As most risk management is done by utilizing financial derivatives, we explain the basic types here. The two basic building blocks are forward and option contracts. Forward-based products include spot contracts (physical contracts), forwards, futures, and swaps. Option-based products include options, caps, floors, and collars, as well as hybrids, and options on futures, forwards, and swaps. One can also differentiate between standardized contracts, traded at exchanges, where clearing is often offered and OTC contracts, which are traded on a bilateral basis. There are four types of standardized contracts traded at power exchanges in Europe and elsewhere: spot contracts, futures, forwards, and options. Spot contracts
The spot contract is normally an hourly contract, but can be even shorter, like the half-hourly spot contract traded at the Amsterdam Power Exchange. The spot contract has physical delivery and is the underlying reference price of most derivatives. The spot contract is not traded on a continuous basis, but through an auction conducted once a day.
The spot contract is a contract giving the buyer the obligation to receive a specified amount of MWs of electricity over the period, and the seller the obligation to deliver the same amount of power at a specific geographical location that might be anywhere in the transmission network or at a single hub.
The electricity forwards and futures are normally traded on a continuous basis, which is also the case for forwards in most of the traditional financial markets. Their reference price is the spot price. A forward contract commits the buyer to purchase (and the seller to deliver) an asset at a specified time in the future at a pre-arranged price. They can be privately negotiated between two parties or traded at an exchange] They often involve delivery of the underlying asset.
Futures are standardized forward contracts, traded on organized exchanges. The main difference between the futures and forwards is the daily marking to market and settlement of futures. Forwards are settled when the contracts reach their due dates.
A swapis a series of successively maturing forward contracts. Two parties agree to exchange a series of cash flows based on a liability or asset. Swaps are commonly negotiated on interest rates, currencies, commodities, and equities. Usually, a quantity of a commodity or a notional amount (a principal sum of money) is used to calculate the payment stream, but is not itself exchanged. Electricity swaps based on price indexes in different regions of the world may prove popular as restructuring evolves. In the Nordic market Contracts for Difference is an example of a swap.
There are several types of OTC forward-based contacts and their payoff structure may be complicated. An indexed contract may be used by the industry to hedge against uncertainty in the electricity price that makes up a substantial part of the cost and similarly the price of the output that makes up a substantial part of the revenue. The contract specifies that the electricity price paid by the buyer is determined by an index that is referred to the output. Likewise, an electricity producer may be interested in a cross-market contract. This contract makes it possible to hedge against the simultaneous uncertainty in fuel and electricity prices that a thermal producer faces. The amount of fuel to hedge is however unknown, since it depends on the future dispatch and can therefore not be hedged with normal forwards or futures. Instead, there are products linking fuel price with electricity price to offset this spread risk. The cross market contracts can be swaps or options on this swap. The most common cross-market contract is a spark spread option. A long-term OTC contract with fixed quantity, but floating price is called a floating contract. The buyer pays the spot price in each period. The contract has the same cost structure as if the buyer is continuously buying electricity in the spot market.
Optionsare contracts that give the buyer the right, but not the obligation to purchase or sell the underlying asset at an agreed upon price in the future. Option buyers (long position) pay sellers (short position) a premium for this right. Call optionsgive buyers the right to buy the underlying asset from the seller at the prearranged strike or exercise price. Put optionsgive buyers the right to sell the underlying asset at the exercise price. Some options are traded on organized exchanges, while others are traded over the counter. There are basically two types of traded options in power markets, namely European options with futures or forward contracts as the underlying and Asian options with spot contracts as the underlying.
Options that are “in-the-money” - the strike price is less, in the case of call options, or more, in the case of put options, than the market price of the underlying asset - can be exercised at a profit. Options that are “out-of-the-money” would be allowed to expire unexercised. European options can be exercised only at the specified exercise date, while American options may be exercised at any time up until the exercise date.
Caps and floorsare simply series of consecutively maturing option contracts. A cap is a series of call options, and a floor is a series of put options. They are always negotiated OTC. Purchasing a call option or cap has a desirable payoff profile, but involves paying a premium. Risk managers sometimes fund the cost of acquiring a cap by simultaneously writing a floor. This combination of a long cap and a short floor is known as a collar.
A considerable component of risk in power trading is volume risk. Hence, many OTC contracts have flexible underlying volumes of electricity. These contracts are called swing options, because the buyer has the option to change its withdrawal from the contract over a certain period of time subject to an energy constraint. A typical example of a flexible contract is the load factor contract. It has a fixed amount of energy and may be an annual contract with a specified utilization time. The flexibility inherited in the contract is found by dividing the utilization time by the total time.
Another type of flexible contract is an interruptible contract, where the buyer has the right to curtail supply at predefined number of occasions. It was introduced as a part of demand-side management programs and is an alternative to build more capital-intensive industry. The contracts are priced according to the frequency of the potential curtailments and how far in advance the notification must occur.
The swing option and the interruptible contract may be used to hedge volume risk, but they do not take into account the real source of uncertainty in supply and demand caused by the weather. This can be done by using weather derivatives that are structured as swaps, futures, and call and put options based on weather indexes. Commonly referenced weather indexes include, but are not limited to, heating degree day (HDD), cooling degree day (CDD), precipitation, and snowfall.
Real options are non-traded assets or liabilities for which the payoff profile replicates that of an options contract, may be embedded in traditional operations or contracts. For example, the decision to construct a new peaking power plant has the characteristics of a call option. The price of constructing the plant is equivalent to the option premium, and the price of operating the plant is equivalent to the strike price. Recognizing real options can help utilities understand tradeoffs between contracting, financial hedging, construction opportunities, and purchasing insurance.
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