Electronic copy available at: http://ssrn.com/abstract=2365179

Creation and Transfer of Price Risk in European Energy Markets 1

Alessandro Mauro

INTRODUCTION

During the past years, the entire world economy has been affected by a massive increase in

energy prices. Yet only a few years ago, there was complete confidence that cheap energy

would last indefinitely. This firm belief, together with natural resources endowments and

politics inertia, explains why many developed economies have reduced their growth forecasts,

all other factors being equal.

It has to be stressed that the current impact of high energy prices on world economies

is due to a risky environment that has been in place for several decades. In this chapter, we

will try to explain the nature of this environment, by assessing a broad identification of risk in

an entire economic system. The aim is to perform the kind of extended risk mapping

commonly done for enterprises in order to better understand why, where, and how risk is

generated, how it is transferred among agents and transformed, and who ultimately bears

such risk. The focus will be on European price risk, and it will consequently be important to

investigate the ways energy prices are formed. The figures and analysis presented will be

mainly based on the current 25 member states of the European Union (EU-25), although most

of the conclusions are valid for other energy dependent countries and regions around the

world.

1 This paper was originally published as chapter 14 in the book “The Professional Risk Managers' Guide to the

Energy Market”, PRMIA, 2007. The author wishes to thank the publisher for allowing new pubblication on SSRN. Other writings from the same author can be found at

http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=880755

Electronic copy available at: http://ssrn.com/abstract=2365179

14-1 CREATION OF RISK

It is possible to give a general description of the ways in which risk is created and

transferred in an economic system. An energy sector as a whole can be depicted as a dynamic

system which is interconnected with other outside energy sectors via many energy inputs and

outputs (imports and exports). Most energy sectors will also possess internal extraction and

production of energy sources. The total amount of energy inside the system, consisting of

production plus imports minus exports, undergoes transportation and transformation

processes before being finally delivered and consumed. Figure 14.1 gives a general graphical

description of this process.

Figure 14.1 Energy markets as a dynamic system

Source: Alessandro Mauro

In such systems, there are essentially two ways in which risk can arise. At the outset,

there is always a primitive creation of risk. This primitive creation can either happen inside

the system or be imported from an outside system, and then imported in the system. At the

same time, the risk present in a system can exit the system through exports to other outside

systems. On the other hand, any risk transferred among agents inside the system will not

increase or decrease the total amount of risk in that system.

It must be made clear that external and internal energy inputs do not automatically

generate price risk. In fact, this will happen if and only if energy prices are variable and free to

fluctuate. In this regard, not only is the market structure important, but also time scale has to

be taken into account.2 There are energy sources whose prices continuously fluctuate, other

2 Markets structures for primary energy sources are quite different among different energy types. For example,

the oil market is quite complex and economists created ad hoc oligopolistic models in order to explain actors’ behaviour and prices dynamics.

which change every day, and still others which are fixed for days or months but can then

move to new levels.3 The latter sources will show monthly or yearly volatility, rather than

daily. From the perspective of this chapter, which will confine itself to daily volatility, every

one of these sources will introduce risk into the system. A source whose price remains fixed

for years will be considered not risky, and in any case it is really hard to find one with this

feature. In order to better explain this aspect, it is worth considering Figure 14.2, which shows

the evolution of energy prices in Europe over the last two decades.4 We should conclude that

principal energy sources show fluctuating prices, over a yearly time horizon.

Figure 14.2

The Evolution of Some Energy Prices in Europe from 1987 to 2004

Source: BP Statistical Review of World Energy (June 2005).

Bearing in mind the general framework previously outlined, it is important to discuss

in detail the ways in which risk enters the European energy markets. We will frequently refer

to Figure 14.3, which depicts in a simplified way the structure of the European energy system.

The figure highlights the areas where risk can potentially arise and where it is potentially

transferred along the supply chain.5 The left-hand part is often identified as “Upstream”

sector, the central part is the “Midstream”, and at the right-hand end there is the

“Downstream”.

3 For an analysis of the factors giving rise to daily price volatility in energy markets, see Mauro (1999). 4 In Figure 14.2, coal is represented by “Marker Price (basis NWE) CIF”, crude oil is “Brent Dated FOB” and natural

gas is “European Union CIF”. 5 Figure 14.3 shows only those parts of the European energy system which will be addressed in this chapter.

Figures are based on data reported in BP (2005) for the year 2004. Figures in italics are limited to principal EU Countries, as the EU-25 data is not reported in BP (2005).

