by Javier Blas*
When European electricity markets recently went haywire for 24 hours, a group of high-flying hedge funds lost money. Given their size, the amounts involved were small, though still enough to cause howls of distress. Should we have some sympathy for their billionaire owners? Before you answer “no” — or perhaps “hell no” — let me describe what happened, and why the hedge funds are right to feel aggrieved.
Early on June 25, EPEX Spot, a key exchange handling electricity trading, released what it called a “feature upgrade” to its main software. By 10:08 a.m. Paris time, the exchange could no longer communicate with its customers even after rushing to reverse the upgrade, according to a preliminary report. The failure created a cascade that, at its most extreme, pushed German short-term power prices 3,000% above typical levels, while French prices plunged to nearly zero. For the market as a whole, the total losses probably are somewhere around €300 million ($327 million) in a single day.
Short-term wholesale electricity prices are set via competitive auctions that consider not just national supply and demand but also cross-border flows — Germany, for example, typically draws on French power. In normal circumstances, Europe’s market is “coupled” – an electron can travel, say, from Norway to Denmark and from there into Germany. The software malfunction broke the algorithm that keeps the market glued together; as a fallback, short-term power prices were calculated for 24 hours as if the market was decoupled, comprised of several unconnected nations rather than a single region. The result? Average day-ahead prices in Germany climbed to €492 per megawatt-hour, up from about €80 in a typical day. The wholesale cost of electricity early in the morning jumped briefly to an all-time high north of €2,300.
When Trading Goes Wrong
German day-ahead average baseload electricity prices briefly surged for 24 hours on Jun. 25 due to a technical glitch at a major European exchange
EPEX Spot has since apologized: “Applying the fallback procedures pertaining to market decoupling from A to Z has revealed overall inefficiencies,” the exchange’s Chief Executive Officer Ralph Danielski wrote in a public letter to market participants on July 10. He added that those shortcomings need to be “addressed,” launching a task force to review the rules.
The chaos had a domino effect. The European Energy Exchange AG, where derivative electricity contracts such as swaps, futures and options are negotiated, relies on EPEX prices. It’s on EEX that the hedge funds lost money, rather than on the spot market that’s typically used by utilities and commodity traders.
The benchmark prices registered on the spot exchange weren’t genuine reflections of supply and demand, but rather the result of an outdated contingency plan that can’t cope with the modern market’s cross-border flows and renewable electricity supplies. But the values were still contractually valid; as antiquated as it is, the fallback mechanism is exactly what the EPEX Spot rulebook dictates.
That left EEX with a decision to make on June 25. Accept the prices as valid and use them to settle derivatives trades, or declare them void and seek alternative values to assay the contracts. Under European regulations, EEX can seek alternative prices if the benchmark values are “apparently incorrect.” In those situations, it can settle derivative contracts using alternative methods, including relying on historical data. The answer would determine millions of euros of gains or losses for the hedge funds involved in the market.
EEX, which owns 51% of EPEX Spot, accepted the prices after “careful consideration,” it said in a brief market update on June 27. It did so even after acknowledging that “EPEX SPOT differed significantly from prices” seen elsewhere. In response to questions, EEX reiterated its earlier statement.
It’s clear that the June 25 European power prices were, at the very least, distorted — but were they incorrect? EPEX Spot followed its rules — regulations that are clear to everyone in the market, not least big hedge funds. Thus, EEX was facing prices that were narrowly correct in form, but completely wrong in nature. Were the prices “abnormal?” Yes. “Artificial?” That too. “Illogical?” For sure. But were they formally “incorrect?” No matter what it had decided, EEX would face formal complaints, and perhaps even legal challenges. So, it opted for the less risky approach.
Ultimately, everyone tried to do the right thing but still achieved a bad outcome. Both exchanges can shelter behind their rules, saying they did everything by the book. But it’s clear that the manuals are no longer fit for purpose. EEX has, too, a conflict of interest: Its ownership of EPEX Spot creates an incentive, real or perceived, to accept anything its affiliate says. A rival exchange to EPEX Spot, called Nord Pool AS, didn’t suffer technical difficulties that day, and its prices were normal. In the future, EEX should revert to using Nord Pool data too if EPEX Spot data is obviously out of sync with the wider market. In addition, the exchange should be prepared to use so-called “shadow auctions” to compute cross-border flows even when markets decouple.
The current rules don’t match the modern reality of the market. If the exchanges don’t address their failings, the regulators, which so far have been asleep during this crisis, should force them to, first at EPEX Spot and then at EEX. This time, the brief market dysfunction has hurt a handful of hedge funds, a constituency for which sympathy is typically in short supply. Next time, the victims of a surge in prices — if it’s sustained — could be someone who we all feel more compassion for: ourselves.
*Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He is coauthor of “The World for Sale: Money, Power and the Traders Who Barter the Earth’s Resources.”
(Bloomberg, July 16, 2024)
