Streetwise Professor

January 12, 2023

Just Because It’s Not All Bad Doesn’t Mean It’s All Good, Man

Filed under: Clearing,Derivatives,Economics,Energy,Exchanges — cpirrong @ 12:02 pm

A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.

These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.

In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.

Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.

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  1. Dr Pirrong once again takes on, without drama, the current price cap discussion in Europe in both his latest post and on our SmarterMarkets™ podcast tomorrow morning. Don’t miss it.
    While natural gas in a pipeline at the Dutch TTF may not be representative of the price of natural gas to many European consumers, what Europe needs now is a physically-settled benchmark price for waterborne LNG, not price controls on the TTF gas market. Other exchanges have tried to fill this need with financially settled, non-correlative natural gas instruments, but these are unlikely to solve the issues in either the near nor the long term.
    #abaxxexchange #lng #natgas #SmarterMarkets(tm) #naturalgas #gas #pipeline #europe #podcast

    Comment by Joe Raia — January 13, 2023 @ 11:37 am

  2. The European gas price cap is an interesting contrast to the one here we have in Australia, which among other differences, applies to spot markets (not futures), & immediately binding (as was set at ~50% lower than prevailing spot rates). With the buggest noticeable effect (so far).is the market seizing .

    Comment by Ross Braithwaite — January 17, 2023 @ 4:04 am

  3. @Ross–Alas, Australia has real price controls, and the country is reaping what your politicians sowed. Market seizing? Who would have *ever* thought such a thing could happen? I mean, only thousands of years of history (literally) and mountains of economic books and papers could have provided a clue.

    I have to say that Australia’s energy policies generally are a masterclass in what NOT to do.

    Comment by cpirrong — January 21, 2023 @ 1:41 pm

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