Interest growing in Italy's power market

The relatively small and illiquid Italian power markets have attracted increasing interest from energy companies and investment banks in recent years. Katie Holliday finds out why this is and what the potential is for Italy’s power market

Despite being one of the less liquid power markets in Europe, over the past five years increasing numbers of banks and European energy companies have ventured into the Italian power market, including Deutsche Bank, Morgan Stanley, Merrill Lynch, JP Morgan, RBS Sempra Commodities, Germany's E.ON and France's EDF Energy.

Indeed, if the region can overcome structural and regulatory issues, experts forecast that over the next few years, the Italian power market could start to behave like the more liquid markets of Germany and the UK.

"In the next few years we expect to start to see pricing four or five years along the curve, such as you would see on Germany's European Energy Exchange (EEX) or France's Powernext," says Francesco Orsi, vice president of energy & commodity derivatives and environmental products for Italy at Barclays Capital.

But, for now, Italy has a lot of catching up to do. At present, the size of Italy's power market is dwarfed by other thriving European players, such as Germany, which trades 4,500 terawatt hours (TWh) per year - around eight times its national demand. Last year, Italy traded roughly one and a half times its national demand at 114 TWh, according to Italian energy consultancy firm K2 Energy Italia. Experts cite low liquidity levels and an uncertain regulatory landscape as the key stumbling blocks towards progress.

In terms of electricity market development, the country has been a slow mover. Italy was the last continental European country to implement liberalisation directives and become interconnected with other European markets. A Transmission System Operator (TSO), TENA, was established in 2004 and transmission networks are now subject to legal unbundling.

A big step towards progress was the partial privatisation of Italy's incumbent energy company Enel. The Italian government capped Enel's market share to less than 50% in 1999, forcing the company to divest part of its generation and enabling the entrance of other domestic energy companies, including E.ON, EDF Energy, French energy company Electrabel, Italy's Edison and Swiss energy company Alpiq.

However, some feel the incumbent's market share has not been capped enough to stimulate a truly competitive environment. According to a source at an Italian bank, who wishes to remain unnamed, Enel's domination of the market is still stifling liquidity development. "The big problem is that there is only one market-marker - Enel - which eliminates any chance for competition," he says. "The spreads between the bid offers and the market price are just too wide and this is not appealing for participants. If more energy companies decided to act as market-makers, this could encourage more counterparties to participate," says Fabrizio Rinaldi, head of power trading at Italian energy company Edison Energy SpA. "One solution is to promote participation through market-makers. If people see big European energy players, such as Edison or Germany's E.ON buying and selling along the curve, this will make other operators more confident about taking positions," he adds.

Structural change

In 2004, the country's first regulated electronic trading platform for power was launched, the Italian Power Exchange (IPEX), which was designed to create a neutral, transparent and competitive marketplace for trading of both spot and futures power contracts. Trading of ‘green certificates', generated from the creation of renewable power, ‘white certificates', generated from energy efficiency projects, and European Union Emission Allowances (EUAs) also takes place on the exchange.

In 2008, the Italian stock exchange Borsa Italiana set up a platform solely for the trade of power derivatives contracts, the Italian Derivatives Energy Exchange (IDEX), but the project has largely been deemed a failure by market participants due to its lack of liquidity. In 2009, IDEX traded roughly 15.8 TWh of power derivatives, according to IDEX data.

But despite the creation of these exchange platforms, the bulk of volumes traded on Italy's power market today take place on the over-the-counter (OTC) market. Liquidity levels on both exchange and OTC, although growing, are still not high enough to attract new players, say experts.

According to Ilaria Restifo, head of power trading at interdealer broker Tradition, low liquidity levels on the OTC market are due to structural issues. "Year-on-year, we have experienced a constant rise in liquidity and volumes in the Italian power market, but the market itself is still lagging behind in terms of structure," she says. "The peculiarity of the Italian market is the distinction of players. Whereas a few have a highly developed trading structure, the majority are not yet properly structured for trading and still rely on a portfolio management approach, which gives rise to intermittent trading."

The Italian banking source agrees that low liquidity is the main obstacle impacting the growth of this market. "The market is growing but the big problem at the moment is the lack
of liquidity. Screen trading is really not liquid enough. We see roughly five to 10 trades happening per day, while we see roughly 50 trades per day on the OTC," he says.

Learning curve

Coupled with a lack of competition, weak demand for hedging products amongst smaller utilities in Italy is also stifling liquidity development, say experts.

Supply/demand fundamentals in the Italian power market shifted dramatically as a result of the financial crisis of 2008. Demand contracted by 6% from 346,630 gigwatt hours (GWh) in 2008 to 325,482 GWh in 2009 according to data from the International Energy Agency (IEA), while at the same time, an influx of capacity came online resulting in depressed energy prices. Because prices are forecast to be low for the foreseeable future, demand for hedging further out along the curve remains subdued.

