Electricity Marketplaces




(1)
Dept. of Accounting and Commercial Law, Hanken School of Economics, Vaasa, Finland

 




4.1 General Remarks


Competitive electricity markets can be structured in two basic ways. Electricity trading can be direct (bilateral) or centralised (exchanges and other organised marketplaces).1 This chapter focuses on the latter. OTC contracts are discussed later in this book.

Centralised trading on exchanges is a good thing to start with when you want to study electricity supply contracts, because exchange-traded contracts are standardised and relatively simple. While the contracts may be uncomplicated, trading is governed by market rules and a large legal framework that is much like the one applied in securities markets. Most of this chapter discusses issues that are regulated even in securities markets. In contrast, individually negotiated bilateral contracts are complex contracts not governed by exchange rules (Sect. 8.​1). In both cases, the system operator’s rules influence product specifications and physical settlement.

In this chapter, we will focus on the core NWE area. After a brief introduction to European electricity exchanges (Sect. 4.2) and the reasons causing their variation (Sect. 4.3), we will study the organisation of some financial (Sect. 4.4) and spot (Sect. 4.5) exchanges. Special attention will be paid to the reduction of counterparty risk and systemic risk through collateral requirements, margining, daily settlement, and netting (Sect. 4.6), because these questions influence the cash flow of market participants. The spot market, that is, the day-ahead and intraday market, is complemented by the balancing market, that is, the market for control reserves (Sect. 4.10). We will also study the regulation of market conduct, market abuse, and money laundering (Sect. 4.7), particular obligations under the EMIR and MiFID II/MiFIR regimes (Sect. 4.8), and market surveillance (Sect. 4.9).

This chapter is complemented by Chap. 5 that focuses on the transmission marketplace, Chap. 6 that discusses the coupling of markets, and Chap. 7 that gives a brief introduction to the allocation of emission allowances.


4.2 Introduction to European Electricity Exchanges


The role of electricity exchanges depends on the market model. While there is no room for electricity exchanges in complete vertical integration, they play an important role in liberalised energy markets.

Electricity exchanges have many functions in liberalised energy markets. (1) They provide a distribution channel for electricity producers. (2) They increase security of supply for electricity wholesalers, retailers, and large end consumers. (3) They can also provide a marketplace for transmission capacity (Chap. 5). (4) They provide a pricing mechanism for both electricity and transmission capacity. The lack of an electricity exchange would not prevent wholesale trade, but it would mean the absence of a reliable price index. (5) Electricity exchanges facilitate the transfer and management of risk. (6) Moreover, they increase the liquidity and transparency necessary for the efficient functioning of electricity markets.2

European electricity exchanges emerged earlier in countries like England and Wales and the Nordic countries that were the first to liberalise their electricity markets.3 The three most important early exchanges were ICE Futures Europe (the UK),4 Nord Pool (the Nordic countries), and European Energy Exchange (EEX, Germany).5

Electricity exchanges are undergoing a process of restructuring. This requires plenty of planning and coordination between the exchanges.

In the Nordic area, Nord Pool is now divided into two exchanges. (a) Nord Pool Spot, the physical market, is operated by Nord Pool Spot AS, a company owned by the Nordic and Baltic transmission system operators. (b) The derivatives exchange is operated by NASDAQ OMX Oslo ASA that is part of the NASDAQ OMX group. The brand name for the group’s commodity related activities was changed to Nasdaq Commodities in 2014. (c) Nord Pool Spot and Nasdaq Commodities used to operate N2EX in the UK market jointly. Since 1 October 2014, Nord Pool Spot is the sole operator of the short-term physical market of N2EX. Nasdaq Commodities remains the operator of the financial power market of N2EX. The transfer aims to replicate in the UK the Nordic wholesale power market model with Nasdaq Commodities operating the derivatives markets and Nord Pool Spot the short-term physical market.

There are similar structures in continental Europe. (a) EPEX Spot SE operates EPEX Spot, the spot market for Germany, France, Austria, and Switzerland. EPEX Spot SE, a French company based in Paris, is controlled by European Energy Exchange AG (EEX) directly and via Powernext SA (Powernext) with HGRT as a minority shareholder. EEX has thus assigned its power spot markets for Germany/Austria and Switzerland to EPEX Spot.6 (b) The derivatives market for Germany and France is operated by EEX Power Derivatives GmbH, a German company based in Leipzig and a subsidiary of EEX (80 %) with Powernext (20 %) owning the remaining shares. (c) APX-ENDEX in the Netherlands and Belgium is now divided into the spot exchange APX and the derivatives exchange ICE Endex.

Other European electricity exchanges include OMIE (the Iberian market, previously OMEL in Spain and OMIP in Portugal), POLPX (Eastern Europe), EXAA (Austria), and IPEX (Italy, also known as GME).7

Coordination is constrained by competition laws. For instance, Nord Pool Spot and EPEX Spot are expected to act like competitors. It is prohibited to agree on market sharing. In March 2014, the Commission fined Nord Pool Spot and EPEX Spot € 5.9 million in a cartel settlement for their non-competition agreement.8

On the other hand, existing market operators are also expected to co-operate as NEMOs “[f]or efficiency reasons and in order to implement single day-ahead and intraday market coupling as soon as possible”,9 but co-operation between NEMOs is “strictly limited to what is necessary for the efficient and secure design, implementation and operation of single day-ahead and intraday coupling”.10


4.3 Variation of Electricity Marketplaces


There are many markets for wholesale electricity trade. While all open and competitive markets are constituted by a similar set of rules at a general level (Ostrom),11 there are differences between electricity exchanges and securities exchanges, and between physical and financial electricity exchanges.

Obviously, there can be more marketplaces, (a) because contracts can relate to different services and rights (electricity supply, transmission capacity, or greenhouse emission rights), (b) because electricity markets are local, national, or regional, (c) because marketplaces and market participants can be regulated in different ways (as financial or physical markets under legal rules implementing EU law or national regulation), and (d) because of the benefits of specialisation and economies of scale.

Moreover, like all marketplaces, electricity wholesale markets and electricity exchanges can be organised in many ways.12 There are many exchanges in the European electricity market with different institutional designs and traded products and sometimes overlapping market areas.13


Physical Supply Contracts Traded on Electricity Exchanges

Few contract types that are settled physically can be traded on an electricity exchange. It would not be possible to settle contracts physically without the simultaneous availability of transmission capacity and the simultaneous generation and consumption of electricity.

Long-term contracts for the physical supply of electricity are not traded on electricity exchanges (Sect. 8.​1). In practice, they require closer technical co-operation and more detailed management of the contractual (principal-agency) relationship between the parties. They are always negotiated individually.

Physical contracts can be traded on an electricity exchange provided that they are standardised short-term contracts. They are traded in the spot market or in the intraday market.


Physical Characteristics of Electricity

The variety of marketplaces is partly caused by the physical characteristics of electricity.

The number of exchanges has been increased by the fact that the physical characteristics of electricity have kept electricity markets national or regional. The transmission of electricity requires lines and transmission capacity. Because of cross-border and cross-zonal congestion, there may be a weak connection between pricing on different electricity exchanges.14

Because of the physical characteristics of electricity, access to trading on a physical exchange must be limited. Trading on a physical exchange results not only in financial clearing and settlement but even in physical clearing and settlement. The electricity pool that can be used for supply purposes is limited, because market participants trading on the exchange must have access to the transmission grid.

The balance requirement influences the matching of bids. While the auction mechanisms are relatively uncomplicated in securities markets, a wider range of mechanisms can be used in electricity markets. Different trades can be settled at different prices like in securities markets, or a system price may be used for different trades (Sect. 4.4.4). Because of physical constraints, market pricing must depend on a large and complex set of calculations.15

Because of the balance requirement, the auction mechanism and physical matching are different things. The TSO must always be responsible for the physical real-time matching of supply with demand.16

The balancing requirement makes it necessary to define the electricity pool that can be used for balancing purposes. This is achieved by the TSO’s balancing rules. In the EU, a supplier may not obtain access to the transmission grid or a spot exchange without a contract on balancing arrangements. The supplier must comply with the TSO’s balancing rules and the applicable trading rules.17

Real-time balancing requirements act as a constraint on the physical settlement of contracts and complicate both the settlement process and the legal framework. For instance, some electricity market transactions occur before the system constraints are fully known or the price is calculated. In extreme cases, the settlement price may be readjusted up to several months later.18


Financial Electricity Exchanges

Similar aspects must be considered even by financial electricity exchanges. First, the underlying commodity is a contract for the physical supply of electricity. The characteristics of the market in the underlying commodity influence the characteristics of the derivates market.19 The quality of the financial electricity market depends on the quality of the underlying physical electricity market: “Until the market for the underlying commodity is working well, it is hard for a robust derivatives market to develop”.20 Second, some of the financial contracts can be settled either in cash or physically.

However, financial electricity exchanges can attract a wider range of participants. While the physical electricity wholesale market is reserved for parties connected to the grid, there is no such requirement for financial electricity products. Financial derivatives can be used for arbitrage and speculation by banks, investment firms, and investment funds.21

For the same reason, there can be a larger variety of contract types traded on electricity exchanges.


Regulation

The variation of marketplaces is increased by the fact that marketplaces are subject to different regulatory regimes.

The applicable regulatory regime tends to be a mix of three main components: the regulatory regime for the electricity sector (physical markets); the regulatory regime for the financial sector (financial markets and derivatives); and environmental law (greenhouse gas emission rights, Chap. 7). Each of these three main components can regulate a marketplace, market participants, products to be traded, and the market participants’ activities, and they can be combined in different ways.

Moreover, market participants are regulated differently depending on their home country, the location of their activities, and how their activities fall within the scope of the relevant regulatory regimes.


Market Design

Globally, differences between exchanges can partly be explained by differences in wholesale market design. They can be caused by the following factors:



  • Stage and nature of liberalisation. All markets are not liberalised and the liberalised markets are not liberalised in the same way. The market design can reflect complete vertical integration or a certain type of liberalised market model.


  • Independent system operator. The use of an independent system operator (TSO or ISO) is mandatory in the EU with liberalised electricity markets, but globally the use of independent system operators may depend on the country.


  • Trading structure. A three-tiered trading structure consisting of a “day-ahead” market, an “hour-ahead” market, and a “real-time” market is customary in the EU, but there are countries outside the EU that have chosen another structure.22


  • Centralisation. There can be differences relating to the level of centralisation worldwide. The two opposites are a compulsory centralised market (a gross pool) and a system where bilateral physical trading is allowed.


  • Settlement price. There can be differences relating to the settlement price. Short-term trades can be settled at a uniform price or with discriminatory pricing.


  • Transmission effects. Moreover, transmission effects can be treated in different ways. Whereas markets in Europe try to minimise the effect of transmission constraints on the price, markets in the US treat them explicitly.


4.4 The Organisation of Financial Electricity Exchanges in the EU



4.4.1 General Remarks


The most important electricity derivatives exchanges in the EU include Nasdaq Commodities (the Nordic countries), the EEX Power Derivatives Market (Germany and France), ICE Futures Europe (a large marketplace with most of its action in the US); and ICE Endex (Belgium and the Netherlands). It is characteristic of derivatives exchanges that they can offer competing products with underlying electricity contracts in the same countries. For example, Nasdaq Commodities offers products even for the German, UK (N2EX), and Dutch power markets.

Somebody must be responsible for the exchange. To function properly, modern exchanges need a market operator that coordinates all activities and acts as the licence-holder, if the holding of a licence is a legal requirement. Moreover, somebody must provide matching, clearing, and settlement services. There could also be a party that holds collateral, money, and other assets belonging to market participants. There can also be brokers.

It is easier to organise and regulate financial electricity exchanges than physical electricity exchanges. The absence of physical settlement reduces transaction costs and increases liquidity.23


The MiFID II Regime

All electricity exchanges operate in a highly regulated environment. As a rule, derivative contracts that are settled financially fall within the regulatory regime for financial markets. Contracts for the physical supply of electricity do not fall within the regulatory regime for financial markets—provided that the contracts can only be settled physically. However, complicated questions of interpretation may arise where contracts for the physical supply of electricity can be settled both physically and financially.24

From a regulatory perspective, there are three main categories of financial electricity exchanges in the EU: venues that fall within the scope of the MiFID/MiFID II regime, venues that fall within the scope of the EMIR regime, and other venues. The scope of the MiFID II regime is very important for parties that wish to do business on an exchange.

Trading venues. Trading venues that fall within the scope of the MiFID II regime are “regulated markets”, “multilateral trading facilities” (MTFs), or “organised trading facilities” (OTFs).25 OTC markets do not fall within the scope of the MiFID II regime, unless the OTC marketplace is a “multilateral system”,26 that is, an organised exchange.27

Contracts. In addition to trading venues, the nature of contracts is important. The scope of the MiFID II regime depends on the contracts traded on the exchange. The regime customarily applies to contracts that are settled financially. The regime can thus apply to financial electricity exchanges. Sometimes the regime applies regardless of how contracts end up being settled.28

Moreover, certain derivatives must be traded on trading venues that are governed by the MiFID II/MiFIR regime. There is an obligation to trade on a regulated market, MTF, or OTF where derivatives belong to a class of derivatives that has been declared subject to the trading obligation.29 There are particular rules on trading on third country trading venues30 or with third country financial institutions.31



There are similar obligations in the US under the Commodity Exchange Act (CEA) that restricts trading in futures.32 According to the CEA, the CFTC has jurisdiction over futures contracts, that is, “contracts of sale of a commodity for future delivery”. The CEA was amended by the Commodity Futures Modernization Act of 2000 (CFMA). The enactment of the CFMA brought about a ‘three-tiered’ layering of commodities and derivatives regulation. The greatest degree of regulation takes place on the designated contract markets, where retail futures trading occurs.33 Futures must not be traded other than on boards of trade designated or registered as a contract market or derivatives transaction execution facility by the CFTC (subject to certain exemptions).34 Swaps subject to mandatory clearing must also be traded through a board of trade designated as a contract market or on a registered or exempt swap execution facility.35 However, many swap agreements are exempt transactions.36


EMIR and Mandatory Clearing

The MiFID II regime is complemented by EMIR that lays down mandatory clearing obligations for some OTC derivatives.37 Consequently, there must be clearing members and other market participants that deal through clearing members.38

In the US, futures trading is a regulated activity.39 Clearing is required for any swap which the CFTC or SEC has decided should be required to be cleared.40 The requirement was inserted into the Commodity Exchange Act by the Dodd-Frank Act.41 The Commodity Exchange Act sets out five factors to be considered by the Commission in reviewing a swap or class of swaps for mandatory clearing.42 There is a connection between mandatory clearing and the requirement that swaps subject to mandatory clearing must be traded on a designated contract market or swap execution facility.43

The distinction between clearing members and other members or clients makes it easier for electricity producers to trade. The distinction is also important for credit institutions that can play two kinds of roles in electricity derivatives markets. First, credit institutions may fulfil margin requirements and provide guarantees on behalf of market participants and act as lenders to them. Second, they can act as general clearing members responsible for the settlement of market participants’ duties. In the latter case, credit institutions assume the counterparty risk.44

This may bring benefits, because a credit institution tends to have information about its customers’ total financial position and ability to settle the transactions, and because a credit institution that acts as a general clearing member for several customers and may be able to net some of the positions in the margin payment process.

Credit institutions in the EU customarily act as general clearing members in the electricity derivatives market.45 When they do, they must comply with capital requirements for their positions. They must also comply with rules on large exposures. These rules can raise concerns for credit institutions, because some energy firms are very large and have large exposures.46

In the following, we can briefly study the regulation of the most important service providers in the light of the practices of major electricity derivatives exchanges. Similar and related issues are discussed in detail in the context of spot markets (Sect. 4.5).


4.4.2 The Operator


A financial electricity exchange has an operator that coordinates the exchange’s activities. The operator makes the rules and decides on access to trading. In the legal sense, one could distinguish between the exchange/market/system/firm, a person that actually manages it, and the business form/legal person.47 Depending on the context, the operator could thus be the exchange/market/system itself, the legal person that the exchange/market/system belongs to, or a person that actually operates the exchange/market/system.48 If the exchange needs an authorisation, the authorisation is given to the system, but both the system and the operator must comply with the requirements49 (for the scope of the MiFID II regime, see Sects. 4.8.2 and 4.9). The regulation of authorisation under MiFID II can be complex.50

An operator can operate (a) one or more markets (b) in one or more countries (c) on its own or in cooperation with another entity or entities. The most important electricity derivatives exchanges in the EU are regulated in different ways and monitored by different regulatory authorities.


Nasdaq Commodities

Nasdaq Commodities is the Nordic marketplace operated by NASDAQ OMX Oslo ASA, a Norwegian company authorised as a commodity derivatives exchange in Norway under the Norwegian Act on Exchanges.51 It is a regulated market under MiFID52 and supervised by Finanstilsynet (the Financial Supervisory Authority of Norway).53 In addition, Nasdaq Commodities is a marketplace for NASDAQ OMX UK Power Futures. The central counterparty and clearing house is NASDAQ OMX Clearing AB.54


N2EX

There is a connection between the Nordic marketplace and N2EX. N2EX used to be a joint venture. In 2010, the Futures & Options Association (FOA) chose the market operated by NASDAQ OMX Commodities Europe (now known as Nasdaq Commodities) and Nord Pool Spot as the preferred marketplace for the trading of UK electricity contracts. On 1 October 2014, Nord Pool Spot took over the physical markets of N2EX. Nasdaq Commodities continued to operate the financial markets of N2EX.

Before the takeover on 1 October 2014, the party acting as clearing house and central counterparty on N2EX was NASDAQ OMX Clearing AB (NOMX Clearing).

Formerly known as NASDAQ OMX Stockholm AB, the company was renamed in September 2013. Its exchange-related operations were moved to a separate company that assumed the name NASDAQ OMX Stockholm AB. The reason was compliance with EMIR.55 NASDAQ OMX Clearing AB is authorised in Sweden and in Norway where it is acting through its Norwegian branch NASDAQ OMX Oslo NUF.56 It was the first clearing house in Europe to submit an application for a re-authorisation of the clearing house under EMIR.57

NASDAQ OMX Clearing AB operates within the scope of an exemption from the need for UK authorisation. It applied for Recognised Overseas Clearing House (ROCH) status in the UK in 2011 when it was still known as NASDAQ OMX Stockholm AB.58 ROCH status would have given it more flexibility and regulatory certainty in the way it conducted its business related to UK. However, an EMIR authorisation is effective for the entire territory of the EU.59

On 1 October 2014, the clearing and central counterparty functions relating to the physical markets of N2EX were transferred to Nord Pool Spot AS.


The EEX Power Derivatives Market

EEX is a regulated market under MiFID and a licenced exchange under the German Exchange Act (BörsG).60 Its operating entity European Energy Exchange AG is regulated under the German Exchange Act. In 2011, Eurex Group acquired a majority stake in European Energy Exchange AG. The sole shareholder of Eurex is Deutsche Börse Group.

EEX consists of several sub-markets. A sub-market of EEX, the EEX Power Derivatives Market is the electricity derivatives market for Germany and France. The EEX Power Derivatives Market is jointly operated by European Energy Exchange AG through its subsidiary EEX Power Derivatives GmbH in Leipzig.61

The competent supervisory authority for the exchange is Sächsisches Staatsministerium für Wirtschaft und Arbeit (the Saxon Ministry for Economic Affairs and Labour) in Dresden.62 BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht, the Federal Financial Supervisory Authority) is responsible for its share of supervision under the German Securities Trading Act (WpHG). In particular, BaFin is responsible for supervising the prohibition of insider trading and market manipulation.63

The central counterparty and clearing house is European Commodity Clearing AG (ECC) in Leipzig.64 It is authorised as a central counterparty under German law.65 At the national level it is supervised by BaFin and the Bundesbank.

Eurex Clearing AG (ECAG) provides clearing services for transactions in certain markets and in certain products (co-operation products) as a central counterparty (Sub-CCP) based on a separate agreement (CCP-Sub-CCP Agreement).


ICE Futures Europe

UK electricity futures can also be traded on ICE Futures Europe in London. ICE Futures Europe is operated and owned by IntercontinentalExchange, Inc., a Delaware company (ICE).

The status of ICE Futures Europe is particularly interesting, because ICE Futures Europe has connections to many regulatory regimes. First, it is a regulated market under MiFID.66 Second, it is a Recognised Investment Exchange (RIE) and a Recognised Auction Platform (RAP) supervised by the Financial Conduct Authority (FCA) in the UK.67 Recognition as a Recognised Investment Exchange under the Financial Services and Markets Act 2000 gives an exemption from the need to be authorised to carry on a regulated activities in the UK. As an RIP, ICE is permitted to operate an auction platform for the purposes of auctioning primary emission allowances under Phase III of the EU Emissions Trading Scheme. Third, ICE is an Exempt Commercial Market (ECM) in the US.

Unlike ICE Futures Europe, ICE’s US competitor NYMEX is a Designated Contract Market (DCM) and Self-Regulatory Organization (SRO). It is therefore subject to full oversight by the Commodity Futures Trading Commission (CFTC) in the US. ICE is subject to less US regulation, in particular because it trades its energy futures overseas through ICE Futures Europe.68


ICE Endex Futures Exchange and APX-ENDEX

The roots of ICE Endex lie in APX-ENDEX. APX-ENDEX Holding B.V. was a holding company that owned operators of spot markets and derivatives markets in the Netherlands, Belgium, and the UK. It was behind APX-ENDEX Derivatives and APX Power UK.

