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Long-Term Transmission Rights in the Nordic Electricity Markets: an Empirical Appraisal of Transmission Risk Management and Hedging

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Long-Term Transmission Rights in the Nordic Electricity Markets: an Empirical Appraisal of Transmission Risk Management and Hedging Petr Spodniak LONG-TERM TRANSMISSION RIGHTS IN THE NORDIC ELECTRICITY MARKETS: AN EMPIRICAL APPRAISAL OF TRANSMISSION RISK MANAGEMENT AND HEDGING Thesis for the degree of Doctor of Science (Economics and Business Administration) to be presented with due permission for public examination and criticism in the Auditorium 6311 at Lappeenranta University of Technology, Lappeenranta, Finland on the 13th of January, 2017, at noon. Acta Universitatis Lappeenrantaensis 734 Supervisors Professor Ari Jantunen LUT School of Business and Management Lappeenranta University of Technology Finland Professor Mikael Collan LUT School of Business and Management Lappeenranta University of Technology Finland Reviewers Associate Professor Olvar Bergland School of Economics and Business Norwegian University of Life Sciences Norway PhD Åsa Lindman Department of Business Administration, Technology and Social Sciences Luleå University of Technology Sweden Opponent Associate Professor Chloé La Coq Stockholm Institute of Transition Economics Stockholm School of Economics Sweden ISBN 978-952-335-046-5 ISBN 978-952-335-047-2 (PDF) ISSN-L 1456-4491 ISSN 1456-4491 Lappeenrannan teknillinen yliopisto Yliopistopaino 2017 Abstract Petr Spodniak Long-term transmission rights in the Nordic electricity markets: An empirical appraisal of transmission risk management and hedging Lappeenranta 2017 73 pages Acta Universitatis Lappeenrantaensis 734 Diss. Lappeenranta University of Technology ISBN 978-952-335-046-5, ISBN978-952-335-047-2 (PDF), ISSN-L 1456-4491, ISSN 1456-4491 The increasingly integrated European electricity markets enable participants to exploit market opportunities and participate in cross-border electricity trading. But, the network gets congested because of the scarce transmission capacity, so electricity prices vary greatly in time and across geographical areas. Market participants thus need an efficient hedging mechanism that limits their exposure to the locational price risks. The hedging solutions against the area price differences that originate from interconnector congestion are commonly called long-term transmission rights (LTRs). This work studies the economics of transmission network congestion in the Nordic electricity markets, including the associated risks and alternative LTR mechanisms and how to manage them. The Nordic electricity markets are selected as a case study for their unique market design and the current regulatory challenge they face with respect to efficiency limits identified in their transmission risk hedging contracts, called electricity area price differentials (EPADs). In addition to the policy and regulatory motivations, the current understanding of derivatives pricing for non-storable commodities, such as electricity, is limited. In particular, the interpretation of the systematic bias between futures prices and the expected delivery date spot prices, called risk premia, is still ambiguous in terms of economic theory. This study employs historical data (2001–2014) on electricity spot and futures markets and utilizes statistical and econometric methods to empirically assess the efficiency of the current Nordic transmission hedging mechanism and to evaluate LTR alternatives (FTR and EPAD Combo). Three main findings may be highlighted. First, despite the presence of systematic price differences between bidding zones and the reference system price, the real economic impacts of these differences are limited. Net-importing bidding zones are identified as the most vulnerable to systematic decoupling of prices. Second, despite the significant risk premia in EPAD contracts, the study finds that EPAD prices are unbiased predictors of the expected spot prices in the long run. Third, the study shows that financial transmission rights (FTRs) hedging effects can be replicated by combinations of EPAD contracts and that the TSOs theoretically auctioning FTR portfolios would need to newly address firmness risks, revenue adequacy, and counterparty risks. Keywords: locational price risk, hedging, electricity markets, Nordic, risk management Acknowledgements The present study was conducted at two departments of Lappeenranta University of Technology (LUT) – 1. Laboratory of Electricity Market and Power Systems, School of Energy Systems (LES), and 2. Department of Strategy, Management and Accounting, School of Business and Management (LSBM) during approximately four and a half years period. The financial support of the Research Foundation of Lappeenranta University of Technology, Suomen Elfi, and Lahja and Lauri Hotinen Fund is gratefully acknowledged. I would like to express