EU regulators outline trading risks of gas price cap

The EU's soon-to-be-launched gas price cap will change trading behaviour in potentially disruptive ways for financial stability, regional regulators have warned.

In their initial assessments of the EU's so-called market correction mechanism (MCM), EU financial regulator Esma and energy regulator Acer conclude that while trading behaviour is unchanged for now, it could shift dramatically and in destabilising ways if the MCM's activation becomes imminent.

The MCM, which will apply from 15 February, would be triggered if the TTF front-month derivative on the Ice Endex exchange holds above €180/MWh for three working days and is at least €35/MWh above Acer's LNG reference price basket, and would limit prices to €35/MWh above this price basket. It will initially apply to TTF exchange-based transactions with an expiry date between the front month and the front year — the European Commission must decide by the end of March whether to extend the mechanism to cover other EU virtual trading points.

Market participants are likely to adapt their trading behaviour in such a way to avoid being bound by the price limit if it becomes likely that the MCM will be activated, Esma said. One alternative is to trade on the over-the-counter (OTC) market, while another is to switch to non-EU venues such as the UK's NBP, which would be used as a proxy hedge of gas for EU delivery. Another option is to trade contracts with an expiry date before the front month or after the front year, while firms still have the option of trading in EU markets other than the TTF unless they become part of the MCM.

But as none of these alternatives is a perfect substitute, disruptive effects may materialise, Esma said — in particular affecting the ability of non-financial counterparties to adequately manage the risks associated with their business activity. While these behaviour changes "would appear rational on an individual basis, it would trigger significant and abrupt changes of the broader market environment, which could impact the orderly functioning of markets, and ultimately financial stability," the regulator warned.

Acer highlighted that not all trading activity can simply shift to the OTC space from exchanges. Financial traders could exit markets and invest in other assets if they perceive that they can be trapped in adverse commercial positions, while smaller physical traders could find it difficult to secure bilateral trading agreements at higher OTC prices, the regulator warned. And credit restrictions could impose trading limitations on larger physical traders, Acer said.

If market participants choose to avoid holding positions in a contract for which the MCM could be activated, this would reduce liquidity in TTF derivatives and lead to a reduction in hedging activities generally, Esma said. This would in turn lead to market participants being exposed to unhedged risks.

A decrease in overall EU gas traded volumes as a result of these trading shifts could make price formation more difficult, because of higher market concentration and reduced price transparency, Acer said. Higher counterparty default risks could also materialise, while the drop in trading activity and rising collaterals required by exchange operators could increase bid-ask spreads in EU gas markets.

By Natasha Fielding