Figure 14.3 A Simplified Representation of the Structure of European Energy System

Source: BP Statistical Review of World Energy (June 2005)

The main single reason for risk arising in European energy markets is linked to the

utilization of primary fossil energy sources (namely oil, natural gas, coal) and uranium. It is

evident from Figure 14.3 that Europe is largely a net importer of each of these sources, as

indigenous production only partially meets European energy demand. In fact, the EU possess

just about 0.6% of world’s proven oil reserves, about 2% of natural gas reserves, and about

19.5% of proven coal reserves. EU energy dependency was 48.1% in 2002, and since 1992 it

has never fallen below 43%, meaning that structurally nearly half of annual energy

consumption has to be imported.6

Imported primary energy sources share some common factors. They have to be

transported and their price is generally variable (see Figure 14.2) and expressed in US dollars.

The latter element implies that a double risk exposure - commodity prices and exchange rates

- as European agents have to buy US dollars in order to pay for energy goods. Most of these

energy sources are not exported and retraded outside Europe, but transformed and used in

Europe. Consequently the risk, having entered the European system, will be transformed and

6 Source: EUROSTAT (2005).

transferred in to related risk in secondary energy sources but will not exit to other areas of

the world.7

Primary energy sources extracted and produced in Europe, accounting for about half

the consumption, bring considerable additional risk as they also necessarily present

fluctuating prices. The general reason is a phenomenon called intra-fuel competition. Crude oil

extracted in the North Sea will compete with oil coming from the Middle East (oil-to-oil

competition). Natural gas from the Netherlands will be sold in the same markets where

Russian or Algerian gas is to be sold (gas-to-gas competition). It is consequently rational, in

the highly import-dependent European energy sector, that import prices and internal ones are

significantly correlated.8 Considering that external sources prices are set internationally, it is

easy to conclude that internal source prices are mostly set internationally, though not in

deterministic ways. One potential difference between imported and internal energy sources is

that imports are paid for in US dollars, certainly giving place to foreign exchange rate

exposure and adding further large quantities of risk. In any case, due to intra-fuel competition,

foreign exchange rate fluctuations will very often also affect internal energy sources prices.

Having clarified how price risk continuously enters the European energy market, it

would be interesting to quantify such risks. This is not simple task as supply and demand

elasticities have to be taken into account, but a rough idea can be given.9 If we consider only

oil, natural gas and coal imported in 2004 (see Figure 14.3), the increase in their yearly

average prices from 2002 to 2004, shown graphically in Figure 14.2, amounts to an increase

of about 63 billion USD in total import costs. This figure takes only imported energy prices

into account and neglects foreign exchange rate exposure (which in this case should reduce

that increase as Euro appreciated against US dollar in the same period) as well as freight

rates, which are explicit if energy sources are bought on an FOB basis and implicit when they

are bought on a CIF basis.10

7 This is true as far as direct price risk transfer is concerned. There may also be indirect transfer through final

good prices (cf. final industrial uses at the right end of Figure 14.3). This possibility is mainly linked to market structures and producers pricing power, meaning the possibility of transferring in products prices the increase in costs. For example, industries such as construction and luxury goods have more pricing power than steel, chemicals and paper.

8 Figure 14.2 also shows a certain tendency for prices of different fuels to move together in time. This is often ascribed to another phenomenon known as Inter-fuel competition, which can easily be explained by observing that three different energy sources - natural gas, fuel oil and coal - will “compete” in order to supply fuel for thermoelectric power, as represented in Figure 14.3.

9 Suitable price risk measures should take into account statistical probabilities of prices changes, using a Value-at-Risk (VaR) approach. For applications of VaR to the energy industry, see Mauro (1999).

10 The freights rates market has experienced the biggest price increases in the recent years. For example, BCI route 4 (dry cargoes from South Africa to North West Europe) opened in 2003 at about 10 USD per metric ton and closed the same year at over 26 USD per metric ton.

14-2 RISK TRANSFER

The main outcome of the analysis performed in the previous section is that a huge

amount of price risk is continuously entering the European energy markets. This risk, in most

cases, will be entirely borne by European energy importers. In fact, once risk enters a system,

it is common for it to be transferred among operators. If the risk is not shifted on to operators

outside the system (i.e. exported physically or financially), the total amount of risk present in

the system will remain constant. The mechanisms and volume of this risk transfer depend on

many factors, principally market structure, risk aversion of actors involved, and policy and

regulation. In this section, we will clarify how risk is transferred within European energy

markets. In order to address this topic, it is still useful to refer to the synthetic representation

reported in Figure 14.3.

