Clarity in Understanding Electricity Contracts and their Associated Risks
by Robert Maxant, Rich Tanenbaum, and George Travers

Deloitte & Touche LLP Capital Markets Group and Savvysoft

(from The U.S. Power Market: Restructuring and Risk Management. Published 1997 by Risk Publications, London.)

A wide variety of physical and financial contracts are currently traded in the power markets. Analysing these contracts is more difficult than analysing their counterparts in the interest rate, foreign currency and equity markets. This is partly because electricity cannot be easily stored or transported and so exhibits a very complex price behaviour. Difficulties related to transmission and distribution, generation, varying ecological considerations and other constraints mean that not all electricity can be valued equally.

Furthermore, electricity market participants, and particularly utilities, cater to many different consumers form both the commercial and the residential side, which means that many different types of electricity contracts have been (and will have to be) created. All of these issues make transacting in electricity extremely complex.

In this chapter, we will describe various types of electricity contracts and identify the variables that affect contract value. To aid understanding, we will apply the concept of financial engineering to electricity contracts. The application of financial engineering allows us to break contracts into understandable pieces to better interpret the determinants of value for each component. Finally, we will provide a framework for analysing similar financial exposures across instruments and/or markets. This will promote a clearer understanding of electricity contract portfolios and provide a base from which hedging and other transacting decisions may be made. This is not a panacea; electricity prices are not transparent, and the market remains complex and volatile. However, the methodology presented here can simplify issues such as volumetric variability.

The building blocks--a review of financial structures

We begin by reviewing the basics of some structures found in the commodity markets.

SPOTS

The simplest form of transaction in any commodity market is the spot transaction-- the purchase or sale of an asset at the prevailing market price. Commodities purchased and sold at spot are paid for and delivered immediately. In the electricity markets, a spot transaction would require physical delivery within 24 hours.

FORWARDS

Forwards are contracts to buy or sell an asset at a future point in time. The price which will be paid at the time of delivery is set in advance--at the time the contract is written. The set price may be a fixed price or may be determined by reference to an index of prices. For example, one might enter into a contract to sell 1,000 MWh for $15/MWh next June 30 ( the total price set today for exchange on June 30 is $15,000). The characteristics of forward contracts therefore specify:

  • commodity description;
  • delivery price;
  • delivery date and time, and;
  • delivery location.

From the standpoint of a counterparty that does not own any electricity (or the fuel and ability to generate it), writing a forward contract to sell at a later date increases its absolute financial risk. In the example above, the counterparty must buy electricity sometime before June 30 in order to cover its short position, and deliver on the contract. If electricity prices fall, the couunterparty is able to purchase electricity at a price that is cheap relative to the contract price. But if electricity prices rise on June 30, the counterparty will be forced to buy electricity at a high price and then sell at the relatively low price of $15.

FUTURES

Futures are similar to forwards. The most important difference is that whereas a forward contract is bilaterally negotiated between two parties who are transacting directly with one another, a futures contract is traded on an organised exchanged. Futures exchanges effectively act as the middlemen between buyer and seller on every trade. This means that one party can buy a futures contract from the exchange, and another party can simultaneously sell the contract to the exchange. So that they appeal to a wide range of buyers and increase market liquidity, futures contracts have to be standardised as to their terms and conditions. Forwards, on the other hand, are individually structured by the negotiating counterparties.

The most important difference between a forward and a futures contract is the enhanced credit provided by the exchange. Transacting parties must put up collateral in the form of cash or Treasury bills to cover their performance and daily losses. This collateral is often referred to as margin. This collateral mechanism, along with the financial strength of the exchange itself, virtually ensures that investors will not suffer losses due to default.

SWAPS

The term swap is used to mean many things in finance, but essentially it is an agreement between two counterparties that allows them to swap two different kinds of cashflow. For explanatory purposes, it can help to think of swaps as a special kind of portfolio of forwards. Each forward in the portfolio is an agreement to purchase the same asset, usually at the same price, but at many different points in time. For example, a natural gas swap might consist of the purchase of 300,000 MMbtu every month for the next five years. This is nothing more than a series of 60 separate forwards. It is a "swap" in the sense that the counterparties will exchange the net of two offsetting cashflow streams..

OPTIONS

With both futures and forwards (and therefore swaps), both the buyer and the seller are obliged to perform under the contract. For example, the seller is obliged to make delivery of the underlying asset, and the buyer is obliged to pay the previously agreed upon price for it. The difference with options is that one party (the option buyer) has a right , and the other party (the option seller) has an obligation. The holder of the option has the right but not the obligation to buy or sell the asset at the previously agreed price. The most common form of option may be cart or home insurance. The insurance buyer pays a premium every year. If their car is not hit, the insurance company keeps the premium. If the car is hit or stolen, the insurance company will pay the damages. The damage money paid to you by the insurance company may significantly exceed the premiums paid, reprenting the payoff on the option. There are different types of options. A call option gives the holder the right to purchase an asset at a predetermined price (strike price) at or until some time in the future. A put option gives the holder the right to sell an asset at a predetermined price at, or until, some time in the future. European-style options are exercisable only at the expiration date of the option contract. American options let the option holder exercise at any time up until the expiration of the option.

