Participant motivation for trading electricity price-risk ...€¦ · Derivative Market Design & Performance © CEEM 2006 21 Inter-regional settlement residue example Settlement residue

© CEEM 2006

Economic management of long term uncertainty: Derivative market design & performance

2Derivative Market Design & Performance © CEEM 2006

Participant motivation for trading electricity derivatives: price-risk management

Generators may have fixed costs but face variable electricity spot priceRetailers may buy electricity at variable spot price & sell at a pre-determined retail priceLarge end-users may buy electricity at variable spot price but sell their products at market-set priceOpposing (complementary) risk profiles:– Generator is a natural seller of derivatives– Large end-user is a natural buyer of derivatives– Retailer potentially both a seller & a buyer


Participant risks in derivative tradingMarket risk: price or volume changes in spot or derivative marketsCredit risk: counterparty fails to meet contractual obligationsRegulatory risk: impact on derivative value due to regulatory decisionsOperational risk: internal decision making, equipment performance (volume risk), liquidity management, exogenous phenomena


Market power issues in electricity spot & derivative markets

Greater role for bilateral tradeAuction: market maker must manage counter-party risks

Buyers can also be sellersBuyers cannot be sellers

Risk assessment depends on spot market power

Derivative market positions restrict spot market power

Few barriers to entrySignificant barriers to entry

Buyers have more discretion in derivative market trading

Buyers have little discretion in spot market trading

Electricity derivative marketsElectricity spot markets


Derivatives:- definitionsA derivative (contract) is a ‘paper’ product:– Derivatives are also called “financial instruments”

Its only relationship to the underlying (physical) product is through the underlying spot price:– The derivative creates a financial obligation on seller

related to a future spot market price outcomeKey derivatives for electricity:– Two-sided contract for differences (CFD) or swap– Call option or cap (a form of one-sided CFD)– Put option or floor (a less-common form of one-sided

CFD)6Derivative Market Design & Performance © CEEM 2006

Derivatives:- key parameters that are usually specified at contract time

Quantity of spot market units to which the derivative applies (e.g. MWh)Spot market period(s) to which derivative appliesStrike price:– Interpretation depends on the type of derivative


A CFD or swap for a single future spot market interval is a piece of paper stating: 1. Contract price (strike price) = pc

2. Contract quantity = xc

3. The future spot time at which contract will bereverse traded (or ‘closed out’) at spot price ps

Trade in CFDs is only related to trade in the physical commodity by the spot price at which the reverse trade is carried out

Two-sided CFD or swap:- definitions


Trader’s view of CFD tradingCFD buyer:– Buys CFD at contract time; cost = pc xc

– Sells CFD at spot time; income = ps xc

– Net cost of CFD to buyer = xc(pc - ps)CFD seller:– Sells CFD at contract time; income = pc xc

– Buys CFD at spot time; cost = ps xc

– Net value of CFD to seller = xc(pc - ps)Efficient market in CFDs required to allow adjustment of xc after contract has been traded


Effect of CFD ‘close-out’Price

Time

uniform contract price(consensus view ofexpected spot price for the duration of the contract)

variablespotprice

CFD buyer paysCFD seller xc(pc - ps)

CFD seller paysCFD buyer xc(ps - pc)


CFD & electricity trading

generators

spot marketin electrical energy

xs, ps

market inCFDsxc, pc retailers

or direct end-users


Cash flow for CFD & electricity trading #1

Retailer recovers cash flow from end-user via a retail tariff

end-user

retailer

$

CFD settlement: xc(pc-ps)

(cash flow directiondepends on sign)+$

spot marketsettlement:

xs, ps

$

generator

$

+$


Cash flow for CFD & electricity trading #2

Retailer recovers cash flow from end-user via a retail tariff

end-user

retailer

$ spot marketsettlement:

xs, ps

$

generator

$

Variable price cash flow (psxc)

Fixed price cash flow (pcxc)


CFD & electricity trading: generator perspective

Generator sells:– CFD for net income after buyback: xc(pc-ps)– Electricity in spot market for income: psxs

Income to generator (= cost to consumer): = psxs + xc(pc-ps)[spot + CFD] gross pool= pcxc + ps(xs-xc) [contract + variation] net pool

pc & ∑xc: market estimates of future ps & ∑xswhere ∑ is the net sum of CFD quantities traded to date for a future spot market period (“open position”)


