Spreads, correlations and cross-commodity trades: finding the edge

At its core, spread trading is about exploiting differences rather than absolutes. Instead of betting on whether power prices will rise or fall, traders focus on how one market moves relative to another. This relative value approach offers several advantages:

• Lower volatility: spreads usually remain more stable than outright prices because they exclude wider macroeconomic or weather-related trends.

• Capital efficiency: margin requirements are often lower for spread positions, enabling traders to utilise capital more effectively.

• Clearer fundamentals: spreads directly mirror underlying cost structures — such as the relationship between power, gas, and carbon, making them strong indicators of market balance.

Outright price bets may capture big moves, but spread trading provides the consistent, risk-adjusted edge that defines structured trading desks.

Fuel correlations: gas, carbon, coal and renewables

The key to successful power trading strategies is understanding how fuel prices are connected; specifically, how the costs of input fuels and emissions influence power prices. In many European markets, gas-fired generation often sets the marginal price, so power prices tend to move in line with gas prices. When gas prices increase, combined-cycle gas turbines (CCGTs) become more competitive in the merit order, resulting in higher wholesale power prices. This strong link between gas and power prices is fundamental to many spread and correlation trades, offering a clear pathway through which fuel costs impact electricity markets.

Carbon prices significantly amplify this effect by making fossil fuel generation more expensive. When EU Allowance (EUA) prices rise, the cost of generating electricity from gas or coal also increases, strengthening the link between carbon and electricity prices. However, this connection isn’t always consistent. Sometimes, high carbon prices can actually minimise profit margins between different fuels, while during periods of price volatility, there may be quick opportunities for profit across clean spreads.

Coal’s influence has gradually decreased as older plants are retired and renewable energy sources have grown. Nevertheless, dark spreads still remain essential for trading in certain regions or seasons, especially during gas price surges or when renewables don’t perform as expected. Traders keep an eye on coal-power relationships as part of their wider fuel-switching strategies, understanding that even small amounts of coal can influence spreads. Looking forward, new links are forming, such as the fact that hydrogen and biofuels are starting to play a role in forward price discussions, indicating the next stage of changes in how generation economics evolve.

Clean spark and dark spreads explained

The industry closely monitors key indicators such as the clean spark spread (CSS) and clean dark spread (CDS). These metrics estimate the theoretical gross margin for gas- and coal-fired power generation, respectively, after factoring in carbon costs:

Clean spark spread (CSS) = Power price − (Gas price × Heat rate) − (Carbon price × Emission factor)

Clean dark spread (CDS) = Power price − (Coal price × Heat rate) − (Carbon price × Emission factor)

Although these metrics quantify the profitability of running a plant, they also serve as broader market signals. A widening CSS relative to CDS can indicate increased gas competitiveness, while a narrowing spread suggests coal (or even imports) may be taking share.

Breakeven points for switching between fuels

When clean spreads converge, traders evaluate the breakeven point where switching generation from one fuel to another becomes cost-effective. These fuel-switching levels often serve as invisible support or resistance zones for power prices. Traders take advantage of these thresholds through:

• Spread options: capturing volatility around switching levels.

• Structured forwards: expressing relative views between fuels or countries.

• Carbon hedging: offsetting emissions exposure when generation mix shifts.

Arbitrage across markets and timeframes

The complexity of the power market generates numerous arbitrage opportunities, both across space and time. Traders seek price differences between markets, delivery windows, and regions to articulate their relative value perspectives or hedge their positions. These opportunities generally fall into three main categories:

• Intraday versus day-ahead spreads: intraday spreads frequently indicate short-term imbalances caused by renewables, outages, or demand spikes. Traders rely on these to gauge system tightness or to rebalance positions from day-ahead commitments. As automation and algorithmic trading grow, intraday arbitrage has shifted to a more data-driven approach, utilising predictive analytics to seize brief price opportunities before they disappear.

• Cross-border spreads (DE-FR, UK-NL): measure price differences between connected power markets, like DE-FR or UK-NL. These differences indicate not just generation costs but also factors like transmission capacity, congestion, and interconnector availability. Disruptions such as maintenance, weather, or policy changes can cause spreads to widen suddenly, creating opportunities for trading and hedging.

• Forward spread roll trades: also known as time spreads or roll trades, involve establishing offsetting positions across different maturities within the same market curve. For instance, a trader might buy summer power and sell winter power. These trades enable participants to capitalise on anticipated changes in demand, fuel costs, or carbon intensity. Achieving success requires a thorough understanding of seasonal patterns, the structure of the forward curve, and the liquidity features of each maturity.

Managing basis risk and liquidity

No spread strategy is completely free from basis risk - the difference between what is hedged and what is actually delivered. For example, a trader might hedge a clean spark spread using gas and power futures from different hubs, creating location and product mismatches.

Key considerations include:

• Hedging mismatched products: aligning contract terms, delivery areas, and time granularity to reduce residual exposure.

• Exchange liquidity vs. Over-the-Counter (OTC) flexibility: listed futures on exchanges such as EEX (European Energy Exchange), ICE (Intercontinental Exchange) and Nasdaq Commodities offer transparency and clearing safety, but OTC markets provide customisation and cross-commodity combinations not always available on-screen.

• Correlation monitoring: dynamic hedging models increasingly use real-time correlation matrices to adjust exposure as relationships between fuels and power evolve.

Effective liquidity management involves knowing when to trade standardised products and when to negotiate bespoke structures that better suit the portfolio’s risk profile.

Conclusion

Spreads act as the power trader’s compass, guiding decisions amid price volatility. They simplify complex fuel, carbon, and cross-border dynamics into clear, measurable relationships, pinpointing where risk and reward are most mispriced.

For experienced market participants, mastering spread logic goes beyond understanding equations; it involves developing intuition about how correlations evolve as the energy system changes. The traders with an advantage are those capable of interpreting clean spreads, connecting gas and power markets, hedging carbon risk, and arbitrage across different times and locations, all while managing liquidity and basis risk.

In a world of rapid transition and data-driven trading, spreads stay the most dependable indicator amid the noise - a disciplined framework for spotting value where others only see price.