APX-ENDEX Derivatives was the electricity derivatives market for the Netherlands and Belgium. It was a regulated market operated by APX-ENDEX Derivatives B.V., a Dutch company.69 APX-ENDEX Derivatives B.V. was supervised by the Netherlands Authority for the Financial Markets and by the Dutch Central Bank. APX Power UK was a market operated by APX Commodities Limited, a company authorised by the UK Financial Services Authority (FSA) to act as a Multilateral Trading Facility (MTF).

ICE Endex Futures Exchange was established in March 2013 after the split of APX-ENDEX into a derivatives exchange and an exchange for physical products.

It is a regulated market operated by ICE Endex Derivatives B.V., a Dutch company. The company’s majority shareholder is ICE with N.V. Nederlandse Gasunie as a minority shareholder. ICE Clear Europe Limited, a company registered in England & Wales, acts as the central counterparty and clearing house. ICE Clear Europe is a recognised clearing house under section 288 of the Financial Services and Markets Act 2000 supervised by the Bank of England.


Phase III Auction Platforms

Most emission allowances are auctioned in Phase III of the EU ETS (Sect. 7.​2). The procedure is based on the Auctioning Regulation70 that also lays down the selection procedure for auction platforms.71 There are several auction platforms. (a) There is a common auction platform.72 The Commission has appointed European Energy Exchange AG (EEX) as the first common platform. (b) However, a Member State may decide not to participate in the joint action.73 Germany, Poland, and the UK have decided to opt out of the common platform and to appoint their own auction platforms. EEX has been selected by Germany as its opt-out auction platform. The UK has appointed ICE Futures Europe as its opt-out auction platform.


4.4.3 Access to Trading



General Remarks


Electricity producers can have access to trading as members, non-members, or clients. They do not necessarily have to become exchange members that trade for their own behalf. Access to trading on a financial electricity exchange is limited in four main ways. First, there is sectoral legislation on access to trading and access to clearing. Second, there is sectoral legislation on authorisations. Third, financial electricity exchanges have their own trading rules. Fourth, there may be legal restrictions on the power of an entity to use derivative instruments.


Non-discrimination

As regards access to trading on a regulated market, the main rule is non-discrimination. Markets governed by the MiFID II regime must have “transparent and non-discriminatory rules, based on objective criteria, governing access to or membership of the regulated market”.74


Direct and Indirect Access

Member States must also ensure that the rules on access to or membership of the regulated market provide for the “direct or remote participation of investment firms and credit institutions”.75 The rules on access to the regulated market are complemented by rules on “direct and indirect access to CCP, clearing and settlement systems”.76

Access can thus be direct or indirect. (a) Financial electricity exchanges distinguish between exchange members (clearing members or non-clearing members) that have direct access to trading and non-members that may not trade directly. Exchange members must comply with margin and collateral requirements and accept netting (Sect. 4.4.5). (b) On the other hand, non-members may be able to trade indirectly, that is, bilaterally with exchange members. While clearing members are contract parties of the central counterparty, a non-member or a non-clearing member has a clearing member as its own contract party. The same margining, clearing, settlement, and netting requirements apply either directly or indirectly.


Entities

There are some restrictions on who may be admitted as member or participant. Regulated markets and MTFs are subject to similar requirements.77 They may admit as members or participants “persons who: (a) are of sufficient good repute; (b) have a sufficient level of trading ability, competence and experience; (c) have, where applicable, adequate organisational arrangements; (d) have sufficient resources for the role they are to perform, taking into account the different financial arrangements that the regulated market [or MTF] may have established in order to guarantee the adequate settlement of transactions”.78


Authorisation

Some market participants that trade in derivatives need an authorisation under the MiFID II regime (Sect. 4.10). There is thus a difference between access to financial electricity markets and access to electricity spot markets. Access to electricity spot markets does not depend on whether or not the firm has an authorisation under the MiFID II regime.

However, exemptions from the authorisation requirements play an important role in commodities derivatives markets. There is no requirement to apply to any regulatory authority for an exemption under the MiFID II regime (or EMIR). Their scope has been reduced.

There are stricter authorisation requirements in Switzerland. According to Swiss law, only securities traders (Effektenhändler) may have access to an exchange. These securities traders are authorised and monitored by FINMA. A Swiss company cannot trade on financial electricity exchanges in the EU without having obtained a Swiss authorisation as a securities trader (Effektenhändler). There is no difference between financial and physical settlement. The financial electricity exchanges that permit remote access to Swiss market participants are regarded as foreign exchanges that need an authorisation under Swiss law.79

There are registrations requirements in the US under the Commodity Exchange Act (7 USC Chapter 1).80 It is unlawful for any person to act as a swap/SBS dealer (swap/“security-based swap” dealer), a futures commission merchant, or an MSP/MSBSP (“major swap participant”/“major security-based swap participant”) unless registered as one.81 There are nevertheless exemptions from the registration requirement. For instance, certain financing affiliates of commercial end-users may be excluded from the definition of MSPs.82

Where an entity needs an authorisation under the MiFID II regime, the entity must also comply with prudential requirements. They consist of capital adequacy requirements and large exposure restrictions (Sect. 4.10), including rules on the protection of client assets. The MiFID II regime is complemented by EMIR that imposes prudential requirements on central counterparties. Moreover, where an entity subject to EMIR enters into an uncleared OTC derivative contract, the entity is required to ensure that appropriate risk mitigation arrangements are in place, including “accurate and appropriate exchange of collateral”.

In the US, swap/SBS dealers and MSPs/MSBSPs are subject to prudential requirements set by the CFTC/SEC (or, if applicable, the relevant prudential regulator related to capital, margin, and other prudential requirements). Dealers and MSPs/MSBSPs are also subject to rules related to segregation and risk management.83


Transactions

There can be restrictions on the entity’s power to enter into derivative contracts. While some restrictions are more closely related to the person or entity using derivatives, others are more closely related to the instruments. Both types of restrictions can be general or sector-specific.

Some restrictions apply to certain types of entities only. For example, the capacity and power of a limited-liability company to enter into transactions is limited,84 and insurance firms must comply with investment restrictions.85

There are also restrictions that are more closely related to the instruments. For instance, the prohibition of market manipulation applies to certain instruments (Sect. 4.7).

One might also ask whether the Regulation on short selling, which restricts uncovered short sales in shares and in sovereign debt86 and lays down transparency obligations,87 applies to the short selling of commodity derivatives.88 The better alternative would seem to be no.89 Commodity derivatives fall within the scope of MiFIR rather than the Regulation on short selling.90 MiFIR confers intervention powers on the ESMA and Member States’ competent authorities.91

In the US, there are more restrictions on how certain entities may enter into derivatives contracts. The Commodity Exchange Act provides that a market participant must be an “eligible contract participant”92 unless the transaction is entered into on, or subject to the rules of, a contract market or a SBS transaction effected on a registered national securities exchange.


Exchange Members and Non-members



Exchange Members

Exchange members may trade on the exchange in various ways depending on the exchange. On one hand, a member can trade directly or through a clearing member. On the other, a member can trade in its own name for its own account, for the account of other members, or for the account of a third party.

Exchange members include electricity producers, distributors, utilities, large consumers (often in energy-intensive industries), brokers, financial institutions, investment firms, funds, and banks that have been accepted as exchange members. Many of them are thus regulated investment firms that must comply with the MiFID II regime. In contrast, it would be unusual for a firm active in the physical supply of energy to be a regulated investment firm.93

Physical and financial electricity markets share some market participants, but it is a rule of thumb that an electricity producer cannot have trading in financial markets as its core activity. The reasons are both commercial and legal. The Enron case is an example of the commercial reasons.94


Clearing Members

A clearing member is the contract party for both the CCP and non-clearing members. In other words, clearing members are members that assume responsibility for ensuring the performance of contracts entered into by other market participants and the responsibility for discharging the financial obligations arising from that participation.95 While the CCP’s exposure to counterparty risk is limited to clearing members, clearing members are exposed to counterparty risk in their dealings with non-clearing members and non-members. Consequently, clearing members bear much of the counterparty risk.96

Clearing members need an authorisation as regulated investment firms. Clearing firms are investment firms, because (a) clearing members provide investment services relating to financial instruments97 and (b) the wording of MiFID II, MiFIR, and EMIR distinguishes between clearing members (that are investment firms) and their clients (that may or may not be investment firms).98 Many of the duties of clearing members have been set out in a Commission Delegated Regulation supplementing EMIR.99

To obtain an authorisation, clearing members must fulfil the MiFID II requirements (Sect. 4.8). For instance, the main rule is that an investment firm must be incorporated in a Member State of the EU, a Member State of the EES, or Switzerland.100

Clearing members have an obligation to make margin payments to the central counterparty and even other contributions (Sect. 4.4.5). Daily margin calls are the norm. In the EU, it is a legal requirement under EMIR that applies to organised OTC trading and imposes prudential requirements on central counterparties. The prudential requirements include exposure management, margins, a default fund, and even other funds such as a clearing fund.101 In OTC markets, a central counterparty collects margins on an intraday basis.102

Clearing members not only make margin payments. To reduce their own capital needs and risk exposure, clearing members collect similar payments from their clients.


Market-Makers

Market-makers are an alternative way to match bids in financial electricity markets. A market-maker is a party that has a duty to supply bid and ask quotes and to enter into transactions on such a basis.

This can be illustrated with EEX. The exchange rules of EEX facilitate the business of market-makers.103 The Board of Management of EEX may decide that market-making will be used for the trading of certain products. An exchange participant may then apply for admission as a market-maker for one or several products. The market-maker assumes the obligation to simultaneously enter limited bid and ask orders (quotes) into the EEX trading system at any time during trading hours and to do business based on such quotes.104


Non-clearing Members

While clearing members are investment firms on financial electricity exchanges, exchange members that deal through clearing members are regarded as clients.105 Clients are not investment firms under the MiFID II in their capacity as clients.106

In the past, exchange members could trade for the account of other members without being regarded as investment firms, provided that a clearing member was responsible for ensuring the performance of the contract as a contract party or by means of a guarantee.107

Exchange members can still benefit from related exemptions under MiFID II. However, there is no general exemption for dealing on own account in commodity derivatives when executing client orders.108 The exemptions are limited to the following services or entities:



  • Intra-group investment services. MiFID II does not apply to “persons providing investment services exclusively for their parent undertakings, for their subsidiaries or for other subsidiaries of their parent undertakings”.109


  • Local energy utilities. Depending on the Member State, there is an optional exemption for entities that only hedge the commercial risks of local electricity undertakings (or natural gas undertakings) and are exclusively (100 %) owned or controlled by them.110


  • Operators of industrial installations. Depending on the Member State, there is a related optional exemption for the benefit of entities owned by operators of industrial installations. This exemption is limited to entities that “provide investment services exclusively in emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients”.111


  • No client funds. There is an optional exemption, under very limited circumstances, for persons who “are not allowed to hold client funds or client securities and which for that reason are not allowed at any time to place themselves in debit with their clients”.112


Non-members

A non-member may not trade on the exchange in its own name. It may enter into contracts in other ways. (a) It may deal as a client through a clearing member. (b) An alternative contract structure is that the client deals through an intermediary broker. Whether the broker is regarded as an investment firm under MiFID II depends on its activities.113

This can be illustrated with Exchange-for-Physical (EFP) transactions. (a) An EFP means the swapping of an OTC derivative for an exchange-traded derivative. It is thus a combination of an OTC transaction and an exchange transaction. (b) First, the parties decide to enter into an OTC transaction for a futures position. They negotiate either directly or through a broker. (c) Second, the parties negotiate with exchange members. An exchange transaction can only be registered by an exchange member. An EFP transaction cannot take place unless the OTC transaction and the exchange traded derivatives are substantially similar. (d) Third, the result of the EFP transaction is that the OTC position is transferred from the OTC market to the futures market. (e) The same mechanism can be used to transfer a futures position to the OTC market.114


4.4.4 The Central Counterparty, Clearing and Settlement



General Remarks


The organisation of a financial electricity exchange consists of various service providers in addition to the operator that holds the licence and exchange members that participate in trading. There is a party that acts as a central counterparty, a party that provides clearing services, and a party that provides settlement services.

Trades must be cleared and settled. If trades between market participants were bilateral and transactions were settled directly between the parties, transaction costs and exposure to counterparty risk would be increased and liquidity reduced. To reduce counterparty risk and increase liquidity when contracts are traded on an exchange, it is customary to use a central counterparty (an entity that becomes the buyer to every seller and the seller to every buyer) and clear transactions through a clearing house.115 A trade repository can be used to centrally collect and maintain the records of derivatives.116

Centralised services can be used even in OTC markets (and in some cases must be used according to EMIR). On the other hand, the use of a central counterparty and centralised clearing can be more capital intensive for market participants if they are required to post significant amounts of initial and variation margins.117

The clearing houses of EEX, Nasdaq Commodities, and ICE Endex (ECC AG, NASDAQ OMX Clearing AB, and ICE Clear Europe Limited) provide clearing for exchange-traded standardised contracts, including standardised contracts traded in the over-the-counter (OTC) market. They can thus work as interfaces for the clearing of OTC transactions.118


Clearing and Settlement

Clearing and settlement basically mean different things. While clearing means the calculation of positions, settlement means the discharging of obligations. In practice, the terms clearing and settlement are often used to describe overlapping functions.

EMIR defines clearing as “the process of establishing settlement positions, including the calculation of net positions, and the process of checking that financial instruments, cash or both are available to secure the exposures arising from a transaction”. The central counterparty is responsible for the operation of the clearing system.119

According to the Auctioning Regulation, the term clearing can mean various processes before settlement, and it can include margining, netting, novation, or other services. The term “settlement system” means an infrastructure that can provide settlement services, which may include clearing, netting, management of collateral, or other services.120

The ECC Clearing Conditions define the term clearing as “financial and physical settlement of transactions as well as collateralisation of transactions”.121

The NASDAQ OMX definition of settlement focuses on the fulfilment of obligations. Clearing is a broad concept that includes even settlement.122


Unbundling of Services

These centralised functions do not necessarily have to be in the hands of one and the same party, that is, the operator of the market. While the operator coordinates activities on the exchange, many activities can be allocated to other parties.

There is a commercial trend towards unbundling driven by the benefits of specialisation, economies of scale, and management of systemic risk. According to the voluntary European Code of Conduct for Clearing and Settlement, the services of trading venues, central counterparties, and central securities depositories should be unbundled from each other, and central securities depositories should unbundle various services such as: account provision; clearing and settlement; and collateral management.123

The regulatory trend is to make the use of a central counterparty and clearing mandatory for more market participants. EMIR makes the central counterparty responsible for the operation of the clearing system.124 Some central counterparties thus act as clearing houses.

Clearing is mandatory under EMIR125 that applies to OTC derivative contracts, central counterparties, and clearing members. In the US, the main rule under the Commodity Exchange Act is that commodity derivatives are traded on an “organized exchange”.126 An “eligible contract participant”127 has more discretion in the US.


The Contractual Relationships

As activities can be unbundled and allocated to different parties, it is possible to distinguish between different contractual relationships such as: the exchange membership (which is necessary for market access); the trading relationship (the contractual relationship between buyer and seller or the trader and the central counterparty); the clearing relationship (the contractual relationship between a party to a trade and the party that is responsible for the process of establishing positions and ensuring that financial instruments, cash, or both, are available to secure the exposures arising from those positions)128; the settlement relationship (the relationship between a party to a trade and the party that organises the payment of sums due by market participants); and the custodian and settlement bank relationship (assets that belong to market participants are kept safe by a custodian bank).

Nasdaq Commodities is operated by NASDAQ OMX Oslo ASA. There is an exchange membership contract between the operator and the member.129 NASDAQ OMX Stockholm AB is used as the central counterparty, clearing house and settlement provider. NASDAQ OMX Clearing AB is a Swedish company acting through its Norwegian branch NASDAQ OMX Oslo NUF. Clearing and settlement are facilitated by a large number of contracts.130

In the EEX Power Derivatives Market, the operating entity is European Energy Exchange AG. European Commodity Clearing AG (ECC) acts as the central counterparty and provides clearing and settlement services.


Governing Law

The contractual framework can be governed by the laws of different countries depending on the relationship.

The exchange operator and clearing house will choose the governing law in their rules. They are likely to prefer the law of their own country. However, because physical settlement is to a large extent regulated by the TSO, it is feasible to agree that physical settlement is governed by the laws of the country to which physical delivery is more closely connected.

Norwegian law is the law that governs transactions and clearing in the Nordic market.131 On Elspot and Elbas, matters relating to the physical delivery of electricity are governed by “the local law of the delivery country”.132

German law governs clearing by ECC.133 On EPEX Spot, “the execution of the physical settlement of transactions” is governed by “the material law of the place at which physical fulfilment is actually provided and/or, in the case of grid-bound products, the material law applicable to the transmission system operator or the hub operator within whose transmission system delivery is effected”.134 EEX has its closest connection to Germany.135


Clearing


Trades are cleared by the clearing house. The central counterparty customarily acts as the clearing house in organised markets.136 Sometimes it is not the clearing house. For instance, there may be two or more counterparties, or a third party may act as the clearing house.

In the EEX Power Derivatives Market, ECC AG acts as the central counterparty and the party responsible for clearing and settlement.137 Spot transactions are concluded even with ECC Lux. PXE spot transactions are concluded with EnCC.138

In practice, only some market participants get access to clearing by the central counterparty/clearing house. Marketplaces customarily distinguish between clearing members and other members, and between direct clearing and indirect clearing.

The trades of clearing members are cleared by the central counterparty. Other members or third parties may trade through clearing members. Direct clearing means that a client deals through a clearing member. When indirect clearing is used, the client deals through an intermediary broker, that is, a broker that is not a clearing member. The intermediary broker passes the client’s trade onto the clearing member for clearing.

The intermediary broker can do this in two main ways. It can act as agent on behalf of the client (non-member broker model). Alternatively, it can act on its own behalf, in which case there is a chain of contracts from the original client to the central counterparty (CCP–CM; CM–client 1/intermediary broker; client 1/intermediary broker–client 2).

In the EEX Power Derivatives Market, there are two or three types of membership representing two levels of access. (a) Clearing members hold either a general clearing license or a direct clearing license based on the contractual framework. They are thus General Clearing Members or Direct Clearing Members. (b) Non-clearing members are trading participants.

Nasdaq Commodities distinguishes even between market participants that are members and market participants that are not members. (a) A clearing member is an entity that has been approved by the clearing house for clearing of principal transactions. A non-clearing member just has direct access to exchange trading. A general clearing member is an entity that has been approved by the clearing house for clearing of principal transactions and client transactions on behalf of non-clearing members. (b) In addition, there are clients representatives and clearing clients. A clearing client is not a member of the exchange. A clearing client trades through a client representative. The trades are registered in a clearing account where the clearing client is account holder. A client representative is a clearing member that represents a clearing client in respect of clearing.


Reason for the Existence of Members and Clearing Members

The existence of two or more member classes can be explained by commercial and regulatory reasons.

The commercial reasons relate to various forms of transaction costs (operational costs, legal costs, costs for the management of risk and information) and the liquidity of the market.



  • Operational costs: Generally, the central counterparty’s costs can be reduced where the number of members that it has to deal with directly is reduced and where functions are delegated to members.


  • Legal costs: The central counterparty’s legal costs can be reduced if the number of members who have direct access to clearing is reduced, because it is expensive to put in place the necessary contractual framework and monitor compliance.


  • Risk and information management: Information costs form a large part of transaction costs. A party responsible for a relatively small group may be able to assess the quality of members better compared with a central counterparty that is less proximate to them.


  • Liquidity and marketing: There can be more trading and more liquidity if some of the members (clearing members) are given an incentive to attract new members (non-clearing members).

There are also regulatory reasons. In regulated markets, MiFID II provides for indirect or remote membership or participation,139 including direct or indirect access to CCP, clearing, and settlement systems.140 In OTC markets, EMIR provides that market participants that are subject to a clearing obligation should be able to become a central counterparty’s clearing members or access central counterparties as clients or indirect clients.141 The duties of providers of indirect clearing services have been set out in a Commission Delegated Regulation.142 Only authorised credit institutions or investment firms that are clients of a clearing member may provide indirect clearing services,143 and a clearing member that offers to facilitate indirect clearing services must do so “on reasonable commercial terms”.144


Settlement


Payment and delivery obligations are discharged when trades are settled.145 They can be settled either by the parties themselves, which is possible in bilateral trading, or in an organised way after clearing, which is the rule in organised markets. An organised settlement system146 is used for reducing transaction costs and counterparty risk.

In practice, the party responsible for settlement can be the clearing house or a third party. Where settlement is both daily and automatic, it is feasible to allocate both functions to the same party.

Nasdaq OMX Clearing AB is the clearing house, central counterparty, and settlement provider. Acting through its branch Nasdaq OMX Oslo NUF, it has a licence from Finanstilsynet (that supervises it under the Financial Supervision Act147) to engage in clearing. The licence is limited to the clearing of derivative trades only. However, the term clearing means even settlement according to Norwegian law.148 Daily settlement is automatic and connected with clearing. Members are connected to the settlement system through several multinational settlement banks.

In the EEX Power Derivatives Market, ECC AG acts as the central counterparty and the party responsible for clearing and settlement. However, the ECC AG is not necessarily the only counterparty for traders. Non-clearing members trade through clearing members.149


4.4.5 Margining, Daily Settlement and Netting


In addition to the general use of a clearing system and a settlement system, counterparty and systemic risk can be reduced by: the use of margin payments; the choice between the settlement of trades at the expiry of the contract or daily; and the use of netting.150 Apart from margining, these and other modalities of clearing and settlement are largely unregulated at Community level. There is a voluntary European Code of Conduct151 containing very general recommendations (in addition to the EFET Code of Conduct for EFET’s own members).


