The problem is a price spike, not market functionality

In the latest Nordea On Your Mind on the current energy crisis, Nordea's Johan Trocmé (JT) interviews Vattenfall's Head of European Energy Trading Frank van Doorn (FVD) and Head of Nordic Energy Trading Laurent Cheval (LC). They describe the drivers of the electricity price spike, how governments could best support the functioning of the market and argue that corporates should be prepared to live with and manage risk from higher volatility. 

JT: Could you briefly describe Vattenfall Energy Trading and your professional role?

FVD: We are the trading unit in Vattenfall. All of the group's transactions in gas, electricity, CO2 certificates, et cetera, are executed by us. You could describe it as us being the market access for the rest of Vattenfall. If our sales units want to hedge planned or actual electricity sales, we buy the gas or electricity for them. Our team comprises about 115 people, based in Stockholm and Hamburg.

JT: As professionals who live and breathe real-time European energy markets, could you try to – in layman’s terms – describe how pricing in the European electricity market works, and why gas is such an important factor for electricity prices?

LC: Our market is, like most markets, based on the marginal cost of production. It is not a 'cost plus' market. There is demand for electricity, and the cost to generate the final unit needed for a given period determines the price, with certain regional spreads owing to different generation mixes and available transmission capacity across regions. While the Nordic region relies mainly on hydro, nuclear and wind power, its electricity prices are influenced by price levels on the continent, which relies much more on gas. Prices are significantly affected by weather, seasons and commodity prices, with the lack of wind, cold winters and gas supply shortages being factors driving them up.

JT: What do you think is most needed for the stability and security of the functionality of European electricity markets at present? From producers, wholesalers, distributors, regulators, lenders or governments?

FVD: European Commission President Ursula von der Leyen has said that the European electricity market is not working anymore, as electricity prices are so high. This represents the perspective of a politician, for whom low or tolerable electricity prices is a policy objective. From our perspective, the market is still functioning well, albeit with significantly lower-than-normal liquidity for both gas and electricity trading. The functionality of the market as such is there. It is the supply shortage for gas which is the main reason for the volatility and the high electricity price.

Policymakers are looking for ways to soothe the pain from soaring electricity bills for European households, including proposals to redistribute funds from non-gas electricity producers. I think this aim is understandable, and it could work. We would be wary of any policy measures that could interfere with price formation in the market, such as the proposals for an EU-wide fossil fuel compensation to reduce price levels in the electricity market. As seen in Spain, such a measure – without further accompanying measures – will risk increasing gas demand, which, at present, we are trying so eagerly to reduce.

LC: State support for commodity and electricity market participants struggling with margin calls for derivatives exposures has been welcome and critical for safeguarding market stability. It should be maintained until the pricing environment has normalised. As for the electricity producers, the number one priority is of course to ensure that all generation capacity is indeed available for use, ready to supply the market as needed. There should also be preparations made for flexible use of assets; for example, to activate dormant thermal heating units for electricity production, should the need arise.

FVD: We have seen mothballed coal-fired capacity started up to add supply of electricity. I think more or less everything that can be done to add capacity has been done or is in the process of being implemented. At least as far as policymakers allow. 

T: How would you describe the supply shortages in the European energy market today? What could be the key tools or measures for managing shortages in the short term and in the long term?

FVD: We have seen shortages start to materialise slowly as far back as last summer, when we noted gas storage facilities in Europe owned or rented by Gazprom not getting filled. It turned out to be the opening act for the situation we find ourselves in today, with Russian gas deliveries to Europe falling towards zero. The EU has intervened and required gas storage facility owners to fill up, which they have succeeded in doing despite the decline in deliveries from Russia. So far, so good. I don't think you could describe today's situation as a shortage of stored gas in Europe. The shortfall from Russia has been largely offset by imports of liquefied natural gas (LNG), but Europe has needed to pay up to outbid the Chinese and other Asian buyers. Accepting this cost has brought storage back up to a level where Europe should be able to get through the winter without severe curtailments, unless it gets very cold.

A big question mark going forward is what level of demand destruction we could see from industry and households opting to, or feeling forced to, use less gas in the current price environment. This could also be a natural balancing mechanism in the market. Before both the COVID-19 pandemic and the war in Ukraine, Europe was consuming roughly 500 billion cubic metres (bcm) of gas. Of those 500 bcm, 180 were imported from Russia. If imports from Russia stay at zero, we will need to find 180 bcm from other suppliers, or reduce demand by the same amount, to close the gap. 

