How does Arbitrage work in the Power Market?
Arbitrage in the power market refers to the trading of electrical energy by taking advantage of price differences across various markets, times, or regions to generate profits. Traders purchase power at lower prices - often when renewable energy production is high - and sell it at higher rates when demand increases or supply tightens. This practice helps stabilize the market by smoothing out price fluctuations and enhancing the overall efficiency of power supply.
Definition
In economics, arbitrage is defined as a risk-free transaction that takes advantage of price differences for the same product across different markets to generate profit. However, this only works under the assumption of perfect information - such as complete knowledge of transaction costs and prices. Paradoxically, when this condition is met, the market is said to exhibit “arbitrage-free” conditions, because no arbitrage opportunities remain possible.
Does (True) Arbitrage Work in Reality?
In reality, the conditions for true—meaning completely risk-free—arbitrage are almost never met. Prices and transaction costs are rarely known with precision in advance, and both can change during the course of a transaction.
The closest to arbitrage-free conditions exist in electronic securities or foreign exchange markets, where information flows and trades happen almost in real time. Yet, even there, arbitrageurs face risks: systems might crash mid-transaction, or prices may shift between buying and selling. Despite these uncertainties, many trades in practice are still referred to as arbitrage.
What Distinguishes Arbitrage from Regular Trading?
In practice, the line between arbitrage and regular trading is often blurred. Both are based on the principle of buying and selling goods, services, or other assets at a profit - acquiring them at a lower price and selling higher.
Typically, trading focuses on the allocation of goods, currencies, or securities, including associated services like transport and distribution, ultimately connecting producers and consumers. Arbitrage, however, primarily aims to bridge market inefficiencies such as incomplete information or resulting misallocations.
Example: A power supplier fulfills a contract to deliver 100 megawatt-hours to the municipal utility of Neustadt. This is considered power trading. On the delivery day, a strike causes several industrial plants to shut down, reducing power consumption below expectations. To offload the surplus, Neustadt’s utility offers the power slightly below market price on the power exchange. A power trader buys it because they have a buyer willing to pay a higher market price. This is a clear case of arbitrage - the inefficiency being the lack of information about the strike at the time of contract signing.
What Types of Arbitrage Exist in the Power Market?
Like all markets, power markets vary in many respects. These differences give rise to distinct forms of arbitrage tailored to the unique characteristics of each market.
Market Arbitrage and Delivery Period Arbitrage
In power trading, references to different markets typically relate to the segmentation by delivery periods. Futures markets handle all transactions where the delivery date is more than 24 hours in the future, with contracts extending up to six years ahead. Shorter-term trades take place on spot markets: on the day before delivery via the day-ahead market until noon, followed by intraday trading.
As the delivery date approaches, forecasts become increasingly accurate regarding how much power will be available from which sources and what the actual consumption will be - factors that directly influence prices. Consequently, power prices for the same delivery period can fluctuate significantly depending on the lead time or the market on which the trade occurs.
Market arbitrage exploits these price differences caused by varying intervals between transaction and delivery times to generate profits. Delivery period arbitrage is also possible within a single market; for example, power traders can buy and sell the same product at different times during intraday trading to capitalize on price shifts.
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Geographical Arbitrage
Unless consumers generate their own power through photovoltaic (PV) systems and use it directly on-site, electricity must be transported from where it is produced to where it is consumed. This alone does not create an opportunity for arbitrage profits. In Germany, as in many other countries, regulations stipulate that power is traded at uniform prices nationwide.
That means wind power from Mecklenburg-Vorpommern that drives industrial equipment in Swabia does not cross into a different pricing zone. Bavarian solar power, on the other hand, that supplies pumped-storage hydro plants in Switzerland or Austria, does—despite the shorter geographic distance.
In countries like Sweden, Italy, or the United States, where power grids are divided into multiple price zones, geographical arbitrage within the national market is not only possible but common practice.
