the negative effects of imperfections. The preferred and most sustainable solution for addressing imperfections is obviously to remove them. Thus, the future development should focus on removing imperfections and improve the markets needed to manage fundamental uncertainties. We will later see that market solutions could be based on a need to manage risk due inefficiencies and that removing them could lead to a drop in liquidity and potentially a close down of markets that are no more needed. This improved efficiency is to the benefit of all (society and market players). Speculators and the ones providing services to the markets being closed (brokers, power exchanges, law firms, IT-providers, consultants etc.) may lose business, and could have incentives to oppose these changes. If uncertainty and risk cannot be removed, markets can be an efficient tool to promote social welfare. Competition and liquidity will promote efficiency of these markets. The basis for creating liquidity is to have a minimum number of market players who have a fundamental need to trade. This could stem from a need to reduce price risk, manage volume risk (planning of maintenance, management of own flexibility in generation or consumption) or managing uncertainty in own consumption or generation (e.g. intermittent generation). When trading forwards they exchange this risk with fundamental market players having the opposite need. This creates the basic liquidity that in turn may attract speculators. Speculators are in this report defined as market players who join the market to take risk in order to create wealth, as opposed to the fundamental market players that are in the market to (hedge) reduce risk and protect value (typically related to own power generation or consumption). Speculators provide liquidity, improving the overall efficiency of the market. It is important to note that speculation could also be a significant part of the market operations of fundamental market players. In this report we refer to the speculator and the fundamental market player as two different kinds of participants even if both activities may take place within the same entity. The FXBM provides market players with access to an adjacent market, accommodating the need for more XB competition. It could typically be a consumer in area A wanting to buy power from a generator in area B (see fig.1), or it could be an owner of an interconnector who wants to hedge future congestion rent. Page 5

6 Figure 1: Two fundamental needs for XB trading. Consumer in A wants to buy from generator in B, promoting competition. Owner of interconnector may want to hedge congestion rent. A liquid market requires market players to be willing to trade. A critical requirement for forward markets is to have a relevant reference price creating trust and confidence. Trust typically stems from competition, liquidity and transparency. 3.2 European requirements defining the target model The target model aims to create efficiency through harmonised market design across Europe, and by implementing efficient solutions (best practice). This top-down approach aims to meet political ambitions on security of supply, competition, efficient utilisation of resources (socioeconomic efficiency) and realising a development towards a carbon neutral power system (zero emissions). The market mechanism has been chosen as a tool to ensure that this is happening in an efficient way. Across Europe different market solutions have been developed. Differences may exist for good reasons (e.g. related to the uniqueness of the local generation mix). Thus, solutions will to some extent always have to account for local differences even if they are to be integrated and harmonised. Several so called top-down processes and projects have on a European level aimed to define target models for what the future market design should look like, including road-maps for implementing these solutions. Some key recent initiatives for developing the target model, all reporting to the Florence Forum, include: ERGEGs European Regional Initiatives (ERI). Initiative to support regional cooperation and harmonisation, further aimed to provide for inter-regional and European integration. ETSO-EuroPEX project. TSOs and power exchanges describing target models for the various market timeframes DAM, Intraday, Reserves and Forward. Project Coordination Group (PCG). Included stakeholder organisations, TSOs, the Commission and regulators. Lead by ERGEG. Developed further target models and a plan for regional and inter-regional implementation of solutions. ACER Electricity Stakeholder Advisory Group (AESAG). Advising ACER in the development of framework guidelines. The group is a continuation of the Ad Hoc Advisory Group (AHAG), which was supporting ERGEG and established to continue the work done by the Project Coordination Group (PCG). Network Codes. This is the next step, where ENTSO-E is to detail the FG into operational network codes. Below is a short description of the target solutions for Day-Ahead markets and for forward crossborder markets. Page 6

