Risk management in ancillary markets: tail risk, liquidity and regime shifts

 Like many elements of the energy industry, operating in the ancillary market can be high-risk, so ancillary-specific risks should be carefully considered. There are a few factors at play as to why the ancillary market is a higher-risk market to enter than the more traditional wholesale energy market. One factor is the specialist nature of the ancillary market in comparison to the wholesale market: while the wholesale market incorporates many different types of market participants, the ancillary market has a few major players, making it a volatile market to trade in, as the actions of smaller market participants can be felt more strongly in the volatility of market pricing. Another factor is the unpredictability of renewable energy and its impact on pricing. Other factors might also include changing regulations and sometimes the lack of immediate funds for trading. Therefore, risk management is very important to try to mitigate any loss of profit thanks to this unpredictability. Any market participants acting as heads of trading or portfolio risk managers will be required to understand the impact of risk management in ancillary markets.

Traders should keep liquidity front of mind, with preparations made for when liquidity is particularly thin. Focusing on financial, technical and operational factors can be key in managing risk in ancillary markets. It's also crucial that disciplined governance is incorporated into any forward trading strategies to manage exposure issues, particularly in very volatile markets. 

Volatility regimes

As it's such a specialist area of the energy industry, the ancillary market has fewer market participants than in the wholesale market, for example. This has resulted in a few major players whose impact in the market can be felt keenly when they make a move. Fewer market players mean less competition, which results in more volatility in pricing. To prevent monopolies from occurring, competition monitoring is a requirement in the market. 

When larger, unexpected events happen in the market, this means those events are also felt more keenly. These are what's known as tail events, such as continuous grid imbalances, which result in huge financial losses. 

Ancillary markets generally operate in either these high volatility or crisis regimes, which include power outages or extreme weather impacts, or at a level of low velocity, known as normal regimes. 

Liquidity risk

When these high-stress events occur, auction depths can become very thin, meaning less volume is available. Liquidity then increases in tandem, which makes closing out positions at the end of the day very expensive.

The concentrated market made up of a few dominant players, for example, a small number of battery storage providers, can exaggerate these conditions, increasing the volatility even further. 

Regulatory risk

In a market as young as renewable energy, regulations and legislation are constantly changing, evolving as quickly as renewable technology itself. Recent changes that have had an impact on the market include international connectivity between different regions, descriptions of product types or the way that energy is dispatched. Changes to any of these factors can have a huge effect on the profitability of an ancillary service. 

The impact of these changes is compounded by the fact that the current market was never designed with renewables in mind. Historically, market models were designed for traditional methods of energy generation, with the ancillary services also following those models. Therefore, as the market re-designs to accommodate a higher renewables mix, new stress testing must evolve to trial and test these market adaptations.

Scenario stress testing

Preparation is always key in ancillary market trading, and a key part of this is trial running any event that might take place before trading occurs. An important element of this is stress testing, which involves simulating very extreme situations, such as power outages or huge drops in power output and testing how trades would profit in these scenarios.

One of these stress testing scenarios is volume reduction shock. Volume reduction shock involves modelling scenarios where volume specifically drops dramatically and unexpectedly, for example, if batteries stop functioning. Traders will test how a portfolio would hold up under these conditions and how to approach a trade differently to receive a different outcome. 

Conversely, another common scenario to stress-test is battery saturation. Stress testing battery saturation cases involves examining a situation when a market might become saturated with too many batteries, rather than examining how battery failure might impact trades. If this happens, ancillary service prices could drop to as low as negative, which would require emergency planning to make traditional revenue models work.

Governance frameworks

In volatile environments such as the ancillary market, it's extremely important to keep a good grip on how much you are willing to risk in specific trading strategies, as well as continuously reviewing how trading risk strategies are performing and how to evolve them. 

Position limits, with particular regard to what position to land on at the end of the trading day, is a crucial monitoring factor that traders on the ancillary market should regularly consider. Determining position limits involves deciding how much exposure risk to tolerate, which in turn controls concentration risks. This is particularly important when dealing with volatile products such as renewables.

Once tolerance risks have been decided, review cycles to examine how risk strategies have performed come into play. Review cycles look at how factors such as liquidity levels are assessed on a daily basis, as opposed to using ad-hoc or annual reviews to guide future decisions. This real-time analysis of trading performance is crucial in the ancillary market because of the frequent levels of volatility and deviation from normal regimes.  This allows traders to react to fast-changing conditions in the market, potentially leading to more successful trading conditions in the future.