CFD & electricity trading:generator with 1MW CFD @ 30 $/MWH

-9,970

-70

+2

-2

0

Income if xs=0 ($)

30-9,97010,0005

30-701004

30+2283

30-2322

300301

Incomeif xs=xc ($)

CFD (pc-ps) ($/MWH)

Spot price ($/MWH)

Spot Mkt Period


CFD & electricity trading:retailer with 1MW CFD @ 30 $/MWH

10,000

100

28

32

30

Cost of 1MW if xc=0 ($)

30-9,97010,0005

30-701004

30+2283

30-2322

300301

Cost of 1MWif xs=xc ($)

CFD (pc-ps) ($/MWH)

Spot price ($/MWH)

Spot Mkt Period


Direct end-user using CFD as a ‘hedge’End-user with 15 MW factory buying directly from spot market:– Assume that product value = (150-ps) $/MWh

At contract time, end-user buys:15 MW CFD @ 50 $/MWh = 750 $/h‘Locked in’ profit = 15(150-50) = 1500 $/h

QuantityMW

Price$/MWh

15

150ps

Profit


Direct end-user using CFD as a ‘hedge’At spot time, consider two cases:1. Spot price = 100 $/MWh

With consumption of 15 MW, spot + CFD tradingcost = pcxc + ps(xs-xc) =50x15+100(15-15) = 750 $/h(same as cost of CFD, regardless of spot price)

2. Spot price = 200 $/MWhEither consume 15 MW with same result as case 1Or shut down factory & earn a profit from the CFD transaction alone:profit from CFD = xc(ps-pc) = 15(200-50) = 2,250 $/h


Quarterly base contract prices, Q2, 2006(AER long term analysis)

QuickTime™ and aTIFF (Uncompressed) decompressor

are needed to see this picture.


Summary of CFD propertiesCFD protects against future price risk:– Incentive to fully hedge expected spot position

Thus CFD market predicts future spot market in both price & volume (hedge volume only)Even when fully hedged, there is still an incentive to respond to spot price:– Rewards voluntary price response– Generator not protected against outage risk


Hedging regional spot price differences in the NEM using spot market settlement residues

A hedge against differences between regional spot prices for one direction of flow– Difference in regional reference prices multiplied by

interconnector power flow for each spot market intervalAn incomplete hedge:– Doesn’t cover interconnector losses or outages

NEMMCO 3-monthly settlement residue auctions– For regulated interconnectors

ACCC required HT to auction Vic > Tas residues:– AFMA contracted to implement & run auction


Inter-regional settlement residue example

Settlementresidue

$50

gen’rnet income

$240

10 MWh

$150

10 MWh

cust’rnet cost

$300$200

Generator sells a 10 MWh hedge contract on region B price to customer at $30/MWh & buys a directed 10 MWh hedge (B-A) from NEMMCO SR

auction at cost of 6 $/MWh (expected spot price difference between regions)

$100

constrained lossless linkwith small

spot price difference

$50

two-region network &regional spot prices

$60SR Auction

Region BNSP

$60 - costs

Region A15 $/MWh

Region B20 $/MWh


Inter-regional settlement residue example ctd

Settlementresidue$49,800

gen’rnet income

$240

10 MWh

$200

10 MWh

cust’rnet cost

$300$50,000

Generator sells a 10 MWh hedge contract on region B price to customer at $30/MWh & buys a directed 10 MWh hedge (B-A) from NEMMCO SR

auction at cost of 6 $/MWh (expected spot price difference between regions)

$49,700

constrained lossless linkwith small

spot price difference

$49800

two-region network &regional spot prices

$60SR Auction

Region BNSP

$60 - costs

Region A20 $/MWh

Region B5000

$/MWh


SRA outcomes (AER long term analysis)






Financial outcomes from Settlement Residue Auctions (NEMMCO, 2006)

Less revenue went to TNSPs than if no SRA’s - the difference is paid by end-users


Annual outcomes of NEM SRAS for FY03(SRC report FY03 see www.nemmco.com.au)

0

10

20

30

40

50

60

SaVi ViSa ViSn SnVi SnNs NsSn NsQld QldNs

Sale price $M Distribution $M


Annual outcomes of NEM SRAS for FY04(SRC report FY04 see www.nemmco.com.au)