Ennio Arlandi, head of energy and commodities trading at IDEX, says smaller participants in the market are unaware of the advantages of using a financial regulated market to manage their risk. "Big electricity companies are aware of the advantages, but it is not the same for the smaller ones. There is a lot to do to educate them of the advantages of a regulated market platform," he says.

Francesco Basile, head of energy management at Italian consultancy K2 Energy Italia, also highlights a lack of demand for modern risk management tools. "The Italian physical and financial power markets are younger than other European ones, so just a few Italian power players are experienced with modern risk management modelling," he says.

However, experts see a surge in the demand for hedging products in Italy once the economy begins to recover.

"Right now, nobody's doing hedging for the longer term, at higher prices," says the European banking source. "Retail consumers see that the price is low and they think it will remain low for a long time, so nobody sees the need to hedge power at 12 or 24 months. But once prices begin to rise again, demand for hedging will return," he says.

Barclays Capital's Orsi also foresees an increase in the demand for hedging across Italian power participants. "The perception of risk amongst utilities and energy companies is beginning to increase," he says. "I believe there is now widespread demand for derivatives for hedging purposes, which is increasing year-on-year," he adds.

Uncertain landscape

Demand for hedging has been dampened by uncertainties over the legal framework for trading power, says Carlo Citroni, head of commodities at Crédit Agricole CIB in Italy. "What is really scary is the legal and regulatory structure of the market," he says. "Every year there is a new issue for power companies and utilities, such as the current uncertainty over whether new power plants will receive carbon allowances. These uncertainties are making it hard for utilities to make decisions long term. That's why people are not thinking about hedging more than one year ahead."

In recent years, Italian power market regulation has undergone deep reforms in an attempt to provide a more transparent and flexible marketplace. Two main changes have emerged from the reforms: system marginal prices have been replaced with a pay -as-bid system for the day-ahead market and legislation for the incentives to produce renewable power - green certificates - has been subject to uncertainty.

In April this year, the government outlined a rules change on green certificates to shift the burden from power producers to power wholesalers. The concerns do not surround the legislation itself, but the uncertainty over whether this reform will be enforced or cancelled, which is currently unclear.

"Uncertainty over the green certificate scheme is significantly impacting the market," says Tradition's Restifo. "They represent roughly €4 to €5 out of the price of electricity per MWh, so if they are not to be continued, this is a big uncertainty for participants."
According to Giorgio Quartini, power and gas trader at E.ON Italy, uncertainty over green certificate legislation is making it difficult to hedge. "If you base your hedging strategy on specific rules of the market, and then suddenly they are changed, this means that what you have done in the past month can be useless," he says.

Involvement of banks

Currently the majority of Italian power market participation stems from both international and local energy companies and utilities with a limited amount of financial institutions actually trading on the market. More and more banks are beginning to show an interest in this market, however. Experts hope that participation from financial institutions will help generate the much-needed additional liquidity required to boost the Italian power market.

According to Orsi, there is a great deal of potential for European banks to begin trading on the Italian power markets. "It is important for them to have exposure across all the liquid power markets in Europe for spread purposes. As a fairly new market with good and sustainable liquidity, players are keen to get on board," he adds.

Waiting game

However, according to K2 Energy Italia's Basile, the potential for financial institutions to become involved on the Italian power markets is limited. "Financial institutions' interest in the Italian power market is still marginal and limited. The complexity of the power products and the trouble linked to an immature market cause a difficult entry," he says.

But a source from a European bank active on in Italian power says these challenges can be overcome. "Italy has a range of specific issues, such as having a lot of borders with other countries and a zonal spot market [where rates differ across different regions]. Any structural changes can have a huge impact, but you can manage this risk by always being aware of the changes," he says.

The Italian power market could grow substantially over the next five years, say experts. According to Borsa Italiana's Arlandi this is why it is important to have the structures in place. "Every time you launch a new market, it takes time for users to understand how to use it. It's natural that it should take some time to do this. We have done all we can to provide a good market model, introduce low fees, clearing facilities and options for physical delivery."

But liquidity improvement will depend on whether enough market participants want to drive this market forward. "Both a good market model and low fees may not be enough: the main driver for liquidity is liquidity itself. This is the reason why a strong commitment by some companies to start the virtuous cycle in the starting phase of a market is also necessary. How fast the market develops will depend on how strong this commitment will be," says Arlandi.

E.ON's Quartini forecasts progress in the near future: "We could reach an equal ratio between the forward and spot power markets in a couple of years. But we will have to wait much longer before we reach the ratios traded on EEX and Nord Pool, where the forward market is six times as large as the spot."

A source from a prominent bank active in the Italian power markets is positive that the Italian power market will reach its potential but agrees that matching its European counterparts will take more time. "Liquidity has increased a lot over the past year. The main objective is to grow the amount of counterparties available in the market, as liquidity feeds liquidity. The Italian power market may not reach the absolute levels of Germany's market, but in around one to three years, we do see it coming close."