Temporal Arbitrage
Not to be confused with market arbitrage is temporal arbitrage. While the former takes advantage of price differences between delivery locations, the latter focuses on price fluctuations across different delivery times. To profit from temporal arbitrage, one must either shift production or store power—or more broadly, store energy.
Power purchased during sunny summer midday hours often costs little to nothing. On especially breezy days, grid operators may even pay consumers to absorb excess electricity. Those who use this surplus to charge batteries or pumped-storage facilities can later feed that stored power back into the grid during the evening - potentially earning two-digit or even triple-digit euro amounts per megawatt hour.
But temporal arbitrage isn’t limited to storage operators. A coal plant operator practicing it might scale back generation and instead fulfill supply commitments by purchasing cheaper, readily available wind or solar power.
Time-delayed feed-in and the associated arbitrage have been the business model of pumped-storage power plants for decades. However, the strong fluctuations in power prices caused by the expansion of renewable energy sources have made this form of arbitrage more dynamic.
Product Arbitrage or Quantitative Arbitrage
Power can be traded in different product formats depending on the delivery duration - such as daily, hourly, or quarter-hourly contracts. In product arbitrage, arbitrageurs either aggregate several smaller units into a larger one (e.g. four quarter-hour blocks into a single hourly product) or break down a larger unit into smaller segments.
This strategy is particularly relevant in intraday trading, where power prices can be extremely volatile - sometimes rising or falling by several hundred percent within just 15 minutes. For producers and consumers, such swings pose risks they try to hedge against. For power traders, however, this volatility opens the door to arbitrage opportunities.
Even on the intraday market, where power prices are centrally auctioned, they can rise or fall by several hundred percent within just one hour.
The Three Key Factors of Arbitrage in the Power Market
Arbitrage transactions occur when the difference between the assumed prices (P) exceeds the expected transaction costs (T) plus risk premiums (R): P > T + R. The challenge for arbitrageurs lies in accurately assessing these three factors.
Power Price Difference
The formula is straightforward: Price difference (P) = Purchase price (E) – Sale price (V). The difficulty, however, is in correctly forecasting the power prices E and V.
Price Risks
The main risk is misjudging the prices. Acting at the wrong moment can lead to overpaying, while misestimating the sale price may result in selling power at a loss—or not at all. Because buying and selling a unit of power never happen simultaneously, the relationship between E and V can shift unfavorably for the arbitrageur. Even fractions of a second can be enough for exchange prices to change.
Transaction Costs
Power market-specific transaction costs (T) vary depending on the type of arbitrage and include exchange fees, grid charges (especially for cross-border power transport), as well as potential substation costs and import tariffs for third countries. Additionally, general operating costs such as office rent, salaries, and corporate taxes must be covered by arbitrage activities.
Transaction Risks
Risks associated with transaction costs mainly stem from resource availability: exchanges may face IT issues, generation facilities and power grids can be fully utilized, and interconnectors - the links between national power grids or bidding zones - may fail. Operational risks, though not specific to the power market, also apply: employee illness, regulatory inspections, customer payment defaults, or insolvencies.
Risk Premiums
Like any business, power traders must assess, calculate, and price their risks. This includes risks from incorrect forecasts as well as transaction risks. Importantly, risk assessments themselves carry the risk of error.
Risks of Risk Assessment
Traders who underestimate their risks risk losses in the long run. Conversely, those who set risk premiums too high place themselves at a competitive disadvantage in the fiercely contested power trading market.
This is especially true for traders who do not - or not only - trade on their own account but offer services to other companies, such as marketing generation assets or power storage, or managing power procurement for large consumers or municipal utilities.
What are the Opportunities and Risks of Different Arbitrage Types in the Power Market?
While power prices can fluctuate in mere fractions of a second, transaction costs in power trading are relatively predictable in the short to medium term. But which power market-specific price and transaction risks are particularly relevant for the various types of arbitrage? This will be illustrated with examples.
