UK energy prices have hit national headlines in recent weeks as the impact of surging wholesale prices has been felt by retail suppliers and consumers alike. Clean spark spreads — the theoretical profit margin for gas-fired power plants — emerged as a tradeable instrument in May to coincide with the UK launching its own emissions trading scheme.
Liquidity on clean spark spreads was initially muted as prices were stable for most of this summer, but prices and trading activity have increased sharply this month, reflecting the increased risk and uncertainty in the UK electricity market going into this winter.
Winter 2021-22 clean spark spreads (£/MWh)
The start of an over-the-counter (OTC)-traded clean spark spread market supported this stability, with the large utilities holding the market fairly still as they looked to catch up on hedging through these products — having been behind plan because of the UK emissions trading system (ETS) market only opening in May.
The clean spark spreads’ generally lower volatility means some utilities may also prefer to mark against these rather than against power contracts — which also take on volatility from the gas and emissions markets.
UK utility SSE said in May that it would hedge some of its wind generation through the gas and carbon markets to reduce its exposure to power market volatility, implying that it would be exposed only to volatility on the clean spark spreads.
But the OTC clean sparks market is largely set up for hedging, which may be holding back speculative activity on the products.
However, pros and cons to the product are derived from what some may consider an inefficiency in its composition. The clean spark spread products all use the front-year UK ETS contract for their carbon component. This means that carbon costs for the summer 2022 contract are still based on December 2021 emissions allowances, despite ETS products being valued at higher prices further out on the curve.
From a hedging point of view this is fine, the large utilities are happy to buy and hold allowances up front for hedging so are also fine using the front-year ETS contract.
And the front-year UK ETS contract is the only truly liquid one on the curve, meaning the legs of the contracts are all tradeable for brokers or market participants looking for arbitrage opportunities with the new products.
But it could be more of a problem for speculative trade further out on the curve, where the traded price is not reflective of the true clean sparks for that period. This has held back some market participants’ willingness to dip into the market.
The December 2022 UK ETS contract has held an average premium of around £1/MWh to the December 2021 contract this month. This equates to a difference of £0.38/MWh on a 49.13pc clean spark spread.
Increased interest, increased risk
The winter 2022-23 clean spark spread has been far more liquid in the OTC market in recent months, while activity on the front-season has been relatively sparse. This is unsurprising in a market set up for hedging — with utilities looking to cover most of their generation a year out from delivery. Regardless of the lower liquidity towards the front of the curve, winter 2021-22 clean spark spreads traded at as high as £27.50/MWh earlier this month, from around £7/MWh in August as wholesale electricity prices surged across the curve and across the continent.
So why is the market pricing gas-fired generation at such a high level? Tight periods are highly likely in the UK power system this winter. Nuclear closures, the mothballing of Calon Energy’s 2.3GW of CCGT assets and, most recently, a fire at the 2GW IFA interconnector with France will be limiting supply while demand is expected to rise with a lack of Covid-19 suppression — although the high energy prices could continue to pressure demand, with the UK steel industry having reduced production when electricity prices were at their highest this month.
And many risks exist that could see more price spikes in the UK system this winter, be it periods of low wind, unreliability at the country’s ageing power plants — including a nuclear fleet largely near the end of its life — tightness in continental Europe limiting imports or another cold year.
The outage on the IFA link saw forward clean sparks jump to a record high, although this appeared to be an overreaction as they dropped back again the following day.
Bidding behaviour amid a period of low wind output had already pumped up the clean spark spreads over the sessions leading up to the fire at the interconnector site however. Some plants have shown a willingness to remain out of the day-ahead market in the hopes of securing very high imbalance prices, which pushed up prices when there was surplus capacity eventually available and the system didn’t not look particularly at risk.
National Grid ESO wasn’t immediately concerned about security of supply, but imbalance prices still rose to up to £4,000/MWh. Intra-day prices were hitting Epex Spot’s £3,000/MWh maximum, which it then increased to £6,000/MWh. And hourly prices in the day-ahead markets followed up to £2,500/MWh, with Nordpool increasing the trigger for a second day-ahead auction to £3,000/MWh from £1,500/MWh.
These prices came as just a few plants were able to set the price in the balancing mechanism when the system was short, with their offers at around £4,000/MWh regularly being accepted because of a lack of competition at the top of the available stack.
The market has then priced in the fact that this appears to be the new precedent when the market is even vaguely tight in the evening, pushing the forward power contracts well above the marginal costs of most plants.
Day-ahead clean spark spreads rose to as high as £280/MWh, based on N2EX prices, making the high of £135/MWh from last winter look small in comparison. Expectation of a single day with clean sparks spreads of £280/MWh over winter would add around £1.50/MWh to clean spark spread expectations for the season. For an individual month, the expectation of one day of clean sparks at £280/MWh would increase the monthly expectation by around £8-9/MWh.
As volatility is likely to continue in the UK and continental power markets, we can expect clean spark spreads to follow — volatility brings with it opportunity and liquidity. In response to growing market interest in clean spark spreads, Argus launched OTC daily price assessments for contracts as far out as next summer — assessments that can be used for increased price visibility, trade negotiation and as mark-to-market for risk assessment and asset valuation.
N2EX day-ahead clean spark spreads (£/MWh)
Sources: Nordpool, Argus
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