The Nord Pool Funds

Striking sparks for frontier investors

Originally published in the February 2008 issue

What makes the Scandinavian traded electricity market and its players relevant to outside investors is that in the last year or more a group of hedge funds has sprung up that allow access to this talent pool and trading opportunity set.

As yet Nord Pool funds are not large in size, the largest fund/managed account combination being around €175 million, but they offer characteristics that make them compelling for investors in alternatives. One of the most significant characteristics of the underlying market is that the Nord Pool spot price for electricity has a negative correlation with equity markets, and a variable correlation with energy markets (see Figure 1).

The second significant factor for potential investors is that the electricity price exhibits high volatility and trending characteristics (as shown in Figure 2).

Electricity prices exhibit high volatility because it is a non-storable commodity. There can be step changes in price caused by, say, a spillover at a reservoir, and Nord Pool electricity price volatility varies from 12 to nearly 40% on a 30 day (annualised) basis in normal markets. Volatility of the German spot market for electricity (which is increasingly linked to the Nord Pool) is significantly higher than the Nord Pool, and exceptionally, in late 2002, volatility reached over 100% on the Platt’s continental electricity price. The typical volatility is comparable to emerging market equity volatility.

A unique characteristic of the Nord Pool electricity exchange is the high hydropower proportion in the traded electricity; water in the hydro reservoir acting as a hydropower inventory therefore plays an important role in the pricing of electricity.

Inventory holding and the seasonality of both demand and supply of hydropower generate inter-year and intra-year autocorrelation in power prices. That is the market price trends. The power price persistence invalidates the applicability of market efficiency concept based on the random walk theory. So the markets can be profitably analysed from fundamental and technical (chartist) perspectives. Electricity prices have stable distributions so they also allow statistical analysis of the markets, and so for example Hurst coefficients are meaningful. Consequently many investment approaches to these markets are valid, including quantitative analysis.

The characteristics of the power price enable capital committed to generate a range of returns depending on the risk framework adopted, but crucially it is possible to generate high returns from trading the market. Track records of individual traders are littered with 70 or even 100% return years, and the first funds had 50%-plus returns in some years. Current trading in a fund format is unlikely to be done on a risk-assuming basis to generate returns of that scale. Rather, many managers of Nord Pool funds prioritise consistency of returns highly as a return target. Typically funds target a return of around 20%.

An evolving market

The Nord Pool market has a history of going through stages of distinct evolution. Finland joined the two founder countries (Norway and Sweden) in the Nord Pool in 1998, and West and East Denmark joined either side of the start of the new Millennium. Each country adds its own power supply mix (coal, gas, nuclear, hydro) and experiences weather patterns differently. So the complexity and volume traded has increased through time giving a broader opportunity set for investors.

Arguably the most significant fundamental change came in 2005 with the Kontek cable that connected Zealand to Germany. From that point the marginal price of electric power in Scandinavia has been influenced by coal prices in Germany and the freight rate associated with it. Whilst the spot market has a system price for the whole of the Nordic region half the time, it also has regional prices during the periods when there are ‘congestions’ in the provision of power. So the relationship between the spot and futures market is complex.

“The addition of CO2 trading really shook the market up too, “says Fredrik Bodecker, MD of Stockholm’s Nordic Commodity Funds (NCF). The opening of new exchanges, such as the power markets developed at the European Energy Exchange and the ICE, give fresh opportunities for arbitrage and spread trading. In short the market has structural richness that should allow returns to knowledgeable analysis. Not the least in this regard is the impact of weather.

Factoring in the weather

The two global weather centres produce weather models that are distributed three times a day. The forecasts extend to 15 days ahead. However the forecasts for 10 days and beyond are generally not considered useful in power markets. A number of analytical firms turn those regional weather forecasts into how much rain will fall in the relevant catchment areas for Norway’s reservoirs. The analytical firms such as Point Carbon then forecast the number of TeraWatt Hours of electricity that will be capable of being produced from the hydroelectric plants at specific times/dates. The balance between supply and demand can be hugely impacted by a temperature swing of 2 °C. The filling of reservoirs can depend on which side of a mountain the rain falls. So there can be occasions when a dry period is forecast, expected to produce 2 TeraWatt-hours (TWh) of electricity, only for rain to fall unexpectedly in the reservoirs and the forecast can change to 14TWhsover a weekend. “It can be a little random with the weather factor,” sighs NCF’s Bodecker.