7 Day-Ahead Markets (DAM). The target model for DAM is to have one single European pricecoupling, thus one algorithm delivering one implicit auction. But, there are still no conclusions on key features of this solution, such as the principles for how to define price areas and bidding areas and what algorithm to use for calculation of prices and flows (various algorithms used today and new alternatives such as flow-based market coupling). There is also no conclusion on the issue of governance, e.g. the question of who is to own and control the algorithm and who is to decide on new development and be responsible for the daily operations. Thus, there is a need for further development, and several alternative solutions exist for the open issues within the target model for the DAM. Forward cross-border Markets (FXBM). The Framework Guidelines (FG) on Capacity Allocation and Congestion Management (CACM) (FG-2011-E-002 of July 29 th 2011) specifies this further: The CACM Network Code(s) shall foresee that the options for enabling risk hedging for crossborder trading are Financial Transmission Rights (FTR) or Physical Transmission Rights (PTR) with Use-It-Or-Sell-It (UIOSI), unless appropriate cross-border financial hedging is offered in liquid financial markets on both side of an interconnector. Thus, there is quite some flexibility in terms of forward market design in the target model. 3.3 Market timeframes and the Nordic learning curve When generators (or consumers) have flexibility, they need to learn how to maximise the value of this flexibility. Further, all market players in the Nordic market are affected by the flexibility in hydro generation, and need to understand and adjust their own market behaviour accordingly ( the Nordic learning curve ). The Nordic system price plays a key role as the main reference price for forwards, and also serves as the benchmark for power used in intraday markets and in reserve markets. If a generator has flexibility, a given MW could be hold back if forward prices are higher, it could be produced tomorrow in the DAM, it could be used in the Intraday market or it could be used for reserves. Thus, the market timeframes represent alternatives, and over time the generator will develop a learning curve and an ability to allocate generation across the timeframes in a way that maximise the economic output and the overall efficiency of the power system. Thus, price signals move across the timeframes providing incentives to allocate resources to the time periods and the products where they are most needed and able to create the most value. This effect is particularly important in a power system where a significant part of the generation has flexibility. In the Nordic region the system price is the key reference price that makes this total set of market timeframes work well together. Thus, the solutions for DAM and FXBM need to be considered carefully as part of a bigger picture. In general the market solutions for the DAM, local forward markets and FXBM need to fit well together, and develop in parallel in the process towards target models when removing imperfections and implementing more efficient market solutions. Page 7

8 4 POSSIBLE MARKET SOLUTIONS In this chapter we will first describe the local markets that are to be connected, both alternative solutions for local forward markets, seven combinations of solutions for local forward markets and DAMs that represents seven levels of market maturity. Finally, we will define five models for FXBMs. 4.1 Two models for creating a local forward market In order to be efficient, a forward market needs a reliable reference price (backed by volume) that is relevant for hedging to a certain number of fundamental market players (basis for liquidity). 1. Forward market with reference towards a local area price. A given area may both have a reliable reference price and a reference price that is considered relevant to a certain number of fundamental market players. This creates the basis for a liquid forward market. One example is the reference price PHELIX, which is a day-ahead price for Germany. The PHELIX has a liquid forward market attached to it. Many market players in adjacent countries also use PHELIX as a good proxy for the price in their local areas. 2. Forward market with reference towards a system price. A given area may be too small to provide liquidity to a forward market on its own. It can then be pooled with other areas, defining a system price jointly for a group of areas. Given that it is considered useful for the combined region, a forward market may be developed. One example is the Nordic system price including Denmark, Finland, Sweden and Norway, where the system price is the basis for a liquid forward market. Both models may grow in importance and can both contribute to European market integration. We may both see reduced bottlenecks and larger price areas (promoting local forwards) in some parts of Europe, while other regions implement regional system prices as effective references for forward markets. 4.2 Seven levels of maturity for the local markets The local market solutions define what FXBM solutions to be used. There is no generic best FXBM solution. But we do believe that one could argue for FXBM solutions being more or less efficient given the level of maturity of the local markets that are to be connected. Based on this view, we suggest a development path towards improved efficiency and market integration. Along this path DAM and local forward markets develop towards target solutions, and the FXBM is developing accordingly, adjusting to the improved maturity of the local markets. The first step is to define the local market solutions in the areas that are to be connected. In the following we describe solutions accommodating the needs of the consumer in A and the generator in B (see fig.1) to manage risk and trade XB, given different levels of maturity of both the DAM and the local forward markets. We describe seven different levels of local market maturity. 1. No DAM in either A or B. Thus, also no local forward market since there is no reference price for the forward contract. In other words; no markets at all. 2. Efficient DAM in B, but no local forward market. Still no markets in A. 3. Efficient DAM in both areas, but no forward markets. 4. Efficient DAM in both areas. Area A is part of a system price with an efficient forward market towards this system price. No forward market in B. Page 8