Margining

Margining means the organised process by which collateral is furnished by market participants to cover financial positions. In the EU, margining is a legal requirement under EMIR152 and the Auctioning Regulation.153

Margining is used both for exchange and for OTC trades. Margins are customarily required even in bilateral OTC trade. In exchange trade, the required collateral is posted directly with the clearing house. If a margin is posted in bilateral OTC trade, it can either be posted with the counterparty directly (which is customary) or through a clearing house.154

The amount of the required margins increases with higher price volatility. An increase in the volatility of spot market prices increases the amount of required margins in the derivatives market more.155

In principle, there can be cash collateral and non-cash collateral. (a) There is a distinction between highly liquid collateral and bank guarantees. According to EMIR, a central counterparty may only accept “highly liquid collateral with minimal credit and market risk”. For non-financial counterparties, it may accept bank guarantees that are demand guarantees. Where “appropriate and sufficiently prudent”, it may accept the underlying of the derivative contract.156 (b) A Commission Delegated Regulation specifies the applicable standards.157 Cash, financial instruments, bank guarantees, and gold are regarded as “highly liquid collateral”.158 Collateral must usually be marked-to-market “on a near to real time basis”.159 There must be “prudent haircuts”.160 Moreover, collateral must remain “sufficiently diversified to allow its liquidation within a defined holding period without a significant market impact”. There are thus concentration limits.161

Commission Delegated Regulation 153/2013 limits the use of financial instruments as highly liquid collateral. Only certain kinds of financial instruments, transferable securities and money market instruments are considered as highly liquid collateral according to Annex I.

Moreover, Annex I limits the use of bank guarantees as collateral. A commercial bank guarantee is not accepted unless it fulfils the following and other conditions: (1) it is a demand guarantee; (2) it is issued to guarantee a non-financial clearing member; (3) it is irrevocable and unconditional; and (4) the CCP can demonstrate to the competent authority that the issuer has low credit risk; (5) it is not issued by an entity that is part of the same group as the non-financial clearing member covered by the guarantee; and (6) it is “fully backed by collateral” that meets further conditions.

The wording of Annex I is problematic. Asking non-financial counterparties such as electricity producers, suppliers, and end consumers to pay for demand guarantees and back them fully by collateral has effects that are contrary to the stated purposes of EMIR.162

The effect of the rule that bank guarantees must be “fully backed by collateral” is that it becomes more difficult for electricity producers to use derivatives that are subject to the mandatory clearing obligation. Obviously, the collateral will need to be provided by the bank’s customer which in most cases is an electricity producer, a supplier, or a large end consumer. This increases costs without reducing systemic risk. It cannot be assumed that both the issuer of the guarantee (a bank) and the customer (a participant active in electricity generation, supply, or consumption) would default at the same time, and the obligations of non-financial counterparties customarily are backed by non-financial and other assets. Because it is very important for electricity producers, suppliers, and end consumers to use derivatives for hedging purposes, the rule that guarantees must be “fully backed by collateral” in a qualified way gives an incentive to use derivatives that are not subject to the clearing obligation. Consequently, transaction costs could be increased, transparency and liquidity reduced, and risks increased. The Delegated Regulation provides for a transitional period of 3 years ending in March 2016163 because of other unwanted effects.164 However, the main problem remains. From the perspective of all market participants, it would have been better to make the transitional exemption permanent.


Daily Settlement

Counterparty risk is reduced if the settlement period is short. While there have been differences between markets in the past,165 it is customary to use daily settlement of positions in financial electricity markets.

Nasdaq Commodities uses Daily Market Settlement and Expiry Market Settlement. In both cases, trades are settled on each bank day in cash. Only the net sum of the payable amounts will be paid to the clearing house.166 Daily settlement is used also in the EEX Power Derivatives Market.


Netting

Gross settlement would require more capital than the netting of payments. Netting belongs to the customary ways to reduce capital needs and manage counterparty risk.167

Netting should be facilitated by a contractual framework to make it enforceable and binding. It is customary to use the ISDA Master Agreement or a similar legal framework (Sect. 11.​6). Legal risks relating to clearing and settlement are reduced in the EU by the Settlement Finality Directive168 and the Collateral Directive.169


4.5 The Organisation of Spot Exchanges in the EU



4.5.1 General Remarks


The organisation of spot exchanges must facilitate both financial and physical electricity flows. Spot exchanges are thus more complex compared with financial electricity exchanges.

On one hand, spot exchange operators may have more legal discretion. This is because spot markets and other physical markets for the physical supply of electricity do not fall within the scope of the MiFID regime.

On the other, they must consider physical constraints. Access to trading must be limited to market participants that have access to the grid and transmission capacity. Matching bids must necessarily relate to electricity flows in the same grid and at the same grid level.170

A spot exchange has a day-ahead market and an intraday market. The products traded on day-ahead markets are hourly power contracts for physical delivery in the next day’s 24-h period. Day-ahead markets are complemented by an intraday market and a balance adjustment market. We will focus on day-ahead markets in this section. Intraday and balance adjustment markets are discussed in Sect. 4.10.


Electricity Pool, Auction Mechanism, Physical Matching

A spot market needs an electricity pool, an auction mechanism, and physical matching.

Bids are matched by the operator of the exchange or the clearing house. There are bids to supply and bids to purchase electrical energy. For every hourly (or sometimes half-hourly) period of the following day, bids to supply are ranked in ascending order of price. Offers to purchase are ranked in descending order of price. The point where supply and demand intersects is the system (marginal) price for the entire geographic region covered by the electricity pool.

Physical real-time matching of supply and demand is done by the system operator that has to monitor the frequency of the power system and call up a producer (a balance provider) to increase or decrease electricity generation to keep the frequency within narrow bounds.


EPEX Spot

The two most important Northern European spot markets are Nord Pool Spot (the Nordic and Baltic area and the UK) and EPEX Spot (Western Central Europe).

EPEX Spot is defined as “a fully electronic exchange offering spot trading in power by closed auction and continuous trading with expiries day ahead and intra-day for the market areas Austria, France, Germany, and Switzerland”.171 One or more market segments are associated with each market area.


Nord Pool Spot

Nord Pool Spot is the largest power market in Europe.172 It is the physical wholesale marketplace for Denmark, Norway, Sweden, Finland, Estonia (since 2010), Lithuania (since 2011), and Latvia (since June 2013).173 Because of market integration, there are no separate national wholesale electricity markets in this region. In 2013, the share of electricity traded on Nord Pool Spot was 84 % of the region’s consumption (up from 76 % in 2011).174

Because of grid bottlenecks, the Nordic and Baltic area is divided into a number of bidding areas. For each country, the local TSO decides which bidding areas the country is divided into. The Nordic market used to be split into six price areas: Finland, Sweden, West Denmark (Jutland), East Denmark (Zealand), South Norway (Oslo), and North Norway (Tromsø). In 2010, Norway was split into five price areas. Sweden was split into four price areas in 2011. Each of Estonia, Latvia, and Lithuania is a price area.175

Nord Pool Spot has provided a model for the organisation of other sport markets in the EU176 and it has activities even outside its core geographical area. Nord Pool Spot consists of Elspot, Elbas, and N2EX. N2EX is the physical market for the UK. The Elbas market covers even Germany.


Elspot

Elspot is the common Nordic and Baltic market for trading physical electricity contracts with next-day supply. On Elspot, hourly power contracts are traded daily for physical delivery in the next day’s 24-h period.


Elbas

Elbas is a physical balance adjustment market for the Nordic and Baltic region including Germany.

Both the Elspot and Elbas market used to include even the KONTEK area in Germany. The German bidding area KONTEK in Nord Pool Spot’s Elspot market was closed down in November 2009 because of the launch of the EMCC market coupling between Denmark and Germany. However, the Elbas market covers Germany as well.

In June 2010, APX-ENDEX, Belpex and Nord Pool Spot agreed to create a cross-border intraday electricity market based on Nord Pool Spot’s Elbas technology.

An improved version of the Elbas trading system was launched on 25 November 2014. The launch of Elbas 4 that replaced Elbas 3.2 (the previous intraday trading system) enabled trade across multiple markets. The transition was identical in all ten countries using Elbas: the Nordic countries, the Baltic countries, Germany, the Netherlands, and Belgium. Elbas 4 improved trading opportunities in all ten countries but even more in Germany.177

In May 2014, the power exchanges APX, Belpex, EPEX SPOT, Nord Pool Spot, and OMIE (including sixteen TSOs) agreed on the core building blocks of the future European Cross Border Intraday Solution. The future Intraday Solution will enable continuous cross-border trading across the whole of Europe with intraday adjustments to trades concluded in the day-ahead market.178

On Elbas, the trading hours are the coming 10–38 h. For the Nordic and Baltic areas, contracts are opened for trading the same day as the Elspot prices are set, normally at 14:00 CET. Trading is closed 1 h before delivery commences.

The German market is different. Before the launch of Elbas 4, trading was open from 08:00 until 13:45 CET and from 15:00 until 30 min before the commencement of delivery.179 With Elbas 4 both 15-min and 30-min products were introduced initially only for trading in the German market area. To further improve trading opportunities within Germany, Germany is handled as four bidding areas. The four bidding areas are identical to the four TSO areas 50HZ, TTG, AMP and TBW.180


N2EX

N2EX commenced its operations in 2010 after NASDAQ OMX Commodities and Nord Pool Spot had been selected by The Futures & Options Association (FOA) to provide market and clearing services for the UK wholesale power market. Since October 2014, N2EX is Nord Pool Spot’s physical power market in the UK.


4.5.2 The Operator


A spot exchange must have an operator that coordinates its activities. A spot exchange can be operated by various kinds of entities.

Whether the operator requires an authorisation depends on the applicable national regulatory framework. A spot exchange operator does not need a MiFID II authorisation in this capacity, because the operation of a spot exchange is not an investment service and the operator of a spot exchange is not regarded as an investment firm under MiFID II.181

In any case, it is not necessary for the operator of a spot exchange to be an entity incorporated in the country in which the physical flows are located. Such a requirement (a) would not be feasible in the technical sense, because the location of physical flows depends on the actual use of the grid and the use of interconnectors, and (b) would not be permitted, because the freedom of establishment, the freedom to provide services, and the prohibition of discrimination based on nationality enable EU firms to operate electricity spot markets in any Member State.

EPEX Spot is operated by EPEX Spot SE, a European company incorporated in France.182 There is no authorisation requirement for the operation of electricity spot markets in France.183 EPEX Spot SE used to be a 50/50 joint-venture of European Energy Exchange AG (Germany) and Powernext SA (France).184 On 1 January 2015, EEX sold part of its shares to the holding HGRT of European Transmission System Operators Elia (Belgium), RTE (France) and Tennet (Netherlands). In exchange, EEX Group got the 53 % stake of HGRT in Powernext. After these transactions, EEX is indirectly the majority shareholder of EPEX Spot. EEX holds 13.3 % of the shares directly. It is the majority shareholder in Powernext that holds 50 %. The remaining 36.7 % share in EPEX SPOT belongs to the holding HGRT.

Nord Pool Spot consists of Nord Pool Spot AS, a limited-liability company incorporated in Norway, and of its subsidiaries. Its shareholders are the Nordic transmission system operators (Statnett SF, Svenska Kraftnät, Fingrid Oyj, and Energinet.dk) and the Baltic transmission system operators (Elering, Litgrid, and Augstsprieguma tikls (AST)).

The physical markets of Nord Pool Spot are operated by Nord Pool Spot AS. Nord Pool Spot AS has two licences because of national regulatory requirements in its home country. First, it has a licence for the organisation of a marketplace under the Norwegian Energy Act.185 The competent regulatory authority is the Norwegian Water Resources and Energy Directorate (NVE). Second, the Norwegian Ministry of Petroleum and Energy (OED) allows Nord Pool Spot AS to organise the physical exchange of power with neighbouring countries.186 Even the physical market of N2EX is operated by Nord Pool Spot AS.187 The competent authority is again NVE.188


4.5.3 Access to Trading


An electricity producer needs access to the spot exchange to trade. Market participants’ access to the spot exchange is regulated in several ways. There are (1) rules on the admission of market participants, (2) rules on the representation of market participants acting on their own behalf (such as rules on internal trading responsibles authorised to act as the market participant),189 and (3) rules on the representation of market participants by a third party (such as rules on external client representatives authorised to act on behalf of the market participant).190

The parties that participate in the organisation and operation of electricity spot exchanges—exchange operators, clearing houses, and central counterparties—customarily organise financial electricity exchanges as well. Consequently, access to electricity spot markets is basically regulated in the same way as access to financial electricity exchanges. However, there are differences caused by the physical settlement of transactions.


Physical Settlement

A condition for the approval of a trading participant is that the applicant can participate in the physical settlement of transactions. The exchange operator and the clearing house require evidence of the applicant’s capability for physical settlement. The TSO’s contractual framework therefore has to be in place for the applicant.

Participants in the N2EX physical market must be parties to the BSC and fulfil all applicable criteria for being ECV Transferees under the Clearing Rules, the ECV Transferee Agreement, and the BSC.191

Participants in the other physical markets of Nord Pool Spot must have in place all necessary agreements to enable them to trade in the physical markets and to perform their obligations192, and they must have entered into an agreement on balance responsibility with the relevant balance responsible party or the TSO.193

Participants in trading on EPEX Spot must also have secured the orderly settlement of transactions.194 According to the EPEX Spot Exchange Rules, the approval of an applicant as a trading participant requires the necessary declarations and evidence of the capability for physical settlement of transactions. The Exchange Rules focus more on financial settlement (in addition to technical facilities and personnel).195

This does not exclude the use of middlemen such as trading agents that act on behalf of one or more admitted participants.196

On EEX, Approved Trading Agents are entitled to effect the conclusion of transactions on behalf and for the account of trading participants. These Trading Agents do not have to be trading participants themselves.197


Clearing

In addition to financial and physical settlement, the applicant must be able to participate in clearing. The applicant firm may do it directly (by being the central counterparty’s counterparty in clearing transactions) or indirectly (by being a clearing member’s client). The firm is not eligible as an exchange member unless it is eligible as a counterparty in clearing transactions under the applicable clearing rules.

On Elspot and Elbas, a member must fulfil the following conditions to be eligible as a counterparty to clearing transactions. It must: “a. have appointed a clearing responsible; b. have established one or more Trading Portfolio(s); c. have established one or more Cash Account(s) for settlement purposes to be either a Pledged or Non-pledged Cash Account; d. have established one or more Clearing Account(s); e. have established Collateral as a Pledged Cash Account or a On-Demand Guarantee, and have met its Collateral Call; and f. not have its access to Clearing suspended or terminated in accordance with the Trading Rules”.198 The member must at all times be able to document that it fulfils the criteria.199

On EPEX Spot, exchange members must take part in clearing on ECC. A clearing member must have concluded a Clearing Agreement with European Commodity Clearing AG, and a non-clearing member with a clearing member.200


Listing and Delisting

In addition to rules on access to trading, the exchange operator adopts rules on the listing and delisting of contracts and decides on the admission of contracts to trading.

Nord Pool Spot AS (NPS) decides which instrument series will be listed on Elspot. NPS also decides on the removal (delisting) of a listed instrument series.201

In the physical market of N2EX, NPS decides which products will be listed and on their removal (delisting). However, delisting may not be effected for physical products which have an open Interest with the clearing house other than zero (0).202

In the EPEX Spot market, EPEX Spot SE decides on admission to trading, suspension, and delisting.203 Suspension and delisting are possible for an important reason, such as where orderly exchange trading is jeopardized.204 In both cases, the decision requires approval by the Exchange Council of EPEX Spot SE.205


4.5.4 The Matching of Bids


Somebody must match the bids in physical electricity markets. It would technically be possible to allocate this task either to the operator of the spot exchange or to another party.206

The operator of the spot exchange matches the bids in the three markets studied here. Bids on EPEX Spot are matched by EPEX Spot SE.207 Nord Pool Spot AS matches the bids in the physical market of N2EX208 (where its function was limited to that of the exchange operator until 1 October 2014) and in the Elspot market of Nord Pool Spot209 (where it also acts as the clearing house and central counterparty).

Depending on the rules of the exchange, there can be even market-makers. Market-makers would need to be approved by the operator. In a market-maker agreement, the operator and the market-maker would agree on the period of day during which the market-maker is required to quote orders, the minimum volume to be quoted, and the maximum quotable net difference between bids and offers.

On Nord Pool Spot, the rights and obligations of market-makers are set out in the individual market-maker agreement. The operator and the market-maker agree on the Market Maker Hours, the Market Maker Volume, and the Market Maker Spread.210

Bids are not necessarily matched in the same way as in securities markets. In securities markets, bids are matched when the submitted prices are equal, and different trades can be settled at different prices. There is more variation in electricity spot markets. Different trades can be settled at different prices in continuous trading. They can be matched by auction and a system price or area price211 may be used for different trades. Bids can be matched to ensure the maximisation of economic surplus.212 The merit order principle can be used for the ranking of bids. The matching of bids is also subject to transmission capacity constraints.


Continuous Trading

Different trades are settled at different prices when bids on the spot exchange are matched continuously like in securities markets.

N2EX. The N2EX Prompt Market (with delivery taking place up to 7 days ahead)213 and the N2EX Spot Market (with delivery normally taking place within the next 48 h period)214 are markets for continuous trading. Transactions are matched automatically when concurring orders are registered in the market operator’s system for electronic trading (ETS). Transactions resulting from orders being matched in the ETS are automatically and mandatory registered for clearing. The Auction Market is not a market for continuous trading.215

Elbas. Elbas is a market for continuous trading. Trading takes place every day around the clock until one hour before delivery. Concurring orders—the highest buy price and the lowers sell price are matched on a first-come, first-served basis.

EPEX Spot. Transactions on EPEX Spot are effected by matching bids either continuously (meaning that bids are entered into the order book for immediate execution) or by auction (meaning that there is an accumulation period during which bids are entered in the order book but not executed).216 Continuous trading is used in intraday markets (in addition to intraday auctions for the German market area).217 During the trading session, orders are then executed “at the best price available in the system”: the best orders in the order book are matched automatically with same-priced orders entered in the order book.218


Auction

The opposite of continuous trading is the matching of bids by auction. In this case, bids are accumulated in the order book during an accumulation period. Different bids are then matched at the same price.219


Single Contract Orders, Block Orders and Other Qualified Orders

There can be various kinds of orders (bids) in auctions depending on the trading rules of the exchange. Orders can thus be qualified.

First, one can distinguish between single contract orders and block orders. The basic form is the single contract order that is limited to electricity supply during a certain hour. Block orders are aggregate bids for several hours, with a fixed price and volume throughout these hours.

For instance, a block of consecutive hours might allow an electricity producer to spread out the start-up costs and also to offer lower prices. An industrial firm as the end consumer might prefer to submit a block order for the start-up of an energy-intensive production process.220

One can also distinguish between various kinds of order types based on how an order is executed.

There are various order categories in continuous trading on EPEX Spot. Buy or sell orders can be “limit orders” (that carry a price limit and can only be executed at this price or at a better price) or “market sweep orders” (that are matched with several contracts).221

Moreover, EPEX Spot allows parties to use the following execution restrictions in continuous trading: “immediate-or-cancel” (IOC, market sweep orders are restricted in this way); “fill-or-kill” (FOK); “linked fill-or-kill” (LFOK); and “all-or-none” (AON). Orders can also be entered with the following validity restrictions: “good for session”; “good till date”; and “iceberg” or hidden-quantity. There are restrictions on how these restrictions may be combined.222

On Elspot, orders are hourly orders, flexible hourly offers, block orders, or linked block orders.223 Block orders cover a minimum of three consecutive hours subject to the block order volume limit. In the Elspot market, block orders are “all-or-nothing orders” but can also be “linked blocked orders”.224

In the Elbas market, the launch of the Elbas 4 trading system in November 2014 increased the number of order types. The previous rules provided for “block orders” and “fill orders”. A block order was an “all-or-nothing order” covering one or more consecutive hours. The volume could also be limited in various ways.225 A “fill order” meant an order that may be matched for the full volume or part of the volume. Both order types are still available. The launch of Elbas 4 made it possible for Nord Pool Spot to introduce three new order types: “Immediate-or-Cancel” (that resembles “Fill-and-Kill”), “Fill-or-Kill” and “Iceberg”.226

There is some variation in the N2EX market depending on the product.227 For the Prompt Market and the Spot Market with continuous trading, the order types are “Fill”, “Fill-and-Kill” (that resembles “Immediate-or-Cancel”),228 “Fill-or-Kill”, “Stop Order”,229 and “All-or-Nothing”. For the Auction Market, the order types are “Hourly Orders”, “Flexible Orders”, “Block Orders”, and “Exclusive Groups”.230

Second, exchange rules may even provide for other types of qualified orders to increase a closer alignment of orders with market participants’ technical or commercial requirements.

It is possible to use price steps to combine prices and volumes on Elspot.231 Consequently, there can be hourly orders232 and flexible hourly offers. A flexible hourly offer is defined as an “offer in the Elspot Market specifying which volume of electricity a participant would be willing to sell at a specified price in any Delivery Hour within the relevant Delivery Day”.233

Third, exchange rules may facilitate gross bidding. When they do, a member may sell its full production volume on the exchange and purchase the full outbound sales volume on the exchange without the internal netting of volumes.

For a member, cross bidding is partly a “make or buy” question (Sect. 2.​3.​5). The member could choose to buy or sell net volumes and use internal invoicing for intra-firm transactions. If the member chooses cross bidding, the need for internal invoicing is reduced and it becomes easier for the member to benefit from the flexibilities of generation and sales.234 On the other hand, there are fees for trading.

Cross bidding can be facilitated by lower fees for amounts that net to zero. The operator of the exchange may offer lower fees for gross bidding as it increases traded volumes and contributes to the liquidity and transparency of the power market.

