Enron's plan for property-price derivatives market

Canary Wharf: cornerstone 

Following on from the post about the 'predictions market' & how various attempts to make financial markets in superficially prospective areas have sometimes come unstuck (water; bandwidth, weather): I'd mentioned that just before the Big Collapse, Enron was planning a property-price derivatives market, meaning futures / forwards at the outset, and ultimately options.

The rationale for there being demand for such a thing was this.  Many individual and commercial entities, as well as outright investors, can find they have a lot at stake as regards the variability over time of property prices in general, and the differences between property prices in different regions (technically, a source of 'basis risk').  Simple examples at the personal level: someone who hasn't yet sold their current property but has committed to buying a new one - needs a hedge against prices dropping while they find a buyer.  Someone who needs to move from London to Manchester for a couple of years but expects to return to London thereafter: needs a hedge against London prices outstripping Manchester over that period.  Someone who wants to lock in an attractive price they've seen the identical house next door fetching when it sold last week, but doesn't plan to move just yet: needs a hedge against local prices falling.  Etc etc etc.  

And of course once a market is established, speculators and punters can pile in: unlike weather (see previous post), people often really do have strong opinions about whether the property market is overheated or underpriced.

So how was Enron going to get the show on the road, back in 2001 at the time of the Collapse?  They put some of their best people on it.  Regionally specific price indices already existed - the sine qua non for derivatives.  Key to any market is liquidity, in turn requiring market makers and critical mass: and, with some aspects of derivatives, the ability to cash out into the physical.  They had a strong relationship with the Halifax (then a big property player and publisher of indices) and planned to start with the London commercial (office space) sector - and to ensure physical delivery, as an opening gambit they were going to buy Canary Wharf !

Sadly, we will never know how this would have panned out ...

ND

By popular request: zonal pricing for GB electricity

Under both Labour and the previous Tory regimes, serious consideration has been / is being given by DESNZ & Ofgem to the introduction of zonal (wholesale) pricing of greater or lesser granularity.  Maybe it'll be a handful of regions with separate mini-markets at the wholesale level, maybe it'll be a serious plethora of pricing nodes, with nothing that could be termed a 'market' at each.  

[To recap: right now there is a single wholesale pricing zone across the whole of GB (not NI) - essentially, the whole of the national grid HV transmission system is a single trading point.  This doesn't mean that all bilateral trade in the UK takes place at the same (half-hourly) price: but there is a single, transparent 'settlement' price for each half-hour, arising out of open-market commercial activity, that is an absolutely vital marker for any number of other commercial applications - settlement of forward deals (many of them representing essential hedging activity); basis of CfD subsidies; basis of 'index-related deals' for companies that want to be exposed to spot market prices (there are some); etc etc.  Open markets for commodities cannot exist without such things, even if the design of each market is strikingly different in detail.  The market we're sketching here looks not at all like, say, the spot market for Brent Crude: but they both have the same essential features.]

Why might there be pressure for change to a more fragmented set-up of regional-or-even-smaller mini (/micro) markets?

The argument is essentially theoretical, albeit based on experiences elsewhere.  Its most vocal advocate is Octopus, the UK's largest energy supplier (with tentacles in all manner of other sectors).  We might explain it by analogy with postage stamps.  Whether I send a letter to someone in the same town, or to Inverness, the stamp will cost the same.  Is that in any way reflective of the costs and dynamics of the post?  Patently, it is not.  Why shouldn't postal rates be properly cost-reflective?  It would surely make for efficiencies.  If you wanna live in Inverness, well, there you go.  It doesn't take much to make the cross-over analogies: if you are determined to build your windfarm in the North of Scotland, why should you get paid for getting your electricity into the GB-wide market at the same wholesale price as if you have a windfarm close to the 'centre of gravity' of GB electricity demand where your product is actually needed?  You sure as Hell cause a lot more problems for the Grid.  Hence the idea of moving, at least to regional wholesale pricing, if not pricing at an even more granular 'nodal' level. 

