Historically energy trading was focused on a few key products – oil, petroleum products, gas and power. However, this relatively simple product range has changed dramatically. As countries try and reduce their dependence on fossil fuel and the limitations of grid based power, the drive for renewable energy has spawned a brave new world of innovative energy products. The list of products traded on The European Energy Exchange (EEX) illustrates this. We describe below the rise of new energy products.
The range of contracts offered for a traditional product like power are extensive. EEX offers spot and futures contracts including intra day, day ahead and weekend trades, as well as location based energy spreads.
In addition to power and natural gas, EEX has contracts for CO˛ emissions allowances and guarantees of origin (GoOs).
It offers trades in EUAs and EUAAs based on the EU Emissions Trading Scheme as well as a secondary market in spot and derivative Kyoto credits (CERs and ERUs).
GoOs are closely linked to renewable energy. They are certificates which confirm that a given megawatt hour of power is being generated from renewable sources and are used by suppliers for disclosure and transparency purposes and cancelled on use. At EEX GoOs can be traded up to three years into the future and there are a range of different GoO derivatives – Nordic Hydro for hydropower from Scandinavia, Alpine hydro for GoOs for hydropower from the Alpine region, and Central Northern European Wind for wind power from North West Europe.
Climate change as a driver
So why are there so many new products in the energy market? As we have seen one of the drivers is nationalefforts to decarbonise economies and reduce the amountof CO˛ emitted from traditional polluting industries.
The Paris climate change text issued in December 2016 explicitly supports the growth of "cap and trade schemes" as a mechanism to meet climate reduction goals. China has announced that it intends to launch the world's largest "cap and trade" emissions trading scheme in 2017 and Mexico is also intending to launch one. The goal of permitting allowances purchased under one scheme to be used against emissions made under a different regime now needs to be addressed and UN climate negotiators will try and establish rules for international trading in meetings in Germany in May.
Another driver behind the development of new energy products has been the growth of new technology. There has been a huge increase in proprietary trading platforms in the energy sector. In fact one of the objectives behind the EU's Mifid II was to ensure that EU regulation kept up with the speed of this technological advance.
A new form of regulated platform, the Organised Trading Facility (OTF), was created in order to bring these systems under regulatory control. Their proliferation in the energy market was so great that the market was able to negotiate its own bespoke exemption from Mifid II for physically settled "wholesale energy products" traded on an OTF.
One of the key risks for these new markets is regulatory risk. As we have seen the energy market had some success in gaining an exemption from Mifid II. However, the scandals caused by fraud in EU emissions trading meant that the emissions market was not so lucky.
Under Mifid II spot contracts in emissions allowances will be treated as financial instruments and regulated. Although companies trading in emissions allowances purely for their own compliance purposes may fall within the ancillary activities exemption, much of the market will become regulated from 2018.
Regulation increases regulatory burden and, therefore, the cost of trading. It can also create new energy products and destroy markets. A good example are trades in some renewable energy products. In the UK, the imposition of the Renewables Obligation on electricity suppliers required them to purchase a proportion of their power from renewable sources.
This gave rise to the Renewable Obligation Certificate (ROC) issued by generators of renewable power and sold to suppliers who are required to surrender them to Ofgem as evidence that they have satisfied their renewables obligation. A secondary market arose in trading ROCs and new documentation to facilitate their trade in the form of a Master Trading Agreement. As the scheme has closed to new generating capacity from 31 March 2017, the ROC market will cease to exist.
In the same way when the UK Government imposed the Climate Change Levy on UK business energy use, renewable energy was initially exempt and renewable generators were able to issue Levy Exemption Certificates (LECs) which were traded. George Osborne destroyed this market overnight by removing the exemption for renewable electricity in his 2015 budget, ending these trades.
As pressure continues to grow to reduce carbon emissions, regimes created to support the transition to renewable energy are likely to continue to foster innovative new energy products. At the same time cash constrained governments will keep their spending under review and it is inevitable that some new products will disappear from the market as cutbacks bite.
This article is an excerpt from our trade and commodities newsletter, In-Short. To view the full newsletter please click here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.