9 5. Efficient DAM in both areas. Both areas are part of a system price with an efficient forward market towards this system price. 6. Efficient DAM in both areas. Area A is still linked to a system price with an efficient forward market. Area B now has an efficient forward market with reference to its local area price. 7. Efficient DAM in both areas. Both areas have an efficient forward market based on the local area prices. 4.3 Five models for a FXBM There are five generic models that are relevant for the discussion. 1. Physical Transmission Right (PTR) w/use-it-or-lose-it (UIoLI). The contract gives the holder a physical right to reserve and use physical capacity to trade a given volume across a specified border. The capacity is used for trading power physically between market parties (e.g. consumer in A and generator in B) on a bilateral contract. Assuming that there is no day-ahead market in one or both of the two areas the PTR would typically have a UIoLI provision, making the capacity available to the TSOs if not utilised by the holder. 2. PTR w/use-it-or-sell-it (UIoSI). This PTR is similar to the one above, but given that market coupling is established, unutilised capacity is now sold to the market coupling. The holder of the PTR will then receive the congestion rent from the market coupling. The rational capacity holder will always sell the capacity to the market coupling, since the market mechanism will ensure maximum profit. The capacity is no longer used for purchase or sale of physical power between parties. They will buy or sell in the local market, and capacity will be optimised in the market coupling solution. Thus, the PTR is in effect a pure financial product with no effect on the physical use of the transmission capacity. 3. Financial Transmission Right (FTR). This contract is in principle exactly equal to the PTR w/uiosi, but the contract is purely financial. FTRs and PTRs w/uiosi can be harmonised and work side by side. This would limit the barrier and cost of managing two different kinds of products. FTRs could be structured as options or obligations. The FTR option entitles the holder to congestion revenues equal to: (Volume X positive price difference) for a given period. The FTR obligation is directional and entitles the holder to the cash-flow stemming from trade in a given direction (Volume X directional price difference). One could also have a one-sided FTR option which gives the holder all positive cash flows stemming from trade in just one of the directions. 4. Contract for Differences (CfD).This contract swaps an area price for the system price for a given volume. When there is a liquid forward market linked to a system price, market players need a CfD in order to manage the risk related to the price difference between the local price and the system price used for hedging. Price differences between areas are not relevant if market players are trading forwards against a system price, given that the two areas are both included in the system price. A CfD is comparable to a FTR obligation; but the reference price is a system price and one area price and not two area prices. 5. Area forwards. This market solution entails that the two markets have both a liquid forward market in each area. Thus, in order to manage XB forward risk you could simply buy one forward and sell the other or vice-versa, and there is no need for having a separate XB forward product. Page 9

10 5 POSSIBLE DEVELOPMENT PATH TOWARDS TARGET MODEL In this chapter we will describe a possible development path towards the target model removing imperfections and improving market efficiency. We further discuss how the Nordic solution fits into this path, how it fits to the target model and how it can be developed and integrated to Continental European market solutions. 5.1 Possible development path - FXBMs given seven levels of maturity We now consider the situation described in figure 1 with a consumer in area A who wants to purchase from a generator in area B. The need for these two market players to hedge XB, both in the DAM and in the forward timeframe, changes as the market becomes more mature. The needs of the owner of interconnector to hedge forward XB risk is not affected by the market maturity, but the ways to do it will change. We now consider the efficiency of alternative FXBM for each of the seven alternative levels of maturity in the local markets. Level 1. Level 2. Level 3 Level 4 PTR w/uioli. The consumer in A can buy from the generator in B via a PTR contract and a bilateral agreement with the seller in area B. No other opportunities exist since there are no markets in either country. A UIoLI provision makes the capacity available to the TSOs if capacity is not utilised under the PTR agreement. Competition is weak (or not existing) in the two areas, but the PTR provides the consumer in A with an ability to buy form an alternative seller, enhancing competition and promoting efficiency. PTR w/uioli. The consumer in A can now buy in the DAM in area B via a PTR contract and a licence to participate in the DAM in area B. A UIoLI provision makes the capacity available to the TSOs if not utilised under the PTR agreement. Competition is weak (or not existing) in A, but the PTR provides the consumer in A with an opportunity to purchase in a competitive market, enhancing overall competition and promoting efficiency. FTR or PTR w/uiosi. The consumer in A and the generator in B will now have to respectively buy and sell electricity in their local DAM. The capacity between the two markets is optimised in the DAM according to the price differences between the two markets, and physical trading XB between market players is no longer an option. They will not miss the opportunity either since the consumer in A no needs to trade XB since there is a competitive and efficient DAM in A, efficiently coupled to area B. There might be exceptions like if a market player has both consumption in A and generation in B, but in general the coupling of two DAM s in A and B promotes competition and efficiency and the need for the FXBM is limited for the fundamental market players. Thus, a forward XB on level 3 will primarily accommodate the needs for speculative trading in addition to the needs of hedging congestion rent to owners of interconnector capacity. If PTRs w/uioli has been the traditional way of trading XB so far (level 1 and 2), one could now replace the UIoLI provision with a UIoSI provision. This will make capacity not utilised by the capacity holder available to the DAM. In fact, the rational capacity holder will always allocate the complete volume to the DAM in order to maximise value. The PTR then works purely as a financial hedge and all capacity is optimised day-ahead. Thus, it would be more consistent to define the contract accordingly, as a financial transmission right (FTR). FTR. The two areas have both efficient DAMs, but area A is part of a region that quotes a system price, and there is a liquid forward market attached to this system price. Area B Page 10