Oh, and for completeness, those advocating such changes say "it'll be cheaper for everyone in the long run".  That's a big leap of faith, though, because although there might (possibly) (in the long run) be an overall system gain from efficiency, the distribution of that gain is unlikely to iron out the positions of the winners and - more significantly - the losers, of which more below.

From first principles, other things being equal I am a big advocate of cost-reflective everything - you need accurate cost / price signals in order to know what's going on in economic life.  It's a matter of policy if you subsequently decide to subsidise those 'losers' deemed to be horribly disadvantaged by this, and unable to rectify matters themselves by reacting rationally to those signals.  That should be the exception, of course, because the aim is positively to incentivise rational responses!

But there are other considerations than efficiency, and I'll highlight two.  The first is political: the great cry of "postcode lottery" goes up - you can hear it already - there being, errr, winners and losers on a geographical basis, with corresponding heartfelt loser-lobbies, and locally-based politicians to heed them.  That includes residential energy users, but also electricity generators.

The second is Liquidity.  For markets to function, there must be liquidity: it's of paramount importance - a big topic, but for those who don't know why this is so, we'll hold a tutorial another day.  How big (in economic terms) does a region need to be before one can be certain of enough free-trading commercial activity to constitute a liquid market?  There's no precise science, and a lot of ignorance in play.  Yes, we can point to some apparently much smaller electricity markets than GB's, where there seems to be adequate liquidity.  But sometimes these turn out to be not genuinely separate markets, but rather 'branches' of the same 'tree'. 

All I would conclude with is this:  the current GB market[1], with the rather blunt, non-granular price signals it sends, may not be quite as efficient as would be ideal, but it is liquid (some say, 'indeed - but only just') and that's a precious thing, not to be taken for granted or tampered with lightly.  If blundering, incomprehending hands break this thing - and Miliband / DESNZ / Ofgem-as-currently-led[2] are just the poeple to do that - it'll be a disaster.  I'm not in the thick of the current market-design dynamics, but I sure hope they know what they are about.

ND
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[1] I had a hand in the design of the original manifestation of the present market (2001), though there have been many modifications since.  You'll accuse me of pride and undue sentimental conservatism?  Fair enough!  But I know what the dangers are.

[2] There have been previous Ofgem regimes - and before that agency came into being, its predecessors 'Ofgas' and 'Offer' before it - that were truly excellent.  The present management is sub-standard.

'Germans Don't Understand Markets', part 94

From time to time I am moved to observe that Germans, as a rule, have no intuitive grasp of how markets work.  Perhaps their postwar social-democrat / Christian democrat tradition is so inherently mercantilist and dirigiste (and, by many lights, successful!) and now so deeply ingrained, that market dynamics pass them by.

At the state level the French 'Enarchists' aren't much better (though you meet far more French business people who know the score).  So there's little hope that 2022 Brussels, with no leavening of UK influence, will have the first clue.  Here's some up-to-date evidence.  

EU leaders pledged to bulk buy natural gas jointly and review the role of the fuel in setting electricity prices as part of plans to protect European consumers from spiralling energy costs ... “Instead of outbidding each other and driving prices up we will pool our purchasing power,” said Ursula von der Leyen

Where to start?  We all know where bulk buying and large-scale procurement by state entities leads, and it ain't prone to driving down prices++.  (It is prone to monstrous corruption: the mysterious middlemen who will insert themselves in this process when the politicians realise they are totally in the dark in such technical matters, will ensure an extra € or two gets added to the unit price, and is silently shared around a bunch of deeply undeserving individuals.  (Libel laws forbid me elaborating, but suffice to say the gas sector has not proved in any way immune from this in the state monopoly days of yore.)  It's just one of those things that can be made to 'sound sensible', sort-of, and is promoted by people like Peter Mandelson who has advocated it in the past.  But experience tells heavily against it.