0

5

10

15

20

25

30

35

SaVi ViSa ViSn SnVi SnNs NsSn NsQld QldNs

Sale price $M Distribution $M


Negative weekly residues for SRAS in FY03(SRC report FY03 see www.nemmco.com.au)

0

50

100

150

200

250

300

350

400

SaVic SnVic NswQld QldNsw

Ann sum of negative weekly residues $K


Negative weekly residues for SRAS in FY04(SRC report FY04 see www.nemmco.com.au)

0

500

1000

1500

2000

2500

SaVic SnVic NswQld QldNsw

Ann sum of negative weekly residues $K


NEM unregulated interconnectorAn unregulated interconnector (MNSP):– Submits offers into the NEM spot market & retains spot

market income– Does not participate in SRA process but can

independently sell inter-regional hedgesMNSP hedge versus SRA auction:– MNSP not restricted on hedge design or duration but

faces similar issues (availability,losses)– SRA auction competes for hedge volume & sets a

benchmark price


Call option or cap:- definition & roleThe seller must compensate the buyer if the spot price is above the strike pricePotential call option buyer:– consumer with inflexible demand– unreliable base load generator

Potential call option seller:– reliable, high operating cost thermal generator– low capacity factor hydro generator


Put option or floor:- definition & role

The seller must compensate the buyer if the spot price is below the strike pricePotential put option buyer:– inflexible base load generator

Potential put option seller:– large electricity consumer


Call & put options: illustration(buy a CFD = buy a Call & sell a Put at the same strike price & same option fee)

Price

Time

variable(possibly high)

spot price

uniformstrikeprice

put option sellerpays

put option buyer xc(pc - ps)

call option sellerpays call option buyer

xc(ps - pc)


Call & put options: featuresOptions are single-sided versions of CFDsUnlike CFDs, the option buyer must pay a fee to purchase the option:– The option fee is based on an estimate of the ‘close-out’

value of the option at spot time:a call option will have non-zero ‘close-out’ value if the spot price exceeds the option strike pricea put option will have non-zero ‘close-out’ value if the spot price is lower than the option strike price

Can create composite derivatives, eg:– A collar combines a call option at a higher strike price

with a put option at a lower strike price


Final value of a call option

call optionvalue

spot price

value to seller

value to buyerstrikeprice

option fee

break-evenoutcome


Final value of a put option

put optionvalue

spot price

value to seller

value to buyer

strikeprice

option fee

break-evenoutcome


Buy CFD: Sell a put option & buy a call option at same strike price & option fee

Option value($/MWH)

Spot price($/MWH)Buy call

Sell put

Buy ca

ll & se

ll put

= buy

CFD


Retailer or end-user who buys CFD & spot

Net cost($/MWH)

Spot price($/MWH)

Buy (CFD+spot)

Buy spot

Buy CFD


Call option & generator with high operating cost #1

spot price($/MWh)

probabilitydensity average

spot pricestrike price forgenerator withhigh operating

costspot priceprobabilitydistribution


Call option & generator with high operating cost #2

Generator would like assured operating surplus to earn return on investmentBut operating cost > expected spot price:– Cannot benefit from a CFD contract

If generator reliable (both start & operate):– Sell call option @ strike price = operating cost– Then option fee provides return on investment:

Size of fee depends on likelihood of:spot price > strike price


Call & spot: generator surplus

generatorsurplus

spotprice

spot marketsurplus

option value

generator surplusfrom spot & option

strike price =operating cost

Assumes spot quantity equals option quantitywhen spot price > strike price(i.e. fully reliable generator)


Call & spot: cost to retailer or end-user

cost

spotprice

spotcost

optioncost

spot costplus option cost

strikeprice

Assumes spot quantity equals option quantitywhen spot price > strike price(i.e. fully reliable generator)


Call option as end-user hedge #1End-user with 100 MW inflexible loadGenerator with 60 $/MWh operating costEnd-user buys call option from generator:– 100 MW, 60 $/MWh, period T, option fee = F

Period T scenario 1:- spot price = 20 $/MWh– Call option inactive, generator does not operate:

Earns fee F

– End-user buys at spot price:Total cost = spot cost + F


Call option as end-user hedge #2Period T scenario 2: spot price = 200 $/MWh– Generator pays end-user the option ‘close out’ value:

