1
Energy Markets

Despite a global sustainability trend including climate protection and more efficient use of energy, worldwide energy consumption will continue to grow over the coming decades (see Figure 1.1). Besides future economic growth, an important driver of global energy demand is policy commitments, such as renewable energy or energy efficiency targets. Depending on scenario assumptions, the average annual growth rate in energy consumption is estimated to be between 0.5% and 1.5% (International Energy Agency, 2012) until 2035, with significant regional differences. Most of the energy demand growth is expected to come from non-OECD countries, with China and India being the largest single contributors.

Figure 1.1 World energy demand. Source: International Energy Agency (2012).

The main primary energy source worldwide is oil, covering 32% of worldwide energy consumption (see Figure 1.2). Second are coal and natural gas, with a share of 27% (respectively 22%). Nuclear energy (6%) and renewables (13%) have a much smaller share. To meet the growing worldwide demand for energy, there will need to be an increase in energy supply from all primary energy sources. However, depending on the scenario, the share of oil and coal will diminish in favour of gas and renewable energy sources (Figure 1.2).

Figure 1.2 World primary energy sources. Source: International Energy Agency (2012).

Not all of the primary sources of energy are used directly for consumption; they may first be transformed into secondary forms of energy, such as electricity or heat. Since part of the primary energy is used for the transformation process, the final consumption is below the primary energy demand. A breakdown of the final consumption into different sectors is given in Figure 1.3.

Figure 1.3 World final energy consumption. Source: International Energy Agency (2012).

The current trends by sector are as follows (International Energy Agency, 2012):

• Industry: The industrial sector accounts for 28% of the total energy consumption and has the highest growth rate among the sectors. The main energy sources are coal (28%), electricity (26%), gas (19%) and oil (13%). It is expected that electricity and gas will gain importance at the expense of coal and oil.
• Transport: The transport sector, which makes up 27% of the energy demand, is strongly dominated by oil (93%). On a worldwide scale, biofuels (2%) and electricity (1%) still play a minor role, but are expected to increase their share to 2% (respectively 6%) in the reference scenario. The actual development will be strongly influenced by future governmental policies.
• Buildings: This sector includes heating, air conditioning, cooking and lighting. It accounts for 34% of the total energy consumption. The energy is delivered mainly in the form of electricity (29%), bioenergy (29%), gas (21%) and oil (11%). There is a clear trend towards a higher share of electricity and gas at the expense of bioenergy and oil.

1.1 Energy Trading

With the development of a global oil market in the 1980s, energy has become a tradable commodity. In the early 1990s, deregulation of the natural gas market in the United States led to a liquid and competitive gas market. In Europe, liberalisation of gas and electricity markets started in the UK in the late 1980s. In the late 1990s, the EU Commission adopted first directives making energy market liberalisation a mandatory target for EU member states along different steps of implementation. Whereas a wholesale market for electricity developed successfully in the early 2000s in some countries (e.g., Germany), a liquid gas wholesale market only existed in the UK. Gas markets in Continental Europe still remained fragmented and dominated by oil-indexed supply contracts. Further consolidation of market areas, easier market access and declining gas demand following the financial crisis in 2008 increased competition and finally led to growing market liquidity for gas markets in Continental Europe and a decoupling of gas and oil prices in the early 2010s.

Besides the commodities coal, oil, gas and electricity, which carry energy directly, the EU introduced carbon emission certificates (European Emission Allowance or EUA) in the year 2005 as part of the EU climate policy. The certificates were designed as tradable instruments for which a liquid market quickly developed. Since carbon certificates are closely related to energy commodities and electricity generation, they will be treated here along with the other energy commodities. Before describing the specific markets for each commodity, the general structure and basic products of commodity markets in general will be introduced. A more detailed description of commodity derivatives products will be given in Chapter 5.

We generally distinguish between over-the-counter (OTC) and exchange-traded markets. The OTC market consists of bilateral agreements, which are concluded over the phone or through Internet-based broker platforms. Such transactions are most flexible since the parties are free to agree individual contract terms. As a main disadvantage, OTC transactions may contain credit risk, meaning that one of the counterparties may not deliver on his contract (e.g., in case of insolvency). As a mitigation, collaterals may be defined to protect the counterparties from losses in such a case. Exchanges provide organised markets for commodities in the form of standardised contracts. In particular, they became popular for derivatives products (futures, options), where the exchange also eliminates credit risk for the market participants.

1.1.1 Spot Market

The spot market is the market for immediate (or nearby) delivery of the respective commodity in exchange for cash. The exact definition depends on the commodity. As an example, the spot market for electricity often refers to delivery on the next day or on the next working day. For coal markets, contracts delivering within the next several weeks ahead are typically still considered as spot transactions. Spot markets can either be bilateral OTC transactions or organised by exchanges. For electricity, gas and EUAs, energy exchanges typically offer spot market products.

A particular form of spot market is the auction market, where buyers submit their bids and sellers their offers at the same time. In most cases a uniform price, the market clearing price, is determined, which balances supply and demand. Such a uniform price auction is popular for electricity spot markets; traded products are typically single-hour (or even half-hour) deliveries.

Spot prices represent the final price of the “physical commodity” in the prevailing situation of supply and demand, and are therefore the underlying of the derivatives market, which is largely driven by expectations regarding the future situation on spot markets. There are various published spot price indices available for the different commodities that provide transparency for market participants and also serve as official references for the financial settlement of futures contracts.

1.1.2 Forwards and Futures

Forward and futures contracts are contractual agreements to purchase or sell a certain amount of commodity on a fixed future date (delivery date) at a predetermined contract price. The contract needs to be fulfilled regardless of the commodity price development between conclusion of the contract and delivery date. In case the spot price has increased, the seller needs to sell below the prevailing spot price at delivery and therefore incurs an opportunity loss, whereas the buyer makes an (opportunity) profit. In case prices decline, the situation is reversed. The buyer of a forward or future is said to hold a long position in the commodity (he profits from a price increase until delivery), the seller is said to hold a short position (he takes a loss from a price increase).

The final profit or loss for the buyer of a forward contract (long position) at delivery date T is the value of the commodity at delivery S(T) minus the contract price K (i.e., S(T) − K), see Figure 1.4. Similarly, the profit or loss for the seller (short position) is K − S(T).

Figure 1.4 Profit or loss of a commodity forward contract.

Forward contracts are the most basic hedging instruments. If a producer of a commodity enters into a forward contract as a seller, he fixes his revenues and is indemnified from further price changes. On the contrary, a market participant who is dependent on the commodity for consumption may enter into a forward contract as a buyer to fix his purchasing costs for the commodity in advance.

The term “futures contract” is used for a standardised forward contract which is traded via an exchange. Often, futures contracts are financially settled, which means that only the value of the commodity at the delivery date is paid instead of a true physical delivery. Futures contracts open up the commodity market for participants who do not want to get involved in the physical handling of the commodity. Since the exchange serves as a central counterparty for futures contracts, market participants do not have to deal with multiple individual counterparties and their associated credit risk. This also makes it easier...