ELS #Energy - European Power Prices: Dislocation of Risk Premiums and Fundamentals

European power prices have spiked recently on the back of a very tight gas market, caused by Russia’s war on Ukraine, as well as weather and technology-related issues affecting Europe’s hydropower, wind and nuclear sectors. Prices started soaring about a year ago, following several weeks of unseasonably low wind levels throughout much of the continent and had few opportunities to fall back as geopolitical worries started creating a price floor in many markets towards the end of 2021.

Recently, however, power prices have spiked frequently, setting new records and even hitting their market roof in the Baltic republics during a few hours in August. Yet, while tight, the power markets have not suffered actual shortages of a size warranting the launch of non-market-based measures even in particular bidding zones, nor such spread-out tightness (geographically, as well as in time) warranting such high price levels hitting consumers so broadly.

One could say what the recent price volatility has showed, is a disconnect between fundamentals and actual prices. The risk of a gas outage, while very real, is resulting in electricity prices which do not reflect the power outages which could be caused by gas in the coming winter. Moreover, while high gas prices now enable stock-building in Europe, ahead of winter to mitigate the outage threat, high power prices now do not, as they could not, result in any electricity stock-building. Hence, while the high gas price represents a risk-management exercise, the high electricity price now does not help mitigating future shortages and will have to be paid for “again” when, or if, they happen.

The energy-only electricity market model has always struggled to price in system risk and political risk in the just beyond fairly immediate time frame. Unlike in markets for storable commodities, a risk premium in futures markets has struggled to develop. As liquidity has plunged also in other energy markets like oil and natural gas, volatility has, predictably, increased. In electricity markets this seems to be even more pronounced. Liquidity in European power markets has fallen by around 40% so far in 2022 compared to 2021 levels. At the same time, hedging is likely increasingly concentrated to gas, also among power traders, as this is where shortages mainly will develop, giving gas prices an unduly high price impact.

Little surprise then, that political pressure is building in Europe to “do something” and “do it quickly”. While the electricity market model could need an overhaul to manage system – and other – risks better over the longer term and enable proper risk premiums on futures markets to develop, this is not a quick fix. Although such a reform might be required given the energy transition to a different type of electricity system, with more inherent fluctuations, it will not solve the current conundrum. Hence, political discussion seems to hone in on price caps in order to mitigate the fall-out on the wider economies from exorbitant energy prices.

This crisis, however, seems to largely revolve around the price signals between different physical markets and their respective paper markets having become dislocated. Muting price signals further is therefore unlikely to solve anything, but rather to cause even deeper dislocations and long-term ripple effects. Not least on investment into renewables in the coming years.

Putting price caps on a dislocated market could end up being akin to putting a bruised leg in a cast, leaving it ultimately even weaker and shrivelled, when a band-aid would have been more relevant. While efforts to protect the wider economy from the effects of dislocation will be necessary, it will therefore be paramount not to cap prices, but to cap costs. Markets, including consumers, need price signals, just not price knockouts. This in order for markets to be able to start finding a new equilibrium as liquidity and price-formation transparency is eventually rebuilt.

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