100x(200-60) = 14,000 $/h– Generator sells electricity, incurs operating cost:

Surplus from spot market = 100x(200-60) = 14,000 $/h

– Generator surplus from spot + call option = F– End-user buys 100 MW electricity at spot price, receives

option ‘close out’ value from generator:End-user cost = 100x200 -14,000 + F = 6,000 $/h + F

– Shielded from spot price > strike price (60 $/MWh)


Call option as end-user hedge #3Setting the option fee F at contract time:– Assume:

Reliable generatorExpected spot consumption = 100MWSpot price probability distribution given in table below

– Then:Ave. spot price = .35x20+.5x30+.15x200 = 52 $/MWh

p r ic e($ /M w h )

2 0 3 0 2 0 0

p ro b a b il i ty 0 .3 5 0 .5 0 .1 5


Call option as end-user hedge #4Expected outcomes for end-user:– Cost without option = 52x100 = 5,200 $/h– Cost with option = (.35x20+.5x30+.15x60)x100

= 3,100 $/h– Benefit from option = 2,100 $/h

Expected end-user benefit from optionequals expected generator spot income– Basis for negotiating F if both are risk averse

Both generator & end-user still see an incentive to respond to spot price


Buy collar: sell a put option at a low strike price & buy a call option at a high strike price

Optionvalue

Spot price

Sell put

Buy collar

Buy call


Retailer or end-user who buys collar & spot

Cost ($/MWH)

Spot price($/MWH)

Buy collar

Buy (collar+spot)

Buy spot


Example: Premium ($/MWH) for all NEM spot prices above strike price for year to 4/02 (Reliability Panel, 2002)

0

10

20

30

40

50

60

0 50 100 150 200 250 300

Strike Price ($/MWh)

Prem

ium

($/M

W/h

)

Queensland

New South WalesVictoria

South Australia

Premium at zero strike price = mean spot price (in hindsight)

Premium at non-zero strike price = fair option fee for call option at that strike price (in hindsight)


Premia for call options @ $50/MWH strike price since 1999 (AER, 05Q2 Stats, 2005)


Example: d-cyhpaTrade exchange-traded call options for NSW peak period (www.d-cyphatrade.com.au)

0200400600800

100012001400160018002000

65 70 75 80 85 90Strike price $/MWH

05Q106Q107Q1


Example: AFMA OTC 10 MW CFDs (www.afma.com.au)

AFMA NEM forward price curve August 2004

0

10

20

30

40

50

60

70

2005 2006 2007 2008

Calendar year

SA peak

Vic peak

NSW peak

Qld peak

SA off-peak

Vic off-peak

NSW off-peak

Qld off-peak


Unitised value of annual $300/MWh cap(IES, 2006)


Events: days in which spot price > 300$/MWH

(IES, 2006)


Unitised value per event ($/MWh)(IES, 2006)


AFMA data on NEM OTC trading(ERIG discussion papers, 11/06)Note: Little OTC trading for SA region


Example: NSW 3rd Tranche vesting contracts(July 1998 to December 2000)

Two types of contract:1. CfDs covering around 80% of franchise load:

NSW govt preferred a strike price of 44.5 $/MWhACCC proposed to reduce this to 37 $/MWh

2. Cap (buy call) & ‘binary option’ floor (sell adder rather than put)

ACCC proposed cap of 37 $/MWh (NSW 65 $/MWh)Floor price of 14 $/MWh representative of fuel costs

This structure was designed to:– Allow 95-98% of franchise load to be ‘vested’– Expose generators to pool prices at the margin


Spot price

NSW 3rd tranche vesting contract, continued. Cost to retailer for spot & type 2 vesting contract (7/98-12/00)

Spot price ($/MWh)

Net cost toretailer

($/MWh)

14

14

37

Binary option fee = $14/MWh adder

Overall cost to retailer:spot + vesting contract

Option cap(ACCC version)

37

Side effect of “binary option”: NSW generators discouraged from wanting the spot price in this region


Example: NSW Electricity Tariff Equalisation Fund(NSW Electricity Supply Amendment Act, 2000, applying from 2001)

