Power Trading: An Introduction

The difference between futures and OTC trading is subtle but important. While futures are traded on exchanges (e.g. EEX) with anonymous counterparties, every OTC trade — usually executed via a broker or broker software — is subject to a known counterparty.

Given the speculative nature of long-term commodity prices, the majority of trades on futures exchanges and OTC platforms are made by commodity traders with no intention of buying physical energy. In turn, those who actually buy or sell physical energy on futures and OTC markets primarily engage in hedging — a risk management strategy to mitigate price fluctuations. 

Here’s an example of hedging: a large factory, which is constantly consuming 4 MW of power, may buy 2 MW in a yearly contract for the upcoming year (i.e. 2 MW * 365 days * 24 hours = 17.520 MWh) at 100 €/MWh. This prevents the buyer from losses should the average spot price go up during the traded year. However, should the average spot price go down by 1 €/MWh, they would have spent 17.520 € more than they could have on the spot market. 

Most large producers and consumers optimize the profitability of their portfolio (so-called portfolio management) by combining spot and futures/OTC trading. Futures can be traded in daily, weekly, weekend, monthly, quarterly and yearly contracts up to six years into the future. 

The mid and long tail of those markets — i.e. all contracts that exceed a horizon of ca. 2 weeks into the future — do not accommodate for the short-term fluctuations typical of wind and solar. In other words, if one trades contracts that are further out than 2 weeks into the future (e.g. a week contract 6 weeks from now), their price will not primarily be determined by weather but other commodity-typical factors such as geopolitical events. 

Most of our efforts within this insights section will therefore be focused on weather-based “short-term power trading”, which encompasses future/OTC trades made up to 2 weeks ahead and all spot trades. 

While the vast majority of trades on futures markets are made for blocks of at least 12 hours, spot exchanges (e.g. EPEX, NordPool) enable traders to buy or sell single-hour, half-hour and even quarter-hour products, up to five minutes before delivery. We can therefore characterize spot trading as a much more fine-grained and short-term way of trading power.

Given the weather dependency of wind and solar energy, spot markets have been growing aggressively in tandem with renewable energies. Particularly Intraday trading (see below) has doubled between 2015 and 2021. In their primary function, spot exchanges enable participants to “correct” production forecast errors and fine-tune portfolio positions.

Power spot trades can be made in Day-Ahead and Intraday markets.

Let’s take a closer look at both.

Auction-Based Trading: Day-Ahead and Intraday Auctions

Many European countries hold their daily Day-Ahead auction at 12:00pm CET. Participants can submit a volume and a limit price for each hour of the next day. After the auction closes, power exchanges apply a macro-economic algorithm based on all submitted volumes and limit prices to determine the total of all traded volumes within a given market and assign a market clearing price (MCP) to every hour. This means that every participant who has submitted a buy/sell bid under/over the MCP will be subjected to the same price for a given traded hour. 

MCPs and traded Day-Ahead volumes are extremely important as they are the most reliable indicators of power pricing and the system’s expected balance throughout a given day. Please note that some countries hold more than one auction to fine-tune prices throughout the day. These auctions might even be conducted for a subset of the remaining hours on the delivery day. In general, all auctions happening after the main Day-Ahead auction (no matter if conducted before or during the delivery day) are usually significantly less liquid and commonly referred to as “Intraday Auctions”. 

Auctions usually serve as the starting point for Intraday Continuous trading. To illustrate this, think of how the produced volume of a given wind farm can be traded.

At around 11am (i.e. before the Day-Ahead auction), the trader looks at the weather-based production forecasts for the wind farm and submits volumes and limit prices for every hour of the next day. While submitted prices will be the same for every hour and likely very low (as almost no costs are incurred for wind turbines to run), volumes could look like this: 

00-01: 12 MWh

01-02: 10 MWh

02-03: 11 MWh

…

23-24: 16 MWh

If the production of the wind farm corresponds exactly to the trades submitted in the Day-Ahead auction, there is no reason for the trader to make corrections. However, given the volatile nature of weather, this hardly ever happens. 

That’s where Intraday Continuous markets come into play.

Intraday Continuous Trading

When traders talk about “Intraday”, they are commonly referring not to Intraday auctions but to “Intraday Continuous” trading, where every product is traded in a designated order book. Order books contain all buy and sell orders for a given product including every order’s volume and price. A trade is made whenever a new sell order price undercuts the highest buy order price or whenever a new buy order price exceeds the lowest sell order price. 

Intraday Continuous order books for a given trading day (i.e. midnight to midnight) open during the afternoon of the previous day and can be traded until 1 hour, 30 minutes or even up to 5 minutes before delivery (depending on the market). There are 24 hourly products, 48 half-hourly products and 96 quarter-hourly products during a given trading day, which theoretically give traders access to up to 168 order books at once.

However, each order book’s liquidity — the frequency of orders placed and volume traded in a given order book — differs across markets. For example, in Germany, hourly and quarter-hourly order books are highly liquid, while half-hourly products are barely traded at all. In the UK, only half-hourly order books exist. 

To illustrate how Intraday trading works in practice, let’s pick up the example from above.

Remember, at 11am, our wind trader sold 11 MWh in the Day-Ahead auction to be delivered during the hour 02-03 (i.e. from 2-3am) on the next day. By the evening, the Intraday Continuous order books will have already opened for the next day, but there is no need for our trader to be active — forecasts still indicate production of 11 MWh for 2-3am on the next day. However, at 11:30pm, the trader receives a new forecast indicating that the wind farm will actually produce 9 MWh from 2-3am, meaning that 2 MWh will have to be bought back before gate closure — the time the order book closes. Assuming the trader is located in Germany, where the gate closure happens 5 minutes before delivery, the outstanding 2 MWh can now be bought at any point in time until 01:55am. 

Please note that regulations in most markets obligate the trader to buy back the 2 MWh surplus sold in the Day-Ahead market. Any position left open after gate closure will automatically be subject to the TSO-regulated balancing price       (often referred to as “running into balancing”). 

Finally, to fully understand the complex dynamics of Intraday trading, one needs to take into account a very important component in European power trading — cross-border Intraday coupling (XBID).

Intraday order books usually experience an increase in liquidity around 3 hours before delivery (due to continuously improving weather forecast accuracies) and are a lot less liquid during the last hour before delivery. The pre-gate-closure slowdown in liquidity is due to the dynamics of cross-border Intraday coupling. Rather than only trading locally, European market participants can be exposed to XBID orders from more than 20 countries shortly after Intraday order books open.

However, XBID order books close (i.e. XBID orders disappear from Intraday order books) exactly 1 hour before delivery. Afterwards, traders can only see orders from within their specific country or TSO control area — often leading to a sudden decrease in order book liquidity. 

Futures/over-the-counter markets are aimed at accommodating a long-term demand and supply of dispatchable energy sources. Spot trading, instead, allows market participants to buy/sell smaller product blocks shortly before delivery to accommodate wind and sun production volatilities. 

Given the overall complexity of weather-based power markets, we will be focusing on short-term power trading       in our next articles.