Crude oil is rarely consumed “as is” in final uses but undergoes refining processes,

producing many oil products which are utilized by both intermediate industries and final

users. Among these products, gas oil and fuel oil are two of the most relevant for downstream

energy markets. Gas oil is used in transportation and for space heating purposes, while fuel oil

is a fuel input in thermoelectric power generation. The European market in refined products

is highly competitive, and the industry is quite large and developed, as Europe accounts for

more than 17% of total world refining capacity. European refiners transform and move a

significant amount of risk in the market since they do not only buy crude oil but also sell

refined products. Both crude and refined product prices are volatile even in the short term,

and correlation among these prices, especially in the medium and long term, is high tough not

perfect. This implies that by means of refined products prices, refiners are able to transfer

downward in the energy markets a part of the risk they incur from crude oil inputs; the rest of

the risk is borne by themselves. By measuring refiners’ risk using a Value-at-Risk approach, a

significant risk reduction can be demonstrated, which is also dependent on the refining

technologies being utilized.11 Anyway, the amount of risk borne directly by refiners is not

trivial. In fact, the refining margin, which is the difference between product prices and crude

oil prices, has always been quite volatile, as shown in Figure 14.4.

11 The amount of risk finally borne by refiners is about half what they would bear should they just bought crude

without selling refined products. This is demonstrated in Mauro (1999).

Figure 14.4

Quarterly Benchmark Refining Margins of a Theoretical Cracking Refinery in NWE Area Processing Brent Crude Oil (Calculated on a semi-variable basis from 1992 to 2004)

Source: BP Statistical Review of World Energy (June 2005)

In the oil industry, there also exists a significant amount of contractual risk transfer,

meaning that the transfer between operators is decided among themselves from the

beginning and set in formal contractual terms. An example is the netback pricing scheme,

where the price of crude oil bought by the refiner is set, using deterministic or semi-

deterministic formulae, on the basis of refined product prices. This obviously reduces risk for

refiners by transferring products price risk to oil producers instead of crude oil price risk. At

the same time, this is also a good example of risk going upwards in the supply chain, if the oil

producer is switching from fixed prices to netback pricing.12 Nevertheless, it should be noted

that even in the case of netback pricing, the amount of risk entering the midstream, due to oil

products price volatility, will remain the same.

Unlike oil, natural gas is consumed as it is and only needs transportation from gas

fields to consumers. This primary energy source has two main destinations: households for

final use (especially space heating) and power generation as a fuel input. Producers mostly

sell the gas to intermediaries and traders, very often through long-term contracts. Gas prices

are mainly set, at least in Europe, using algebraic formulae whose inputs are prices of other

primary and secondary energy sources:

P = f (E1, … , En) [14.1]

12 It is also frequent the case that oil producers directly enter the midstream sector by building or buying stakes

in refineries, again changing their original risk profiles.

Where P is the gas price and Ei are energy input prices. The real formulae usually contain

additive and multiplicative terms. There are always time lags for the calculation of average

energy input prices, consequently reducing short-term gas price volatility. Moreover, energy

input prices are generally expressed in US dollars, so exchange rates are also included in the

formulae. Finally, these formulae are never used to calculate prices every day but over longer

intervals, say, every one to three months, and during this time prices remain fixed at the most

recently calculated level. Each first partial derivative in the formula will express the

sensitivity of the gas price to the energy input prices; they are normally positive and

constitute a very distinct feature, as they change from formula to formula.

Very often, the energy input prices in the formulae are crude and refined products

prices. The price European importers pay for natural gas is determined by formulae set in

long-term contracts, and they are usually able to sell gas to customers (power generators,

firms and households) according to very similar formulae, to which they add a fixed mark-up.

The result, which is often referred to as a cost “pass-through,” brings a nearly perfect

contractual risk transfer and residual risk being close to zero.13 This long-established practice

is welcomed by producers, as gas is often extracted in association with crude oil, and also by

gas traders, because this link will always assure that gas prices are competitive against the

two main available substitutes, which are fuel oil in the electricity industry and heating gas oil

in the households market.

It is worth stressing that this is the current situation mainly in continental Europe,

where liberalization in the gas market is a recent development and far from complete. The

United Kingdom, however, began gas market liberalization swell in advance of the rest of

Europe. Many years after liberalization, we can say that gas price is determined by crossing of

demand and supply curves, and so a competitive market sets the price of spot and future

delivery of this energy source. This is probably the first case where we see the beginning of

the abandonment of the oil formula pricing practice, and today it is a quite common belief that

UK gas prices are de-linked, or decoupled, from oil prices, eventually constituting an

autonomous source of risk.14 Nevertheless the UK case shows that, for the most part,

decoupling is only active in the short period (days or weeks) and is less frequent when prices

13 Note that this contractual risk transfer is not limited to price risk but also affects many other aspects, from

volume risk to legal and infrastructural risk, which are addressed by specialized clauses. For example, the typical take-or-pay clause obliges the buyer to pay, even if he does not take delivery of the gas.

