Gas proxy still relevant in SEM

Historically, gas prices in Great Britain have largely influenced hedging strategies in the Irish Single Electricity Market (SEM), acting as the proxy commodity of choice. A proxy hedge involves using one commodity in another market with prices that are closely correlated.

GB gas prices are chosen due to its inherent link to the power market with gas-fired generation accounting for most of the electricity generation in the market. With the new market design introduced by the Integrated Single Electricity Market (I-SEM) project in October 2018, some market participants wondered if this correlation between National Balancing Point (NBP) gas proxy and the power market would remain.

However, the latest research from Cornwall Insight Ireland shows that rather than the correlation between the gas proxy and the power market diverging, it has remained active. The chart below shows an association of 72% across five years, with this linear relationship still being observed post I-SEM (83%).

A graph showing SEM front-month power in comparison to National Balancing Point Gas

Conall Bolger Head of Ireland at Cornwall Insight Ireland, said:

“The risk for participants where the ability to forward hedge is limited means that they are fully exposed to the range of prices in the market and any potential volatility that arises. Ultimately price spikes in the wholesale markets may be reflected in the prices paid by consumers; wholesale energy prices were a common factor in many of last year’s retail price increase announcements.

“One tool that SEM participants historically used was proxy hedging. This is where in the absence of forward products a trader will buy a closely related commodity instead. They will hold on to this until the actual product (electricity) they need is tradable.

“The long-term challenge with this approach is the correlation between the power price and the gas price on which the proxy hedge depends for its effectiveness. With growing renewables volumes in the market, the relationship between the two factors becomes less straight forward, meaning that the utility of the proxy hedge may decline over time. An inability for participants to hedge due to the lack of forward liquidity may ultimately prevent people from adequately managing their risk – particularly during adverse conditions.

“We have seen some new entrants offering hedging and forwards services, which is a development that should be welcomed as it may facilitate more competition in the market and improve participants’ ability to manage their risk.”