Long-term transmission rights in the Nordic electricity markets: An empirical appraisal of transmission risk management and hedging

Abstract

The increasingly integrated European electricity markets enable participants to exploit market opportunities and participate in cross-border electricity trading. But, the network gets congested because of the scarce transmission capacity, so electricity prices vary greatly in time and across geographical areas. Market participants thus need an efficient hedging mechanism that limits their exposure to the locational price risks. The hedging solutions against the area price differences that originate from interconnector congestion are commonly called long-term transmission rights (LTRs). This work studies the economics of transmission network congestion in the Nordic electricity markets, including the associated risks and alternative LTR mechanisms and how to manage them. The Nordic electricity markets are selected as a case study for their unique market design and the current regulatory challenge they face with respect to efficiency limits identified in their transmission risk hedging contracts, called electricity area price differentials (EPADs). In addition to the policy and regulatory motivations, the current understanding of derivatives pricing for non-storable commodities, such as electricity, is limited. In particular, the interpretation of the systematic bias between futures prices and the expected delivery date spot prices, called risk premia, is still ambiguous in terms of economic theory. This study employs historical data (2001–2014) on electricity spot and futures markets and utilizes statistical and econometric methods to empirically assess the efficiency of the current Nordic transmission hedging mechanism and to evaluate LTR alternatives (FTR and EPAD Combo). Three main findings may be highlighted. First, despite the presence of systematic price differences between bidding zones and the reference system price, the real economic impacts of these differences are limited. Net-importing bidding zones are identified as the most vulnerable to systematic decoupling of prices. Second, despite the significant risk premia in EPAD contracts, the study finds that EPAD prices are unbiased predictors of the expected spot prices in the long run. Third, the study shows that financial transmission rights (FTRs) hedging effects can be replicated by combinations of EPAD contracts and that the TSOs theoretically auctioning FTR portfolios would need to newly address firmness risks, revenue adequacy, and counterparty risks.