Nord Pool Spot used to make its gross bidding service available for members in the Participant category only. From 1 February 2015, the gross bidding service was expanded to include the Client member category.235

The Gross Bidding Agreement includes additional provisions regarding Trading in Elspot by Participants with both sales portfolios and purchase portfolios. The agreement applies only to the area of one TSO.236 The Participant undertakes to carry out gross bidding for all sales portfolios and purchase portfolios and to refrain from internal netting/matching of purchase interests in the purchase portfolio(s) with sales interest in the sales portfolio(s).237 The Participant is entitled to a reduced fee. A reduced fee is paid for the amount of purchase and sales volumes that nets to zero. Standard fees are paid for the remaining volume.238

The Gross Bidding Agreement—Clients contains similar provisions for the Client member category.239


System Price

The choice of the auction method can be combined with a system price. In the day-ahead market, bids to supply are ranked in ascending order of price for every hourly (or sometimes half-hourly) period of the following day. Offers to purchase are then ranked in descending order of price. The point where supply and demand intersects is the system (marginal) price for the entire geographic region covered by the electricity pool.

Trading on Elspot is based on a system price and area prices. There are general rules on the matching of hourly orders at the point of intersection between the aggregated offer and bid curves240 and particular rules on the procedure to be applied in the event that a point of intersection between the purchase and sales curves is not achieved.241

After market participants have submitted bids indicating the amount of power they want to buy or sell at different price levels and the gate is closed,242 Nord Pool Spot draws demand and supply curves for each hour based on the submitted prices and volumes.243 All trades are settled at the price for the point where these curves meet (the intersection point, the system price). The results are subject to final confirmation in accordance with the applicable NWE Price Coupling procedures.244

This is nevertheless just the simplified main rule. Price calculation is made more difficult by the permission to submit various kinds of orders—hourly orders, flexible hourly offers, block orders, linked block orders, and convertible block offers245—and by transmission capacity constraints. The existence of transmission capacity constraints may require market splitting and area prices (Sect. 5.​2).246 Moreover, where a point of intersection is not achieved (“non-matching”), various actions will become necessary.247

When bids on EPEX Spot are matched by auction (rather than continuously), supply and demand orders are matched after an accumulation period during which orders are entered in the order book.248 The orders sent to EPEX Spot SE by exchange members remain in the order book unless they are executed, modified, or cancelled.249 Once the order book is closed, orders may not be modified or cancelled and are irrevocable.250 The auction takes place after the order book has closed.

The price determination algorithm aims at optimising “total welfare, i.e. the Seller Surplus, the Buyer Surplus and the Congestion Rent including tariff rates on interconnectors”.251 The price determined by the algorithm at the time of auction is the price at which all trades will be executed.252 The price is the price at the intersection point of the supply and demand curves, that is, the aggregate supply and demand curves of exchange members’ single orders and block orders for each contract. The existence of conditional bids makes it a bit more complicated to determine the intersection of the supply and demand curves.253

The particular provisions on volume market coupling on the German/Austrian auction segment are no longer necessary as EMCC has been replaced by NWE price coupling.254


Merit Order

The merit order principle means two things. First, all trades are settled at the same clearing price. Second, bids are matched in the order of merit.

The merit order is the order in which generation capacity is utilised. In practice, the merit order ranking of a certain utility depends on its variable costs. Combined with competition in the electricity markets, the merit order principle could lead to the most efficient use of generation resources. Electricity with the lowest variable generation costs is used first (wind power, hydropower, nuclear power). Installations with higher variable costs are not used until required by demand.

Merit order rankings can be determined in different ways. (a) There could be a centralised way to determine them based on each utility’s variable costs. (b) Alternatively, the merit order could be determined based on the buy or sell orders submitted by rational market participants. This is the method used by Nord Pool Spot and one of the two methods used by EPEX Spot. (c) The ranking of utilities can also be manipulated by legislation.

The manipulation of merit order rankings by legislation would influence the use of generation resources and the allocation of investment in generation resources. The scope of the market that is based on the merit order principle can also be reduced by increased use of other mechanisms. The merit order principle benefits intermittent generation technologies with low (zero) variable costs. Merit order rankings could be manipulated, for instance, to increase investment in electricity produced from waste or the production of CHP. On the other hand, the scope of the market that is based on the merit order principle is partly reduced by the preferential treatment of RES-E.

Member States of the EU have a duty to ensure that TSOs and DSOs (a) guarantee the transmission and distribution of RES-E and (b) provide for its priority access or guaranteed access to the grid. What applies to RES-E applies to electricity produced from waste or the production of CHP.255 Feed-in tariffs are manipulated under EU law and Member States’ national laws.

In Germany, the biggest market in Europe, preferential treatment is facilitated by EEG 2014.256 (a) EEG 2012257 required TSOs to purchase renewable power at fixed feed-in tariffs.258 They were compensated by electricity undertakings further down the chain.259 Final consumers ended up paying the difference between market prices and the fixed feed-in tariffs.260 (b) According to EEG 2014, small installations continue to benefit from fixed feed-in tariffs (Einspeisevergütung) and do not have to sell on the market.261 Other producers of RES-E are supported by market premiums (Marktprämie) paid on top of the market price.262 The TSO still has a duty to purchase RES-E.263


Contract

The rules of the exchange can set out: at what point in time the matching of bids results in a binding contract; how long bids remain binding; whether bids are revocable264; and whether trades may be cancelled. There can also be different kinds of bids (order types) depending on the matching method (how an order is executed).


Limitation of Liability

The matching of bids in the spot market is more difficult compared with the matching of bids in securities markets. To mitigate its own risk exposure, the operator of the exchange may want to increase its discretion to refuse orders and reduce its liability to bidders.



In Nord Pool Spot’s physical markets, the exchange operator reserves a limited right to “reject, cancel or refuse to display or match” orders that are not in compliance with the Trading Rules or the applicable law.265 In the physical market of N2EX, the exchange operator reserves a limited right to refuse orders.266 There are usual limitation of liability clauses and a force majeure clause for both markets.267

On EPEX Spot, the operator is only subject to a best-efforts obligation and liable only for damage caused by wilful acts or through gross negligence. There is a cap for liability.268


4.5.5 Excursion: Unbundled or Integrated Post-trading Systems


Trades must be cleared and settled. Clearing and settlement systems belong to “post-trading” systems.269 There is a difference between post-trading systems designed for securities and electricity spot markets.


Securities Markets

It is customary to distinguish between flow-related activities and securities-related activities in securities markets. Flowrelated activities start after the matching of bids and end with the transfer of securities, cash, or both between final market participants. Securitiesrelated activities are independent of the completion of transactions. For example, they include establishing securities in book-entry form, deposit, account providing, and asset servicing.270


Spot Markets

While similar flow-related activities are used in electricity spot markets, one can distinguish between activities relating to financial flows and physical flows. (a) Clearing activities relating to physical flows play an important role in electricity spot markets. Such electricity-related clearing activities relate to the maintenance of balance in the grid. The fact that there are electricity-related clearing activities influences the organisation of clearing and settlement. (b) Clearing activities relating to financial flows can be defined as the process of establishing settlement positions, including the calculation of net positions, and the process of checking that the necessary electricity, collateral, and cash are available.271 (c) In electricity spot markets, securities-related activities are limited to collateral and can thus be called collateralrelated activities.


Integration or Unbundling

The various post-trading functions can be integrated or unbundled. This leads to questions about the market participant’s counterparty. Should the clearing house be the central counterparty? Can the clearing house be the central counterparty regarding physical flows?

EMIR provides that the central counterparty is responsible for the operation of the clearing system.272 The voluntary European Code of Conduct for Clearing and Settlement is based on the assumption that the functions of central counterparty and clearing house should be combined. However, the Code recommends the unbundling of the functions of trading venue (exchange operator) and central counterparty.273

The integration of the functions of clearing house and central counterparty, and the separation of the functions of exchange operator and clearing house, might be explained by issues relating to the management of risk, information, and costs. There are nevertheless differences between financial flows and physical flows.


Financial Flows

There are issues for and against combining the roles of clearing house, central counterparty, and provider of settlement services for financial flows.

On one hand, combining the roles can reduce systemic risk and transaction costs by increasing access to information. As an information hub, the clearing house receives and produces information. Access to this information enables it to assess counterparty risk and its own risk exposure as central counterparty. One of the basic ways to manage systemic risk is to collect sufficient collateral from market participants in the form of margins and otherwise. Information costs (transaction costs) can be reduced if the same entity acts as a central counterparty, clearing house, settlement agent, and collateral agent.

On the other hand, it may be easier to manage systemic risk, if the clearing house is separate from the exchange operator. The separation of functions makes it necessary to exchange information. If the clearing house is not the exchange operator responsible for the access of market participants and the matching of bids, the operator and the clearing house should exchange information about: compliance with the terms of market access274; and matching bids.275 The separation of functions can facilitate mutual monitoring. The exchange of information and mutual monitoring can increase transparency.


Physical Flows

While the clearing house is often the party that acts as central counterparty for financial flows, it can neither supply nor extract electricity in its capacity as clearing house. The same can be said of the exchange operator. It does not matter whether the operator or the clearing house has a contractual obligation to supply or extract electricity. Neither the operator nor the clearing house can direct physical electricity flows. Physical flows must be managed by the TSO.

If the central counterparty for financial flows nevertheless acts as the central counterparty for physical electricity flows, it is exposed to the risk that the agreed flows will not happen because of the TSO’s actions. This risk is addressed in the trading rules and clearing rules (Sect. 4.5.6).


4.5.6 The Central Counterparty


There is more work for central counterparties and parties responsible for clearing and settlement in spot electricity markets than on financial electricity exchanges. In both cases, the parties must regulate legal rights, especially financial rights. In spot markets, the parties must also regulate physical flows and service (supply or off-take) rights (Sect. 2.​5.​7). One can therefore ask whether the central counterparty is the central counterparty for financial or service rights or both, whether the clearing house is the clearing house for financial or physical flows or both, and whether the settlement provider is the settlement provider for financial or physical flows or both.


Central Counterparty for Financial Flows

As regards the central counterparty for financial flows, EMIR provides that the central counterparty is responsible for the operation of the clearing system.276 The voluntary European Code of Conduct for Clearing and Settlement recommends the unbundling of the functions of trading venue (exchange operator) and central counterparty.277

The spot exchanges studied here have designated the clearing house as the central counterparty, but the party designated as the clearing house/central counterparty can be either the exchange operator (Nord Pool Spot) or a third party (EPEX Spot and N2EX in the past).

EPEX Spot SE (a French company) has designated European Commodity Clearing AG (a company with its seat in Leipzig) as the clearing house. The clearing house acts as the central counterparty for payment and delivery of the contracts traded or registered at the exchange.278

The physical markets of Nord Pool Spot share the same operator, Nord Pool Spot AS (a Norwegian company). Nord Pool Spot AS is the counterparty for trading in the Elspot market and (since 1 January 2011) in the Elbas market (after replacing its subsidiary Nord Pool Finland Oy as the counterparty at Elbas).279

In the past, Nord Pool Spot AS was neither the clearing house nor the central counterparty for trading on N2EX. The clearing house and central counterparty was NASDAQ OMX Stockholm AB (a Swedish company).280 Since 1 October 2014, Nord Pool Spot AS is the central counterparty and clearing house in the physical market of N2EX.281

If there is a central counterparty, there must also a contractual mechanism to ensure that once the bids are matched into a trade, the trade gives rise to two contracts with the central counterparty as there is no bilateral contract between the two market participants. If the exchange operator is the central counterparty (Nord Pool Spot), information flows are easier to manage. If the exchange operator is not the central counterparty (EPEX Spot), information flows must be regulated in more detail. To reduce risk in the latter case, clearing must be initiated by the exchange operator that matches the bids, and it must be initiated automatically.

The mechanism is relatively simple on Elspot, because Nord Pool Spot AS is both the exchange operator and the central counterparty/clearing house: “Clearing is initiated by NPS entering into a Transaction as central counterparty and registering the Transaction on the Clearing Accounts of the Account Holders involved”.282

More regulation was needed in N2EX when Nord Pool Spot AS acted as the exchange operator and NASDAQ OMX Stockholm AB was the central counterparty/clearing house.283 Transactions concluded on the trading system are now automatically subject to clearing.284

On the derivatives market of EPEX Spot, contracts are deemed to have been concluded between European Commodity Clearing AG (ECC) as the central counterparty and each of the trading participants when corresponding orders are matched.285 Spot market transactions are deemed to have been concluded both between ECC and ECC Lux (European Commodity Clearing Luxembourg S.a.r.l.) and between ECC Lux and the trading participant in the same way.286 The clearing conditions of the central counterparty and clearing house focus on financial flows.287


Central Counterparty for Physical Flows

One may ask whether the central counterparty for financial flows can act as the central counterparty also regarding physical electricity flows. Physical flows must be managed by the TSO. If the central counterparty for financial flows acts as the central counterparty for physical electricity flows, it is exposed to the risk that the agreed flows will not happen because of actions by the TSO.

There are various complementary ways to mitigate risk and agency costs in the relationship between the central counterparty and the TSO. They include, among others: information management; the alignment of interests; and risk management through contracts: (a) One can improve the TSO’s chances to do its job properly by improving the quality of information and by making even market participants responsible for balancing and coordination. (b) Generally, agency costs between the central counterparty and the TSO could can be reduced where their interests are aligned through contracts, share ownership, or otherwise. (c) The central counterparty’s risk exposure can be mitigated through contracts. First, the central counterparty’s risk exposure can be mitigated by limiting or excluding its liability to trading participants in various ways: the responsibility for the physical settlement of trades can be allocated to a third party; the central counterparty can assume best efforts obligations instead of obligations to achieve a result; or the liability of the central counterparty for loss or damage relating to physical settlement or actions attributable to the TSO can be limited or excluded. Second, the TSO can be made party to a three-party or multi-party contract relationship.

There are many examples of such practices in the spot markets studied here.

In the physical markets of Nord Pool Spot, all shares of the operator (Nord Pool Spot AS) are owned by the Nordic and Baltic TSOs. The operator acts as the clearing house and central counterparty. The TSOs’ interests are therefore aligned with those of the clearing house and central counterparty.

However, there is no share ownership between the operator (Nord Pool Spot AS) and the relevant TSOs in the physical market of N2EX. Neither does the operator function as the central counterparty and clearing house. This requires a more detailed contractual framework that market participants must comply with.

Like the physical market of N2EX, the EPEX Spot market requires a detailed contractual framework with the TSOs. (a) There are multi-party agreements called balance agreements between the TSO, trading participants, the central counterparty/clearing house, and the party responsible for settlement.288 Moreover, some participants in the EPEX Spot market are balance responsible parties responsible for balance groups.289 (b) The liability of the central counterparty (European Commodity Clearing AG, ECC) is limited in various ways. First, the central counterparty (ECC) is not responsible for the physical fulfilment of trades. It only guarantees fulfilment. Second, its subsidiary (European Commodity Clearing Luxembourg S.a.r.l., ECC Lux) has assumed responsibility for the physical settlement of trades. Third, clearing members have a duty to settle all obligations arising from the matching of orders or registered OTC transactions290 (and each clearing member is liable as a guarantor towards ECC Lux for non-clearing members’ financial liabilities).291 Fourth, ECC and ECC Lux exclude their liability for the actions of the TSO, and for their own actions to the extent that they are based on the TSO’s actions.292


4.5.7 Clearing



General Remarks


The core of clearing is the calculation of net positions.293 This core function can be complemented by various actions that reduce counterparty risk and make settlement easier. It can also be complemented by the operation of settlement. One can distinguish between the clearing of financial flows and physical flows.


Clearing of Financial Flows


The clearing of financial flows can be combined with different functions. In the Nord Pool Spot and EPEX Spot markets, the clearing house is the central counterparty, holds collateral, and takes care of financial settlement. In the Nord Pool Spot market, the clearing house is the exchange operator. On EPEX Spot, the clearing house is a separate entity (ECC).


Clearing of Physical Flows


In practice, the most important electricity-related clearing and settlement activities belong to the responsibilities of the TSO. The contractual framework of the TSO dictates much of the contractual framework that regulates physical electricity flows.294 The operator of the spot exchange and the clearing house must align their rules and actions with the TSO’s regulatory framework and actions.


Allocation of Liability and Regulation

This influences the contractual framework and the allocation of liability.

There can be differences between physical and financial flows and the legal path of electricity. (a) As a rule, financial flows are aligned with the legal path of electricity. (b) However, because of the physical characteristics of electricity, electricity flows do not necessarily follow the legal path. Electricity that a spot market buyer extracts from the grid is not really the same package of electricity that the electricity producer supplies to the grid. (c) Moreover, the TSO must maintain balance in the grid and has the regulatory framework for doing so. Balancing influences physical flows and financial flows.

Physical electricity flows do not have to be perfectly aligned with financial flows between market participants. On the other hand, contractual sanctions can be triggered where a party fails to fulfil its physical supply or off-take obligations. The TSO will take the necessary measures to maintain the physical balance and can also enforce contractual remedies against the defaulting party. Contractual remedies can also be enforced by the central counterparty, clearing house, or exchange operator. Liability can be allocated to a trading party or even to the central counterparty or the clearing house.

The allocation of liability is a question of proper management of agency relationships. Sanctions for non-compliance can increase incentives to comply with contractual obligations, reduce counterparty and systemic risk, reduce transaction costs, increase liquidity, and increase the effectiveness of the marketplace.

It is possible for the exchange operator, clearing house, and central counterparty to take contractual measures to hold themselves harmless from actions by the seller, the buyer, and the TSO relating to physical electricity flows.

This is reflected in the contractual framework of the spot exchange in three main ways. First, the contractual framework of the spot exchange does not have to regulate electricity-related clearing in detail. Second, it requires the parties to agree on grid access, transmission capacity, and communications with the TSO. The contractual framework applied between market participants and the TSO is often called the balance agreement (Sect. 4.10). Third, the operator of the spot exchange, the clearing house, and the central counterparty exclude their liability for things caused by the TSO’s actions and for non-fulfilment of physical supply or off-take obligations. Fourth, balance responsibility can be allocated to a balance responsible party.


Balance Agreement with the TSO

The legal framework for the clearing of financial flows can thus be simplified when market participants are required to enter into a balance agreement either with the TSO or with a balance responsible party that has entered into a balance agreement with the TSO.

The trading rules of Nord Pool Spot require market participants and clients to have entered into on agreement on balance responsibility with a balance responsible party or the TSO.295

On N2EX, the deliverable electricity contract volumes are delivered in accordance with the terms of the BSC (including the terms of each clearing transaction or ECV Transfer and the clearing rules).296 For this reason, the clearing house’s counterparties must have established access to an energy account.297

On EPEX Spot, the physical delivery of spot market transactions must be effected according to the clearing conditions and the balance agreements.298 Trading on EPEX Spot is not possible without a balance agreement or a balance responsible agreement.299 The balance agreement means “all contractual agreements between the transmission system operator … and the Trading Participant as well as between the transmission system operator … and ECC and ECC Lux regarding the settlement of power … deliveries”.300


Communications to the TSO

The parties’ supply and off-take obligations must be communicated to the relevant TSO in an organised and timely way.301

In principle, the party responsible for these communications could be the exchange operator, the clearing house, the central counterparty, the relevant clearing member, or a non-clearing market participant. However, market participants cannot obtain information about the matching of bids and the existence of a contract with the central counterparty unless information is communicated to them.

Information should thus be communicated to market participants. To reduce risks inherent in communications, information about the matching of bids can be communicated automatically by the exchange operator to the clearing house, and the clearing house can communicate information about the contents of the supply and extraction obligations to the market participants (and the central counterparty, if the clearing house is not the central counterparty). Both communications can also be made simultaneously.

The operator of EPEX Spot sends contract information to the clearing house/central counterparty once orders have been matched.302 The clearing house/central counterparty sends information to the trading participants, or it is provided within the system of the market.303

In the physical market of N2EX, communications are automatic. The exchange operator’s transaction confirmation also serves as confirmation by the clearing house of the creation of the corresponding clearing transactions.304

Communications are simple on Elspot, because the same entity acts as the operator of the exchange, the clearing house, and the central counterparty. NPS can allocate information about matching bids and transactions to the relevant clearing accounts.305

Information should also be communicated to the TSO. (a) Generally, the operator of the exchange and the clearing house can decide on the scope and contents of the regulatory regime for the operator-clearing house-TSO interface. For instance, they can decide whether to regulate this issue in detail or leave it unregulated. (b) The scope and contents of the regime nevertheless depend on the number of TSOs as the exchange operator and the clearing house must adapt to the regulatory regime of the relevant TSO or TSOs.

The regime can be larger in scope and more detailed where the number of TSOs is one. In this case, it is easier to adapt the regulatory regime of the exchange operator and the clearing house to the regulatory regime of the TSO.

Where the number of potential TSOs is large, it would not be feasible to regulate the interface in detail for each and every TSO. Leaving the issue of communications to the TSO unregulated by the exchange operator and the clearing house would mean that communications to the TSO are regulated (1) by the TSO’s legal framework for grid access and transmission capacity and (2) between each market participant and the TSO. In this case, the contractual framework of the spot exchange would merely refer to contracts between TSO and the market participant (balance agreements). Another market participant can also act as a “balance responsible party” coordinating the activities of a group of market participants.

As the number of potential TSOs can influence the regulatory regime, there is a fundamental difference between Elspot or EPEX Spot on one hand and N2EX on the other. Whereas activities on Elspot and EPEX Spot must be adapted to the regulatory frameworks of many national TSOs, the only TSO relevant for the N2EX market is National Grid.

Communications relating to physical electricity flows are largely regulated by the TSO in the Elspot market of Nord Pool Spot and EPEX Spot.

