The Dynamics of Power Spot Prices: an Overview
7 Dec 2022
Kamil Pluta, Systematic Trading
At the time of writing this article, power prices and their volatility levels are continuously reaching new records in Europe. This is due to a combustible combination of complex price drivers in power markets and increasingly unstable energy supplies.
To shed light on how daily power prices are set and predicted, this article zooms in on the main fundamental and technical spot power price drivers.
Power Spot Price Drivers — a Daily Journey
Power spot trading usually begins with the Day-Ahead auction, where market participants submit volumes and prices for every hour of the next day. After the auction closes, orders from every bidding zone are subjected to a pan-European price coupling algorithm called EUPHEMIA to establish a market clearing price (MCP) which is applied to all market participants for every hour of the day.
The MCP is subject to the so-called merit order effect — available generation units, ranked according to their marginal cost, from cheapest to most expensive. The MCP is determined by the most expensive unit required to match demand.
Since power derived from renewable energy sources has the lowest marginal costs (e.g. once installed, generating power from wind turbines or solar panels is almost free), renewables are at the beginning of the merit order curve and therefore always prioritized when available.
Hence, the higher the capacity of renewable power plants, the higher the likelihood of more costly power plants (such as gas and coal) being pushed out of the market — effectively reducing the power price.
Once the fundament of an hourly price for a given trading day has been laid by the merit-order-driven MCP, many market participants utilize the Intraday Continuous market to fine-tune and correct auction-based positions.
As a result, even after the MCP has been determined, hourly power prices remain in constant flux until gate closure (which can happen as late as five minutes before the power is delivered). Intraday price fluctuations therefore lay the basis for price spreads in power spot trading.
To facilitate price comparisons in an extremely volatile market, Intraday Continuous prices are commonly indexed as follows:
VWAP: the volume-weighted average price between gate opening and gate closure
ID3: the volume-weighted average price for the last 3 hours before delivery
ID1: the volume-weighted average price for the last hour before delivery
During the journey from auction forecasting to constant Intraday fine-tuning, market participants continuously analyze the following price drivers to take accurate positions in both the Day-Ahead auction and throughout the day in Intraday Continuous markets.
Fundamental price drivers:
Demand. There is a direct correlation between expected demand and the price for a given product — e.g. a rise in demand drives prices up.
Solar and wind production. There is an inverse correlation between expected production from renewable energy sources and the price for a given product. Whenever there is a lot of sun/wind, large amounts of power are produced at low marginal costs, driving prices down. Particularly in Intraday Continuous markets, sudden changes in regional solar and wind production forecasts can cause large upward and downward price spikes.
Residual load. The two price drivers above constitute what traders refer to as residual load — i.e. the amount of demand that can’t be served by renewable energy sources. There is a direct correlation between residual load and the price for a given product — high residual load drives prices up. This effect follows the same logic as merit-order-based market clearing pricing.
Power plant availability. The higher the availability of non-solar/wind “backup” power plants, the lower the likelihood of a shortage in supply (which forces costly cross-border imports or critical reserve activations). Hence, there is an inverse correlation between power plant availability and the price for a given product — i.e. a wide coverage of non-solar/wind power plants tends to drive prices down.
Available transfer capacity. Whenever supply exceeds demand in a specific market, the surplus can be made available to a “coupled” neighbor market. Hence, there is a relation between a market’s available transfer capacity and the price for a given product — e.g. more available import capacity from adjacent countries with lower energy prices drives prices down.
Commodity prices. The marginal production costs of non-renewable power plants are naturally increasing each time oil or gas prices are rising (often based on geopolitical news). Therefore, there is a direct correlation between fossil fuel prices and power prices unless the production of renewable energy is able to cover 100% of the demand.
Activation of balancing energy. Continuous balancing of production and consumption within the grid is vital to maintain a grid frequency of 50 Hertz and thereby ensure an uninterrupted power supply. As a result, transmission system operators (TSOs) constantly activate energy reserves to counteract imbalances. The volume of imbalance, typically published by TSOs after the end of product delivery, can be positive (whenever demand exceeds supply) or negative (whenever supply exceeds demand). A positive volume of imbalance often indicates a price increase (and vice versa) for upcoming hours of delivery.
Technical price drivers:
Historical patterns. Morning and evening demand increases or spring and summer demand decreases are very simple examples of historical patterns that can have an effect on the market in spite of the fundamental price drivers mentioned above. The analysis of historical patterns can therefore be an additional indicator of how power prices will develop.
Market biases and traders’ influence. Even more than historical price patterns, behavior-driven trends (usually analyzed over the span of a few days) can be a very powerful driver of power spot prices — often up to the point of superseding fundamentals-driven price indications.
While power spot markets are predominantly exposed to a complex mix of fundamental price drivers, historical patterns and behavior-driven trends add to the intricacies of spot price predictions.
Therefore, energy market participants are constantly challenged to scrutinize every fundamental and technical price driver simultaneously to develop a comprehensive perspective on price movements in Day-Ahead and Intraday markets.