11 Level 5 Level 6 Level 7 has no liquid forward market. As was the case for level 3, the fundamental need to trade XB forwards is low. Since area B has a well-functioning DAM, it is likely that it will soon either join the system price or develop its own local forward market, thus developing towards level 5 or 6 quite rapidly. A FTR between the two area prices could be a tool for TSOs to hedge congestion rent, possibly providing basic liquidity to attract speculative trading. CfD. Both areas are have efficient DAMs and are part of the same or different system prices with liquid forward markets. As for level 3 and 4, market players will not have a need to trade physically between the areas, but they may be concerned with the price differences between the system price used for hedging and the local area price. Thus, there is a real need for CfDs in order to mitigate this risk. FTRs could serve as a solution for owners of interconnectors who want to hedge congestion rent, but a secondary market in FTRs would probably not be liquid since market players lack a need to trade between areas. Level 5 and 6 are alternative steps towards level 7 based on differences in the structure of the local forward markets in area B. FTR. Both areas have efficient DAMs, area A is linked to an efficient forward market with a system price and CfDs and area B has a liquid forward market attached to its own area price. Market players lack a need to trade physically between the markets, and have no XB risk unless in the special case of being exposed with consumption and generation in each market. A FTR between the two area prices could be a tool for hedging congestion rent, but liquidity in a secondary market would be weak since market players also on this level lack a need to trade. Area forwards. Efficient DAMs and forward markets in both areas. If owners of interconnectors, fundamental market players or speculators want to hedge congestion rent, manage XB risk or trade the price difference between the areas for speculative purposes, they can now buy a forward in A and sell a forward in B or vice-versa. There is no longer a need for a FXBM. Some observations can be made along the development path from level 1 to 7. First, we note that markets become more mature and inefficiencies are being removed for each step. This creates value both to the market players and to society. In this process some market solutions are losing liquidity and are being closed down, while new market solutions are opened, gaining liquidity and replacing the old ones. Ultimately, at level 7, there is no longer a need for a FXBM at all. Second, the need to trade forward XB is very limited after market-coupling. Next, one should implement the most efficient market solution possible at each level directing liquidity to one efficient solution only, and finally, one should carefully consider the transition from one level to the next ensuring removal of imperfections and implementing of improved market solutions, preferably follow a predefined procedure (roadmap and/or guideline) providing transparency and predictability to all involved parties. Page 11