The one that really amuses me is "review the role of the fuel in setting electricity prices".  Boris - another ignorant prick - has mouthed similar words.  Well, review away, fellahs; but I can tell you in a couple of sentences what the answer is.  The price of any traded commodity** is set by the cost (or opportunity-cost) of the marginal source of supply (or demand, in some cases), which for most of the time in European electricity is NATURAL GAS.  Occasionally it is something a bit more obscure and we get negative prices (something else that has always puzzled German politicians).  But the dynamics are exactly the same.

Gottit, Ursula?  Great: so you can save that million € being asked for by McKinsey or whomever to answer the question for you.  All part of the C@W service.

By the way, this situation is destined to prevail for many years - in fact, decades, as far as anyone can see - however much new 'renewable' electricity capacity is brought on line.  The only truly 'dispatchable' renewable source is hydro from reservoirs (as opposed to run-of-river).   In practice, biomass can be, too (if it isn't already running baseload because of the vast subsidies involved) - but large-scale biomass ain't renewable: its deemed renewable status is a massive scam.

Of course, Ursula's oh-so-predictable follow-up question is: what can we do about it?   Ans:  well, you can suspend the laws of gravity for just so long as you are willing to throw money at it.  But that's what happens:  you waste even more money, and it still comes out the same when, eventually, you've had enough.   Gottit?   Well no, sadly; probably not.

ND

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++ presumably, as dearieme has wittily observed BTL, "in homage to their success in buying vaccines jointly"  

** the physical commodity, that is.  Forward prices are set by completely different dynamics.

Germans REALLY Don't Understand Markets (part 94)

Now I know this becomes repetitive** ...   and by "Germans" here, I mean ... and their pocket euro-wallahs in Brussels: 

Europe Considers Steps to Curb Speculation in Carbon Market 

(Bloomberg). The European Union is considering curbs on speculation in the world’s biggest carbon market where record prices have lured hedge funds in search of profits. EU emission permits jumped to an all-time high of EUR 40.12 on Thursday, extending their gains to about 70% over the past year. That gain, in part, has been down to large-scale investors speculating in the market. Europe’s cap-and-trade program, started in 2005, is the region’s key policy tool to cut pollution. The European Commission, the EU’s regulatory arm, could introduce a limit on the number of CO2 allowances that can be held by investors in a central registry of the Emissions Trading System, according to people with knowledge of the matter. Doing this would prevent financial investors holding too much sway in the market.

Sheesh.  

(a) the record high prices this week have b*****-all to do with speculation, and EVERYTHING to do with very cold weather, and euro-policies that are SPECIFICALLY DESIGNED TO INCREASE THE PRICE OF CARBON.

Can I make myself plainer?  FFS!

(b) if you suppress spec interest in a market, you starve it of liquidity - the quickest route to the death of the market.

To give an example:  20 years ago, the Next Big Thing was going to be weather derivatives.  Oh, people said, this'll be a tremendous market - loads of people want to hedge their exposure to weather: look, lots of people insure against it already - and lots more could benefit from the clever products you can design using derivatives. 

Well, the "market" was duly set up, and away it went.  Lots of capable banks and energy companies and trading houses and exchanges invested time & effort & people to become players.  But ... nothing, much.  

Why?  Because nobody is willing to take the other side of the bet:  literally no punter is willing to gamble on what the temperature will be next July!  (Unlike the price of crude oil, or gold, or the FTSE, or Bitcoin etc etc.)  So - no speccies in the "market" ... and no market.  Simples.

Left to their own devices, these euro-types are going to make some big, big mistakes.  Can a Tobin Tax be far behind?

ND 

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** For those who haven't heard this story from me before:  When the EU Emissions (i.e. carbon) Trading Scheme was first mooted, the Germans insisted that the initial allocation of permits should be fairly lavish, and free (as opposed to auctioned).  In this way, they said, it would have no impact on German electricity prices (based, as they were, on coal).  I and others told them that, whatever became the price of carbon when trading started, the price of electricity would increase by exactly that amount, free allowances or not.  Oh no, they said - how could that be?  All our generators have sufficient free allowances.  Yes, Jürgen, but as soon as there's a market price on them, they have an opportunity-value ... 