14 This does not necessarily imply the abandonment of a formula structure similar to equation [14.1]. Formulae linking gas prices to electricity prices and the Purchase Power Index are reported in the UK, stemming from strong competition and volatility in the domestic electricity market. This also underlies the transfer of pricing power from gas traders downward to gas users and risk transfer upward from gas users to gas traders.

are observed on a longer time scale. In order to appreciate this point, it suffices to consider

Figure 14.5.

Figure 14.5 Monthly average prices of Brent crude and UK natural gas, 1997 - 2004

Source: Platt’s Oilgram Price Report and Heren Report’s European Spot Gas Markets.

According to Figure 14.5, the price of gas exhibits seasonal variations in the short term

but it is driven by oil price trends in the medium to long term.15 Even in the oldest liberalized

market in Europe, although the natural gas price broke the deterministic dependency

structure implicit in equation [14.1], it is not true that an independent internal source of risk

was created in a medium to long term time horizon.16 On the other hand, in the short term, we

have seen the emergence of an autonomous risk source due to the equilibrium between

demand and supply within the gas market. UK gas operators use gas trading to transfer these

two different risks, which are consequently mirrored in gas prices.

This trading activity was fostered by the creation of the National Balancing Point (NBP)

gas hub in the UK. A hub is a physical or virtual marketplace where actors can freely exchange

energy. At certain times the retrading ratio for the NBP hub, the number of times gas is traded

among operators before physical delivery, was more then 15. This means trading activity is

quite liquid as operators can easily change their exposure to gas price, and hence the presence

of the hub is facilitating the transfer of risk. The overall amount of risk in the system in neither

15 This claim relies on graphical analysis only and is not based on statistical analysis such as cointegration or

Granger causality tests. 16 The UK gas market was probably in the best position, of all EU member countries, to de-link the gas price from

oil price in the short-term horizon, as it was mainly relying on internal gas production to meet domestic demand.

reduced or increased, however, as the general rule is that risk transfer modifies the identity of

operators bearing such risk but not the quantity of risk.

Always bearing in mind the market structure of Figure 14.3, we now turn to the

analysis of coal, which is another relevant primary energy source. Coal, like natural gas, does

not need to be transformed after extraction and before final use. Coal is the most utilised

primary energy source for power generation worldwide. Traditionally, prices used to change

in the medium to long term, as shown in Figure 14.2. Recently, there has also been a

widespread of daily indices, and now coal prices are showing daily volatility.17 The bulk of this

volatility is again entering the European energy markets. In order to understand whether and

how it is transferred downstream, it is worth taking into consideration the power generation

industry and electricity markets.

Figure 14.6

Monthly average prices of electricity exchanged at the EEX and a coal basket, 2003-

2004.18

Source: European Electricity Exchange (www.eex.de) and Coal International Report

Figure 14.6 shows the presence of a strong relationship among coal prices and the

price of electricity traded at the European Energy Exchange (EEX), the German power

exchange.19 This is interesting but not surprising, as Germany is by far the biggest coal

producer in the EU25, with about 36% share. Coal prices are set internationally, not in

Germany, while the German electricity market is mainly a regional one. German power

17 This phenomenon is mainly linked to the surge in demand and international trading. In just two years, from

2003 to 2005, world coal trade rose about 15%. Source: Energy Information Administration (2005). 18 Baseload future for calendar next year at EEX. Source: www.eex.de 19 See footnote 15.

producers are simply transferring coal prices and their volatility downward through

electricity prices. Although not in a deterministic way, a kind of fuel price pass-through is

again in place, while specific factors related to the electricity market can explain the imperfect

correlation even in this case. As in the case of Germany case, it can quite often be

demonstrated that prices of secondary sources of energy (such as thermal energy) are mainly

determined by the price of primary sources of energy.

The examples above show that the decoupling concept is not the be-all and end-all

when it comes to explaining risk transfer in the midstream European energy markets.

Especially in the medium to long term, we have demonstrated that primary energy prices are

the principal driver for other energy prices. It is possible to outline a general framework in

order to understand how energy prices are formed. Whenever prices are not controlled or

capped by regulators, they are determined starting from two main inputs, following a

dependency summarized in the following equation:

(Energy price)i = i * (primary energy price ) +

i * (idiosyncratic factors) [14.2]

This formula, even though qualitative in nature, is capable of representing all the

different cases we have studied hitherto. It depicts the dependence of the UK gas medium to

long term gas price on oil prices but also on short-term demand and supply conditions related

to the gas market. These conditions are the “idiosyncratic factors” inherent in the UK gas

market. Refined products show a kind of dependence on crude prices which is not perfect but

is generally based on a relationship coherent with equation [14.2]. Finally, the formula

explains the EEX electricity price dependence on coal prices, which is not a perfect or

deterministic one.