12 Figure 2. Possible development path towards target models and integrated markets the seven levels. 5.2 Governance issues Governance has to do with the distribution of roles and responsibilities between market players, TSOs, regulators, ministries, power exchanges and other providers of market services (clearing houses, brokers, market coupling entities etc). The governance solution is critically important to ensure efficient development towards the target model, since stakeholders may have incentives that are not in line with overall targets. In particular this is the case for entities that are profiting from market imperfections and inefficiencies. The governance solution has to promote efficient utilisation of resources, ensure that the most efficient market solutions are used along the development path, and that we experience real development towards the target model. In the specific area of FXBM the Nordic and CWE regions have different solutions and a different history. In the CWE-region, the TSOs cooperate in CASC to provide explicit auctions (PTRs). They are now on the track towards implementing FTRs and creating a common platform, and common products, in line with the target model. In the Nordic region the TSOs established Nord Pool for both physical and financial trading, including CfDs as a Nordic FXBM. Nord Pool was then split in a physical spot exchange and a financial derivatives exchange, and the TSOs have kept ownership of the physical power exchange only. The financial exchange is now owned and operated by NASDAQ-OMX. Thus, Nordic TSOs have also facilitated and established a FXBM, but when the market was well established they sold the derivatives exchange and they have not been a participant in this market themselves. From a governance perspective this in the Nordic region perceived to promote competition and a level playing field between competing providers of market services, such as power exchanges and brokers, promoting the ideas behind unbundling. The Nordic TSOs have kept ownership of the monopoly public service function (the physical spot exchange), ensuring a regulated and cost based operation of the monopoly day-ahead market. Thus, the FXBMs in CWE and the Nordics have both been initiated by the TSOs, both are providing the market with trading opportunities, and they are probably both in line with the target model. To ensure pan-european progress towards the target model, it is important to ensure a governance solution that limits the influence and control of those who may be motivated to limit Page 12

13 progress towards higher levels of efficiency and market maturity. Different stakeholders may, to various degrees and at various steps of the development path, have motives to limit progress. One example is that new market solutions that are reducing bottlenecks, reducing price differences across borders, and limiting the need for forward XB hedging (e.g. a single price coupling and flow-based market coupling) are removing market imperfections that today create business opportunities to some. They may all have incentives to block progress. Another example is that grid investments and the new market solutions could create the need for a different set of price areas, possibly not following the national borders. This could be a threat to traditional thinking and structures that are based on a national perspective. Pan-European institutions (ACER, ENTSO-E) and governments (ministries and DG Energy) probably need to play a key role in order to promote social welfare and ensure progress based on a strong commitment though international agreements. 5.3 Nordic fit to development path One might conclude that the following features of the Nordic forward market are in line with the target model: 1. Have established implicit auction in the Nordic region, and a tight volume coupling towards Central West Europe (CWE). Have a Nordic system price backed by a significant market share in the DAM. 2. Have established a forward market towards the system price, which is the most liquid market of its kind worldwide. 3. Have established a CfD market, providing an opportunity for hedging of local area price risk towards the system price. 4. Have established a secondary market for CfDs which is highly liquid compared to other FXBMs. Liquidity has also been growing significantly year by year. Whereas the following features might be considered missing: 1. There are not XB forward products on all connections between the Nordic region and Continental Europe 2. The TSOs are not providing liquidity to the XB forward market. They have established the market, but they are not participating in the market by selling CfDs, In the following we will discuss the missing features above, if they are indeed desirable in the Nordic context and if so, possible strategies on how to address them. Finally, we will suggest a development path for the Nordic region in terms of both the regional FXBM within the Nordic region and the FXBM-solutions on connections towards Continental Europe. 5.4 Possible gaps between Nordic solution and target model Missing forward XB products on interconnectors. The fundamental need for market players to trade forward XB is probably close to not existing on the border between the Netherlands and Norway. The demand for a product is probably primarily driven by speculation. All generation and consumption is allocated to efficient DAMs on both sides of the NorNed cable. The market players in the Netherlands manage forward risk by trading in liquid forward markets, either with reference to the local Dutch area or towards the PHELIX, which has proven to be an increasingly efficient proxy for the Dutch price area. In the Nordic area market players use the forwards on the system price, and CfDs if needed, to manage their forward risk. Liquidity in the CfD for South-Norway could be weak, but a FTR towards the Netherlands will not help the local Page 13