A lo!  When market trading of carbon commenced, the price of electricity in Germany (as anywhere else where prices were set by fossil fuels), went up by exactly the coal-equivalent amount!  Teuful! - how can this be?!  And the Bundestag held a parliamentary inquiry! 

Germany: another burst of suicidal energy policy

As the whole world knows (but Greens prefer to ignore) Germany's Energiewende policy has been monstrously expensive but of very poor efficacy as regards its ostensible aim (CO2 reduction) - as few bangs for the buck as it's possible to imagine.  By any ranking, the top two countries in Europe on CO2** are the UK and Denmark.  Most commentators have said: the Germans will think twice before their next round of energy policy-making.

But no.  They've just conducted an auction for subsidies to decommission, prematurely, 5 GW of coal-burning power stations in 2021 - and in a second round, a further 10 GW to close in 2022.  They are claiming it as a great success, naturlich - but it's actually a madhouse: the "winning" first-round bids have been from relatively modern & efficient black coal plants (the newest being of 2015 vintage), leaving open the stinking abominations that are their lignite plants.

Additionally, Germany has no Capacity Market, meaning no explicit price signals for the looming, everybody-knows-this German electricity capacity crunch.

In the round, the "design" of their system is utter nonsense.  I have long said the Germans don't understand markets; and they ain't doing anything to contradict that.  

ND

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** I well realise some of you say this is a competition you'd rather not enter

Negative Prices - a Rich Irony

I don't know how many people are aware of negative (wholesale) prices in the energy industry.  They often come as a surprise to the layman, but were easily and correctly predicted by those who understood the game, way back when electricity was first mooted as a candidate for being commoditised and de-monopolised into a traded market.  They would arise because some kind of pricing dynamics would be needed that disincentivised over-production.  

Why would this be an issue?  (a) The difference between peak demand (6 pm on a freezing winter's evening) and least demand (3 am on a hot summer's morning) is extreme, and both must be catered for, ideally via price signals; (b) quite a lot of electricity generation is "must run" - nuclear and run-of-river hydro being the traditional ones, but even back in the early nineties it was obvious that solar- and wind-power would be coming on in ever larger quantities.  (Of course, in those cases "must run" is by green-policy fiat, whereas nuclear is to a large extent a safety issue.**)  So there was always the logical possibility that must-run would exceed demand, at which point some generators whose marginal cost was zero might need to be offered a lower-than-zero price - i.e. paid not to generate.

And so it transpired, mostly in the German electricity market++ to start with.  I've written about German power dynamics before: they are bizarre (the Energiewende is absolutely inane) and the cogniscenti weren't even slightly surprised when it started happening there.  However, such was the widespread puzzlement in Germany itself^^, the leading technical stiftung in that country, Fraunhofer, started publishing minute-by-minute explanations of each and every instance.  (This was when the examples were fewer than one a month.  They soon became much more frequent, and the good Fraunhofervolk began to tire of doing these analyses.)   

Short periods of negative pricing are now utterly commonplace in electricity markets around the world.  (Dis)incentivising via price signals is not the only mechanism for balancing electricity grids, of course: grid operators typically retain the right to make generators switch off because they're told to.  However, in the case of 'green' electricity (and sometimes other generators) there is often compo to be paid - part of the less-visible subsidy regime, even if no premium is paid for the electricity they do generate.  But market mechanisms are best.

Rich Irony    Now we come to the funny bit.  The costs of constructing some types of renewable electricity generation sets are plummeting, especially for wind and solar; and of course the variable costs are close to zero.  In several markets, they don't need the traditional type of subsidy - a guaranteed offtake price - any more.  That's great.  (There are other, less obvious subsidies on offer, such as not being made to pay for the trouble their intermittency cause the grid.)

But here's the thing.  In many countries now there are auctions for who gets to build new generating plant, where bidding is for how much subsidy you'll accept - lowest bidders win.  Already, some applicants have bid in at zero, meaning they don't need a cash subsidy at all ...  Sometime soon, windfarms are going to start bidding in at "negative subsidies", i.e. they will be willing to pay in order to join the game!   

Ain't markets wonderful?