It is worth underlining that equation [14.2] can also explain primary energy sources

prices, and this is why the dependent variable on the left is generically referred to as the

“energy price”. In fact, equation [14.1], which establishes a deterministic functional

relationship for gas prices (i.e. a primary energy source), is just a special case of equation

[14.2].20 Finally, the latter even clarifies price behaviour within the oil market, for example

prices for various types of crude oils or crude oils quoted in different areas, such as the

Northwest Europe and the Mediterranean basin.

20 Even if equation [14.2] was stated in simple additive terms, it could be generally stated as [14.1], without specifying a precise functional formula.

In conclusion, European energy markets are characterized by a central source of risk,

primary energy prices, which most of the time should be identified with the oil price. Other

energy prices are linked to this central risk via their individual Bi; there are also idiosyncratic

risks, which arise from particular features of markets. In the light of this model we should

conclude that, along the supply chain depicted in Figure 14.3, there is primary energy risk

transfer plus the transfer of internal risk in the shape of idiosyncratic risk.21

14-3 FINANCIAL RISK TRANSFER

The previous section was concerned with the ways in which risk is transferred in

European energy markets through price and contractual relationships. It should be

underlined that there will necessarily be agents along the supply chain who, for various

reasons, are not able to transfer as much risk they would like to, leaving them with a certain

amount of risk to bear. Economic theory, thanks to the work of the Nobel laureate J.K. Arrow,

has demonstrated that this result is sub-optimal and agents are better off if they can trade

financial instruments against uncertain future outcomes in all possible different states of the

world, according to their subjective risk propensity.22 If this is the case, then markets are said

to be “complete.” In fact, financial instruments have been developed and are being traded in

European energy markets and risk transfer through these financial instruments is in place

and is important. For example, the residual risk that refiners cannot transfer from crude

prices into refined products prices, can still be finally borne by them but also transferred to

financial intermediaries by means of financial hedging operations on single exposures (e.g.

crude oil swaps) or combined ones (e.g. crack spreads).

As in other areas of the world, this financial risk transfer is operated through both

financial exchanges and over-the-counter (OTC) bilateral relationships. European commodity

exchanges traditionally are not the largest markets in comparison to all global commodity

financial exchanges as only one exchange is included in the world’s ten largest.23 The one

exception is the International Petroleum Exchange (IPE), where futures and options on Brent

crude and gas oil have been traded for many years. The extreme liquidity of spot and financial

21 The model for energy prices in equation [14.2] is an application to energy markets of the Capital Asset Pricing

Model (CAPM), which explains stock prices as dependent on a common risk factor, the market portfolio, and other risk sources that are specific to the single stock.

22 See Arrow (1964). 23 See UNCTAD (2001) and Mauro (2004).

trading on Brent crude oil has established this quality as a “benchmark” for the bulk of

European and many non-European types of crude oil, whose prices are more or less closely

linked to that of Brent. The role of this market is crucial, as it has been allowed operators to

effectively manage their direct oil prices exposure stemming from either physical oil trading

or deterministic formula exposure (i.e. equation [14.1]). Even indirect exposures, deriving

from price dependence as per equation [14.2], can be managed on the IPE whenever the

primary energy price input is constituted by crude oil price. As we have already stated, the

primary energy price in equation [14.2] is very often that of Brent crude.

In Europe, there also exist other organized and regulated markets, younger and smaller

than IPE, which have national or regional extent. They trade energy goods, essentially

electricity and natural gas, for which there is still no single common EU market. Figure 14.7

gives a summary of these markets and their products.24

Figure 14.7

Principal non-hydrocarbon exchanges in Europe

Source: Internet sites of the various Exchanges.

Most of these markets are focussed on the very short-term exchange of electricity,

essentially being marketplaces where physical demand and supply meet. Many among them

24 Updated at the time of writing. As far as the gas market is concerned, UK gas futures are traded at the IPE,

while spot gas for UK and Belgium at the APX.

are really “pool” auction markets, where bids for supply and demand are first submitted and

then fulfilled on a daily basis.25 On the other end, the most important ones (Nord Pool, UKPX

and EEX) also allow operators to transact financial futures expiring even four to five years

ahead.

Recalling the general finding summarized in equation [14.2], it is crucial to stress the

fact that, as far as electricity and gas are concerned, idiosyncratic factors are very important in

the determination of prices. These specific elements are constituted by all the non-

forecastable events affecting supply and demand in the short term; regarding the demand

side, weather conditions are probably the most relevant. Consequently, it is argued that the

role of these European financial markets is highly relevant as they are currently letting

operators transfer idiosyncratic risks and such risks are not addressed and intermediated by

the IPE Brent futures. They are thus helping to make markets more complete in Arrow’s

sense.

It is difficult to assess the extent and instruments traded in OTC financial markets,26

together with the volume of their trading activity. Generally, they act as intermediaries for

price risks, on a one-to-one contractual basis, which are not directly addressed in organized

markets, through financial instruments that are generally less standardized than those that

are exchange traded. Nevertheless, European energy OTC markets play an important role in

risk transfer.