The release of the weather analysis is done line by line by region – so the analysis rolls out over a period of minutes giving a wave of fresh inputs to the market. An analogy would be to have re-calibrated equity models from analysts released several times a day. To reiterate, these are forecasts. A more absolute input to the market comes from electricity producers via the exchange. Suppliers of electricity have an obligation to report to the Nord Pool all unplanned power plant outages or transmission difficulties within 15 minutes. This applies whether it is a small combined-cycle plant or a large nuclear facility. There can be 6 to 10 such outage (urgent market) messages a day. This is something like agricultural commodity markets receiving confirmed crop reports several times a day. So not only is this a market with many nuances, but there are a lot of fresh information inputs each day. Bodecker says that he operates in an “extremely transparent market.”

Some of the factors affecting the markets are given in Table 1. Clearly there is some overlap of factors, and intuitively there has to be a link between the trading of CO2 emission credits and power production. How the carbon market affects the power market is shown conceptually in Figure 3.

A significant change to the traded power markets in recent years, as has been the case for commodity markets, has been the emergence of financial players. Well known financial names like Barclays Capital, Goldman Sachs, and Tudor Investments are a big part of the flows in these markets, and they have changed the way the market behaves, say market participants, causing an increased occurrence of gapping for example.

Says NFC’s Bodecker “I’ve noticed the reaction to the analysts fundamental call has changed. Whereas the price used to revert to the direction of the fundamentals quickly, the financial players can force the price on and away from fundamental value. They have probably added a lot to the market liquidity too because there is a lot of delta hedging going now.” Shepherd Energy’s Jörgen Johansson agrees: “the financial players take the markets further away from fundamentals, and have increased the market volatility.”

There are a few disadvantages for investors looking at Nord Pool funds. Although Interkraft Energy Fund started trading in 1998, and Markedskraft has over a three-year track record most of the funds have short track records. Very large investors are probably excluded from the sector because it is extremely difficult to put $150 million to work in one fund, as is their preference. Also for investors tracking financial markets generally there is a lot to get to know and understand in electricity trading. The drivers for return are different than equity markets, this allows a lack of correlation but means some effort is required just to understand the managers’ monthly letters. The whole market is subject to event risk like last summer when six nuclear plants closed on an unscheduled basis. Some of the balancing positives arise because the funds are usually structured as onshore funds (‘national funds’ in Sweden). These funds have managers and administrators that are regulated, and the fund terms are good: monthly liquidity, frequency of reports and audits is good, subscriptions can be as low as SEK 50,000; there are 1% management fees, and most performance fees are set at 20%, though some charge 25% and try to charge subscription fees. All positions in the market (including OTC options) are cleared, and subject to SPAN-type margining.

For most of the funds the strategies are scalable to significantly larger size than the current level. In addition, academic analysis1 of the Nordic power market is a recent phenomenon, allowing market participants to take advantage of market inefficiency on a structured basis to an extent no longer available in equity markets.

It is expected that the market for electricity trading will continue to grow as new entrants come in, and the market develops as, for example, EMREX comes in to clear next year. Market participants expect further excitement. NCF’s Bodecker says that “over recent years we have seen a number of grey swans, but it does not mean that the black swan (of an extreme unlikely event) is not out there.”

Just as he expects his fund returns to benefit from such an appearance, so do most trading participants in the Nord Pool expect to thrive on volatility.

1. For example Forecasting Weekly Electricity Prices at Nord Pool, Hipolit Torro, Universitat de Valencia

“A significant change to the traded power markets in recent years, as has been the case for commodity markets, has been the emergence of financial players”

THFJNord Pool Basics

The Nordic electric power market features direct trading among players (bilateral trade) and trading via the Nordic power exchange, Nord Pool. A steadily increasing proportion of power trade takes place via the Nordic Power Exchange.

Electric production differs considerably among the Nordic countries. In Norway, nearly all electricity is generated from hydropower. Sweden and Finland use a combination of hydropower, nuclear power, and conventional thermal power. Hydropower stations are located mainly in northern areas, whereas thermal power prevails in the south. Denmark relies mainly on conventional thermal power, but wind power is providing an increasing part of the demand for energy.

Nord Pool is the world’s first international commodity exchange for electricity, green certificates and emission allowances and credits (EUAs and CERs).

The core business of the Nord Pool group is trading and clearing physical-delivery and financially-settled power contracts in the Nordic region (Finland, Sweden, Denmark and Norway). Nord Pool is a licensed clearinghouse, and is owned by the national grid companies of Norway and Sweden. Forward contracts trade several years out, and the current near contract is Q1 2008. In concept and practice Nord Pool operates in a similar way to an agricultural commodity market.

The group has more than 400 members from 20 countries across a wide range of energy producers and consumers as well as financial institutions. Nord Pool has 113 members from 18 countries in the carbon market. More than 52 new members have joined Nord Pool this year, including Citigroup Global Markets.

The turnover for the first three-quarters of the year was 817 TWh traded on the exchange (up 32% Y-0-Y) and 1024.2 TWh cleared from the OTC market (down 7%). Turnover on the Spot (short term) Elbas market is expected to double this year.