ND  
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** Of course the very existence of nuclear power is by policy-fiat, too 
++ For afficianados, there was also an early (and quite unexpected) instance of a negative price in the UK gas market, where the underlying logic is the same, though conditions are rarely so extreme as in electricity.  It was, in essence, a freak occurence, albeit wholly explicable after the event
^^ As noted here before, even educated and professional Germans truly don't understand how markets work 

Technical Note (may safely be skipped):  a word on one of the technical spin-offs of all this.  Some readers may be aware that "traditional" modelling of the seemingly random and jerky behaviours of spot prices in commodity markets uses "geometric brownian motion" as the explanatory mathematical assumption to capture volatility, with its associated parabolic function.  It works brilliantly for post-rationalising & analysing price evolution across all the "traditional" commodities - metals, oil, agriculturals etc (in conjunction with a mean-reverting function, and sometimes a seasonality function and a drift factor).  It even worked for modelling natural gas when that started to be traded, notwithstanding spot prices in that market that were (and remain) vastly more volatile than ever before encountered.  But it doesn't work for power: (a) because the extremes of electricity prices include blips that are more even extreme than can be "explained" by a standard volatility function, however high you turn the dial; and (b) brownian motion can't "explain" / represent negative prices!  Another function was required.  I'm proud to say that Enron had people doing original mathematics: and to cut through the heavy stuff (though I can explain if you wish ...) the answer was an inverse hyperbolic sine (sinh^-1), coupled with a Poisson distribution for the blips.

Now you know.

Meanwhile, Back In The Markets ... Big Events

Has anyone reported this in Europe?  On Monday, the new US LNG terminal at Sabine Pass was formally opened, sending out a cargo of gas bound for Portugal.  Yes, folks, that's an export terminal.  Shale gas is a-comin' our way.

The past week has seen a serious uptick across the energy commodities' forward curves - Brent up 7% across the whole structure, UK natural gas up 20% at the near-end, even coal up 5% at the back end.  Brent is still in modest, uninformative contango (as is gas) so a parallel upwards shift doesn't betoken an end to basic oversupply.  But hey, the producers will be happy enough to be able to lock in at higher prices.  20% in one week is not to be sneezed at - any fully-hedged UK utilities will be smiling broadly: any that were exposed will have been scrambling, maybe even to buy some of that US gas on a long-term contract.

And of course Sterling (spot) has had what some see has a post-Obama speech boost, though it's not at all as pronounced as the commodities - more within the range of general noise.

The opening ceremony at Sabine Pass could be seen as more significant than the COP21 "signing ceremony" in New York on Friday.  Signing? 

"The US, China and India - the three biggest climate polluters - have all committed to join the agreement, possibly as early as this year."

Possibly as early as that, eh?  Oh well.

ND

Gold hits a five year low; a positive message?

Perhaps the Greek crisis won't come back after all and Mr Schauble will play nice from now on?

Perhaps China creating money to give to private companies to buy their own shares is perfectly fine?

Perhaps that ISIS lot will just toodle-pip off and those nice Iranians won't sponsor global terror anymore?

Perhaps Mr Putin is fed up with his picnic in Ukraine and is about to leave for home?

All of these things must be true to an extent if we are to believe market signals. The price of Gold has fallen to near $1000 an ounce, a five year low. Looked at historically, since the Brown Bottom, gold is still 4x higher than 2002, but of late the price has really cratered. China and the Oil Producing countries have been stocking up on supplies sold by European countries and new supply from Africa and Russia - they are less likely in the future to buy more gold so the price is declining. Also India has put on strong restrictions against gold hoarding which has been a challenge in its economy for hundreds of years (i.e. wealth is stored and not productively invested).

But longer term a low gold price suggests the preachers of economic doom are at a low ebb, with the world economy recovering still and has a bit of growth left in it yet.

I won't be buying into a contrarian bet soon - perhaps if the price reaches below $900 will be the time to consider it....certainly I did well in 2008 buying at $600 an ounce but that that time buying anything would have seen strong returns over the next few years.