For example, in the OTC segment, agents are able to transfer risks related to crude oils

other than Brent or located and traded in different places. OTC markets also intermediate a

large proportion of oil refined products risk for both the NWE and MED areas. Again, even

these OTC oil financial markets often address idiosyncratic factors which determine the prices

of these commodities. In fact, there are no regulated financial markets for crude oils and oil

products of these kinds, with the single exception of NWE gas oil traded on the IPE. For the

same reason, the bulk of financial instruments on coal delivered in NWE are traded in the OTC

market.

The OTC markets’ role is also important in European electricity and gas markets.

Specialized publications, such as European Power Daily from Platt’s and European Spot Gas

Markets from Heren Energy, give daily price assessments for electricity and gas OTC spot and

forward deals. These deals are more and more frequently agreed between operators in many

25 More information can be found in Mauro-Sgarioto (2001) and Mauro-Sgarioto (2002). 26 It is even difficult to clearly define what an OTC market is and to distinguish it from an organized exchange. On

this topic see Energy Information Administration (2002), pag.48.

European hubs and are often intermediated by brokers.27 Moreover, the rapidly developing

OTC electronic marketplaces are not concerned with physical location and can efficiently

create trading liquidity. Probably the most successful example is the Intercontinental

Exchange (ICE), which took over the IPE and currently also lists European petroleum

products, crude oil, electricity and natural gas.

These European financial markets, both organized-regulated and OTC, are contributing

to an increase in market completeness but, due to their still limited number, the market as a

whole is far from complete in Arrow’s sense. Consequently, it is nowadays inevitable that

prices are the means used to transfer many aggregated idiosyncratic risks, as per equation

[14.2]. In light of this, it is thus possible to define European markets as imperfectly

aggregating markets. This current state is not efficient as operators are seeking to hedge some

states of the world, but in so doing they are unwillingly exposed to new risks. A significant

example of this is constituted by weather events. In fact, weather risk is currently mainly

transferred and intermediated in bulk within electricity and gas prices, so bundled with other

types of risk, i.e. infrastructural risk, regulatory risk, etc.28 It is obvious in any case that at the

present stage of development, markets have to aggregate and intermediate different

idiosyncratic risks in order to attract sufficient liquidity and develop further.

Markets specialization will come in a further maturity phase. This development can

already explain what will be the main future driver of competition among markets. The

winners will be those better able to address the idiosyncratic risks which are more important

for operators, successfully removing them out from existing aggregated prices. This will imply

the identification of standard values for the relevant features of the good and the creation of a

market structure as close as possible to perfect competition. These processes are often

identified as the commoditization of a good. Nowadays, this development is evident in carbon

dioxide (CO2) emission trading, where existing markets added financial products on CO2

allowances, as reported in Figure 14.7, and they are now struggling to win market shares.

Emissions trading will be discussed in the next section.

Finally, we should highlight the fact that financial markets are not and never be a

panacea allowing risk transfer in every case, as sometimes only price and contractual risk

transfer will remain viable. A typical example is constituted by airlines, which are to be

27 Platt’s assesses daily spot and forward electricity prices for UK, Germany, Austria, Switzerland, France, the

Netherlands, Belgium and Spain. Heren publishes gas prices for the UK NBP and the continental hubs of Zeebrugge (Belgium), Bunde (Germany), and Title Transfer Facility (German-Dutch border).

28 In the last few years, weather derivatives trading has been developing, mainly in the OTC segment and focussed on temperature risk. Attempts to introduce exchange-traded products have been done by the London International Financial Futures Exchange (LIFFE).

included into the “industrial final users” category at the right-hand of Figure 14.3. The price of

jet fuel, which is a refined oil product, is a large part of their operating costs. However,

because of their often considerable credit risk, airlines are not allowed to enter into hedging

operations. They can only use their pricing power, transferring fuel costs and risks to their

final prices, much of the time explicitly through so-called “fuel surcharges”.

14-4 THE IMPACT OF POLICY AND REGULATION

Energy sector regulation, together with broader industrial and environmental policy,

has a considerable impact on market structures and actors’ behaviour. Policy and regulation

were probably the main drivers for market liberalization and often fostered or slowed the

commoditization of energy goods. They can have a pervasive impact on risk creation,

especially regarding internal risk sources, on downward and upward risk transfer and on the

choice of the subjects that will ultimately bear risks.

