The concept of liquidity is often used in the sphere of financial markets. An adequate level of liquidity is crucial to decide whether to participate in trading. Energy markets also require an optimal level of liquidity for an adequate operation and to obtain a reliable commodity price benchmark. But, what do we mean by liquidity? How can you measure it? and what is the effect on energy markets? In this blog we want to answer these questions.
The importance of liquidity to the energy markets
Liquidity can be defined as the degree to which a product (such as electricity or gas) can be quickly bought or sold without affecting its price and without incurring in significant transaction costs. A high degree of liquidity, therefore, is the best evidence of strength in any market. In turn, a good level of liquidity will mean that commodity prices better reflect changes in supply and demand fundamentals. Thus, decisions on consumption of electricity or gas will be efficient. This information will bring to us a correct signal in order to develop investments (production capacity, transportation capacity, storage, etc.). In addition, a liquid market will be characterized by the participation of a large number of buyers and sellers (market players) who will be willing to negotiate at any time.
So, an ideal scope will be created for the participation of all types of companies, including independent firms, so that they can compete on an equal footing with vertically integrated companies. In contrast, the lack of liquidity will act as market entry barriers.
Therefore, a market with adequate level of liquidity becomes a key requirement for the level of competence and effectiveness in wholesale energy markets. But, how can we measure liquidity?
One of the main indicators to determine whether a market is liquid or not is the volume of transactions made: a higher trading volume of a product will result in a higher level of liquidity in the market.
In addition to the volume of transactions, the market should be able to absorb it without affecting the transaction price. In this regard, the so-called churn rate is frequently used. This ratio is defined as the proportion of the trading volume to physical demand. Churn rate measures the frequency with which the product (gas or electricity) is negotiated; thus a high ratio means a good level of liquidity in the market. Later we will see the threshold level that can determine an optimal level of liquidity.
Another aspect to consider is the transaction costs on the market. To this end, we analyze the so-called bid-ask spread, which is the difference between the maximum price at which the market wants to buy (ask) and the minimum price at which the market wants to sell (bid). A narrow spread reduces transaction costs and increases the certainty about the price level to be achieved. Therefore, the lower the spread, the greater liquidity in the market.
Finally, the time of the transactions carried out is also useful to measure the level of liquidity in any market. A large number of transactions in a given time give an idea of how fast a purchase or sale of a product can be made at any time.
Liquidity in the European energy markets
Besides knowing what liquidity is, it is important to know the situation in the European energy markets.
Natural Gas market
As we have commented in previous blogs, in Europe there are several Gas Hubs. However, they do not have the same characteristics. Historically, the National Balance Point (NBP) has been Europe’s hub benchmark. In fact, United Kingdom’s hub is the only spot market considered as genuinely liquid and its trading volume represents roughly 70% of all transactions. This hub is followed by the Dutch Title Transfer Facility (TTF). These two markets are those with a higher level of liquidity. On the other hand, it can be considered that the German hubs (NCG and GPL), Belgian Zeebrugge Trading Point (ZTP/ZEE) and northern France hub (PEG Nord) have an acceptable level of liquidity, while the one which is located in southern France (TRS) or the Italian hub (PSV) have a lower level of liquidity. These are followed by markets that are being put in place or those who have already started functioning as the Spanish MIBGAS with a not significant level of liquidity.
As previously mentioned, one of the main indicators to measure liquidity in a market is trading volume. This will give us valuable information about the success or failure in its development. As shown in Table 1, in terms of volume traded, the NBP is almost 50% higher than the second, the TTF. Meanwhile, the TTF exceeds almost 3 times the volume of the rest of hubs. Therefore, when considering this criterion, there are two hubs in Europe leading the list by a large margin.
Traded volume on European Gas Hubs | European Comission
Another key element in determining the level of liquidity is the active participation of financial agents in the market. Although it is difficult to determine who can be considered as an active player in the market, we can say that an active agent could be the one who improve the level of liquidity, the competition in the negotiation and generally creates a sufficient bid-ask spread. Also under this criterion, both the NBP and the TTF show the highest number of active participants.
Finally, as already mentioned, another important criterion to measure the level of liquidity is the so-called churn rate. Somehow, this tool collects the above criteria, because if there are many participants constantly negotiating many products for a high volume, the churn rate will be high as well. According to the International Energy Agency (IEA), when the churn rate has reached a value equal to or greater than 10, the hub will have a high level of liquidity. In fact, many agents take this value as a reference to determine whether or not to participate in the market. Once again, the only two hubs that exceed this value are the NBP and TTF.
Summary of European Hubs main characteristics (2014| Oxford Institue for Energy Studies)
Electricity market
In this case, the German, British and Nordic wholesale electricity markets are those with the highest degree of competence. The Germany-Austria market area leads the volume of transactions in the futures market. According to the latest report carried out by the European Commission, more than a half of the transactions Over the Counter (OTC) last year (58%) were performed in this market. The second place is to the French market, which has recently overtaken the British and it becomes one of the fastest growing markets in this respect in recent years. One reason for this growth is due to increased availability of nuclear generation, which can be traded on the market.
On the other hand, one of the features that can be observed in European markets is the increase in the volume of short-term contracts due to the increase of intermittent renewable capacity, present in many European countries as a result of the will to reach the objectives for 2020. Obviously, this is true for countries whose technologies of renewable generation are supported exclusively by market mechanism. In this regard, in the Spanish case the most negotiated contracts in 2014 and 2015 were the Quarterly and Month-Ahead.
Traded Volume in Spanish Forward Market | ICIS
Another factor that helps to have a high degree of liquidity is the electricity interconnections. These have been successfully implemented throughout Europe; however some difficulties are encountered in Spain. In fact, one of the reasons cited to explain the lack of liquidity in the Spanish wholesale markets is precisely the delay in the implementation of the electricity interconnection with France, postponed due to technical problems from the Iberian Peninsula side.
Finally, if we look at the most recent European markets churn rates we can also appreciate that it is the German market that has a higher value.
Volume traded in the main European forward markets, Q1-2015 | European Comission
Churn rates in main wholesale electricity markets | European Comission
In a nutshell, liquidity is a key analytic tool for measuring effectiveness and competition level in energy markets.
As a consequence of the progress towards a European energy single market and portfolio product extensions we will observe higher levels of liquidity. An example of this is given in the recent addition of German and French products in the Iberian electricity futures market: OMIP.
On the other hand, in the medium term the European gas market will witness the entry of new flows of natural gas, mainly from the United States through shiploads of LNG. With this fact we will see changes in market dynamics: increased competition and greater liquidity. A greater degree of liquidity will enable price formation in the hubs to better meet demand, especially in the short term.
Enrique Battistini | Energy Consultant
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