Risks of Market Arbitrage or Delivery Period Arbitrage
Example of Market Arbitrage or Delivery Period Arbitrage
A power trader buys power on the OTC forward market (“over the counter,” outside of exchanges) at €80/MWh for delivery on September 9 between 2 p.m. and 3 p.m. On September 8, based on weather forecasts, he anticipates less renewable energy availability the following day than previously expected. Indeed, power on the day-ahead market for the same delivery window already trades at €82/MWh. Considering this a realistic forecast, the trader sells his forward contract power on the day-ahead market at that price.
The next morning, his weather analyst revises the forecast, now expecting prices to climb further to €86/MWh. Since power is offered at €84/MWh, he buys at this price. If his prediction proves correct, he will later be able to sell that power on the intraday market—where delivery periods are even shorter—with a profit.
Price Risks
This type of arbitrage carries significant price risk. The weather might have turned out better than initially assumed at the time of the forward contract purchase, potentially resulting in losses for the trader. Similarly, in intraday trading, it’s highly uncertain whether the trader’s intraday forecast will hold—especially if it contradicts the broader market sentiment reflected in prices.
For long-term forward contracts, which cover monthly, quarterly, or yearly delivery periods rather than daily or hourly windows, prices are less influenced by weather forecasts and more by political, economic, and strategic uncertainties.
The fluctuating prices reflect a multitude of factors, including expected expansion of power infrastructure (renewables, storage capacity, transmission grids), market design (energy-only markets and/or capacity markets), subsidies, and regulations such as the EU emissions trading system. Also influential are anticipated investments by energy-intensive industries. The daily swings in long-term forward market prices (see chart) often come down simply to which analyst currently holds the most credibility.
The long-term forward market for Germany reflects market forecasts: power prices are expected to remain high through the middle of the decade as emission certificates - and thus fossil fuel-based power generation - become more expensive. By the end of the decade, however, it is anticipated that the expansion of low-cost renewables will more than offset this effect, leading to a decline in power prices.
Transaction Risks
Network, software, or hardware issues affecting the buyer, seller, or trading platform can disrupt power trading. Problems occurring at either end of the transaction can delay deals at critical moments. If power prices fluctuate during these delays, it can impact arbitrage outcomes—sometimes positively, but potentially negatively as well. A notable example took place on June 25, 2024, when cross-border allocation of transmission capacity briefly failed.
As the gap between forward contracts and delivery widens, so do the associated price risks—and with them, specific transaction risks. Over longer terms, the likelihood that suppliers or potential buyers face financial difficulties increases. The availability of generation facilities and skilled personnel also becomes more uncertain over time.
Geographical Arbitrage
Example of Geographical Arbitrage
While solar power in Germany surges on summer days, nuclear reactors in France risk overheating and must shut down. During these periods, power prices in France spike unexpectedly, while German prices fall below zero around midday. Traders holding forward contracts for German power have a strong chance to realize significant arbitrage profits in France - provided they have sufficient interconnector capacity.
Price Risks
Unlike most other commodities, power’s temporal risk does not increase with distance, as transmission across the grid occurs virtually instantaneously. A kilowatt injected into the grid in Schleswig-Holstein can be withdrawn in Paris at the same moment, assuming adequate transmission capacity. Therefore, power sent from Germany cannot lose value en route to France.
The price risk for geographical arbitrage is theoretically structured much like that of delivery-date arbitrage. However, traders must understand the pricing mechanisms of both regional markets, which can vary greatly due to regulations, consumption patterns, and generation profiles.
Transaction Risks
Overall risk in geographical arbitrage tends to be higher than in market-based arbitrage, because power flows through multiple grids and network levels. Though transmission is near real-time, longer distances increase the risk of failures in transmission and transformation components—lines, interconnectors, and substations.