Nord Pool Spot AS (NPS), the exchange operator/clearing house/central counterparty of Elspot requires market participants to have agreed on balance responsibility either with the TSO or a balance responsible party.306 After clearing, exchange members must fulfil their physical supply or off-take obligations. Although NPS is the central counterparty, it excludes its own liability for non-fulfilment of these obligations: “Non-delivery or non-off-take is to be settled with the relevant Balance Responsible Party or Transmission System Operator in accordance with applicable rules, with no liability for NPS”.307 Instead, NPS has chosen to regulate cash flows based on cleared transactions.308

The same regulatory technique is used in the EPEX Spot market. Communications to the TSO are regulated by the relevant TSO rather than the exchange operator or the clearing house. The exchange operator (EPEX Spot SE) sends a confirmation to the parties309 and information to the clearing house/central counterparty (ECC) once orders have been matched. After this, the exchange operator is not concerned about communications to the TSO. Following registration by ECC, the payment and delivery obligations arising from transactions are governed by the clearing conditions of ECC.310 ECC communicates reports regarding transactions to the trading participants.311 The physical delivery of the spot market transactions is “effected” directly by the trading participant towards ECC Lux,312 and the delivery obligations are “executed” by nominating the purchases or sales to the relevant TSO (after which electricity is supplied to the grid and extracted from the grid).313 Where a trading participant fails to fulfil its delivery or acceptance of delivery obligation, sanctions may be enforced by ECC (even on behalf of ECC Lux) under the clearing conditions and by the TSO under the balance agreement.314


4.5.8 Excursion: Clearing of Physical Flows in the N2EX Market


We can study the clearing of physical flows in more detail in the light of the N2EX market. In the N2EX market, communications to the TSO are regulated more explicitly compared with Elspot and EPEX Spot. The rules of the N2EX market can thus provide more information about the necessary mechanisms.

There are three major issues contributing to the more detailed regulation on N2EX. (a) The first is the existence of just one TSO (National Grid) for the market. (b) Moreover, the regulatory regime applied in the UK market is influenced by the contract and regulatory style characteristic of common law countries. In common law countries, contracts tend to be larger in scope and more detailed than in civil law countries.315 (c) In addition, participants in the UK physical market must comply with the Balancing and Settlement Code (BSC) in the UK.

BSC is a legal document that sets out the rules and governance for the balancing mechanism and imbalance settlement process in the UK. BSC is delivered by the Balancing and Settlement Code Company (BSCCo). ELEXON is the BSCCo. The sole shareholder of ELEXON is National Grid.

Now, National Grid has, according to the terms of its own licence, a duty to establish statements and guidelines.316 National Grid must have the BSC in force to comply with its own licence requirements. This is reflected in the licences of installations. It is a condition of a Generation and Supply Licence that licensees are bound by the BSC; they must become BSC Parties by signing and/or acceding to the BSC Framework Agreement which gives contractual force to the BSC.317

The BSC sets out in what capacities a party may act, that is, the available categories of BSC parties. Parties to the BSC are essentially entities that are parties to the Framework Agreement.318 Each party may act in one or more participation capacities under the BSC. For example, a party can be: a Trading Party (a party that holds Energy Accounts); or a Supplier (a Party that holds a Supply Licence and has metering systems registered in Supplier Volume Allocation (SVA).319

Some entities have Energy Accounts. Energy Accounts are allocated to the following Parties: (a) Parties who are responsible for imports and exports of electricity (typically generators and suppliers); (b) Interconnector Error Administrators (IEAs); (c) other Parties wishing to trade; and (d) National Grid (as the TSO).320 A Party has only two energy accounts: a Production Energy Account; and a Consumption Energy Account.321

The operator of N2EX (Nord Pool Spot AS) and the market’s central counterparty/clearing house (earlier Nasdax OMX Stockholm AB, since 1 October 2014 Nord Pool Spot AS) must adapt to the legal framework of the TSO (National Grid) including, in particular, the Balance and Settlement Code of the BSCCo (ELEXON).

As OTC markets must comply with the same requirements, the EFET General Agreement Concerning the Delivery and Acceptance of Electricity (Sect. 8.​3) has been complemented by a GTMA Appendix. GTMA (the Grid Trade Master Agreement) is the standard set of terms under which the majority of electricity forward trades take place in the UK.322 The EFET GTMA Appendix applies to individual contracts which must be notified and considered for settlement purposes under the Balancing and Settlement Code.323

Such compliance requirements are reflected in the clearing rules for the N2EX market. They can only be understood in the context of the BSC.

The clearing transactions are created automatically. The transaction confirmation from the market operator (Nord Pool Spot AS) also serves as a clearing confirmation from the clearing house.324

However, electricity contract volumes (ECVs) that are deliverable under a clearing transaction or any ECV transfer must be delivered in accordance with the terms of the BSC in addition to the terms of each clearing transaction or ECV transfer and the clearing house’s clearing rules.325

Each clearing account holder must, therefore, maintain an energy account,326 and each “energy contract volume transferee” (ECV transferee) must also be party to the BSC.327 Clearing transactions registered to a clearing account will be notified to its associated energy account.328

Whenever a clearing transaction is registered to a clearing account that is associated with an energy account of an ECV transferee, a corresponding ECV Transfer will be deemed to be created and executed automatically between the relevant account holder and the ECV transferee.329

Notifications are important for the proper functioning of the exchange and for the management of physical electricity flows in the grid. Breaches of notification rules under the BSC can amount to a default on obligations under the clearing rules (cross-default).330

All notifications go via the clearing house. The clearing house (or its nominee) receives notifications and makes them on behalf of all counterparties.331 In order for the notifications and procedures to have legal relevance and trigger physical electricity flows, the clearing house must follow the BSC.332

The clearing house cannot take care of notifications in respect of transfers to energy accounts, unless the clearing account holder appoints the clearing house as ECV Notification Agent according to the BSC.333 This requires a particular contract (ECV Transferee Agreement) between the clearing house and the account holder,334 and the account holder must party to the BSC.335

Although the clearing house takes care of notifications of energy contract volume transfers to energy accounts, such ECV transfers are separate from clearing transactions and do not influence clearing transactions as such.336 ECV transfers do not create clearing transactions according to the legal framework applied by the clearing house/central counterparty. The clearing house has just an obligation to act as ECV Notification Agent. It is neither party to the ECV transfer nor a fiduciary. The clearing house has stated this both in the particular ECV Transferee Agreement337 and in its clearing rules for the N2EX market.338

However, the clearing house is responsible for notification failures. Where the clearing house breaches its notification obligations, it is liable to indemnify the account holder for delivery failure costs.339 Where the notification failure is the result of the failure of the account holder or its ECV transferee to comply with its own obligations under the clearing rules or under the BSC, the account holder must indemnify the clearing house in respect of any delivery failure costs directly attributable to that notification failure.340


4.5.9 Settlement


Clearing is followed by settlement. One can again distinguish between the settlement of financial flows and physical flows. In the spot market, the financial settlement of transactions means the payment of the purchase price for the bought volumes.341 Table 4.1 shows the settlement of physical and financial flows in Nord Pool Spot.


Table 4.1
NPS settlement of physical and financial flows
























Physical settlement a

TSO
 

Balance Responsible Partyb

Parties

Clientc

Participant

NPS

Financial settlement d

Settlement Banke

Settlement Bank

Settlement Bank


aNord Pool Spot Physical Markets, Trading Appendix 4, Clearing Rules (27 November 2014), section 4.1.3: “… Non-delivery or non-off-take is to be settled with the relevant Balance Responsible Party or Transmission System Operator in accordance with applicable rules, with no liability for NPS”

bNord Pool Spot’s Physical Markets, General Terms, Trading Rules (1 February 2015), section 3.1.4

cNord Pool Spot Physical Markets, Trading Appendix 4, Clearing Rules (27 November 2014), section 2.1.3: “NPS recognises the following membership categories: a. Participant b. Client Representative c. Client”

dNord Pool Spot Market, Trading Appendix 1, Definitions (27 November 2014): “Settlement means the process which by trades in the Markets are handled through cash transactions”. Nord Pool Spot Physical Markets, Trading Appendix 4, Clearing Rules (27 November 2014), section 4.1.4: “Cash Settlement will be based on the Transactions recorded with NPS only, and will not reflect non-delivery or non-off-take”

eNord Pool Spot Physical Markets, Trading Appendix 4, Clearing Rules (27 November 2014), section 3.3.1: “Each Member must at its own cost establish and maintain at least one Cash Account in an NPS approved settlement bank and in a currency approved by NPS”. Nord Pool Spot Market, Trading Appendix 1, Definitions (27 November 2014)


Settlement of Financial Flows


Like financial clearing, financial settlement is regulated by the clearing rules of the clearing house.342 EMIR requires central counterparties to use central bank money to settle their transactions, where practical and available,343 and to use Zug-um-Zug mechanisms (delivery against payment).344

The clearing house is more focused on the settlement of financial flows than physical flows. In the EPEX Spot market, the exchange operator (EPEX Spot SE) defines “settlement” as the payment of transactions executed on EPEX Spot and handled by the clearing house.345 The clearing conditions of the clearing house (ECC) regulate payments in detail.346 On Elspot, the clearing rules of the central counterparty/clearing house regulate cash settlement347 but not really physical settlement.348

Financial settlement can be governed by the law chosen by the clearing house. The clearing house would probably choose the law of its own country as the governing law. The choice would be limited to financial settlement and would not cover physical settlement that is to a large extent regulated by the TSO and governed by the laws of a country to which physical delivery is more closely connected.

On Elspot and Elbas, transactions are governed by Norwegian law. However, matters relating to the physical delivery of electricity are governed by “the local law of the delivery country”.349

On EPEX Spot, the clearing conditions are governed by German law. However, “the execution of the physical settlement of transactions” is governed by “the material law of the place at which physical fulfilment is actually provided and/or, in the case of grid-bound products, the material law applicable to the transmission system operator or the hub operator within whose transmission system delivery is effected”.350 Moreover, Leipzig has been chosen as the place of performance and venue.351

A market participant needs an account for the financial clearing and settlement of transactions.352 Where the account is held depends on the nature of the market participant.

On Elspot, only members are eligible as counterparties to NPS in clearing transactions. To be eligible as a counterparty, the member must, in addition to other things, have established: one or more trading portfolios; one or more clearing accounts; and one or more cash accounts for settlement purposes.353 The cash account or accounts must be maintained in an NPS approved settlement bank and in a currency approved by NPS.354

On EPEX Spot, each clearing member and the central counterparty must have a settlement account at the central bank.355 There is no such requirement for non-clearing members and trading participants.356

Exposure to counterparty risk and systemic risk depends on how often trades are settled financially. To reduce counterparty risk and systemic risk, trades are settled daily.

Trades are settled daily on each business day on Nord Pool Spot’s Elspot, Elbas,357 and N2EX358 markets including EPEX Spot.359

The clearing house issues invoices to trading participants. In practice, the payment time must depend on who takes the necessary actions. Payments can be made on the trading day when they are debited from the trading participant’s account by the clearing house. Where the making of payments requires actions by trading participants, they cannot be made before the trading participant is notified of the amount due, and the trading participant must be given some time to organise payment. To reduce payment time, automated payments can be used.

On EPEX Spot, payments are made on the trading day.360

On N2EX, all invoices are due on the same banking day as they are issued.361 This is combined with automated cash settlements. The bank is instructed and authorised to debit the account and make payments to the clearinghouse upon the clearinghouse’s instructions.362

On Elspot, invoices fall due on the first clearing day following the invoice day.363 The invoice due date is the same as the Elspot market’s power contract delivery date (for all banking days).364

The clearing house issues self-billing invoices to itself, where the clearing house is the central counterparty. Where the clearing house issues self-billing invoices, it would have an incentive to delay its own payments to reduce its working capital.

On Elspot, the clearing house issues invoices to members and self-billing invoices to itself as the central counterparty.365 An invoice falls due on the first clearing day following the invoice day.366 The value date of a self-billing invoice is the second clearing day following invoice day.367 Penalty interest is payable on overdue payment.368

Self-billing invoices are used on N2EX as well. All invoices are due on the same banking day as they are issued (and at such time as set out in the clearing schedule).369

Because of its function, a clearing member must undertake a duty to fulfil all payment obligations from transactions by its affiliated non-clearing members. A clearing member is thus not a mere agent. Sanctions will be triggered in the event of default on these payment obligations.

On EPEX Spot, the clearing rules provide that a clearing member must fulfil all payment obligations from transactions by its affiliated non-clearing members.370 There are sanctions in the event of default.371 One can distinguish between financial payment obligations and physical delivery obligations. (a) The liability of the clearing member for the fulfilment of the trading participant’s obligations covers even physical delivery. Physical delivery obligations are fulfilled towards ECC Lux, a subsidiary of ECC.372 This is because ECC and the clearing member assign the claims to delivery and/or acceptance of delivery to ECC Lux.373 ECC guarantees the fulfilment of physical delivery transactions by ECC Lux to the trading participants.374 The clearing member can nevertheless only pay money to ECC Lux or ECC. Their duties are limited accordingly.375 (b) In the derivatives market, the liability of a clearing member is limited to payment obligations.

Where a client trades through a client representative on Elspot, the client’s counterparty is the central counterparty.376 The client representative is not a counterparty, but it must ensure that its clients post collateral.377 In the past, the central counterparty used any collateral posted by the client representative where the client representative failed to post missing collateral.378 This rule was deleted in the 2014 Clearing Rules.

There are similar rules in the N2EX market. Interestingly, the client representative must immediately post the missing collateral where a clearing client fails to post collateral. If it does not post the missing collateral, the central counterparty applies collateral that the client representative has posted for principal trading.379

Financial settlement is based on cleared transactions, that is, transactions recorded with the clearing house. It does not reflect actual electricity flows, that is, supply or failure to supply electricity, or off-take or failure to off-take electricity. Actual electricity flows and the failure to comply with obligations to supply or off-take electricity are regulated by the TSO.380


Objections


The fact that financial settlement is separate from physical settlement also means that one must distinguish between objections against trade confirmations and objections against invoices. (a) Because of the balance requirement, objections against trade confirmations are more urgent. This should preferably be reflected in the market rules. Objections against trade confirmations should be made promptly and trade confirmations should be considered approved in the absence of such notifications. (b) Where objections are raised against invoices, the notice period could be longer.

On EPEX Spot, objections against trade confirmations must be raised immediately after receipt and no later than by 12:00 am on the next business day. Objections against invoices or credit notes by ECC or ECC Lux must be raised “forthwith, however, at the latest within a period of 10 ECC business days after receipt” of the invoice.381

On Elspot, a market participant must notify NPS of errors immediately after becoming aware of them.382 The distinction between errors caused by NPS and other errors has been deleted.383 The liability of NPS is limited. First, the trading rules of the Elspot market contain a no-waiver clause. Failure to exercise any right under the trading rules does not operate as a waiver of the party’s rights or remedies.384 Second, Nord Pool Spot has reserved the unilateral right to reject, cancel or refuse any order—on the other hand, it has such a right only where it deems that the order is not in compliance with the trading rules or the applicable law.385

In the N2EX market, market rules distinguish between trading errors, errors involving clearing transactions, and cash settlement errors. (a) Like on Elspot, the market operator (Nord Pool Spot AS) has a limited right to refuse orders in the event of trading errors. Any change or cancellation triggers a corresponding change or cancellation to the corresponding clearing transactions. An account holder may not raise any other objections against the clearing house (in the past NASDAQ OMX Stockholm AB, since 1 October 2014 Nord Pool Spot AS) in respect of trading errors.386 (b) The clearing house may correct substantial errors involving registered clearing transactions.387 (c) Where a cash settlement has been carried out incorrectly, the account holder must notify the clearing house as soon as possible and not later than five (5) banking days after the cash settlement took place.388 However, the clearing house may carry out a corrected settlement in the event of certain substantial errors.389 (d) The clearing house is not liable to any account holder for any exercise or non-exercise of these powers provided that it acts in good faith.390 (e) There is a no-waiver clause.391


Settlement of Physical Flows


The clearing of financial and physical flows and the settlement of financial flows is complemented by the settlement of physical flows. Cash settlement and physical delivery are the two main forms of contract settlement in commodity markets in general. However, electricity spot markets have their own characteristics.

In traditional commodity markets, a contract party has an obligation to deliver the commodity at maturity (where the party has a short position in the contract) or an obligation to take delivery of the commodity (where the party has a long position in the contract). The commodity is then delivered as specified in the delivery conditions of the contract. Most contracts for the delivery of a commodity set out the modalities of delivery, including, for instance, time of delivery, place of delivery, payment of transportation fees, quality, and possible quality substitutions. Furthermore, most commodities can be in the possession of somebody, and it would be possible for the central counterparty to hold title to the commodities to be delivered.

In electricity spot markets, however, there are constraints on the physical settlement of contracts. Because it is not yet technically and commercially possible to store electricity in large quantities for the purposes of trading, and because the transmission of electricity requires wires and transmission capacity, electricity is physically supplied to the grid and extracted from the same grid by the market participants themselves. Balance in the grid is managed by the TSO. The central counterparty is not in a position to supply or extract electricity.

The particular characteristics of physical electricity markets influence: (a) the regulation of access to the marketplace; (b) the obligations and liability of the central counterparty; (c) the scope of the TSO’s contractual regime; and (d) the modalities of physical settlement.


Access

To ensure that bidders are able to fulfil their obligations, the exchange operator must require evidence of the capability for the physical settlement of transactions before it can accept a market participant. This requires, in particular, evidence of: a clearing agreement; participation in the contractual framework of the TSO; and the necessary organisation (personnel and technical facilities).392


Liability of Central Counterparty

The central counterparty has reduced its risk exposure by allocating the responsibility for the physical settlement of trades to a third party and by excluding or limiting its liability for non-performance.

In the EPEX Spot market, European Commodity Clearing Luxembourg S.a.r.l. (ECC Lux) has assumed responsibility for the physical settlement of all transactions for which European Commodity Clearing AG (ECC) has assumed clearing as the clearing house and central counterparty. ECC Lux is a subsidiary of ECC.393 The central counterparty is not responsible for the physical fulfilment of trades. It only guarantees fulfilment.394

Where a trading participant has defaulted on its delivery or acceptance of delivery obligations, ECC is entitled to take all the required measures to safeguard the performance or reduction of the damage.395 However, the most important consequences in the event of default are regulated in the legal framework applied by the TSO (the “balance agreement”).396

Both ECC and ECC Lux (the central counterparties) have excluded all liability for measures by the TSO and their own measures based on the TSO’s measures.397 Where the TSO has taken measures, the changed volumes form the basis of settlement.398

There is a difference between EPEX Spot and the physical markets of Nord Pool Spot. In this case, rights are not assigned and the original central counterparty remains the central counterparty also for physical flows. Cash settlement is based on agreed flows. The central counterparty is not responsible for problems with physical flows. Actual electricity flows and obligations triggered by failure to comply with obligations to supply or off-take electricity are regulated by the TSO.399


TSO’s Regime

The modalities of settlement and delivery depend on the legal framework of the TSO. The exchange operator’s and the clearing house’s rules can regulate the settlement of payments and leave the settlement of electricity flows to be regulated by the TSO and effected by the buyer and seller.

This can be illustrated by the way EPEX Spot Operational Rules define the underlying electricity and delivery of EPEX Spot physical power contracts: “Electrical power transiting over a Transmission System managed by a TSO, which defines the voltage, frequency, cosine φ (displacement factor) and cut-off frequencies, in compliance with the contractual obligations of the prevailing concession agreement for the general power grid … Delivery at any Injection or Withdrawal point on the relevant Transmission System”.400

The exchange operator (EPEX Spot SE) defines “settlement” as the payment of transactions executed on EPEX Spot and handled by the clearing house.401 The exchange operator thus focuses on payments. Moreover, the exchange rules refer to the clearing conditions of the clearing house (ECC)402 that regulate payments but leave the modalities of physical electricity flows to be regulated by the TSO in what is known as “balance agreements”.403

Evidence of the capability for physical settlement of transaction is a “precondition for approval as a Trading Participant” under the ECC Clearing Conditions.404

A trading participant has a legal obligation to fulfil its delivery obligations and/or acceptance of delivery obligations to ECC Lux.405 ECC guarantees the trading participants the fulfilment of these transactions by ECC Lux in accordance with the contract.406

The clearing member is liable as a guarantor to the extent that ECC Lux can demand the payment of money instead of the delivery or the acceptance of delivery from the clearing member (in particular in the event of default).

Consequently, there are rather complicated multi-party relationships (trading participant—clearing member—central counterparty/ECC—central counterparty for physical deliveries/ECC Lux) that need to be regulated in ECC Clearing Conditions in detail and depending on the context (spot transactions,407 derivatives transactions408).

Cascading is used for physical delivery where the delivery period of futures exceeds 1 calendar month.409


Modalities of Physical Settlement

Electricity must always be supplied at a certain grid and voltage level at a certain delivery point. Moreover, electricity must be supplied in the current, frequency and voltage applicable at the relevant delivery point in accordance with the standards of the TSO and the contract terms.410

The contract must determine an entry point for electricity flows into the grid and an exit point for electricity flows from the grid. In practice, it is sufficient to identify the grid and the grid level, or the “bidding area”.411 A bidder must make bids in the area where the bidder’s production or consumption is physically connected to the grid.412 If there are many TSOs,413 the area must be the area of the relevant grid operator.

The points of entry and exit are customarily in the same country, because grids or bidding areas have traditionally been regional or national.

For technical reasons, it is not necessary to specify the place of the performance of the obligation to “deliver” electricity. If there is a “delivery point” for legal reasons, it could be any injection or withdrawal point on the relevant transmission system.414

The N2EX Trading Rules and Clearing Rules do not define the place of performance of the delivery obligation as such.415 Neither does the Balancing and Settlement Code.