Examples of regulatory impacts in the European energy markets are legion, spanning

the range from short-term measures to long-term structural policies. We recall the example of

Italy, where in 2002 the government blocked electricity tariffs, which were usually set as a

pass-through formula in line with Equation [14.1], thus transferring price risk upward to

electricity producers. In 2001 the European Commission approved the EDF-EnBW

transaction, subject to the granting of access to generating capacity. Consequently, EDF began

to make electricity capacity available to third parties through virtual power plants. This

contractual relationship assures the possibility of taking delivery of electricity without

bearing fuel price risk and operational risk.29

Environmental policy can potentially impact every industry in the picture outlined in

Figure 14.3, as it is generally empowered to decide pollutant emissions levels from factories

and energy products quality specifications. For example, the refinery industry has been

affected by both these aspects, considering that in the past years much attention had to be

devoted to lower emissions from refineries and to improving refined products quality. The

latter increased refining industry risk, as legislation forced the introduction of new cleaner

29

Another example comes from the tolling scheme where an agent, called the “toller”, is entitled to provide fuel to a power station and can take delivery of the electricity generated, thus directly bearing all the price risks. Banks often require such a scheme to be in place in order to finance the construction of a power station.

products, which are less commoditised and whose prices are consequently more volatile.30

Another impact on the refining industry came from the banning of single-hull oil tankers in

European ports, which restricted the number of available vessels, again tightening the market

and increasing price volatility.

Probably the best example of internal risk creation, new market introduction and risk

transfer principally due to public policy is the case of EU Emission Trading Scheme. In 2003

the European Union announced that CO2 emission trading would begin in 2005, before the

start of the first Kyoto Protocol commitment period in 2008. The scheme is a “cap and trade”

system, based on the initial allocation of emission allowances to companies, which then would

have to meet their limits by either reducing CO2 emission or acquiring emission rights from

other companies. This new market is interesting from a theoretical point of view, as operators

are not exchanging a good but a negative externality from production which has been

transformed in a commodity by policy makers. The extent is bigger than the energy market,

covering more than 12,000 industrial installations in the EU. The scheme is having a

significant impact on operational costs and on the quantity of risk in the system, which has

increased at a stroke. From the beginning of December 2004 to July 2005, the price of a

permit to emit in the year 2005 one metric ton of CO2 increased from 8.50 EUR to more than

29 EUR.

Recalling the general scheme of Figure 14.3, it is clear that the quantity of risk not

stopping along the supply chain will generally end up with final users. They are the final

destination of the big contractual risk transfer actually in place in the European energy

market. If final energy users are other enterprises, they can transfer at least a part of the risk

further downstream through prices, depending on the kind of goods they produce.31 On the

other hand, if final users are households, they cannot further transfer risk downward, and

consequently energy price fluctuations will affect their available income and their ability to

buy other goods or to save. Consequently, the bulk of the risk in the system is borne by the

subjects who are not professionals and do not have access to financial energy risk transfer.

But here again we find the impact of policy and regulation, as in many EU member states there

exist price protection mechanisms favouring and protecting households, continuing to foster

30 This development also shows that there is a kind of life cycle in the commoditization of goods. Starting from an

initial introductory phase, a growing quantity of the good will comply with the features of this specific commodity, arriving at a maturity phase, which at some point will be stopped by the introduction of new standards and new commodities.

31 See footnote 7.

the so called “public service view” of energy goods.32 This implies that price risk is again moved

upstream to energy suppliers. It is important to underline that this practice favours the

reduction of energy price consciousness by households, which is a highly undesirable

objective for energy policy. In order to give the full picture, mention must also be made of the

repeated EU efforts to move price risk further upstream, that is, to agents outside the

European energy system. For example, external gas producers were asked to change the

terms of long-term contracts, which define gas price through oil indexation as in equation

[14.1], with the aim of reducing imported price risk. These efforts had no significant effect in

recent years.

The examples introduced in this section have highlighted some of the main objectives

that are currently driving European energy and environmental policy makers: environment

protection, further liberalization of energy markets, protection of final domestic customers

and increased commoditization of energy and environmental goods. If these goals are clear,

timing of interventions is very often uncertain, real intervention can be incoherent and

policies among EU member states are often not coordinated. These are important aspects of

what is commonly referred as “regulatory risk,” which is seriously affecting the amount and

the ways in which risks are transferred, generally reducing the use of financial transfer while

indirectly favouring price and contractual risk transfer. In the final analysis, risk transfer is

limited and sub-optimal, implying that along the supply chain there are operators bearing

more risk than they would ideally like.

14-5 CONCLUSIONS

The current extremely high oil price environment clearly shows the problems caused

in the EU-25, and in many other developed countries, by high dependency on external energy

sources. This situation is surely due to poor natural resource endowments, but it has been

exacerbated by society’s attitudes and by politicians’ decisions, or lack of decisions. Fossil

fuels were favoured for decades only on the basis of their presumed lower economic cost.

Other issues, such as environmental costs, social costs and risk exposure were largely ignored.