The EU's target is to reduce gas consumption by 15%, which is 75 bcm out of the 180 bcm gap. It is a bit too early to call how this will play out, as the heating season in Europe only starts in October. But it would seem quite reasonable to expect that many households will attempt to reduce their gas consumption significantly, and perhaps even more so for businesses, where many heavy gas or electricity users may need to implement closures. The high prices will surely trigger some behavioural and consumption changes. And authorities could also enforce gas rationing, which would then reduce consumption by users who may have locked in lower prices for a period under a long-term supply contract.

LC: The current state of the European electricity market is not just about a gas shortage – far from it. We had a summer with very low wind speeds, reducing available wind power. We have had a dry season in Norway, leaving water reservoir levels low and reducing availability of hydro power in Scandinavia. These factors have all contributed to raising electricity prices sharply. But so far, we have not had any blackouts. There has not been an actual shortage of electricity as such, where supply could not meet demand. Market participants have certainly made preparations for what to do if such a shortage were to arise, but I think the market is currently in pretty good shape to be able to avoid it.

JT: Do you think the European electricity market will need to be reformed in terms of functionality, pricing mechanisms, interconnectivity between countries or other key features?

LC: Look, commodity markets tend to be highly cyclical. We are in one of those cycles at the moment, just like we had a commodity price boom in 2008, which was followed by a collapse. This is the way commodity markets behave, and today is no different. Even though the conflict in Ukraine is exacerbating already higher-than-normal electricity prices through reduced supply of Russian gas, the market is still functioning. You could argue that one aspect of market functionality that needs to improve is that market prices should drive investments. High prices should normally lead to more investments in additional generation capacity. But here, political uncertainty regarding, for example, nuclear power has made market participants hesitate, driving buffers in available capacity to cover for factors such as seasonality, weather variations and technical maintenance to shrink.

FVD: The 35-40% of European gas consumption imported from Russia has essentially been removed. It is quite natural for this to lead to a price spike for gas. If anything, this is evidence that the markets are working as intended. For reference, when we saw the first wave of COVID-19 start to depress economic activity in April 2020, we had a gas price of some EUR 10 per MWh. Now it is about EUR 200. It is a volatile market, but a functioning volatile market. At present, the immediate need is not to redesign the functionality of the market, but rather for global investments in LNG capacity to replace imports of Russian gas into Europe.

The high market prices for gas and electricity should be a powerful driver for such investments to happen quickly, and this is how the market should work. We do not see an obvious need to change or 'fix' the market. It is working as intended. There is certainly a case to be made for state support for electricity users, but this should not be through measures to influence price. Government interference in price setting could be exactly the sort of thing which would disrupt actual market functionality.

LC: Regarding margin calls, there is always a trade-off between liquidity, credit risk and market risk. A few years ago, we had bank guarantees in the Nordic markets. But bank guarantees require credit limits, so they are no silver bullet making the margin call issues disappear. For banks, however, managing these kinds of liquidity and credit risks is very much at the core of their business. For energy companies, it can become a greater challenge to stay on top of them and manage them in an environment with extreme market volatility or disruption. 

Given the strains in today's environment, with state guarantees coming into the picture, I would expect a future discourse on whether this futures system with cash-settled collateral is the right way to go. There are other options on the table, and bank guarantees could emerge again as a potential tool to use.

FVD: A variation margin between two counterparties is meant to protect against the credit risk of the counterparty defaulting. The paradox in the sort of strained situation we have at present is that the margin call as such could be what drives a counterparty into default. You could consider capping the margin requirement, but I think that would also be risky. We have already seen state support for energy companies in a market with rising prices, and I hope this will also be forthcoming in a market with falling prices. The recipients of support essentially have a healthy business, but are facing specific problems with meeting margin calls in an environment of extreme absolute prices and price movements. For the state to play an active role there to help mitigate 'artificial' problems for industry participants is, in our view, not interference with price formation in the market. Ensuring that there is adequate liquidity in the market is of paramount importance.

JT: How do you think Nordic large corporates should think about their energy requirements and costs at present? Is the crisis a blip that may normalise quickly? Are there longer-term risks to prices or availability?

LC: Again, commodity markets are cyclical. Prices will go up and down, and this will of course continue to affect electricity prices. I think volatility is there to stay, and that large corporates should plan accordingly in their risk management. Historically, energy costs have been a key focus for some very energy-intensive companies. Going forward, this should be a focus for many companies. The need to actively manage these risks has increased, and this has become a long-term trend, not least owing to a rising share of renewable energy in our electricity generation mix. This makes pricing more vulnerable to weather, in particular, short-term wind, when the bid curve in the market is steep. Time will tell what level of volatility in the electricity market society and corporates can tolerate, which will dictate how much baseload power there needs to be in the system.

FVD: The electricity price spike has mainly been triggered by the gas price soaring as a result of a shortage of Russian gas imports to Europe after the invasion of Ukraine. How long that upward pressure on prices will last is very much up to how long the conflict will last, which no one knows today.