The market volatility you haven’t been reading about

Prices in Europe’s energy markets have surged to historic levels in recent weeks, prompting headlines of a great energy ‘squeeze’ and ‘crunch’ that could plunge Europe into an energy crisis during the winter months.

While these high prices illustrate the growing pains the energy system is currently experiencing, they are only half of the story. The same volatility can be observed on the prompter side of the energy market, indicative of a market and grid designed for fossil fuels that is struggling to phase them out.

In this month’s Viewpoints, we explore why volatility on the forward curve may not be the biggest challenge that the UK and Europe face this winter, and why the prompt market is experiencing even larger growing pains on the road to Net Zero.

Trouble along the forward curve and investor risk

Transitioning away from fossil fuels poses a myriad of problems for all energy-market participants. For thermal plants, it means transitioning from operating in a baseload profile to becoming marginal assets that provide flexibility and help to keep the lights on.

This change removes their ability to hedge along the forward curve and means the value of these assets is becoming increasingly dependent on price movements closer to the time of delivery.

With the market tending towards the prompt, there will be a requirement for greater flexibility - not just in assets and consumers - but also in lending structures and investor appetites for risk-taking. Traditional measures of asset value such as long-term spark spreads may present a bleaker picture than the reality, with flexible assets pivoting to capture value during the most volatile individual half hours where power pricing can far exceed the forward curve.

Whilst this may provide more value than traditional spark spread trading strategies it also carries inherent risk, creating an inability to forecast, and therefore hedge revenues which institutional investors may struggle with under current business models.

Inputs and outputs

This effect can be seen in the market today, as poor forward clean sparks are eroding the incentive for Combined Cycle Gas Turbine (CCGT) stations to run – a key asset in the present stack providing flexibility to the grid.

The cost of gas inputs and carbon, both at or near all-time highs in forward markets, mean that CCGTs require strong wholesale power prices far down the curve to justify either their purchase or build. Further down the curve, spark spreads are negative, suggesting these assets are not profitable under traditional strategies. This in turn could slow the build of much-needed flexible asset capacity.

In recent weeks we’ve seen a doubling in power prices from the day-ahead auction to the imbalance price, and this volatility looks set to continue over the balance of winter, in the UK in particular. Factors pointing to tightness include National Grid ESO reporting an expectation of issuing several margin notices over winter, the removal of 1GW of capacity after the recent fire at an IFA1 substation, and the incredible exposure to wind levels and forecast deviations that we saw this summer.

Figure 1: EPEX Day-Ahead Pricing January 2021 - Present

Whilst the North Sea Link is coming online, the return of some key assets and the expectation of a wetter and relatively mild start to winter may help to ease prices in the short term, and move the market’s focus back to curve products. We expect to see periods of significant prompt volatility and high prints in the coming months at the prompt.