Posted on June 24, 2010

It came as a surprise when EnergyHedge Ltd announced that the new hedge market would be driven by the ASX’s existing futures platform. Just about everyone acknowledges that a Kiwi solution would be good for the local economy, but the fact remains that ASX already has a platform, has two NZ electricity futures contracts actually configured and trading (one each at Benmore and Otahuhu), and existing futures market participants with systems and processes set up to fully support a robust electricity futures market.

The Minister’s reforms feature stringent requirements around the form and development of the new market, and at the end of the day, it would appear that time had run out for the local new-entrant to prove concept, and create the momentum necessary to meet the reform timeline.

It is a shame that NZX won’t be providing the new electricity futures market, but at least the industry now knows where it stands in terms of basic hedge market infrastructure. Furthermore, the two ASX contracts are in place for the Minister’s June deadline, the only thing missing being the market-making requirements set out in the reforms package.

Market-making is required of the five largest gentailers in order to create liquidity, and involves the compulsory trading of a specified minimum futures contracts, both buying and selling, with no more than a relatively small difference in price between the offered buy and sell prices. Despite now having certainty around the platform, the really big question remains: will this be enough to generate the liquidity required by the reforms? However, there is an even more fundamental question lurking in the background: is the specified liquidity test, the requirement for 3,000 GWh of “unmatched open interest” by June 2011, sufficient to demonstrate the new market is working?

Here’s a subtle point: what does 3,000 GWh of unmatched open interest actually mean? Open interest in a futures market usually refers to the total number of contracts open on a particular day. Since every market transaction involves two futures contracts, one bought and one sold, the use of this term suggests the equivalent of 3,000 GWh open interest in the electricity futures market would actually only be 1,500 GWh in CFDs. For example, a 1 MWh CFD involves one contract and two parties to the hedge, but the equivalent hedging positions in the futures market requires two 1 MWh futures contracts, one between buyer and clearing house, the other between seller and clearing house. So our liquidity test may, in fact, only be 1,500 GWh of underlying volume hedged between buyers and sellers.

Taking into account the fact that the ASX contracts trade at two nodes currently (Otahuhu and Benmore) and are mooted to trade also at Whakamaru, we could be down to 500 GWh of hedged volume at each of the three nodes. ASX futures are offered for three years, further reducing the annual volume to the point where just 38 futures contract (19 MW hedged) in each year would satisfy the liquidity test. A handful of trades amongst the major players would soon create this level of trading.

Notwithstanding the finer point of the meaning of open interest, this all points to one conclusion: achieving liquidity will require more than just passing the Minister’s liquidity test. Not that achieving a certain volume of open interest is a sufficient condition for liquidity in a futures market, anyway. There is no formal definition of liquidity, or agreement on the exact conditions required, but in general terms three conditions should be met: firstly, that the prices of traded contracts are readily available to any person wanting to trade on that market; secondly, that trades can be made easily and readily; and finally, that individual trades do not significantly affect the price of immediately subsequent trades.

The first criterion is easy to satisfy in a futures market, given that prices are available on the ASX’s web site. The second criterion requires more than just having access to the futures market via an ASX market participant. More fundamentally, it is about the ability to observe the price in the market, and have confidence that a trade can then be made immediately, at or close to that price. The third criterion is a function of the ‘depth of the market’, which is to say the number of contracts (relative to the total daily trading volume) offered at or near the current market price.

When a market is liquid, the difference in price between the offers to sell and bids to buy contracts (the so-called bid-offer or bid-ask spread) is small, typically less than 1%. The bid-offer spread represents the ‘cost of liquidity’ in exchange traded securities and commodities, such as futures, because it measures the cost of making a transaction without delay. For example, if the bids to buy and offers to sell sit at $100/MWh and $101/MWh, respectively, then the bid-offer spread is $1/MWh. A buyer wishing to transact must accept a premium of $1/MWh to make an immediate trade, and vice versa, a relatively small price to pay for liquidity.

But what if the bid-offer spread widens to $10/MWh? Many buyers and sellers will not accept a 10% premium and trading may grind to a halt. This is exactly what can happen when large trades soak up offers to buy or sell, and move the market to a significant extent in the absence of liquidity.

To create liquidity the five major market participants are to enter into market-making arrangements with the ASX, requiring them to simultaneously offer to buy and sell minimum volumes of contracts, with each side (buy and sell) priced within a small percentage of the other. The market-maker’s maximum spread on EnergyHedge is currently 10% but my guess is that it will need to be significantly smaller to have any hope of creating liquidity on the ASX.

Beyond market-making, there are two fundamental changes that will need to take place in our relatively small market. Most importantly, a culture change is required within the major physical players, the large gentailers. Prior to the final split of ECNZ in 1999, and the rapid move to vertical integration that resulted, we actually had a working futures market for electricity at Haywards, and it had a significant volume traded through it. But vertical integration spelled its doom, and unless there is an acceptance that vertical integration must reduce, and that a substantial minimum volume must be hedged through the new market rather than through the acquisition of load, then the new market may not flourish. With the average level of vertical integration amongst the major gentailers likely to be in excess of 80%, one would hope there is some room to move.

On a more optimistic note, liquidity begets liquidity: if the market-makers develop enough liquidity to attract the large financial intermediaries that currently transact on the ASX for Aussie electricity futures, these players will add liquidity. They will also use the futures market as a hedge against new offers (for example, industry standard CFDs) that they make to smaller players who do not wish to directly participate in the futures market, including new entrants and larger consumers, thus facilitating greater competition at multiple levels in our market.

The development of the new hedge market is one of the most exciting, and potentially market shaping, reforms seen for many years, but only if it develops liquidity. The ASXe has fallen, the die is cast, but there is much liquidity to pass beneath the proverbial bridge before we can truly say the new market has delivered.

Greg Sise, Managing Director