In this chapter we have shown that the latter element was and remains important and should

be carefully considered in order to see the full picture.

32 On this topic see Mauro (1999).

Politicians have only considered the cost issues and have not seen the risk aspect of

energy sources. The European economy was exposed to extreme fossil fuel price risk, and the

inertial approach was essentially maintained, even after the two oil shocks of the 1970s. The

low perception of the risk part of the story implied that energy costs were not corrected for

the risk. From this point of view, renewable energy sources were totally neglected as they

could not compete with fossil fuels on a cost-only basis. If price risk had been included in the

economic valuation, renewable sources could have been competitive a long time ago.

Nowadays, it seems more likely than in the past that European energy police will try to

bring about a reduction in dependence on fossil fuel sources. Any gradual switch to renewable

sources will have an impact on the market structure depicted in Figure 14.3, on the relative

importance of the two factors in equation [14.2] and generally on risk creation and risk

transfer. In fact, renewable sources (wind, hydro, solar, etc.) are mainly linked to local and

regional elements and hence idiosyncratic factors will increase in importance. At the same

time, the reduction of external energy dependency will move risk from outside import to

internal creation, although it is difficult to assess whether the total amount of risk will

increase or decrease. Along the supply chain, this will force changes in the way risk in

transferred among operators. If, as seems likely, energy markets continue to liberalize, risk

transfer through freely agreed prices will increase.

The increased future relevance of renewable energy sources, together with the

forecastable tendency to further financialization and commoditization in energy markets,

imply also that the development of regional idiosyncratic financial markets will continue and

that they will address new sources of risk. Consequently, non-energy actors will also be

attracted into these markets, as agricultural operators were into weather derivatives, and this

will foster market liquidity. The essential life of these financial markets will also be

guaranteed by the pervasive introduction of technologies.

The development of risk creation and transfer in European energy markets can now

only partly be envisioned. Surely the role of policy and regulation will continue to be crucial,

as they heavily influence agents’ behaviour and the developments of markets. As this chapter

has shown, price risk creation and transfer are complex and important factors. It is desirable

that policy makers take these aspects into account when producing new regulation in order to

avoid errors and under-estimates of past decades.

LIST OF ACRONYMS AND ABBREVIATIONS

o CIF: Cost, Insurance and Freight. o CO2: Carbon Dioxide. o EDF: Electricitè de France. o EEX: European Energy Exchange. o EU 25 or EU: European Union, formed by Austria, Belgium, Cyprus, Czech Republic,

Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Republic of Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, United Kingdom.

o EU ETS: European Union Emission Trading Scheme. o EUR: Euro, the European Union single currency. o EUR/USD: exchange rate between EUR and USD. o FOB: Free-on-Board. o IPE: International Petroleum Exchange. o LIFFE: London International Future Financial Exchange. o MED: Mediterranean basin area. o NBP: National Balancing Point, the main UK gas trading Hub. o NWE: North-West Europe area. o PPI: Purchasing Power Index. o Ton or t: Metric ton, which is 1000 Kg. o TTF: Title Transfer facility o TWh: TeraWatt per hour, which is one billion KWh. o MWh: MegaWatt per hour, which is one thousand KWh. o OCM: On-the-day Commodity Market. o UKPX: United Kingdom Power Exchange. o US: United States of America. o USD: US dollars.

REFERENCES

o Arrow, J.K, (1964), “The role of securities in the optimal allocation of risk-bearing”, Review of Economic Studies 31 No.3, pp.91-96, April 1964.

o BP (2005), “BP Statistical Review of World Energy”, June 2005. o EIA (2002), “Derivatives and Risk Management in the Petroleum, Natural Gas and

Electricity Industries, Energy Information Administration, U.S. Department of Energy, Washington, October 2002.

o EIA (2005), “International Energy Outlook 2005”, Energy Information Administration, U.S. Department of Energy, Washington, June 2005.

o EUROSTAT (2005), “Energy, Transport and Environment indicators”, Eurostat, Luxembourg, 2005

o Mauro, A., (1999), “Price Risk Management in the Energy Industry: the Value at Risk Approach”, Proceedings of the 22nd Annual International Conference, International Association for Energy Economics.

o Mauro, A., (2003), “Le borse delle merci”, The Independent Review, n°4-2003. o Mauro, A., Sgarioto, R., (2001), “The valuation of Italian generation assets using a

spark spread option model”, Proceedings of the Eni Gas & Electricity Forum, Milano, June 2001.

o Mauro, A., Sgarioto, R., (2002), “Verso il Pool elettrico: un nuovo metodo di valutazione delle centrali”, rivista Energia, n.1-2002.

o UNCTAD (2001), “Overview of the world’s commodity exchanges”, UNCTAD Secretariat, Geneva.