Remark: the referred article 34 & 35 are currently article 30 & #1 in Guideline FCA

1. Forward market & NC FCA
criteria explained.
Small & large bidding zones
combined, is it possible?
An egg of Columbus satisfying both physical laws and competition
Heine Rønningen 01.10.2014

2. Why do we need a forward market?
• Greed:
• Trading.
• Risk taking with expected
positive return.
• Fear:
• Hedging.
• Offsetting risk stabilizing
expected return.
• Greed & Fear:
• Order of the factors is important.
• Fear comes first in a well
functioning market.
• Market design must be based on
hedging needs.
• Must be able to attract risk
capital.

3. • Distribution of returns:
Risk takers expected return must be positive
Risk premium is kept at
a decent level by
competition
Hedging premium from generators
Hedging premium from consumption
Maximum return on risk capital
Additional market activity = Zero sum
game
+
=

4. Different hedging needs in generation/
consumption could lead to high hedge premium
• Convenience yield/Natural backwardation: Insufficient short
term supply / Insufficient long term demand
• Traders heaven RISK < RETURN: Too high hedge premium an
indicator of inefficient market
• Why is the free lunch rejected by risk takers?
• Is it a competition issue?
• Socializing trading by Introducing TR that cannot be
used for hedging (firmness etc.) => a step in the wrong
direction.
• Hedgers heaven RISK > RETURN: Too low hedge premium:
• Shake out of risk capital.
• Socializing hedging by Introducing TR that reduces risk
too much => a step in the wrong direction.
• What is highlow when it comes to risk premium? Is it
possible to find neutral KPI?
• Different Bidding Zones cannot be outright compared.
• Need adjustment for differences in natural volatility.
---Normalized marketprice, --- Actual Marketprice
High supply, low demand
Low supply, high demand

5. A inefficient market «needs» regulation
• Need a clear understanding of the problem to select the right
tools for solving the problem:
• What is “wrong”: no need for hedging, dominant market players,
small bidding zones, information unevenly distributed…..
• How to intervene: selecting the right tool depending on the problem.
• Reaching the objective: thresholds for ending market intervention.
• NC FCA regulates market intervention with a intention to
improve market efficiency:
• One single tool/instrument to solve all kinds of problems (TR).
• Market intervention is default solution in all Bidding Zones.
• Criteria for exemption in Article 35.
• “No” criteria to continue intervention.

6. NC FCA requires hedging opportunities in all
Bidding Zones
• NC FCA criteria for TR exemption:
• Available and relevant hedging instruments:
• Article 35 a: Relation between hedged item (generation or consumption) and hedging
instrument. Thresholds according to IAS39
• Efficient pricing of hedging instruments:
• Article 35 b: Requirement for hedging cost (hedging instrument spread). Based on Richard
Roll spread model.
• Nordic area: 12 Bidding Zones with efficiency requirements.
• No need for efficient instrument pricing in all Zones if thresholds in Article 35 a is
met (e.g. Systemprice hedge could qualify).
• Cannot expect to qualify for Article 35 a) under very wet/dry conditions
• => No market makers on EPAD is a step in direction of TR in the Nordic
countries

7. • Value offset hedged item and hedging instrument must correlate:
• Slope between 0,8-1,25
• R-squared > 0,8
• Hedged item = generation/consumption:
• Each hedged item belongs to 1 Bidding Zone.
• No hedged item is x-border.
• Dynamic BZ creates uncertainty.
• Hedging instrument = long term contracts:
• Local Bidding Zone
• Neighboring Bidding Zone
• TR + Neighboring Bidding Zone
• Systemprice (UCP)
• EPAD + Systemprice (UCP)
NC FCA Article 35 a: IAS 39 criteria

8. NC FCA Article 35 b: Implicit spread
• Richard Roll, Professor at UCLA
• “A Simple Implicit Measure of the
Effective Bid-Ask Spread in an Efficient
Market” in “The Journal of Finance,
Vol. XXXIX. NO. 4, September 1984.”
• The most quoted market efficiency
model based on market data only
• Implicit spread = 2 x Square root
(Absolute value (Covariance (Short
term change: Long term change)
• Actual spread < Implicit spread
Ask
Bid

9. Spread requirement not too demanding. Last levels of
efficiency must be reached on a voluntary basis

10. Small Bidding Zones and Competition
• Systemprice area consists of 12
Bidding Zones.
• 12 Bidding Zones with
requirements for hedging
opportunities could be a tuff
challenge.
• No market maker on Norwegian
EPADs at Nasdaq OMX.
• Assumption of a physical
rationale for the 5 Bidding Zones
in Norway.

11. How to improve competition?
• National border serves as the only
fixed Bidding Zone border: --------
• Fixed borders could also be
implemented internally in Norway.
• One possible border could be south
of NO3: --------
• If new fixed borders are
implemented. EPADs for larger
areas could be quoted.
• TSO will face the same degree of
freedom to change Bidding Zones.
No reality change from current
solution.

12. How to improve competition?
• EPAD South = VWAP (NO1, NO2,
NO5)
• EPAD North = VWAP (NO3, NO4)
• 5 BZ => 2 EPADs with improved
competition compared to
individual zones.
• Correlation EPAD South and NO1,
NO2, NO5 not perfect, but better
than Systemprice.
• 5 BZ still 5 BZ in DA/ID/IB.
• EPAD North could be expanded to
include SE1 and SE2 + several other
options
EPAD Sør
EPAD Nord

13. What if BZ changes across fixed borders?
• E.g. expanding NO5 north: --------
• Under current rules: NO5 can be
expanded. No need for new BZ.
• With new solution: a new BZ NO6 will be
implemented. Capacity between NO5 and
NO6 can be set unlimited => NO5 and
NO6 will be equal priced. Same result as if
NO5 is expanded under current rules.
• EPAD South and EPAD North can be
calculated under the new rules.
• EPAD North = VWAP (NO6,NO3,NO4)
• The objective of improved competion and
better correlatation still valid, even for
NO6
EPAD Sør
EPAD Nord
NO6
NO5

14. What is needed?
• Solution requires no system changes for physical markets.
• Solution is purely a commitment to keep some borders fixed.
• Solution gives the opportunity to trade longer term contracts with reduced basis risk
compared to outright Systemprice and improved competition.
• Fixed borders should be implemented with considerations to physical constraints (south
of NO3 is an example).
• Gives the opportunity to quote «x-national border EPAD» based on generation mix or
other => More attractive for both hedging and trading
• Hydro EPAD (NOx, SE1, SE2)
• Thermal EPAD (FI, DKx, SE4)
• Same method can be used for PHELIX splitting
• Physical or financial does not really matter. Last level of Congestion rent can be
accounted for seperatly.

15. Different physical and financial zones also
applicable for continental Europe
PHELIX ELIX Systemprice
• Other markets have the same solutions (oil, gas, coal, freight) where the relation physical and
financial structure is not 1:1.

16. Focus:
• Avoid a polarized debate with bad compromises
• Physical expansion of Bidding Zones to improve competition could lead to
costly countertrades or new unnecessary interconnectors.
• Small Bidding Zones could lead to less competition => local monopoly.
• Create conditions for both physical and competition needs
• Regulations can push the market in the right direction
• Regulations can never take a deregulated market to a high efficiency level
• IEM includes competition as an instrument to reach the objective of a
well-functioning market.