my deep gratitude to my past and present supervisors, Professor Satu Viljainen, Professor Ari Jantunen, and Professor Mikael Collan, who have inspired me to cross the disciplinary, methodological, and personal boundaries and gave me the trust and support to fulfil my research ambitions. I am very grateful for the insightful and constructive comments of this dissertation’s reviewers, Associate Professor Olvar Bergland and Dr. Åsa Lindman. I would also wish to thank my colleagues and co-authors from LES, namely Dr. Mari Makkonen, Dr. Olga Gore, Dr. Nadia Chernenko, Dr. Salla Annala, Dr. Jussi Tuunanen, Associate Professor Samuli Honkapuro, Dr. Kaisa Salovaara, Dr. Evgenia Vanadzina; and from LSBM, namely Professor Kalevi Kyläheiko, Professor Kaisu Puumalainen, Professor Sami Saarenketo, and Associate Professor Heli Arminen. Thank you for sharing your experience, knowledge, precious time and friendship during this long journey. My acknowledgement is also dedicated to Professor Felix Höffler from the Institute of Energy Economics (EWI) at the University of Cologne, and the colleagues from the institute, especially Simon Paulus and Dr. Sebastian Nick, who have all shared with me their time, expertise in energy economics, and friendship during my research visit stay. Further, Adjunct Professor Mats Nilsson from Luleå University of Technology has always offered a deep market insight that provided a reality check for my ongoing research, for which I am very indebted. My dearest thanks is devoted to my beloved family - my wife Leena and our beautiful daughters Minni and Lotta, my parents Věra and Peter Spodniak, and my parents-in-law Irja and Erkki Tuominen. Without your continuous love, care, and support, I would have never come this far. Petr Spodniak December 2016 Lappeenranta, Finland Contents Abstract Acknowledgements Contents List of publications 9 Abbreviations 11 1 Introduction 13 1.1 Motivation and research focus ................................................................ 14 1.2 Research objectives and questions .......................................................... 16 1.3 Prologue to the Nordic electricity markets .............................................. 18 2 Literature review 23 2.1 Transmission pricing and congestion management in the spot markets . 24 2.2 Derivatives pricing and transmission risk hedging in the futures market 26 2.3 The relationship of spot and futures electricity prices ............................ 30 3 Data and methods 33 3.1 Data ......................................................................................................... 33 3.2 Methods used ........................................................................................... 36 4 Results 39 4.1 Paper I: Area Price Spreads in the Nordic Electricity Market: The Role of Transmission Lines and Electricity Import Dependency ........................ 40 4.2 Paper II: Efficiency of Contracts for Differences (CfDs) in the Nordic Electricity Market .................................................................................... 41 4.3 Paper III: Forward Risk Premia in Long-term Transmission Rights: The Case of Electricity Area Price Differentials (EPADs) in the Nordic Electricity Market .................................................................................... 42 4.4 Paper IV: Informational Efficiency on the Nordic Electricity Market – the Case of European Price Area Differentials (EPADs) ........................ 43 4.5 Paper V: Long-term Transmission Rights in the Nordic Electricity Markets .................................................................................................... 44 4.6 Paper VI: Long-term Transmission Rights in the Nordic Electricity Markets: TSO Perspectives ..................................................................... 45 5 Discussion 47 5.1 Spot price uniformity and its determinants ............................................. 48 5.2 Efficiency of the Nordic long-term transmission rights .......................... 50 5.2.1 Risk premia in the Nordic electricity price area differentials (EPADs) ...................................................................................... 50 5.2.2 Long-run and short-run relations of Nordic spot and futures prices ........................................................................................... 54 5.3 Alternative long-term transmission rights ............................................... 57 5.4 Limitations of the study and further research avenues ............................ 60 6 Conclusions 61 References 63 Publications 9 List of publications This thesis is based on the following research publications. The rights have been granted by publishers to include the papers in dissertation. I. Spodniak, P., Viljainen, S., Jantunen, A., Makkonen, M. (2013). Area Price Spreads in the Nordic Electricity Market: The Role of Transmission Lines and Electricity Import Dependency.
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