Ancillary vs wholesale markets: understanding decoupling and convergence

While many traders operate within the mainstream wholesale energy market, whether day-ahead or intraday, there is another interconnected but independent market that offers an opportunity for profit. This is what's known as the ancillary market, which can include services such as frequency regulation. To execute trades successfully, it's crucial that cross-market traders and portfolio managers understand the key differences between ancillary and wholesale markets. 

Sometimes, the connections between these two markets can break down, resulting in decoupling. The best way to define decoupling is when ancillary service pricing breaks away from intraday or day-ahead wholesale markets. This might occur because of timing problems, differing product ranges or constraints on the network. 

Depending on how much stress the market is under, it can become constrained, which can trigger convergence. 

This crucial ability to identify structural drivers will allow traders to become more reactionary, making adjustments when variables change compared to the normal structure and behaviour of the ancillary market. 

Structural differences

There are a number of different methods for trading in the wider energy market, with two of the most prominent types being auctions and continuous trading. The wholesale energy market more commonly uses the former method of auctions, particularly in the case of the day-ahead market, but also in the case of intraday trading, while the balancing markets of the ancillary market utilise the continuous model for a more real-time approach. 

Pricing can take the form of either capacity or energy pricing, both of which feature nuances beneficial to each market. Ancillary markets need to be able to alter the amount of power generated, so tend to favour capacity pricing to compensate for backup energy, but also favour energy delivered, which tends to be a preference for the wholesale market. 

Drivers of decoupling

Decoupling occurs when the wholesale market and ancillary disconnect: there are a number of ways this can occur, depending on how the market is behaving. Flexibility scarcity is one such way, when easily deployable sources of power, such as batteries, aren't available, making ancillary regulatory pricing spike. Energy prices, however, may stay low, meaning the two markets decouple.

Volume constraint is another reason, as renewable energy can be a very intermittent source of energy. Usually, when renewable energy underproduces based on forecasting, other sources of energy must be deployed to make up for the shortfall, such as batteries. However, sometimes more energy than is forecasted ends up reaching the network. This means that even when there is an overproduction of energy, the price of energy may remain low, but balancing kicks in, causing the ancillary market to spike by contrast.

When convergence occurs

Convergence occurs during very high-stress periods, for example, when not enough energy is generated for high-load periods, or when there are unexpected power outages. The constraints on the network cause it to behave differently as the network struggles to deal with the lack of power. Wholesale prices increase to help level the demand-supply issues, causing the ancillary market to readjust pricing, also to mirror these spikes. When power is overproduced to very extreme levels, however, negative pricing can also be seen across the board to reflect the value of the surplus energy. This is called convergence. 

Activation-driven energy spillover can also occur, which closes the gap in pricing difference between the wholesale and ancillary markets.  This is when reserve energy is used, but at the market price of energy, making the difference between the two markets decrease. 

Negative Pricing Correlation: In periods of extreme renewable oversupply, both markets can converge at or below zero (negative pricing), as both energy and services are not needed. 

Spread trading logic

To successfully trade on either market, knowledge is key to help inform profitable trades. One of the key areas to monitor for the ancillary market is ancillary, or spot spreads. Keeping an eye on the spread between day-ahead and balancing prices gives market signals to traders. A tightening of reserves may be required, for example, in the case of widening spreads in relation to energy. 

Correlation shifts, on the other hand, refer more to how correlated ancillary and spot pricing are in each market. When markets are more unpredictable, correlation is seen more and is tighter than in calmer markets, when the two are less connected. Convergence trades are more profitable in closely correlated markets, meaning that traders should look out for these signs to execute more successful, lucrative trades. 

Portfolio implications

All of these factors can have an effect on how and why traders select certain portfolios, and so they need to employ certain tactics to ensure that portfolios remain balanced and profitable. Revenue diversification is one method of keeping portfolios balanced. This involves revenue stacking, selling energy in the spot market while selling capacity in the ancillary market. It's most commonly used in relation to storage solutions such as batteries. 

Another key strategy is risk offset. This involves investing in assets that allow traders to switch between different markets. This balances the risk of operating in either market, avoiding putting a trader's eggs all in one proverbial basket. Instead of putting all profit potential in the spot market, for example, the trader can also engage in the ancillary market, avoiding the risk of falling spot prices.