Physical settlement is effected by nominating purchases or sales to the relevant TSO.416 A market participant cannot nominate them without a prior contractual framework with the TSO. The existence of a contractual framework that facilitates settlement belongs to the customary conditions for exchange membership. There can nevertheless be clearing members and non-clearing members with different obligations.417 Where the market participant cannot fulfil its supply or off-take obligations itself, it should find a party that can.

On EPEX Spot, trade information is transmitted by the exchange operator (EPEX Spot SE) to the central counterparty and clearing house (ECC). The delivery procedure means nomination of the contract by ECC and the balance responsible members to the TSO.418 In case of market coupling contracts, a contract is nominated to the TSOs on the electrical borders by the designated shipping agent.419


4.6 Reduction of Counterparty Risk and Systemic Risk



4.6.1 General Remarks


Counterparty risk and systemic risk are mitigated in various ways in both financial and physical electricity markets. First, there are collateral calls and margin requirements. Second, set-off and netting are used to reduce net exposure. Third, there is daily financial settlement. These techniques influence the cash flow of market participants. They can either give incentives to participate in organised trading or incentives to use bilaterally negotiated OTC contracts.


4.6.2 Collateral Calls and Margin Requirements


Market participants are required to furnish collateral to reduce the central counterparty’s risk exposure and systemic risk. Collateral requirements limit the market participants access to the marketplace and trading (in addition to explicit trading limits420). Margins furnished by market participants are the most important form of collateral.421

Exposure to counterparty credit risk and the required amount of collateral can depend on the traded contract. (a) There is a difference between “one-sided” and “two-sided” exposure to credit risk. Financially-settled options lead to one-sided exposure because one counterparty has already fulfilled its own obligations after paying the premium. Exposure to counterparty credit risk is two-sided in forward-type contracts that are settled physically and in swaps. (b) Moreover, because a derivative contract derives its value from the underlying asset, its value changes during its life, creating difficulty and complexity in collateral arrangements as collateral is posted and reposted throughout the life of the contract.422

Collateral must be furnished by clearing members.423 Depending on the exchange, non-clearing members may be required to furnish collateral to the relevant clearing member or the clearing house.

All members—participants or clearing customers—must furnish collateral in the Elspot market of Nord Pool Spot. Even clients must furnish collateral when trading through their client representatives.424

In the physical market of N2EX, each account holder is subject to collateral calls.425

As regards Nasdaq Commodities, each account holder must provide collateral under the clearing rules.426

Each exchange participant must deposit the required margins and the daily settlement payments on EEX.427

In the EPEX Spot market, each clearing member must deposit margins.428 A non-clearing member must deposit margins at its clearing member.429

In principle, collateral should be furnished to the clearing house for the security of compliance with obligations owed to the central counterparty. In practice, however, the same entity often acts as the clearing house and the central counterparty. The rules of the market can therefore be vague about the beneficiary of the collateral and the obligations secured by the collateral.

In the physical markets of Nord Pool Spot, the beneficiary is Nord Pool Spot.430 On EPEX Spot, the beneficiary is ECC and the obligations are the obligations of the clearing member towards ECC “for its participation in clearing at ECC”. The margins furnished by a clearing member are intended to “secure risks from its own transactions or transactions guaranteed by it”.431


Form of Collateral

There are many potential forms of collateral and other credit enhancements.432 In principle, there can be cash collateral and non-cash collateral. The quality of collateral is regulated by EMIR433 and a Commission Delegated Regulation laying down the main rules.434 (These requirements are discussed in Sect. 4.4.5). Within such limits, market participants may be given some discretion to choose the form of collateral. The level of discretion depends even on the exchange. For operational reasons and for the sake of liquidity and transparency, central counterparties prefer to limit collateral to cash deposits and/or on-demand guarantees. There is nevertheless variation between exchanges.

On Nord Pool Spot, members (that is, participants, client representatives, and clients)435 must provide collateral through any one, or a combination, of the permitted forms of collateral.436 The permitted forms of collateral are pledged cash accounts or demand guarantees.437 A member must have one or more cash accounts for settlement purposes. A cash account is either a pledged or a non-pledged cash account.438 A member may also provide as collateral “any security instrument accepted by NPS under an Aggregated Collateral Arrangement with the Member”.439

These Aggregated Collateral Arrangements allow members who trade in both Elspot and N2EX markets to have their collateral requirements calculated on an aggregate basis and enable them to provide a single aggregated pool of collateral as security for their total exposure to Nord Pool Spot. This reduces their overall collateral costs and working capital requirements.

In the N2EX market, each account holder is subject to collateral calls.440 Collateral can consist of cash, a letter of credit or bank guarantee, or of other collateral.441 For instance, collateral for daily margin calls must be furnished in the form of cash or otherwise.442 The value of cash collateral and bank guarantees has been defined in advance. The value of other acceptable collateral is determined by the clearing house.443

In the EPEX Spot market, each clearing member must deposit margins “in cash or in securities or stock loan rights accepted by ECC”,444 and a non-clearing member must deposit margins at its clearing member.445 On EPEX Spot, the clearing house thus specifies the kind and amount of collateral that must be deposited by a clearing member.446 ECC also determines their collateral value.447

Each exchange participant must deposit the required margins and the daily settlement payments in the EEX Power Derivatives Market.448 A clearing member must deposit collateral in cash, securities, or book-entry security. Emission rights are not regarded as securities or book-entry security.449 However, even they will be pledged by a trading participant.450

Nasdaq Commodities defines collateral as “assets in the form of cash in the eligible currencies and/or the eligible securities and/or Bank Guarantees, as specified in the Collateral List from time to time”.451 The Collateral List452 sets out what collateral is eligible and how eligible collateral is valued. To illustrate, securities cannot be accepted as collateral unless they have daily prices available via Reuters. Market participants that are non-financial counterparties under EMIR are permitted to provide as collateral a demand guarantee issued by a bank.

The Auctioning Regulation distinguishes between futures and forwards based on margining. Futures are subject to cash variation margining. Forwards are variation margined through non-cash collateral.453


Margin Calls and Payments to the Default Fund

There are various kinds of margin calls (or collateral calls). The customary forms are (a) initial or basic margin (collateral) calls and (b) variation margin (collateral) calls. In addition, (c) cross-margining and collateral groups can be used.

EMIR provides that the central counterparty must collect margins “on an intraday basis, at least when predefined thresholds are exceeded”.454 Regulated margins include initial margins and variation margins.455

EMIR also requires payments to a default fund to cover losses arising from the default of one or more clearing members when they exceed the losses to be covered by margin requirements.456 The central counterparty decides on the size of the contributions.457


Initial or Basic Margin

The purpose of initial margins (often referred to as base or basic margins) is to cover within-day price volatility and is payable at the time the contract is concluded.458 Whenever a position is opened, a trading participant thus has to deposit this margin with its clearing member and the clearing member in turn has to deposit this margin with the clearing house. The more volatile the contract is, the greater is the initial margin requirement.459

The clearing house of Nasdaq Commodities (NASDAQ OMX Clearing AB) will set the base collateral requirement for each clearing account when the account is initially established. The clearing house will take into consideration the account holder’s financial soundness, expected volume of transactions, the default fund requirement, and other factors which the clearing house deems relevant.460

Nord Pool Spot requires minimum collateral from all members. The minimum collateral call can be adjusted at NPS’s discretion. It can also be set individually. The minimum collateral must be established prior to the commencement of trading.461

On N2EX, the clearing house determines the base collateral call for each clearing account when clearing accounts are initially established.462

ECC Clearing Conditions lay down the method for the calculation of the different margin requirements for derivatives market transactions (EEX) and for spot market transactions (EPEX Spot).463

On EEX, a SPAN® Initial Margin must be furnished for the costs of closing out net positions in futures and options.464 On EPEX Spot, a Spot Initial Margin must be furnished to cover the default of net payers for ECC.465 Moreover, there are contributions to the Clearing Fund and Additional Margins.

Contributions to the Clearing Fund concern Clearing Members. The Clearing Conditions of ECC provide that a clearing licence cannot be granted unless the institution contributes to the Clearing Fund.466 A Clearing Member must contribute to the Clearing Fund regardless of other margins. ECC can utilise these funds in the event of a default of the Clearing Member.467 Contributions to the Clearing Fund are complemented by intraday supplementary margins.468

On EPEX Spot, the basic margin (initial margin) is called the Additional Margin. It covers the risk of the maximum costs incurred for closing out all open positions of a trading participant on the next exchange trading day subject to the assumption of the most unfavourable development of prices. The Additional Margin is fixed for the entire term of the contract. ECC establishes the amount of the Additional Margin.469


Variation or Close-Out Margin

Variation margin is charged during the life of the contract. It is designed to mitigate replacement risk and settlement risk (or counterparty credit risk). Additional collateral must be posted by the party holding a position that is loss-making against current market prices.470

Variation margin calls can be very substantial in times of significant price volatility. Market participants need to have sufficient capital available to cover such margin calls if they wish to trade. This can act as a constraint on trading activity.

Ofgem gives the following example: “[I]f a forward contract was struck at £50/MWh, but prices have risen to £80/MWh, the variation margin call on the seller would be £30 for every MWh delivered under the contract (in addition to the initial margin)”.471

Variation margins can consist of daily margin calls and extraordinary margin calls. In addition, there can be other variation margins. Variation margins can also be called close-out margins.

On Nasdaq Commodities, daily margins472 are complemented by extraordinary margins. The clearing house may issue an extraordinary margin requirement for special circumstances.473

On Elspot, there are collateral calls each clearing day in addition to the minimum collateral. Their amount is “the total purchase price for each Member’s net electricity purchase in trading during a period of days decided by NPS, including VAT”.474 There are also extraordinary margin calls.475

The modalities have been regulated in more detail for the N2EX market. In addition to base collateral calls, there are daily margin calls and extraordinary margin calls. Account holders must on each clearing day provide collateral for any daily margin calls.476 Daily margin calls consist of several components. On one hand, there are both intraday margin calls and end-of-day margin calls.477 On the other, the clearing house considers the following: a billing margin, a delivery margin, an initial margin, and a variation margin.478

ECC has adopted separate rules for establishing the amount of collateral for derivatives transactions and spot market transactions. Clearing members must request collateral at least to the amount established based on the calculation method of ECC from their non-clearing members.479

On EPEX Spot, a clearing member must furnish collateral to the clearing house in the form of contributions to the clearing fund480 and margins.481 In addition to the initial margin (the Additional Margin), various kinds of margins are used.

A clearing member must furnish margins on each ECC Business Day to secure risks from its own transactions or transactions guaranteed by it,482 and request collateral at least to the amount established based on the calculation method of ECC from their non-clearing members.483 A clearing member must furnish supplementary margins when the clearing house (ECC) demands it, and a non-clearing member when the clearing member demands it.484 In the spot market, a trading participant must furnish an initial margin.485

Various kinds of margins are used on EEX, that is, in the derivatives market.486 In addition to daily margins487 and supplementary margins,488 the clearing rules distinguish between additional margins,489 premium margins,490 and delivery margins.491 The Premium Margin is required for open short positions in options (and not required for open long options). It resembles the Additional Margin for futures.492 The Delivery Margin is used for gas contracts rather than electricity contracts.493


Cross-Margining, Collateral Groups

The use of cross-margining or collateral groups depends on the exchange.

Cross-margining means that margin requirements are applied over the lines of different kinds of products or entities. According to MiFIR, it fosters “non-discriminatory and transparent access to CCPs” and “effective competition between trading venues for derivatives”.494 EMIR permits “portfolio margining”.495

ECC uses collateral groups. Collateral is divided into different groups based on the obligations that the collateral is designed to secure in the event of a clearing member’s default.496


Calculation of Margin Requirements

There must be a calculation method for margins. The question is addressed by the EMIR framework.497 However, to ensure that central counterparties duly manage the risk they face, it does not specify the approach which they should take.498 Various methods can thus be used to protect the “resilience” of the central counterparty depending on the exchange.499

NASDAQ OMX Clearing AB (“NOMX Clearing”) uses various models. It uses a Nordic SPAN model for commodities.500 Many of the features of its SPAN model differ from the original SPAN design.501

In the physical markets of Nord Pool Spot, the clearing house/central counterparty has discretion to determine the required amount of collateral.502

In the N2EX market, there are base collateral calls, daily margin calls, and extraordinary margin calls. (a) The amount of base collateral is in the discretion of the clearing house/central counterparty (Nord Pool Spot AS) that considers “relevant factors”.503 (b) Moreover, account holders must on each clearing day provide collateral for any daily margin calls.504 The clearing rules define how intraday and end-of-day margin calls are calculated.505 The clearing house considers several components when calculating a daily margin call.506 However, the relative weight of the calculation parameters is in the discretion of the clearing house.507

On EPEX Spot, the amount of margins is specified by the clearing house/central counterparty.508 Margins are deposited to secure the contract obligations guaranteed by ECC.509 ECC must use a method for the calculation of the margin.510 The amount of the margin is based on the default risk of a clearing member and of its non-clearing Members.511 A non-clearing Member must deposit margins at its clearing member at least to the amount established based on the calculation method of ECC.512

In principle, the required amount of collateral could reflect the bargaining position of the parties. Where the amount of collateral is in the discretion of the clearing house, the interests of the clearing house or the reduction of systemic risk have a higher relative weight. Where the amount of collateral is low or set out in advance and limited, or where its quality is low, the interests of electricity producers, buyers, or other market participants have a higher relative weight.

Because of the benefits of holding collateral, the holding of collateral signals a stronger position than not holding it. Possession of collateral reduces risk exposure, increases the efficiency of the use of capital (as the party does not furnish collateral itself or, if it does, may recollateralise collateral that is in its possession), and may even increase income (as assets used as collateral are re-invested).513 For the same reasons, there can be an incentive to hoard collateral.

The fact that collateral is furnished to the clearing house signals that the reduction of systemic risk has a higher relative weight. Where collateral is furnished to clearing members, one can assume that the interests of clearing members have a higher relative weight.

In the physical markets of Nord Pool Spot, members and clients provide collateral to the clearing house/central counterparty.514

On EPEX Spot, a clearing member furnishes collateral to the central counterparty/clearing house (European Commodity Clearing AG)515 and a non-clearing member to its clearing member.516


Extraordinary Margin Calls

Systemic risk can rise to unacceptable levels where the amount of collateral held by the central counterparty is too low because of a change in circumstances or otherwise. For this reason, the clearing house/central counterparty must have discretion to make extraordinary margin calls.

In the physical markets of Nord Pool Spot, NPS may call for extraordinary and immediate posting of collateral. The collateral call can be set individually, according to member category, or for all members. NPS also has discretion to “apply any other risk calculation procedure that the NPS considers appropriate under the relevant circumstances”.517

On N2EX, NPS may issue an extraordinary margin call to an account holder if it decides that extraordinary circumstances so require. Extraordinary circumstances are matters that indicate a higher credit risk in respect of the account holder.518

On EPEX Spot, ECC has the right to demand a supplementary margin at any time on account of the risk assessment which it carries out.519


4.6.3 Set-Off and Netting


The commercial purpose of set-off and netting is to reduce counterparty risk, systemic risk, and operational costs by replacing multiple payment (or delivery) obligations with one net payment (or delivery) obligation. Netting is easier where parties trade with a central counterparty.520 In the EU, it is regulated by the Settlement Finality Directive521 and the Collateral Directive.522 Set-off and netting should be regulated carefully in the clearing rules to achieve their commercial purpose.


Terms

When employed on electricity exchanges, the content of set-off and netting tends to be influenced by: the nature of the contractual obligations; the nature of the relationship between market participants; the event; and the bargaining power of the parties.

First, there are various kinds of contractual obligations. On physical electricity exchanges, contracts are settled both physically and financially, and there are payment obligations due to collateral calls. To achieve the purpose of set-off and netting, it is necessary for the operator of the exchange and the central counterparty to regulate all three aspects—physical, financial, and collateral-related aspects—of set-off and netting.

Second, there are different kinds of relationships between market participants. To begin with, there are different kinds of market participants. For instance, trading participants range from clearing and non-clearing members to clients, and each trading participant may belong to a group of companies. The functions of a central counterparty can be allocated to one entity or divided between a central counterparty and a sub-CCP. Moreover, the obligations of a party can be owed to one or more different market participants. For instance, there are obligations owed to the TSO, the CCP, and trading participants. It is therefore necessary to regulate payments in different kinds of party relationships.

Third, situations vary. One can distinguish between: normal business relationships; default; and insolvency.

Fourth, set-off and netting rules can reflect the bargaining power of the parties. There are differences between financial flows and physical flows.

As regards financial flows, the central counterparty would prefer to net at least all accounts receivable and accounts payable towards any clearing member. However, it would be customary for the central counterparty to ensure that the obligation to provide collateral cannot be set off against the central counterparty’s payment obligations. The central counterparty and the TSO tend to reserve a unilateral set-off right in the event of a party’s default, and they use close-out netting in the event of insolvency.

As regards physical flows, whether physical off-take or supply obligations can be netted depends on the rules of the TSO. This can be illustrated with the practices of Elspot, N2EX, and EPEX Spot.


Example: Elspot

In the Elspot market of Nord Pool Spot, the previous trading rules setting out the central counterparty’s right to set off obligations523 have been replaced with netting rules. The older provisions on the central counterparty’s right to set off obligations continue to apply in Nord Pool’s physical gas market.524

According to the new rules, cash settlement amounts are netted cash amounts and the open balance in each product series is a netted value, either a purchase position (a positive value) or a sales position (a negative value).525 Collateral requirements are determined on a net basis for the whole group of companies.526

The central counterparty/clearing house may instruct a client representative to close out and net positions and set off obligations in the event of a client’s non-compliance event.527


Example: N2EX

The N2EX market shows the complex nature of set-off and netting rules. In the N2EX market, one must distinguish (a) between the legal framework of the TSO on one hand and the legal framework of the central counterparty/clearing house on the other, and (b) between payment obligations on one hand and the physical supply or off-take obligations on the other.

Physical supply and off-take obligations will be netted. Only the net position will be reported by the clearing house.528

Also payments cleared by the clearing house will be netted,529 and the amount of daily margin calls is partly based on net positions.530

However, collateral calls and cash settlement amounts will be calculated separately. They will not be set off or netted against each other.531

Upon the occurrence of a material default event, the clearing house may close out and net the position of the account holder.532

Similar netting and set-off rules are applied to payments to or payable by the BSC Clearer. They will be netted “and replaced by a single obligation upon the Party or the BSC Clearer (as the case may be) who would have had to pay the larger aggregate amount to pay the net amount (if any) to the other”.533 However, while each party waives set off rights in relation to the BSC Clearer,534 the BSC Clearer does not waive its own rights in the event of a party’s default. In the event of a party’s default, the amount owing by the BSC Clearer will be set off against the amount(s) in default.535


Example: EPEX Spot

In the EPEX Spot market, the clearing house will net accounts receivable and accounts payable from spot market transactions. There are rules on netting: (a) by the clearing house/central counterparty (ECC) in relation to any clearing member and the Sub-CCP536; (b) by ECC Lux in relation to a trading participant537; and (c) by ECC Lux in relation to ECC.538

In the event of a clearing member’s default, the clearing house/central counterparty may close out and net the clearing member’s positions.539

There are close-out netting provisions applicable in the event of the insolvency of a clearing member. Clearing members may conclude similar close-out netting agreements with their non-clearing members.540


4.7 Market Conduct, Market Abuse and Money Laundering



4.7.1 General Remarks


In the EU, market participants must comply with an extensive market conduct regime on both financial and physical electricity exchanges. The regime reflects a piece-meal approach and consists of four broad areas: open ethical standards; specific rules on market integrity; specific rules on transparency and disclosures; and specific rules on money laundering. The regime is complemented by exchange rules and EFET’s Principles of Good Conduct for energy trading.

You need both open ethical standards and specific rules. Open ethical standards foster compliance with the more specific business conduct obligations.541 The standards are open in the sense that their exact contents can only be determined after the fact. Specific rules focus on the most important issues and are more precise.


Compliance

Market participants need to comply with the market conduct regime. They also need to organise compliance to ensure that their representatives comply with the applicable rules.542 Particular compliance programmes help the firm to manage legal risk in advance.


Sources

Because of the piece-meal approach, the market conduct regime that market participants must comply with has many sources. It has four main components. (a) One of them is the market conduct and market abuse regime of the governing law. (b) The provisions of the governing law must implement the EU market conduct regime. (c) In addition, the exchange operator may have adopted ethical guidelines and market conduct rules. (d) EFET’s Principles of Good Conduct for energy trading can help to determine what behaviour is acceptable market practice.


EU Law and Convergence

The limited scope of the EU market conduct regime has obviously contributed to the limited scope of mandatory legal regulation in the past. However, the fact that a sector or market is unregulated at EU level does not mean that it would be totally unregulated. There is industry self-regulation. Many aspects have been regulated by the operator of the electricity exchange and through contracts. For example, the prohibition of insider trading, the prohibition of market manipulation, and market conduct obligations, may also have been based on electricity exchanges’ codes of conduct in the absence of mandatory regulation.543

The EU market conduct regime is nevertheless more important than its limited scope would imply. There is a spill-over effect. EU law influences the regulation of market conduct either directly or indirectly. On one hand, EU law can regulate the activities of market participants (such as investment firms, operators of regulated markets, central counterparties, or electricity firms) directly. On the other, sectoral regulation can influence behaviour outside its original scope.

