Liquidity Intervention Options Prepared By: Issued: May 2013 Status: FINAL 4 Barb Mews London W6 7PA United Kingdom Liquidity Options Analysis CONTENTS PART I - INTRODUCTION AND SUMMARY 4 1 Introduction 5 1.1 Context and Background 5 1.2 Purpose and Scope 6 1.3 Structure of this document 7 2 Executive Summary 10 2.2 Liquidity Drivers 10 2.3 Intervention Options 10 PART II – LIQUIDITY DRIVERS 12 3 Overview 13 3.1 Introduction 13 3.2 Summary of Findings 13 4 Market Structure & Trading Arrangements 15 4.1 Introduction 15 4.2 Gas Market Correlation 15 4.3 Power Market Volatility 17 4.4 Generation Mix & Intermittency 18 4.5 Market Coupling and Physical Interconnection 22 4.6 GB Trading Arrangements 23 4.7 Low Carbon Reforms 26 5 Industry Structure & Business Models 27 5.1 Introduction 27 5.2 GB Industry Structure & Concentration 27 5.3 Typical GB Business Models 29 5.4 Drivers of Vertical Integration 34 5.5 Current Level of Vertical Integration 38 6 Margining and Financial Regulation 41 6.1 Introduction 41 6.2 European Market Infrastructure Regulation (EMIR) 41 6.3 Liquidity Impact of EMIR 43 6.4 Markets in Financial Instruments Directive and Capital Requirements 45 PART III - INTERVENTION OPTIONS 47 7 Overview 48 7.1 Introduction 48 7.2 Intervention Options 48 8 Analytical Framework 50 8.1 Overview 50 8.2 Reduce Barriers to Entry and Competition: 51 Prepared for DECC 2 of 142 May 2013 Liquidity Options Analysis 8.3 Minimise Costs, Complexity, and Risks 54 8.4 Align and Comply with Reform and Regulation 56 8.5 Assessment Scoring 57 9 Physical Self-Supply Restrictions 59 9.1 Option Definition 59 9.2 Assessment of Partial SSR 65 9.3 Assessment of Full SSR 66 10 Functional Separation 68 10.1 Option Definition 68 10.2 Assessment of Functional Separation – Agency Model 71 10.3 Assessment of Functional Separation – Full Separation Model 73 11 Mandatory Auctions 75 11.1 Option Definition 75 11.2 Assessment of Mandatory Auctions 78 12 Mandatory Market Making 80 12.1 Option Definition 80 12.2 Assessment of Mandatory Market-Making 83 13 Supplementary Intervention Options 85 13.1 Introduction 85 13.2 Ofgem Minimum Proposals 85 13.3 CfD Reference Price 88 13.4 Credit Interventions 89 13.5 Collateral Interventions 91 13.6 Transparency Interventions 92 14 Conclusions 94 14.1 Overview 94 14.2 Benefits 95 14.3 Costs and Risks 97 14.4 Alignment and Compliance 99 14.5 Recommendations 100 APPENDICES 101 A Assessment Criteria 102 B VIU Business Models 107 C SSR Analysis 109 D Case Studies 112 E Credit Risk Management, Collateral, and Margining 115 F Assessment by Intervention Option 119 G Assessment by Criteria 139 Prepared for DECC 3 of 142 May 2013 Liquidity Options Analysis PART I - INTRODUCTION AND SUMMARY Prepared for DECC 4 of 142 May 2013 Liquidity Options Analysis 1 Introduction 1.1 Context and Background 1.1.1 The GB wholesale power market exhibits low levels of liquidity relative to other major European markets and international commodity markets. While the recent surge in volumes traded at the N2EX exchange has markedly improved the depth in Day-Ahead auctions and short term markets, liquidity in forward trading products remains poor by comparison to both the NBP gas market and the Nordic and Continental power markets. 1.1.2 According to the latest Ofgem liquidity data, 2012 traded volumes were 900 TWhs, down from 1100 TWhs in 2011. This corresponds to a churn rate, by which we refer to the ratio of traded volumes over underlying physical consumption, well below 3. This compares unfavourably to past levels of liquidity, especially the churn rate greater than 9 achieved briefly by the GB market in the immediate period after the launch of NETA. Figure 1 below illustrates the development of GB power market churn rates over time. (Note that 2012 figures in the graph have been scaled to a full year based on data up to the end of Q3). We have received updated data during this assignment from Ofgem on which the above-mentioned figures are based). Figure 1: GB Power Market Churn Rates1 1.1.3 By comparison, in recent years the NBP gas market has exhibited a churn rate in the range of 10- 12 times underlying physical consumption, while the Nordic and Continental power markets continue to deliver churn rates above 6-7 times the underlying physical consumption. Furthermore, what liquidity there is available is predominantly focussed on the front 12 months of the forward curve and standard baseload products. There is very limited depth beyond 12 months or in peak and other shaped products. 