14 market players manage their risk towards the system price. Thus, in terms of market efficiency, capacity is efficiently utilised, markets are efficiently coupled and the fundamental market players have the solutions they need to manage forward uncertainty and risk (level 6 of market maturity). It TSOs need to hedge congestion rent they could auction FTR-options, but the fundamental market players do not need this product. To manage forward risks the Nordic players use forwards of the system price and CfDs, while the Dutch market players use forwards on the Dutch price or on PHELIX. When Dutch market players use PHELIX for hedging, they will have a need for an FTR-obligation (=CfD) in order to swap PHELIX for the local price (APX). TSOs are not providing liquidity to the FXBM. It might be questioned if the Nordic TSOs need to do this in order to be in line with the target model given that: the need for physical forward XB is removed when implementing implicit auctions and market coupling in the DAM, ensuring efficient utilisation of cross border capacity liquid forward markets are established towards the system price and market players use CfDs to manage the price difference between the local areal price and the system price the Nordic model of unbundling TSOs has in addition to the separation of generation and grid also included a view that TSOs should not trade forwards, either as a counterparty selling forwards or as a provider of trading platforms. TSOs established the forward markets, but withdrawn when the trading platform and the liquidity was established The liquidity of the Nordic CfDs is limited but still strongly improving and superior to the liquidity in the markets for PTRs and FTRs elsewhere in Europe. This liquidity is there without the participation of the Nordic TSOs. Thus we believe that it could be argued that the existing solution within the Nordic region is in line with target model since: TSOs have taken initiatives to create FXBMs There is a market for secondary trading There is established a division of roles between market players, TSOs and power exchanges for physical spot trading and financial forward trading that is in line with the principles of unbundling is creating market trust through separating regulated monopoly public service functions (DAM) from the competitive market service functions (derivatives) 5.5 Nordic region development path Three areas may prove important in the near term for the Nordic region increase the efficiency of the DAM by participating in interregional and possibly a European price coupling, establish efficient principles for defining price areas and finally accommodate a possible requirement for a forward XB solution that could be implemented on all connections between the Nordic and CWE regions. Algorithm in the DAM. The goal is to ensure an efficient DAM though a single price coupling including, in the first instance, the Nordic region, CWE and the UK. The solution is to be expandable to facilitate European-wide market integration. This could possibly realise a significant increase in XB capacities due to improvements in the algorithms. Defining price areas. The Nordic region will experience challenges related to having more price areas (in Sweden). A greater number of market players (now also in Sweden) will experience the challenge of managing local area price risk. The system price will continue to be the preferred reference for hedging since competition is limited within the price areas. This will make CfDs the preferred tool, but liquidity could be weak due to limited competition within the price areas. An FTR between two price areas or a FTR-option (congestion rent) would not help mitigate this risk. Limiting the number of price areas would on the other hand create more competition within each Page 14

15 area and direct trading into fewer CfDs and thus promote liquidity and the ability of the market players to manage risk. The Nordic market needs transparent principles for the use of price areas. Uncertainty on what price areas we will have in the future creates a risk that is very difficult to manage, if not impossible. This risk has a cost to society, making planning of generation and maintenance difficult for market players and adding cost to all future investments. These socioeconomic costs need to be considered and included in the socioeconomic analysis done when new price areas are defined. One could potentially seek to develop a solution with fever and larger price areas possibly across national borders (promoting competition and liquidity in the CfDs), and at the same time possibly allow for more bidding areas (accommodating the need for efficient short-term optimisation). More analysis and work is needed in order to explore these possibilities and develop principles for defining these solutions further, and their related costs and benefits. FXBM in the Nordic-CWE area. There are two kinds of products to be considered: Swaps (FTR-obligations / CfDs). Market players may need to swap risk. The Nordic players need CfDs to swap system price for local area prices. This solution has to remain. Swaps between the areas are not needed since market players have risk is towards the system price and not towards the neighbouring area. The PHELIX price has developed a similar role as the Nordic system price, since market players in Continental Europe to a significant extent use PHELIX as a proxy for their local price. Thus, Continental players may need FTR-obligations (=CfDs) to be able to swap PHELIX for local area prices. This creates an opportunity for defining a standardised swap-contract that could be used in the combined region. The product could be traded on competing trading platforms (power exchanges and OTC). The introduction of flow-based market coupling and a different set of price areas could further promote a need for a CWE/German/Continental system price and a growing need for these swap contracts. Regional forwards towards system prices (or PHELIX) can be used to trade the price difference between the two regions (level 7), no explicit XB product is needed. Congestion revenue (FTR-options). TSOs may need to hedge congestion rent. TSOs could want to hedge congestion rent possibly promoting investments. FTR-options could provide an opportunity to do so. Generators and consumers do not need this product to manage their fundamental risk, thus limiting the demand for secondary trading. If the TSOs do not need to hedge congestion rent, we see no need to create a market solution for FTR-options. A fundamental counterparty for the TSOs could probably be pension funds if congestion rent is sold on long-term contracts. If TSOs need this product, they could create a standardised contract to be used throughout the regions and provide a common platform for auctioning (auction office like CASC). Page 15

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