A form of CFD to cover default tariff load:– Between state-owned retailers & Ministerial Corp’n,

underwritten by state-owned generators:Strike price based on IPART estimate of LRMCVolume set ex-post at NEM settlement:

– Uncertain volume deters gens from other contractsReturn of ETEF surplus to gen’s is discretionary:

– Reduces their incentive to offer lower than LRMC– Encourages them to bid up spot price if ETEF high

Poor social, economic & environmental policy:– Winners: residential with air-con, interstate gen’s– Losers: low income & contestable consumers


Institutional structure for ETEF (NSW Treasury, Dec 2000)


NSW Electricity Tariff Equalisation Fund(NSW Treasury, December 2000)

For each retailer, the volume of energy covered is that supplied under regulated retail tariffs. This creates moral hazards for both retailers & customers. The load-shape may worsen & the effective LRMC rise.


Calls will be made to state-owned generatorswhen required to “top-up” the fund (NSW Treasury, Dec 2000)


Issues raised by ETEFRegulated tariff will subsidise consumers with “expensive habits” (e.g air-conditioning)Retailers can pass on these risks via ETEF– Underwrites A/C marketing drives (eg EnergyAust)

Retailers may try to bias ETEF volumes:– Up when spot price high, down when low

Discourages NSW generators from selling other forward contracts (as in South Aust):– Increases risk to other customers & retailers

Generators are effectively uncontracted when the ETEF fund is in surplus & no calls expected


EnergyAustralia residential airconditioning marketing campaign, December 2000

“EnergyAustralia can provide you with advice on your airconditioning needs. Just call 131364 and talk to our energy experts about 2 years interest free on any airconditioning system” (EnergyAustralia “bill stuffer”, 12/00)

Supported by NSW government’s Electricity Tariff Equalisation Fund, with volume set ex-post


NEM load duration curves, January-March 2001 & 2003(NECA quarterly Market Statistics)

In 2001 NSW load >90% peak for ~5% of time

In 2003 NSW load >90% peak for <2% of time


Average small consumer load profiles in Sydneyfor 2000/1 Summer (H Coleburn, Energy Australia, August 2001)

Average customer consumption - Summer 2000/01 Profiles

0.00

0.50

1.00

1.50

2.00

2.50

No AC, HotWorkday

kW

Air conditioning usage

No AC, AvgWorkday

AC, Hot Workday

AC, Avg Workday

2:00 4:00 6:00 8:00 10:00 12:00 14:00 16:00 18:00 20:00 22:00

Air-conditioning load is very temperature sensitive:• A/C load on hot summer day much greater than on average summer day• Load for consumers without A/C show much less temperature sensitivity


Growing temperature sensitivity of demand in South Australia (SA DM Taskforce, 2002)

SA System Load vs Temperaturen 1994- 2001 WD 19:00

1999-2000

2000-01

1994-95

1997-98

1200

1300

1400

1500

1600

1700

1800

1900

2000

2100

2200

2300

2400

2500

2600

2700

2800

2900

3000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42

Deg C

MW


Alternatives to ETEFCareful use of CFDs, caps & collarsSwaptions: options over CFDs, caps & collarsFlex products:– Flexible volume CFDs, caps & collars

Weather derivatives:– Call option on weather event, such as temperature or

rainfall– Broker tries to match counter-party interests

Physical actions such as improved house design (derivative market assists valuation)


Summary, derivative contractsWhen used well, derivative contracts: – Reduce spot market price risk– Do not interfere with spot market incentives– Can be used as a vesting contract to impose

transitional financial obligationsGiven well designed spot & derivative markets, trade in derivatives can:– Predict future spot market conditions– Provide flexible risk management facilities – Improve control of market power


Current use of derivatives in the NEMRisk management framework incomplete:– Aggregate volume information not available to support

generation and network planning– Little end-user participation in derivative trading, so risk

chain incompletePossible remedies:– Develop measures of hedge volume by region– Restructure retail tariffs to spot & forward form:

Consider using profile forward volumes for small end-users

– Introduce a more advanced NEM spot market design:More and smaller market regionsIntroduce Voltage Value Functions


Many of our publications are available at:www.ceem.unsw.edu.au

Documents

Participant motivation for trading electricity price-risk ...€¦ · Derivative Market Design & Performance © CEEM 2006 21 Inter-regional settlement residue example Settlement residue