1 Ofgem, “Secure and Promote”, 2012, p. 7 2 The Financial Services Authority which has been abolished and replaced by two successor organisations. The Prudential Regulatory Authority (PRA) which forms part of the Bank of England and the Financial Conduct Authority Prepared for DECC 5 of 142 May 2013 Liquidity Options Analysis 1.1.4 Ofgem first identified low liquidity as an issue in 2008 and since then it has undertaken a number of market assessments and consultations to identify options to address it. In its most recent consultation (December, 2012), Ofgem explored a range of options primarily designed to ‘secure and promote’ recent industry led developments including “locking-in” the recent surge in Day- Ahead auction volumes. 1.1.5 Low liquidity obscures investment signals and reduces risk management and route to market opportunities. It represents a potentially significant barrier to entry, growth and greater competition in generation and supply markets. A liquid wholesale power market is also a key enabler of the Government’s Electricity Market Reform programme which aims to bring forward new investment from a range of sources. 1.1.6 The relatively higher liquidity of the NBP gas market together with its correlation to the GB power market creates the possibility for participants to achieve certain hedging and risk management objectives through the NBP market. Nonetheless, reliance on the gas market as a proxy increases costs and risks and therefore the lack of power market liquidity continues to be a concern. 1.1.7 Given the importance of liquidity to meeting Government’s competition objectives, the government is seeking powers in the Energy Bill to allow it to intervene if necessary. We understand that such powers may be deployed should the Government conclude that Ofgem’s proposed interventions need to go further and/or can be more quickly delivered through secondary legislation. 1.2 Purpose and Scope Purpose 1.2.1 The Department of Energy and Climate Change (DECC) has commissioned ESP Consulting to carry out an assessment of the options for intervening. Such an assessment will be used to support ministers during the passage of the Energy Bill and to help identify the Government’s preferred approach to provide a basis for consultation, if appropriate. The primary purpose and objectives of this work is to: i) Define a clear and concise framework for analyzing and assessing different options for intervening in the GB power market. This framework needs to balance the potential liquidity benefits against the costs and risks associated with the intervention (both implementation and ongoing) as well as with the fit and compliance with ongoing and forthcoming market reforms and regulations; ii) Detail the primary intervention options and the manner and degree to which design features can be flexed to achieve different outcomes (e.g. to achieve liquidity in different areas of the curve, minimise delivery risk, impact on the trading requirements of different business models); iii) Set out a clearly defined menu of interventions for consideration supported by: - Clear choices and recommendations relating to the design detail; - An analysis/explanation of the rationale for particular design choices; and Prepared for DECC 6 of 142 May 2013 Liquidity Options Analysis - Where relevant, descriptions of how these options have been employed in other sectors/markets. This menu should include not just primary intervention options, but also supplementary measures, which on their own may not be sufficient to meet Government objectives, but which nonetheless might be worth including as part of a wider package; and iv) Provide technical advice on the implementation and ongoing arrangements (regulatory and/or operational, e.g. trading platforms) necessary under each option for the Government, regulator and obligated parties. Scope 1.2.2 The Government’s primary objective is to promote competition and market access in a way that supports well-functioning wholesale and retail markets and the delivery of EMR. In this context, a well-functioning wholesale market is one which affords participants across a variety of different business models with: i) Sufficient access and routes to the market to allow them to enter and compete; ii) An effective suite of instruments which supports trading and hedging activities as well as robust management of wholesale market risks; and iii) Transparent, clear and unbiased market information and data against which to base trading and commercial decision making. 1.2.3 This implies a longer term and broader focus on removing structural barriers to entry and competition which extends well beyond (short term) measures which potentially deliver an immediate impact on GB market traded volumes. It also implies a focus on the forward markets where liquidity is currently low. While impacts on other areas of the curve are considered and within scope of this report, the Government recognises the recent progress in improving liquidity in the prompt markets. 1.3 Structure of this document 1.3.1 The remainder of this PART I of the report presents a summary of our findings and conclusions in Chapter 2.