Liquidity and competition in ancillary markets: why small volume changes move prices sharply

Ancillary markets are an important component of the energy market because they provide stability and grid regulation. In contrast to the wholesale energy market, which tends to be denser, the ancillary market is much thinner. This means that even micro adjustments can cause ripples within the ancillary market, also known as auction-clearing volatility. 

But how can market participants react to these changes? Some traders opt to utilise auction clearing data, whereas others take advantage of market participation analytics.

If you're a reserve trader or asset manager, it's crucial for the success of future trading that you understand how liquidity can affect ancillary markets and your participation risk in the market.

Market depth in ancillary auctions

Liquidity dynamics in the ancillary market behave slightly differently from those on the wholesale market. They are much thinner in depth: this means that fewer bids or changes to capacity volume can cause market-clearing prices to change more readily than in the wholesale market. 

The ancillary market had a much more limited pool of participants to interact with in comparison to much bigger energy trading scenarios. They operate on a reserve auction basis, using a smaller pool of energy producers. Many ancillary players also rely on battery storage as a source of energy. This narrower pool of sources can often result in a lack of backup liquidity, meaning price shocks can occur when bids are withdrawn.

Impact of new entrants

New technologies and energy sources are revolutionising the ancillary market, with options such as batteries fulfilling supply requirements as soon as demand appears. They have become a preferred solution due to their ability to deliver energy immediately, reacting to short-notice bid activity and offering liquidity when it's needed. This immediacy can cause something called price compression because of their low-cost operation.

However, while they can offer stability due to their fast-acting nature, batteries can also cause volatility, as once they are depleted, they must be charged again, so they may not always be readily available. This knock-on effect is short-lived price surges as more expensive sources of energy plug the gaps. 

Volume sensitivity, clearing mechanism sensitivity and regulatory revisions

When traders execute an action, for example, a price auction or pay-as-bid, this is referred to as the clearing mechanism. When markets are thin, this can cause a steep supply curve, which means exterior factors such as higher reserve requirements by the TSO can increase the clearing point further up the curve. This can then go on to cause volatility in the market, which can be exacerbated when certain energy producers restrict the amount of energy entering the market. When even small procurement adjustments are made, expensive forms of energy might then be called upon to fulfil demand, causing price spikes.

When regulations change, for example, procurement requirements or local changes are applied, this can affect the supply of energy, which can cause ripples of volatility in the market. 

Auction concentration risk

As the ancillary market is structured using a few specialist market participants within a thin market, dominant players tend to emerge which control the majority of capacity. These dominant players can control pricing, triggering price spikes in the ancillary market that don't correspond with wider market activity. This gives them a monopoly, making it difficult to stabilise the marketplace. 

Because the ancillary market is so specialist, it can cause a barrier to entry for new players joining the market, which stifles competitiveness in the market. Limited numbers of participants mean that the stability associated with competition is lacking in the ancillary market. 

Monitoring liquidity indicators

In a market where participants are few, the market is thin, and volatility tends to be high, knowledge is a useful tool in successful trading strategies. While keeping abreast of minor activities that occur within the market, such as the ongoing impact of small volume shifts, it's crucial that a more holistic approach is taken that takes into account the entire market and its behaviour. 

Therefore, it's key that when operating within the ancillary market, a monitoring framework is introduced in order to have an overview of any impending price shocks. A version of the following framework could anticipate changes in the market to enable reactivity in a changing, thin market:

Bid volumes and ratios

When the ratio between offered volume and demand is tight, this could suggest prices will soon begin to climb. Keeping a continuous watch on the flexibility between these two points can help traders react before price shocks occur.

Clearing spread compared to prior activity

Comparing activity between two points is a good way to judge whether the market is changing positively or negatively. A sure sign that liquidity is reducing is when the price increases in comparison to the previous period, for example, the previous hour or day, increases dramatically, so it's important to monitor and act on these changes. 

Stacking concentration

A smaller pool of market participants equals a higher level of volatility in the market, so getting to know the behaviour of these players is beneficial. Keep an eye on the market share of the dominant players - if one player is markedly more dominant than the other players, there could be the potential for high levels of volatility.