Exchange operators and firms are often active in regulated sectors or markets and sectors or markets still unregulated at EU level.544 (a) It is possible that part of the business of the operator of a power exchange falls within the scope of MiFID II (as the operation of a financial derivatives exchange545 or an exchange for trading in emission rights fall within the MiFID II regime546). For instance, many marketplaces have fallen within the scope of the MiFID regime because the MiFID regime applies to various kinds of marketplaces that have rules (regulated markets and multilateral trading facilities are defined as marketplaces operated in accordance with non-discretionary rules).547 (b) Exchange operators have adopted particular market conduct rules as part of organisational requirements under MiFID548 and MiFID II549 and monitor compliance with them.550 (c) On the other hand, part of the business may remain outside of the directive’s scope (as intraday or day-ahead spot electricity contracts for the physical supply of electricity and balancing contracts are not financial instruments,551 the operation of a spot exchange for electricity contracts that must be settled physically is not an investment service,552 and the operator of such a spot exchange is not regarded as an investment firm under MiFID II553). (d) It would not be practicable for a market participant to adopt different internal compliance programmes and different ethical guidelines and market conduct rules for similar activities depending on whether an activity falls within the regulated or the unregulated area. If an exchange operator has to comply with the MiFID regime or a similar national regime anyway, the operator may require compliance with the same standards in a spot marketplace that does not fall within those regimes as such. (e) Moreover, to use EU law as a model or “platform” can help to reduce transaction costs where market participants are active in both regulated and unregulated areas and have a legal duty to comply with both regulatory regimes.

Consequently, the ethical guidelines and market conduct rules of the exchange operator are bound to be aligned with the rules and principles of the EU legal regime even in markets that do not fall within its scope.554 There is convergence of the regulation of market conduct. Convergence is not driven by the bodies of the EU or Member States alone, or just by financial regulators in the US, the EU, or the Member States of the EU. It is also driven by exchange operators and market participants that voluntarily comply with regulation.

The harmonisation of regulation and the convergence of rules can bring several benefits according to ISDA555:



  • a reduction in market participants’ costs for managing risks;


  • an increase in cross-border business, customer choice, and competition;


  • a reduction in distortions of competition as market participants can select their counterparties for trading based on economic rather than regulatory factors;


  • a reduction in the risks to financial stability, because it becomes easier for firms to apply integrated risk management policies and easier for the competent authorities to monitor the more organised markets;


  • an increase in the ability of financial firms to centralise booking and risk management of OTC derivatives in single entities;


  • a reduction in compliance costs for firms no more subject to supervision and inspection by multiple regulators or no more subject to different requirements depending on the regulator; and


  • a reduction in the relocation of businesses for regulatory rather than economic reasons.


The EU Legal Regime

The EU legal regime for the regulation of market conduct consists of several components: MiFIR/MiFID II (replacing MiFID); REMIT (Regulation on wholesale energy market integrity and transparency)556; MAR (Regulation on insider dealing and market manipulation)/MAD II (Directive on criminal sanctions for insider dealing and market manipulation)557 (both replacing MAD)558; and the Money Laundering Directive.559

Electricity exchanges fall within the scope of the MiFID II/MiFIR regime because of the definition of regulated markets, multilateral trading facilities, and organised trading facilities560 (in combination with the definition of multilateral systems561 and financial instruments). The operator of an electricity exchange must adopt particular market conduct rules as part of organisational requirements under MiFID II562 and monitor compliance.563

Specific abusive practices affecting wholesale energy markets are prohibited in three main ways: through general financial markets legislation; through prohibitions of specific abusive practices in wholesale energy markets; and through competition law. (1) The general market integrity and disclosure regime for financial markets applies to investment firms (MiFIR564), issuers (MAR, the Prospectus Directive565), and a large group of other persons (MAR). The scope of this regime depends on the field of activity of the firm, the nature of contracts, to whom they are offered, and other things. (2) Specific abusive practices in wholesale energy markets are addressed by REMIT. The rules laid down by REMIT are aligned with those applicable in financial markets but consider the specific characteristics of wholesale energy markets.566 In the future, similar rules may be adopted for carbon markets.567 (3) REMIT is without prejudice to MAR/MAD II and MiFIR/MiFID II, including the application of European competition law.568 The third alternative is thus competition law.

REMIT was adopted in 2011, because the earlier regulatory regime for financial markets did not properly address market integrity issues for electricity markets. Behaviour that undermined the integrity of electricity markets was not clearly prohibited.569 The scope of the regime for financial markets was too limited as it only applied to financial instruments. Neither did it consider the electricity market’s sector-specific conditions, in particular the connection between the derivatives markets and the underlying physical market.570

While few electricity producers have an obligation to comply with the MiFIR/MiFID II regime, many must comply with provisions implementing MAR, and all electricity wholesale market participants must now comply with REMIT.


EFET’s Principles of Good Conduct for Energy Trading

Laws are complemented by industry self-regulation such as the EFET Principles of Good Conduct. All new EFET member companies have to sign up to ten principles before their membership application can be accepted.571


Compliance

Market participants need to organise compliance to ensure that their personnel comply with the market conduct regime.572 Particular compliance programmes help the firm to manage legal risk in advance by reducing bad practices. The firm can also try to mitigate or avoid risk by means of safe harbours (Sects. 4.7.4 and 4.7.5). In electricity markets, REMIT influences the organisation of compliance. MAR lays down similar requirements.573

REMIT requires “persons professionally arranging transactions” to take action against inside trading and market manipulation. Such persons include at least trading venues like energy exchanges and brokers.574 First, they must “establish and maintain effective arrangements and procedures to identify breaches” of the two prohibitions. Second, “any person professionally arranging transactions in wholesale energy products” who “reasonably suspects” that a transaction might breach the prohibition of inside trading or the prohibition of market manipulation must notify it to the national regulatory authority without further delay.575

Therefore, these persons should pay attention to transactions that look suspicious.576 ACER has given guidance on suspicious-looking transactions.577

The Market Surveillance of North Pool Spot must report (1) any suspected cases of market manipulation and insider trading to the national regulatory authority under the REMIT and (2) any suspected breaches of other laws and regulations affecting the North Pool Spot market according to the terms of the market place licence from NVE.

In practice, most actual breaches relate to disclosure obligations and cases of market manipulation and insider trading are relatively rare.578


4.7.2 Open Ethical Standards, Good Business Conduct, Fairness


Open ethical standards can be based on legal or non-legal sources. For electricity markets, the most important legal sources of open ethical standards include the MiFID II/MiFIR regime, the regulation of electricity markets, rules adopted by spot market operators, and the governing law. The most general ethical standard characteristic of electricity markets is “fairness”. We can focus on the MiFID II/MiFIR regime, the regulation of fairness, the EFET Principles, and exchange rules.


The MiFID II/MiFIR Regime

MiFID II lays down open standards the operators of regulated markets, multilateral trading facilities, and organised trading facilities, and for investment firms dealing with customers.

The MiFID II/MiFIR regime requires, directly or in effect, because of the spill-over effect or after the adoption of its rules as legal transplants, exchange operators to apply the following rules:



  • transparent and non-discretionary rules and procedures for fair and orderly trading 579;


  • rules on the disclosure of sufficient publicly available information to enable users to form an investment judgement580;


  • the prohibition of disorderly trading conditions, conduct that may involve market abuse, and breaches of the rules;


  • rules laying down an obligation to observe fairness in dealings with clients 581 regardless of the nature of the client or the client classification system582; and


  • rules on regular monitoring of compliance with the rules.583

There is a similar regime in the US. The Commodity Exchange Act lays down business conduct standards for swap dealers.584


Fairness

The MiFID II/MiFIR regime is not the only regulatory regime that lays down fairness requirements. Fairness requirements can be found in other parts of financial markets regulation and the regulation of electricity markets.

In the electricity sector, fairness requirements are particularly important because of the existence of natural monopolies,585 the high volatility of spot prices, and the system’s reliance on the integrity of market participants.

The question of fairness has been addressed in three main ways in EU electricity markets law. First, the regulator should determine or approve rules for the electricity sector according to the Third Electricity Directive. When doing so, it should try to ensure that the electricity sector operates in a fair and economically efficient manner.586 Second, wholesale market participants must comply with the provisions of REMIT. REMIT is based on the general notion of fairness in dealings with other market participants and clients.587 As regards financial markets, MiFID II focuses on fairness to clients and the adoption of rules for fair trading.588 One can also note that an earlier proposal for EMIR contained a fairness obligation for central counterparties.589 Third, the growing regulation of market coupling addresses fairness in many respects.590

Obviously, Member States’ laws may lay down fairness obligations applied in contract or in tort. Civil liability of general application complements the specific obligations based on sectoral regulation. There is plenty of variation depending on the Member State.591


EFET’s Principles of Good Conduct for Energy Trading

The EFET Principles of Good Conduct are designed to reflect the following values: integrity of action; respect for others; open communication; professionalism; and observing the spirit of a truly open and sustainable wholesale marketplace. According to the wording of the ten principles, EFET member companies have a contractual duty to:

1.

respect free and fair competition as the basis for trading energy;

 

2.

engage in no activities that would amount to market abuse, market manipulation or fraud, and to relay no information known or strongly suspected to be false or misleading;

 

3.

deal with each other in accordance with established market practices and the standards expected of professional market counterparties;

 

4.

deal with customers fairly and with integrity and manage any conflicts of interest that may arise appropriately;

 

5.

organise their energy trading business effectively, respecting appropriate segregation of staff duties, and exercise diligent control over trading functions;

 

6.

establish effective risk management policies and control procedures governing the key risks managed by their energy trading functions;

 

7.

establish compliance policies setting out the company’s procedures for fulfilling all legal and regulatory obligations and any related corporate governance rules relating to their energy trading functions;

 

8.

ensure that their traders are suitably qualified and properly supervised to carry out their duties, including where appropriate to have taken relevant industry examinations;

 

9.

prohibit their employees from giving or receiving bribes and from indulging in other corrupt behaviour in all circumstances; and establish policies governing gifts and hospitality, highlighting acceptable and unacceptable practices; and

 

10.

maintain accounts related to trading transactions and risk books in accordance with relevant accounting standards and respecting normal audit practices.

 


Exchange Rules

All these issues on open ethical standards, good business conduct, and fairness have even been addressed in rules adopted by the operators of electricity exchanges. There can be a difference between physical markets and financial markets. While physical electricity exchanges need rules that ensure the operation of physical electricity markets, financial electricity exchanges need rules on conduct in relation to clients. This can again be illustrated with the physical markets of EPEX Spot and Nord Pool Spot, and the financial markets of Nasdaq Commodities and EEX.


EPEX Spot

The operator of EPEX Spot (EPEX Spot SE) has adopted a Code of Conduct. The Code applies not only to exchange members but also to the operator itself.592

Exchange members must comply with the Code when doing business in the market. The Code reflects REMIT593 but is not limited to matters governed by it. All instructions and rules of the relevant supervisory authorities, including EPEX SPOT SE are part of the Code.594

Generally, an exchange member must not take actions that “are detrimental to the orderly operation of the market”. Failure to comply with the prohibitions of the Code is punished by a warning, a suspension, or the withdrawal of exchange membership.595 The sanctions are cumulative.596 The operator of the market may also seek compensation for damage.597


EEX

Like the EPEX Spot Code of Conduct, the EEX Code of Conduct is focused on market abuse and transparency.598 In addition, it regulates the way to treat clients.


Nord Pool Spot

Nord Pool Spot has adopted ethical guidelines (that are no longer in force after a major change in October 2014)599 and market conduct rules (that are in force).600 Before Nord Pool Spot took over the N2EX market in the UK, the ethical guidelines and market conduct rules applied to all physical markets of Nord Pool.

The market conduct rules lay down compliance obligations for all members of Nord Pool Spot’s physical markets.601 Each member must comply with them itself602 and adopt internal rules for any person involved in trading and/or clearing on its behalf.603 The market conduct rules are without prejudice to obligations under any applicable law604 but prevail over other provisions of the Trading Rules. This means that they will influence the interpretation of more specific rules and can be used to fill gaps.605

The market conduct rules reflect the contents of REMIT. In addition, they lay down a general obligation to observe good business conduct. The general obligation consists of an open prohibition (members must not “apply unreasonable business methods” when trading on NPS)606 and a dynamic duty (members must “seek to act in accordance with good business practice”).607 These open duties are complemented by particular dynamic duties and particular prohibitions.

The general good business conduct obligations laid down by the market conduct rules are dynamic also in the sense that members must:



  • “seek to promote integrity and efficiency in the Physical Markets”; and


  • “take due account to any relevant regulatory or legal obligations, any proper and relevant professional standards of conduct, and the need for the Physical Markets to operate fairly and efficiently for all Members”.608

In addition, the market conduct rules prohibit certain activities:



  • A member must not apply unreasonable business methods.609


  • Orders and transactions must be genuine.610


  • A member must not improperly influence the price or price structure in the NPS physical markets.611


  • A member must not disturb other members’ access to or participation in the market.612


  • The abuse of inside information is prohibited.613 The market conduct rules also define inside information and related concepts.614


  • Market manipulation is prohibited.615

The market conduct rules require a member to disclose information to the public616 and to provide information to NPS.617 The rules on public disclosure are based on REMIT and applied to the Nordic and Baltic electricity markets. A member is required to publicly disclose “information relating to the Nordic or Baltic electricity market” regarding its business or facilities.618 Public disclosure is limited to certain type of information “relevant to facilities for production, consumption or transmission of electricity”. For instance, a member must disclose information about outages.619

There are disciplinary sanctions for non-compliance with the market conduct rules.620 A breach can result in disciplinary sanctions that include a daily charge, a warning, or a violation charge. The choice of sanctions is in the discretion of the board of Nord Pool Spot AS.621

Nord Pool Spot used to have Ethical Guidelines. They were removed from the Nord Pool Spot rulebook from 27 October 2014. According to Nord Pool Spot, the Ethical Guidelines were no longer necessary as their subject matter was, to a large extent, covered by other parts of the Nord Pool Spot rulebook. Moreover, the Ethical Guidelines were explicitly stated to be “non-sanctionable” and Nord Pool Spot was of the opinion that the rulebook should only contain legally binding documents.622 One can also note that there were no ethical guidelines for the N2EX market in the past and that it was necessary to align the regulation of all physical markets of Nord Pool Spot.

In any case, the previous Ethical Guidelines can still give information about the general ethical requirements applicable to market participants.

The ethical guidelines for Nord Pool Spot were binding but, unlike market conduct rules, there were no formal sanctions for their breach. Sanctions could be enforced only in case of breach of law, administrative provisions, or the rules of the exchange.623 The purpose of the ethical guidelines was to increase trust in the market, that is, to make people expect that Nord Pool, its participants, and clearing customers observe good standards of conduct and act in an ethical manner.624

The ethical guidelines laid down several general principles that probably still apply. They apply either to categories of parties or transactions.

Many of the principles apply to participants and clearing customers:



  • participants and clearing customers must comply with laws and regulations and the rules of the market;


  • participants and clearing customers must comply with general standards for good business practice and good professional behaviour625;


  • participants and clearing customers must act “responsibly and seriously”,626 their actions should be justifiable “in a way acceptable to others”, their actions should be documented, and they should be open about the purpose of their actions627; and


  • participants and clearing customers must not compete in an unfair manner.628

Moreover, there are general principles applicable to all transactions made in Nord Pool’s markets:



  • they must be performed “with a genuine and generally acceptable business purpose”629;


  • fictive transactions and mock agreements are prohibited630;


  • it is prohibited to give false or misleading information to the market631;


  • participants and clearing customers must not manipulate markets632;


  • it is prohibited to depart from the pattern of market behaviour unless it is motivated by serious commercial or technical reasons633; and


  • a participant or clearing customer that is “a leading player in respect to the relevant supply or demand for electricity or electricity derivatives” must assure that it does not “in any inconsiderate way” affect the price development in the relevant market.634

Some general principles apply to investment firms dealing with clients. In practice, they must reflect the MiFID II regime.635 There are also organisational requirements relating to: compliance by the board and the management636; the appointment of a compliance officer637; and internal ethical guidelines.638


N2EX

In the N2EX market, the Market Conduct Rules apply to market participants, account holders, and brokers (Market Conduct Parties).639 They cannot trade in the N2EX market without having to comply with the provisions of the Market Conduct Rules and the applicable law.640 All contractual obligations are governed by English law.641

Where a Market Conduct Party grants trading system access to a third party, it must ensure that the third party complies with the Market Conduct Rules as if they applied to the third party. The third party must sign an adherence form.642 The Market Conduct Rules are enforced by the Market Surveillance Unit of Nord Pool Spot AS.643

In addition to a general obligation to comply with the provisions of the applicable law including information-related duties, the Market Conduct Rules lay down a general prohibition to apply “unreasonable business methods”, and a general duty to “seek to act in accordance with good business practice”.644


Nasdaq Commodities

Like N2EX, Nasdaq Commodities requires market participants not to apply “unreasonable business methods” and to “seek to act in accordance with good business conduct” according to its Market Conduct Rules.645 The rules contain detailed disclosure requirements relating to market participants’ own business or facilities or the business or facilities of clients.646


4.7.3 Market Integrity and Transparency



General Remarks


Traditional ways to increase market integrity include transparency, duties to comply with certain standards, and the prohibition of harmful acts. In particular, there are: (a) rules on registration, reporting, and monitoring; (b) rules laying down duties to other market participants and clients; (c) rules on public disclosure of inside information; and (d) rules that prohibit market abuse.


Approach to Regulation

Market integrity is regulated in two main ways. First, it is regulated by transmission system operators and the operators of electricity exchanges. Extensive industry self-regulation is necessary for the functioning of the transmission system and electricity exchanges. TSOs would not be able to fulfil their own obligations such as managing electricity flows on the system647 without the transparency of market participants’ plans and actions. Transparency is facilitated by detailed balance contracts. Moreover, it is necessary for TSOs to require market participants to observe minimum standards. In order for electricity exchanges to work, market participants must even comply with other transparency and disclosure obligations. Second, market integrity is regulated by EU law and the governing law. The regulation of market integrity in European electricity markets follows in the footsteps of the regulation of financial markets.

EU financial markets are largely integrated after the implementation of the Financial Services Action Plan (FSAP).648 The FSAP was based on the idea that “a genuine Single Market for financial services” is “crucial for economic growth and job creation in the Community”.649 It was assumed that “an integrated and efficient financial market” requires not only freedom to provide investment services across the EU and home-country control but also market integrity.650 This led to the adoption of legislation that increased transparency and prohibited market abuse.

After the unbundling and integration of EU electricity markets and the emergence of electricity exchanges, it became necessary to adopt similar EU-wide rules on the integrity and transparency of wholesale energy markets.651

The regulatory regime for financial markets did not properly address these issues in electricity markets. The gap was addressed by REMIT and by the MAR/MAD II regime. They take into account inter-linkages between spot markets and related derivatives markets.652


Integrity

REMIT was designed to “foster open and fair competition in wholesale energy markets for the benefit of final consumers of energy” by increasing the integrity and transparency of wholesale energy markets.653 Their integrity and transparency were expected to benefit final consumers through the price mechanism. Price is influenced by transaction costs and market participants’ perceived exposure to risk, among other things. A reduction in these costs and risks means increased liquidity and demand. The question of “integrity” or “confidence in the integrity of electricity and gas markets” is therefore a question of how to reduce transaction costs and perceived risk.654


Transparency, Market Abuse, REMIT

MAR and REMIT lay down disclosure and reporting obligations and prohibit market abuse. Generally, these Regulations are designed to reflect the connection between disclosure and market abuse issues, and the connection between physical markets and derivatives markets.

The regulation of disclosure obligations should be aligned with the market abuse regime. If the two regimes are not aligned, there is a risk that information that must disclosed can simultaneously be regarded as inside information that must be kept secret.

In electricity wholesale markets, the regulatory regime should also be aligned with the regulation of securities markets, because physical electricity trading is complemented by derivatives trading. The REMIT definitions of inside information, insider trading, and market manipulation under REMIT have therefore been aligned with those applied in securities markets. The alternative would have been to expand the scope of MAR. But although MAR has a broad scope, it was not regarded as appropriate to extend it to “behaviour that does not involve financial instruments, for example, to trading in spot commodity contracts that only affects the spot market”.655

The definitions of the regulatory regime should consider the specific characteristics of wholesale energy markets.656 REMIT provides examples of factors that should be considered.657 The Commission is empowered to adopt delegated acts for this purpose.658 Moreover, in the case of wholesale energy products, the competent authorities should consider the REMIT definitions when interpreting the related provisions of MAR.659

To sum up, the harmonisation of EU financial markets laws and the adoption of REMIT have contributed to the convergence of electricity exchange operators’ market integrity rules as exchange rules must be aligned with mandatory provisions of law.


Registration, Reporting and Monitoring


Registration, reporting, and monitoring rules form an important part of the market integrity regime. Market participants must ensure compliance with overlapping regulatory regimes in this respect. They must comply with: the regulation of the electricity sector; the market abuse regime for trade in financial instruments; and the MiFID regime for investment firms.660 In the following, we will discuss the regulation of monitoring (by ACER and national regulatory authorities), registration obligations, the duty to disclose market data to regulators or the TSO (Congestion Management Guidelines), the duty to disclose generation or load estimations (CACM Regulation), and data storage before moving on to the market abuse regime.


Monitoring, ACER

There is a fundamental monitoring-related difference between electricity markets regulation and securities markets regulation. Electricity market participants must co-operate with many monitors.

