Electricity Derivatives: Managing Energy Price Risk and Reward
Businesses, whether it be utilities or airlines, are exposed to fluctuations in the energy commodities markets. If the price of their input fuel increases or decreases, this price change can have material impacts on their bottom line. Enter electricity derivatives in the power generation industry. Electricity derivatives offer a mechanism to hedge electricity price exposure to volatile price swings that may occur in the future. In this electricity derivatives guide, we’ll walk through what electricity derivatives are, the types of electricity derivatives, and the benefits and risks associated with electricity derivatives. Let’s get started.
What are Electricity Derivatives?
Energy derivatives are financial products whose value is derived from an underlying commodity like electricity, natural gas, or oil. These derivatives can be traded on an exchange like the Chicago Mercantile Exchange (CME) or New York Mercantile Exchange (NYMEX) or through an over-the-counter (OTC) basis.
Electricity derivatives, a type of energy derivative, can primarily be used for a few purposes including generation planning, risk hedging, or speculation. Generators can guarantee revenue, utilities can hedge electricity price volatility, and traders can speculate on the price of electricity using the different types of electricity derivative products available in the market.
Types of Electricity Derivatives
Energy and electricity derivatives are relatively new products introduced into the market over the last 50 years. Heating oil futures kicked off this derivative trend in the 1970s followed shortly thereafter in the 1980s and 1990s by propane gas, crude oil, unleaded gas, natural gas, and finally electricity futures.
Generally speaking, there are a few different types of electricity derivative products - electricity futures (including risk hedging and speculating), swaps, options, and forward contracts. These products allow market participants to protect downside risk while allowing them to capture the upside they’re after. However, the sword cuts both ways.
Electricity Futures Contracts
Futures contracts are all about standardization. The delivery date, location, quality, and quantity have been predetermined. Think of a futures contract as one where all of the terms of the transaction have been established in advance. This leaves price as the only item for negotiation between the counterparties. One of the goals of standardization is to not have to correct for quality and have the sole focus of the transaction be on the price. A futures contract is created when both the buyer and the seller agree on a price.
Think of electricity derivatives as a side bet on the future price of electricity. The electricity market has hedgers and speculators. A “short” hedger sells futures to hedge a long position in electricity while a hedge that’s long buys futures to hedge a short position. Electric power generators are short hedgers that sell futures to hedge a long position in electricity. Marketers like retail energy providers sell power to a utility as a short hedger because it can’t produce electricity. Conversely, REPs will purchase futures to hedge their short position.
Speculators can be useful by offering an insurance product to hedgers to reduce their risk. Unlike hedgers, speculators hold a position in the underlying electricity commodity. The risk for speculators increases by being long or short futures. However, speculators’ risk is compensated because hedgers are willing to pay speculators for the insurance speculators provide. Speculators stay in the market to make a profit, which can come from the insurance they sell to market participants.
Electricity Swap Contracts
Two parties come together to exchange or “swap” specific price exposure over a predetermined period in what’s called an electricity swap contract. Swaps in electricity markets came into vogue in the 1990s. Swaps are generally transacted OTC serving virtually the same function as an electricity futures contract. One of the parties agrees to pay a fixed payment stream while the other party agrees to pay a variable payment stream. The buyer makes a fixed payment while the seller makes a variable payment.
These two parties must agree on the fixed price, which determines the variable price, the tenor, and the size of the swap. Swap buyers make money when electricity prices increase while they lose money when electricity prices decrease relative to the fixed payment amount. Swaps can be tools to hedge electricity price risk exposure or speculate on the future price of electricity.
Another type of swap is what’s called electricity basis swap. This swap allows participants to manage electricity price differences at different locations. Basis swaps lock in a fixed price at a location that’s different than the delivery location of the electricity. These agreements can be either a financial or physical delivery contract.
Electricity Options Contracts
Options contracts for electricity generally come in two flavors - a call and a put. The buyer of an electricity put option pays for the right, but not the obligation, to sell electricity at a specified price, also called the strike or exercise price, at a specific point in time. Call options are used by electricity consumers for the right, but not the obligation, to buy electricity for a specified price at a specific time. Sellers (power plants) and buyers (electricity consumers) can use a combination of electricity calls and put options to narrow the price band of the electricity they’re looking to sell or buy.
Generators use put options to guarantee a minimum payment for the electricity they produce in addition to the price they receive for the sale of their generated electricity. End users (electricity consumers) enter into call options to avoid the risk of rising electricity prices, while ensuring they have access to lower-priced electricity. Power marketers sit between generators and end users entering into both put and call options to facilitate market liquidity among other goals.
Electricity Forward Contracts
A forward contract obligates one party to buy and the other party to sell a specific amount of electricity produced for a fixed price on a specific date in the future. The maturity date of a forward contract obligates the seller to deliver electricity to the buyer who pays the fixed purchase price.
If the market price of electricity is higher at the maturity date relative to the fixed purchase price, the buyer makes a profit. Alternatively, if the market price is lower at the maturity date, the buyer takes a loss. Forward contracts, unlike futures contracts, generally don’t have standardized terms and conditions. Counterparties use forward contracts for customization to meet the particular needs or goals of the parties to the transaction.
Benefits of Electricity Derivatives
Electricity futures, swaps, options, and forwards are financial tools used by market participants that include power plants, traders, marketers, and end users. The buyer and seller of these contracts have different motivations in the market. As a result, the benefits of electricity derivatives, including price stability, speculation, and risk mitigation, depend on the counterparty to the contract.
Electricity producers (power plants) can use electricity derivatives to lock in the price of electricity they’re looking to sell. Traders may find electricity derivatives helpful to bet on the future price of electricity, both price increases and decreases. Risk mitigation is a tool market participants use to protect against future electricity price volatility.
Risks Associated with Electricity Derivatives
Participants in the electricity markets may take on one of the following roles - generation, transmission or distribution, marketing, and consumption. Generators naturally have a “long” electricity position. When electricity prices increase, the plant’s value increases and vice versa. Marketers can be both “long” and “short” electricity. They’re long if they buy fixed-priced electricity but don’t have a market. In contrast, marketers are short if they sell fixed-price electricity before securing an electricity supply contract. Electricity consumers are typically “short.” Consumers benefit when prices decrease and are hurt when prices increase.
Basis risk is a common risk with electricity derivatives resulting from a difference between the buyer and seller's location, time, or quantity of electricity. Time basis risk occurs when the futures and spot electricity prices do not converge on the delivery date. Location basis risk happens when the price of electricity at location A differs from the price of electricity B on the delivery date. Quantity basis risk rears its head when the generator, marketer, or end user incorrectly estimates the amount of electricity they’ll sell or buy in the future.
Conclusion
Electricity derivates are financial products deriving their value from the price of electricity. Power markets offer participants four electricity derivative contracts - futures, swaps, options, and forwards. Price stability, speculation, and risk mitigation are noted benefits of electricity derivatives. Risks associated with electricity derivatives include basis risk that arises due to a mismatch between the location, time, or quantity of electricity bought and sold between counterparties. To sum up, electricity derivatives are instruments used by market participants to protect against the risk in the electricity market.
