Europe is divided into many different power market zones interconnected by a variety of transmission cables and subsea interconnectors. These transmission assets are generally owned by Transmission System Operators (TSOs), which earn revenues from these assets linked to the flowing of power from low- to high-price zones. Throughout most of the EU, TSOs are obliged to sell rights to this cross-border transmission capacity ahead of time. Indeed, EU regulation requires them to do so unless the relevant national regulators can justify an exception.

Use of LTTRs rare in the Nordic market

The use of so-called long-term transmission rights is rare in the Nordic system, with the notable exception of Denmark. However, with the incorporation of the EU’s third energy package into Norwegian law, Norway’s national regulator, RME, is considering whether transmission rights should be offered on transmission capacity between price zones. The case is made more complicated by Norway’s increasing interconnection with markets outside of the Nordics through the NordLink, NorNed and North Sea Link subsea interconnectors to Germany, the Netherlands and Great Britain respectively.

In a recently published report, we look at the rationale underlying the use of transmission rights and the pros and cons of selling them for each of these international cables.

LTTRs as an alternative for hedging

Part of the rationale for the sale of transmission rights is that they provide market actors with an opportunity to hedge the price risk associated with operating in multiple markets. A French generator thinking about supplying a German consumer must effectively sell power at the local French price and buy power—to meet its supply commitments—at the German price. The generator/supplier therefore faces a risk the difference in prices between these two markets moves against them—potentially preventing such agreements unless mechanisms are available to hedge this risk. Transmission rights—which effectively pay out the value of the price difference between two markets—offer a means of doing so.

However, this isn’t the only means by which the sale of transmission rights can influence hedging opportunities. Transmission rights could also be used to support hedging by actors with exposure to the Norwegian price alone.

Is there a need to support hedging opportunities?

Before we consider the consequences for hedging opportunities of issuing transmission rights however, it is worth considering whether interventions are required to support hedging opportunities in the Nordics at all. The Nordic energy regulators have developed a system of metrics designed to monitor the functioning of the Nordic financial power market, which is commonly used to hedge power price risk. Although these metrics do not provide a definitive answer as to the health of the market, they do help identify trends. As part of our work, we have calculated these metrics based on detailed data from the main exchange, Nasdaq.

Perhaps the most interesting result is the recent decline in open interest for Nordic system price contracts. These contracts are the foundation of power price hedges using financial contracts. Open interest provides an indication of the volume of such contracts that are being held and, by extension, the volume of power price exposures being hedged. Although liquidity in Nordic power financial contracts has been in long-term decline since at least the financial crisis, open interest has proved remarkably resilient over this period—that is, until 2019. The chart below shows the total volume of open positions in Nordic system price futures contracts, expressed in TWh, over time. Since 2012, and probably longer, these volumes have exceeded 200 TWh. However, from 2019 onwards, open interest declined significantly and has not meaningfully recovered.

The decline in open interest suggests that the contracts are covering smaller volumes of hedging activity. Although the reasons for the decline are unclear, it may be that hedgers are choosing to hedge their exposures by other means.

Even if one believes that there is a need for action to support hedging opportunities, it is not immediately apparent that introducing transmission rights helps.

LTTRs as a ‘bridge to liquidity’

There are, in theory, two mechanisms by which the sale of transmission rights might help Norwegian actors hedge their power price exposures. The first mechanism is often referred to as the ‘bridge to liquidity’ argument and goes like this. Imagine you are exposed to the NO2 area price – namely the power price for Kristiansand and southern Norway. Hedging this exposure using financial contracts may be difficult and costly, not least because there is no exchange-traded futures contract referenced against the NO2 price.

However, you might be able to construct an NO2 future by combining a German futures contract with a transmission right paying the difference between the German and NO2 price. In this case, the transmission right forms a metaphorical bridge to the liquid German futures market and can open up new hedging possibilities. Note that this approach is open to hedgers with no direct interest in either the German market or the German power price. In this example, Germany simply provides a liquid exchange for the forward trade of electricity.

The effect of LTTRs on speculative trading

The second mechanism, and potentially the most relevant, is the effect transmission rights could have on speculative trading. Transmission rights may be bought by trading desks as part of a trading strategy that involves trading multiple interrelated contracts. If a trader purchases a transmission right that exposes them to the NO2 price, it might trigger a desire to make an offsetting trade in a (hypothetical) NO2 futures contract. In this way, trade in transmission rights increases liquidity in these other contracts. How important these effects are likely to be is an open question and discussed in further detail in the report.

Sales of LTTRs may impact network tariffs

It is also important to note that the sale of transmission rights could have impacts beyond hedging opportunities. Perhaps the most important of these is the possible impact on consumer network tariffs.

As noted above, cross-border transmission assets generate revenues. In Norway, these revenues are used to offset consumers’ network tariffs. In 2020, Statnett earned around EUR 60m on flows across the NorNed cable. Our projections suggest that, by 2030, revenues across the NordLink, NorNed and North Sea Link cables—the last of which is just coming online—will amount to about EUR 134m.

When selling transmission rights, these revenues are given up and replaced by the sale value of the transmission rights. If the auction price of transmission rights is high enough, total revenues will increase, and transmission tariffs can therefore be lower. However, if the auction price is low, total revenues fall and transmission tariffs need to be higher.

The price that transmission rights would get at auction isn’t clear, but data on other transmission-rights auctions shows that auction revenues can differ significantly from the revenues earned by the underlying assets. Our calculations suggest that, around 2030, consumption network tariffs in any individual year could be anything from 16% more to 14% less than otherwise as a result of transmission rights’ impact on Statnett’s total annual revenues.

In thinking about the impacts of issuing transmission rights, the regulator must therefore consider not just how to secure hedging opportunities but also how to safeguard the interests of network tariff payers more broadly.