Arbitrage and rents in European long-term transmission rights

Arbitrage in European Long-Term Transmission Rights Drives Systematic Rents

Special rights that allow companies to hedge electricity price differences across borders are being underpriced. Financial traders are buying these cheap rights and immediately making trades in the forward market to lock in profits. This effectively transfers money from electricity consumers to these traders.

In interconnected European electricity markets, volatility is a constant challenge. Electricity cannot yet be stored economically. To manage this, market participants use forward markets—contracts to buy or sell electricity at a set price for future delivery. These help hedge against sudden price spikes. When liquidity is low at specific borders, Transmission System Operators (TSOs) issue Long-Term Transmission Rights (LTTRs). These rights act like European-style call options (financial contracts that grant the right to buy an asset at a set price). They allow holders to capture the price spread between two neighboring markets.

Historically, regulators assumed LTTRs were primarily used by physical hedgers (like power plants or retailers) to manage risk. However, a persistent gap has emerged. LTTR auction prices consistently fall below the prices found in the forward markets. This discrepancy suggests that the rights are not being priced efficiently. This leaves a window for opportunistic behavior.

The disconnect between options and forwards

The current regulatory framework for LTTRs suffers from several design shortcomings. As noted by ACER (2024), these instruments often feature short maximum maturities of one year. They also lack a secondary market for easy resale. Finally, they suffer from "incomplete financial firmness" (reduced payouts during extreme force majeure events).

Because of these limitations, physical hedgers often find LTTRs less attractive than other derivatives. Consequently, the market is increasingly dominated by financial traders. These traders have a lower willingness to pay for the actual insurance aspect of the right. The authors observe that this shifts the auction dynamics. The marginal, price-setting bidders in LTTR auctions are often financial traders rather than the physical participants the system was designed to protect. This creates a systemic underpricing of the rights relative to the actual price spreads seen in the forward markets.

Capturing the spread through dual positioning

The paper explores how traders exploit this mispricing through a specific arbitrage mechanism. According to option pricing theory, an LTTR holder can lock in a profit by combining their long position in the transmission right with a strategic position in the forward market.

The process follows these logical steps: 1. Acquisition: A trader buys an LTTR in an auction where the price is lower than the current forward spread. 2. Offsetting Position: Immediately after the auction, the trader enters the forward market to sell the spread. They take a short position in importing markets (selling forward in the high-price zone). They also take a long position in exporting markets (buying forward in the low-price zone). 3. Profit Realization: By holding both the LTTR and the forward position, the trader effectively cancels out the volatility of the spot price spread. The profit $\Pi_T$ becomes the difference between the forward spread price and the LTTR auction price, minus transaction costs [Equation 1].

The magnitude of this effect is not uniform. Using the Bachelier option pricing model, the authors illustrate how this strategy depends on the stability of the cross-border spread. As shown in, when volatility ($\sigma$) is high, the "time value" of the option increases.

This makes it more attractive to simply hold the LTTR rather than hedging it with forwards. Conversely, when spreads are large and stable, the arbitrage opportunity is most potent.

Empirical evidence in the German market

To validate this mechanism, the study employs a panel regression on EEX futures contracts traded between 2018 and 2025. The authors look for a specific signature. They seek a price movement in the forward market that coincides exactly with the publication of LTTR auction results.

The results provide strong empirical support for the arbitrage hypothesis, particularly in the German market. The paper reports that overnight returns of annual German futures are significantly more negative when the auction-specific LTTR price spread is more positive. This indicates that arbitrageurs are indeed selling the spread in importing markets. This action drives prices down. Furthermore, the authors find that the size of this effect scales with the volume of auctioned capacity ($Q_{i,t}$). The effect also shrinks as volatility increases. This matches the theoretical predictions in .

The study also utilizes an event study to ensure these movements are not merely coincidental. As shown in, the impact on German annual futures is immediate and non-persistent.

It appears only at the moment auction results are published. This suggests that the spikes in traded volume seen in and represent market participants actively realizing profits.

Interestingly, the authors note that while volume spikes are visible in the Austrian market, the effect on settlement prices is negligible. This is likely because most Austrian trades are cleared bilaterally rather than through the central exchange.

Limits to the arbitrage loop

While the evidence for arbitrage is compelling, the paper identifies several factors that prevent the market from reaching perfect efficiency. First, transaction costs act as a barrier. These include funding liquidity and the costs of posting margin (collateral required to cover potential losses). If the cost of maintaining the hedge is too high, the arbitrage gap remains.

Second, the supply of LTTRs is inelastic (supply that does not change regardless of price). Unlike a standard commodity, the capacity of transmission rights is fixed by the TSO. Traders cannot "buy more" rights to close the gap. They can only trade the related forward contracts. This has a finite impact on the overall price.

Finally, the study acknowledges that it cannot quantify the exact total rents earned by these traders. Firm-level data is not available. We can see the effect of the rent on market prices, but we cannot see the exact bank balances of the participants. Additionally, the paper does not perform a complete welfare analysis. It remains to be seen if the increased liquidity provided by these traders offers any offsetting benefits to the broader electricity system.

A transfer of costs to the consumer

The verdict is clear: the current design of European LTTRs facilitates a systematic transfer of wealth. The authors conclude that because these arbitrage rents are financed from congestion income, the ultimate cost is borne by electricity consumers. This income would otherwise be used to reduce transmission tariffs (grid fees).

The study demonstrates that LTTRs currently deliver limited hedging value to the people who need it most. Meanwhile, they provide reliable rents to financial actors. For regulators, the takeaway is that any redesign of transmission rights must move beyond simple auction mechanics. It must address the fundamental lack of demand for these instruments among physical hedgers. Code to reproduce these findings is reportedly available; see the paper for the canonical link at https://github.com/cstiewe/lttr-arbitrage.

Figures from the paper