Payment delays or defaults by foreign customers are not inherently more likely but typically lead to higher administrative and legal costs than domestic cases. In long-term forward contracts, political risks also emerge - such as changes to transport fees, customs duties, or regulatory frameworks.
Product Arbitrage
Example of Product Arbitrage
One morning, a power trader notices a producer offering four quarter-hour delivery blocks between 4 p.m. and 5 p.m. at an average price of €100/MWh. Simultaneously, a buyer offers €102/MWh for the full hour. The trader completes all five transactions, securing an arbitrage profit of €2/MWh.
Price Risks
Prices can shift within fractions of a second. The brief moments between buying and selling carry the risk that favorable price spreads may vanish or even turn into losses.
Transaction Cost Risks
Infrastructure problems pose the main threat here. Compared to other forms of arbitrage, product arbitrage comes closest to the ideal of risk-free arbitrage.
Temporal Arbitrage
Example of Temporal Arbitrage
A windy autumn night is forecast. The operator of a pumped-storage power plant buys power on the day-ahead market for delivery between midnight and 7 a.m. at an average price of €92/MWh to fill the half-empty reservoir. The following morning, industrial demand will ramp up before sunrise, pushing prices between 6 a.m. and 11 a.m. to nearly €145/MWh. This alone promises a profitable trade - but the opportunity doesn’t end there.
Weather forecasts indicate that photovoltaic output at midday, despite the season, will be enough to push power prices below €100. In the afternoon, wind speeds will pick up but not sufficiently to fully compensate for the fading solar energy. As a result, day-ahead market prices for delivery between 4 p.m. and 10 p.m. range from €123/MWh to over €290/MWh.
The operator opts to offer only enough power in the morning to refill the reservoir over midday. This strategy allows selling the maximum storage capacity during the evening hours at the day’s highest prices.
Statistics from the Federal Network Agency reveal that on the morning of November 21, 2024, pumped-storage power plants injected significantly more power between 2 p.m. and 8 p.m., when prices were higher, than they did during the morning hours, despite relatively elevated midday prices. (Source: SMARD, own illustration).
Price Risks
Similar to short-term delivery-date arbitrage, the main risk lies in changes to weather and consumption forecasts between the purchase and sale. More daring pumped-storage operators might even gamble on higher intraday market prices, choosing to sell the stored power later. Depending on subsequent weather developments, this strategy can either boost or reduce their revenues.
Transaction Risks
Energy conversion inevitably involves losses. While these losses initially represent predictable transaction costs rather than outright risks, they do require larger price spreads to secure arbitrage profits.
Pumped-storage plants operate at roughly 80 percent efficiency. This means that for every megawatt-hour purchased and stored, only about 800 kilowatt-hours can be sold and delivered. Weather adds another layer of uncertainty: evaporation losses can occur, especially in summer, while rainfall can replenish storage capacity.
Battery storage systems have conversion losses below five percent, but cooling costs apply. Cooling systems designed for typical local temperatures may struggle during extremes, potentially forcing temporary shutdowns or, in worst cases, causing permanent capacity reductions.
Technical failures can also cause major losses in temporal arbitrage: if a plant goes offline at the delivery moment, operators must repurchase the already sold power - often at much higher prices - to meet their obligations.
Conclusion
The art of arbitrage is not just about spotting and exploiting price differences. Beyond forecasting power prices, traders must consider a wide range of factors and carefully weigh risks.
Moreover, the power market is intensely competitive. Genuine arbitrage opportunities are swiftly discovered and exploited by numerous market players. As a result, sustainable business models rarely arise from such openings, since arbitrage chances rarely stay secret or stable—competitors quickly follow suit.
To maintain profitable arbitrage trading in the power market over time, traders need comprehensive expertise in trading venues, regulations, generation types, and meteorology. Accordingly, a company like FlexPower assembles a team of specialists whose success depends not only on individual expertise but also on effective collaboration.
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