While EU financial markets are governed by the principle of home country control,661 this principle did not extend to electricity markets in the past. Monitoring practices depended on the Member State, and trading activities could be subject to multiple jurisdictions with monitoring carried out by different authorities located in different Member States.662 This became a problem because of the increasing integration of wholesale energy markets.663

The Third Electricity Directive did not solve the problem. The Directive does require each Member State to designate a single national regulatory authority664 whose duties include the monitoring of exchanges.665 However, the Directive does not require many exchange-related duties. Such duties are limited in three respects. First, while the Third Directive requires the regulatory authority to monitor what can be described as competition issues on electricity exchanges,666 it does not address other exchange-relevant issues. Second, a Member State may provide that the monitoring duties are carried out by other authorities instead of the regulatory authority.667 Third, TSOs monitor activities to the extent that they relate to physical flows on the system, and exchange-related issues are customarily monitored by securities markets regulators.

Monitoring issues were partly addressed by REMIT. First, REMIT facilitates stronger cross-border market monitoring. Stronger cross-border market monitoring is regarded as “essential for the completion of a fully functioning, interconnected and integrated internal energy market”, and “vital for detecting and deterring market abuse on wholesale energy markets”.668 Second, REMIT is also an attempt to increase clarity as to what authority is responsible for monitoring.669 According to REMIT, ACER is regarded as best placed to carry out such monitoring.

However, there are still many monitors. (a) National regulatory authorities continue to monitor electricity markets at the national level. Close co-operation is therefore necessary between energy regulators.670 Depending on the Member State, market monitoring duties may be allocated to competition authorities.671 (b) Moreover, REMIT does not limit the work of securities markets regulators and competition authorities under EU law.672 Co-operation is therefore required even in this respect to facilitate efficient monitoring of all aspects of trading in wholesale energy products.673

This leaves the ACER with a relatively weak monitoring role. The Agency collects data and lets other regulatory authorities access the data it has collected.


Registration and Reporting to ACER Under REMIT

The REMIT nevertheless requires the disclosure of information to ACER and to national regulatory authorities.674

Market participants have to comply with four main reporting obligations that include: a registration duty (REMIT); a duty to report transactions (REMIT); a duty to disclose market data (Congestion Management Guidelines); and a duty to disclose inside information (REMIT).


Registration

A market participant must register with one national regulatory authority in the EU675 prior to entering into a transaction which is required to be reported.676 REMIT contains a list of market participants and others subject to the registration duty.677 Generally, they include persons who enter into transactions in one or more wholesale energy markets.678 Because the “crucial criterion” is the entering into transactions, many entities are regarded as market participants in this respect.679 A separate legal person must register regardless of the fact that a parent, subsidiary or other related entity is already registered.680

The definition of wholesale energy markets is a broad one.681 Wholesale energy markets are markets within the EU on which wholesale energy products are traded.682 As it does not matter where and how “wholesale energy products” are traded, even intra-group transactions (OTC contracts entered into with another counterparty which is part of the same group) are regarded as wholesale energy products.683 On the other hand, contracts for the supply and distribution of electricity or natural gas for the use of final customers are not wholesale energy products unless the final customer has a large consumption capacity.684

For an EU firm, the competent national regulatory authority is the regulatory authority in the Member State in which it is “established or resident”.685 In electricity markets, the national regulatory authority is designated in accordance with the Third Electricity Directive.686

This registration duty is without prejudice to obligations to comply with the applicable trading and balancing rules that require other kinds of registrations (with the exchange operator, the clearing house/central counterparty, and the TSO).687


Transactions

The registration obligation is complemented by an ongoing disclosure obligation. Market participants must provide ACER with a record of wholesale energy market transactions, including orders to trade. REMIT contains a list of the data to be reported.688 The transactions to be reported and the modalities of reporting are defined by the Commission by means of implementing acts.689 There is a Commission Implementing Regulation setting out the details.690

The ongoing duty to report transactions does not apply to the extent that the market participant already has reported the transaction in accordance with MiFID II/MiFIR or EMIR.691 National regulatory authorities have access to information collected by ACER.692


Disclosure of Market Data by the Primary Owner of the Data

In addition to general disclosure obligations, electricity firms must disclose market data as set out in the Congestion Management Guidelines, that is, Annex I to Regulation 714/2009693 and Regulation 543/2013 amending Annex I.694

The new disclosure obligations under Regulation 543/2013 are not limited to congestion management in the narrow sense. They are relatively broad and detailed and designed to complement the regulation of the disclosure of inside information under REMIT.695 The liability of the parties is nevertheless limited under Regulation 543/2013.696

The disclosure obligations under Regulation 543/2013 apply to data relating to generation, transportation, and consumption of electricity.

The entity subject to the disclosure obligation is “the primary owner of the data” defined as “the entity which creates the data”.697 The primary owner of the data depends on the nature of the data:



  • TSOs are regarded as primary owners of data in most cases.698


  • Generation units and DSOs must provide information on total load.699


  • Generation units and production units must provide information relating to actual generation.700


  • Generation units must provide information relating to the unavailability of generation and production units.701


  • Consumption units must provide information relating to the unavailability of consumption units.702


  • Production units must provide information relating to the forecast of generation.703


  • Generation units and DSOs must provide any relevant information required to calculate the year-ahead forecast margin for each bidding zone.704


  • Power exchanges and transmission capacity allocators must provide information relating to the use of cross zonal capacities.705

Information is submitted to TSOs706 or to the central information transparency platform.707 In the latter case, parties subject to the disclosure obligation must use a third party acting as data provider on their behalf as agreed by the TSO. Information must be submitted in the required form. It must be “complete, of the required quality and provided in a manner that allows TSOs or data providers to process and deliver the data to the ENTSO for Electricity in sufficient time to allow the ENTSO for Electricity to meet its obligations”.708 ENTSO-E must develop a manual of procedures.709


Generation or Load Estimations

The CACM Regulation provides that the individual grid models that each TSO is required to prepare should include information from generation and load units.710 If a generator or load unit is required to provide information to the TSO responsible for the control area for the purposes of capacity calculation, it must provide information for each capacity calculation timeframe. The data to be provided is specified in the TSO’s generation and load data provision methodology.711


Data Storage

Market integrity is fostered and monitoring made easier by electricity producers’ data storage obligations. Large generation undertakings—that is, “generation undertakings which own or operate generation assets, where at least one generation asset has an installed capacity of at least 250 MW”—must store hourly data per plant and keep it at the disposal of the national regulatory authority, the national competition authority, and the Commission for 5 years. The duty applies to data that is “necessary to verify all operational dispatching decisions and the bidding behaviour at power exchanges, interconnection auctions, reserve markets and over-the-counter-markets”.712


Public Disclosure of Inside Information: General Remarks


Some firms are subject to an ongoing duty to disclose inside information to the public. This duty is based either on REMIT or MAR.713 MiFID II, REMIT, and MAR complement each other. Reporting obligations under REMIT are without prejudice to reporting obligations under the MiFID regime and the market abuse regime.714


Market Abuse Regulation

MAR is less important than REMIT in electricity wholesale markets, because both MAR and its disclosure obligations have a limited scope.

One of the problems relates to the issuer. According to MAR, the issuer of financial instruments must disclose inside information to the public where the inside information directly concerns the issuer.715 While it is clear that securities traded on an exchange are issued by a certain issuer and traded on the secondary market between other parties, many contracts traded on electricity exchanges are not issued in any meaningful sense by an issuer other than the exchange operator that decides on the listing of contracts.716

Moreover, MAR mainly applies to qualified financial instruments, that is, financial instruments traded on a regulated market, multilateral trading facility (MTF), or organised trading facility (OTF).717 Many contracts traded on electricity markets are not financial instruments.

In some cases, however, MAR applies to products auctioned on an auction platform whether or not they are financial instruments.718 In some cases, MAR could even apply to certain spot commodity contracts.719 Emission allowances are defined as financial instruments720 (and neither emission allowances nor contracts for green certificates are regarded as wholesale energy products for these purposes).721

The inside information rules of MAR apply to different kinds of contracts traded on electricity markets:



  • Financial instruments. “Inside information” is defined as qualified information relating to “financial instruments”, “commodity derivatives”, “emission allowances or auctioned products” or issuers of financial instruments.722 Because of the broad definition of “financial instruments”,723 some “derivative contracts relating to commodities” such as electricity derivatives can be regarded as “financial instruments”.


  • Related instruments. Moreover, inside information rules apply to “spot commodity contracts, which are not wholesale energy products”724 and “emission allowances or auctioned products” that are not financial instruments.725 Emission allowances under the EU ETS are regarded as “financial instruments”.726


  • Trading. The inside information rules of MAR apply to “financial instruments” and related instruments qualified in relation to trading on a regulated market, an MTF, or an OTF.727 On the other hand, actions are not qualified. MAR applies to “any transaction, order or behaviour … irrespective of whether or not such transaction, order or behaviour takes place on a trading venue”.


  • Exclusions. It is clear that MAR does not apply to trading in spot electricity contracts or physical electricity forward contracts where contracts are settled physically.728 Generally, some contracts fall outside the scope of the inside information rules of MAR. There are electricity contracts that do not have the characteristics of derivative financial instruments according to the main rule.729 There are electricity derivatives that are not regarded as “financial instruments” as they are “for commercial purposes”. There can be electricity contracts that are regarded as “financial instruments” but not traded on a regulated market, an MTF, or an OTF. Moreover, wholesale energy products that must be physically settled and are traded on an OTF are not financial instruments.730 Such trading only affects the spot electricity market or the physical electricity forward market.


REMIT

Because of the limited scope of MAR, it was thought necessary to extend the scope of this regime while considering the specific characteristics of wholesale electricity markets.731 According to REMIT, each “market participant” must publicly disclose inside information in respect of its business or facilities.

The scope of the duty to disclose inside information is broad, because duties to disclose inside information under REMIT and MAR are complementary rather than mutually exclusive, because the disclosure duty under REMIT applies to market participants rather than issuers, because the disclosure duty under REMIT applies to wholesale energy products whether or not they are financial instruments,732 and because the definition of inside information is broad under REMIT.

This raises several questions. What must be disclosed? Who must disclose something? To whom and how must the disclosure be made? When does the disclosure have to be made? Are there exceptions? We will focus on REMIT and physical electricity markets.


Inside Information


For the purposes of REMIT, “inside information” is “information of a precise nature which has not been made public, which relates, directly or indirectly, to one or more wholesale energy products and which, if it were made public, would be likely to significantly affect the prices of those wholesale energy products”.733 For the purposes of MAR, “inside information” means similar information that relates to financial instruments or their issuers.734

The definition of inside information is thus a broad one. It can be broader than “transparency information” to be published under Regulation 714/2009 or referred to in Regulation 543/2013.735 However, information is not inside information if it has already been made public. Neither does inside information consist of the market participant’s own trading plans or trading strategies.736

Like in securities markets, inside information under REMIT consists of many elements.737 There are nevertheless some differences.


Wholesale Energy Products

Information is not inside information under REMIT unless it “relates” to one or more wholesale energy products and, if it were made public, would be “likely to significantly affect” the prices of those “wholesale energy products”.738 For example, inside information in the electricity derivatives market often relates to large production volumes that should be reported to the operator of the exchange but have not yet been disclosed to the market.739 Changes in production schedules can influence price when the volumes are large. In practice, prices could be influenced even by information from an important electricity producer’s board meetings.740


Expectations

Inside information is qualified by the expectations of market participants. Unlike in securities markets, there are limitations on the information that is regarded as legally relevant.

First, inside information may consist of information that must be disclosed to the public because of legal requirements or market rules.741

Second, inside information may consist of “information that a reasonable market participant would be likely to use as part of the basis of its decision to enter into a transaction relating to, or to issue an order to trade in, a wholesale energy product”.742 For instance, this could be “information relating to the capacity and use of facilities for production, storage, consumption or transmission of electricity or natural gas or related to the capacity and use of LNG facilities, including planned or unplanned unavailability of these facilities”.743

Third, where MAR applies to derivatives on commodities, information is not inside information under that Regulation unless it, “if it were made public, would be likely to have a significant effect on the prices of such derivatives or related spot commodity contracts”, and “this is information which is reasonably expected to be disclosed or is required to be disclosed in accordance with legal or regulatory provisions at the Union or national level, market rules, contract, practice or custom, on the relevant commodity derivatives markets or spot markets”.744


Precise Nature

Like in securities markets,745 information cannot be regarded as inside information unless it is “of a precise nature”. The holder of the information bears the risk of assessing the nature of information correctly: “The precise nature of the information is to be assessed by the holder of the information on a case-by-case basis and depends on what the information is and on the surrounding context”.746

Information is deemed to be of a precise nature if two cumulative conditions are satisfied. The first relates to the existence of a set of circumstances or an event. The second relates to their effect on prices.747

According to the wording of REMIT, information is “deemed to be of a precise nature if it indicates a set of circumstances which exists or may reasonably be expected to come into existence, or an event which has occurred or may reasonably be expected to do so, and if it is specific enough to enable a conclusion to be drawn as to the possible effect of that set of circumstances or event on the prices of wholesale energy products”.748

As the existence of information of a precise nature can trigger the disclosure obligation (provided that all the other requirements are met), there is a connection between (a) the existence of such a “set of circumstances” or “event” on one hand and (b) the point in time when the disclosure must be made on the other.

The question of the existence of information of a precise nature is particularly important in protracted processes in which there are intermediate steps (such as negotiations, decisions, or contracts) taken by one body but no final and effective decision without approval by another body. How likely must the occurrence of future events be?

Protracted processes have been discussed in Markus Geltl v Daimler AG and addressed in MAR.749 In Markus Geltl v Daimler AG, the CJEU held that information relating to an intermediate step which is part of a protracted process may be regarded as precise information.750 Moreover, even a future set of circumstances or event may trigger the disclosure obligation, provided that “it appears, on the basis of an overall assessment of the factors existing at the relevant time, that there is a realistic prospect that they will come into existence or occur”.751 In the light of Markus Geltl v Daimler AG, the following test must be used to determine whether it is reasonable to think that a set of circumstances will come into existence or that an event will occur:

1.

An assessment must be made on a case-by-case basis of the factors existing at the relevant time.752

 

2.

High probability is not required.753

 

3.

On the other hand, the occurrence of the set of circumstances or events must not be implausible.754

 

4.

Therefore, the expression “may reasonably be expected” refers to future circumstances or events from which it appears, based on an overall assessment of the factors existing at the relevant time, that there is a realistic prospect that they will come into existence or occur.755

 

According to MAR, an intermediate step in a protracted process is regarded as inside information “if, by itself, it satisfies the criteria of inside information”.756


Entities Subject to the Obligation to Disclose Inside Information


The broad scope of the definition of inside information is complemented by the broad scope of entities that are potentially subject to the disclosure obligation under REMIT.


Market Participant

A market participant must disclose inside information which it possesses in respect of its own business or facilities.757

The number of entities subject to the disclosure obligation is increased, because: (1) the threshold of market connection that triggers the obligation is low; (2) circumstances attributable to the entity can include circumstances of other entities that are sufficiently closely related758; (3) the disclosure obligation extends to a larger group of people in the case of selective disclosure759; (4) the disclosure obligation applies regardless of whether the wholesale energy product is a financial instrument or not760; and (5) some electricity market participants are subject to disclosure obligations under MAR as issuers of financial instruments or emission market participants.761


Market Connection

We can study the low threshold of market connection first. Each “market participant” in the “wholesale energy market” must disclose inside information under REMIT. The “wholesale energy market” means any market within the EU on which wholesale energy products are traded, and a “market participant” means any person who enters into transactions or places orders to trade in one or more wholesale energy markets. Even transmission system operators are regarded as market participants.762

The market connection (that is, entering into transactions, including the placing of orders to trade) is not qualified according to the wording of REMIT.

One might therefore ask (a) whether entering into (at least) one transaction or placing (at least) one order to trade in (at least) one wholesale energy market in the EU can trigger the ongoing disclosure obligation, or (b) whether there must be a greater number of transactions or orders, or a more permanent market connection.

The disclosure obligation seems to be triggered by one transaction for three reasons. First, REMIT provides that a market participant must register with one national regulatory authority in the EU.763 The registration obligation and the disclosure obligation should apply to the same entities. Second, clear thresholds are to be preferred to make it easier for market participants to comply with the disclosure rules. Third, this would increase: the pool of information that enables market participants “to assess the overall demand and supply situation and identify the reasons for fluctuations in the wholesale price”764; and the efficiency of electricity markets.


Attributable Circumstances

The second factor increasing the number of entities subject to the disclosure obligation under REMIT is the fact that circumstances attributable to the entity can include circumstances of other legal entities.765 MAR is narrower in this respect as an issuer’s ongoing disclosure duty is limited to “inside information which directly concerns that issuer”.766

When determining the “market participant” subject to the disclosure obligation under REMIT, the starting point is the legal entity (or natural person) that places an order to trade in the wholesale market.767 The entity must publicly disclose inside information in respect of its business or facilities.

However, circumstances attributable to the entity are not limited to business directly carried out by the entity or facilities directly owned by the entity.768 The entities, business, and facilities attributable to the market participant have a broad scope. They include:



  • business and facilities that the entity owns;


  • business and facilities that the entity controls;


  • business and facilities for whose operational matters the entity is responsible in whole or in part; and


  • business and facilities of other entities that belong to the same firm by reason of share ownership or control. These entities are the entity’s parent undertaking and affiliated undertakings (“related undertakings”) as defined in the Seventh Company Law Directive.769


Selective Disclosure

The third factor relates to selective disclosure. A larger group of people is subject to the disclosure obligation in the event of selective disclosure.770 Where a market participant discloses inside information in relation to a wholesale energy product “in the normal exercise of his employment, profession or duties”, the market participant must “ensure simultaneous, complete and effective public disclosure of that information”. Where a person employed by, or acting on behalf of, a market participant discloses such inside information in that way, either that person or the market participant must ensure public disclosure.771


Limitations on the Duty to Disclose Inside Information


Market participants have a duty to disclose some but not all inside information under REMIT. The disclosure duty is limited in four main ways.


No Inside Information

Obviously, there is no duty to disclose inside information if there is no inside information in the first place.772 (a) Information is not inside information to the extent that it has been made public. (b) Moreover, information is not inside information under REMIT unless it “relates” to one or more wholesale energy products. There is no obligation to disclose information about: general corporate matters; securities issued by the entity or related entities; or wholesale energy products as such. There can, nevertheless, be a duty to disclose such information under securities markets laws, market rules, the rules of the transmission system operator, or otherwise. For instance, information can be regarded as inside information according to the provisions of MAR that complement the provisions of REMIT.773


Knowledge

The second limitation relates to knowledge. A market participant has no duty to disclose inside information unless the information is in its possession.

This limitation can be important in practice because of the broad scope of circumstances attributable to the market participant.774 For instance, inside information can also relate to a parent or affiliate company’s business or facilities. The market participant does not need to disclose circumstances that it is not deemed to be aware of.

MAR lacks a similar general limitation. On the other hand, it also limits disclosure obligations to the circumstances of the issuing legal entity.775 There is an exception. While emission allowances are regarded as financial instruments that fall within the scope of MAR, an emission allowance market participant is subject to wider disclosure obligations like commodities market participants under REMIT.776


Qualified Inside Information

The third limitation relates to the nature of inside information. (a) The duty to disclose inside information under REMIT is limited to inside information “in respect of business or facilities”. The disclosure must include “information relevant to the capacity and use of facilities for production, storage, consumption or transmission of electricity … including planned or unplanned unavailability of these facilities”.777 (b) There is thus no duty under REMIT to disclose information that is not closely enough connected with business or facilities. In contrast, MAR limits the disclosure obligation to inside information that “directly concerns” the issuer.


Delayed Disclosure

The fourth limitation is that the disclosure of inside information may be delayed under REMIT778 and MAR779 if the conditions are met.


Manner of Disclosure


REMIT sets out the manner of disclosure only in very general terms. The main rule is that market participants must disclose inside information publicly “in an effective and timely manner”.780

MAR lays down a similar requirement. According to MAR, inside information must be made public “in a manner which enables fast access and complete, correct and timely assessment of the information by the public”.781 MAR refers to the Transparency Directive in this respect.782 MAR will also be complemented by delegated acts. There are earlier implementing rules on the technical modalities for appropriate public disclosure of inside information for the purposes of the directive that it replaces.783


Compliance with Other Disclosure Requirements

In practice, this disclosure requirement may be met when the disclosure fulfils simultaneous disclosure requirements based on EU law in the energy sector.784 Disclosure requirements under REMIT are without prejudice to other disclosure requirements and the disclosure requirements often cover the same events or circumstances. However, compliance with one set of rules does not automatically fulfil compliance requirements under another set of rules.785


Time of Disclosure

The disclosure must be made in a “timely manner”.786 In the event of selective disclosure, there must be simultaneous disclosure to the public. If the selective disclosure was non-intentional, the public disclosure must be made as soon as possible.787

REMIT is complemented by ACER Guidance. According to ACER, market participants should develop a clear compliance regime towards real time or close to real time disclosure of inside information and the further REMIT requirements. ACER also gives examples of best practices.788 For instance, ACER Guidance lays down minimum IT requirements for effective disclosure and requires the use of “Urgent Market Messages” that fulfil certain requirements as to form.789


Delayed Disclosure

REMIT and MAR set out when the public disclosure of inside information may be delayed. One can distinguish between the right to delay public disclosure in general, the right to delay it following a selective disclosure, and exemptions.

Several conditions are attached to the right to delay public disclosure according to the main rule:



  • Exceptional nature. It must be exceptional to delay disclosure. The main rule is disclosure.790


  • Legitimate interests. The market participant may delay disclosure only in order not to prejudice its legitimate interests.


  • Non-misleading. Delayed disclosure is permitted only provided that it is not likely to mislead the public.


  • Confidentiality. Delayed disclosure is permitted only provided that the market participant is able to ensure the confidentiality of that information.


  • No decisions. Under REMIT, delayed disclosure is permitted only provided that the market participant makes no decisions relating to trading in wholesale energy products based on the information.791

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