CAPS AND FLOORS

To understand caps and floors, it helps to recall our explanation of swaps. Just as a swap is a portfolio of forwards, each one with a different delivery date, a cap or floor is simply a portfolio of options, each one with a different expiration. A cap is a portfolio, or "strip", of calls, while a floor is a strip of puts. The puts and calls that make up caps and floors are European in exercise style, and will usually all have the same strike price.

So futures and swaps are subsets of forwards. Caps and floors are groups of options. It seems that understanding forwards and options is the key to understanding all kinds of transactional structures. We will see shortly.

EXAMPLES OF ENERGY STRUCTURES

Now that we understand the building blocks, we can link them to structures that are observed in the electricity marketplace. We will begin by identifying simple examples of contracts. In the marketplace, among a variety of choices, an electricity market participant could potentially choose to enter into any of the transactions listed in Table 1.

TABLE 1. TYPES OF ELECTRICITY TRANSACTION
Buy or sell a fixed amount of electricity at a fixed price on a given date and time in the future
Buy or sell a fixed amount of electricity at a floating price on a given date and time in the future
Buy or sell an undetermined amount of electricity at a fixed price on a given date and time in the future
Buy or sell an undetermined amount of electricity at a floating price on a given date and time in the future
Buy or sell a fixed amount of electricity at a floating price, subject to a minimum price, on a given date and time in the future
Buy or sell a fixed amount of electricity at a floating price, subject to a maximum price, on a given date and time in the future
Buy or sell a fixed amount of electricity at a floating price, subject to a minimum and maximum price, on a given date and time in the future
Buy or sell an undetermined amount of electricity at a floating price, subject to a maximum price, on a given date and time in the future
Buy or sell an undetermined amount of electricity at a floating price, subject to a minimum price, on a given date and time in the future
Buy or sell an undetermined amount of electricity at a floating price, subject to a minimum and maximum price, on a given date and time in the future
Buy or sell a fixed amount of electricity at a fixed or variable price, that may be interrupted
Buy or sell a fixed amount of electricity at a fixed or variable price, that may be interrupted, with the interruption cancellable (bought-through) at a higher price
Buy or sell as much electricity as needed for a fixed dollar amount
Buy or sell at least a minimum amount of electricity at a fixed price
Buy or sell at most a maximum amount of electricity at a fixed price

In the cases listed in Table 1 where the price of electricity floats, the floating price might be the spot price of electricity on the delivery date, or a price index (e.g. the prices of Nymex futures contracts for delivery at Palo Verde or the California-Oregon Border). It might also be based on the purchaser's or the supplier's profit margin, or their fuel costs, or an index related to weather (temperature or rainfall, for example), or some other index (aluminum or some other metal), or even some average of any of these. As a final variant, the reference price might be based on an average over time, such as the average price of "peak" spot electricity during the month prior to delivery.

Decomposing the contracts

The transactions listed in Table 1 are simplified examples of actual structures in the electricity market yet they do not look very simple. Why? In part, because they each appear likely to have a unique range of values under different market prices (the profile of this range is referred to as the "payoff structure"). Through financial engineering we can decompose these contracts into their most granular components--the constituent building blocks we described earlier (forwards and options). This decomposition allows us to see common structures within different instruments--as the detailed example below makes clear.

INTERRUPTIBLE BUY-THROUGH CONTRACT

Let us assume that the marketing division of a utility, UtilCo, enters into an interruptible "buy-through" type contract under which UtilCo commits itself to sell firm power at fixed prices. UtilCo has the right to interrupt the service at certain times of the year. However, if UtilCo exercises this option to interrupt service, the "buy-through" feature gives the buyer the right to continue to use electricity, when it is available, at the higher prevailing prices. The buyer is obliged under the contract to purchase all the power it needs from UtilCo, unless UtilCo elects to use its option to interrupt. the actual quantity demanded by the buyer will vary time and is uncertain (i.e. it is not fixed in the contract).

For this simplified example, we will assume that UtilCo has the power available to allow the customer to exercise the higher priced buy-through option. We will also assume that the price at which the customer buys interruptible power, and the price at which it will purcahse any power after buying through any interruption, are fixed in advance. These simplifying assumptions allow us to illustrate the instruments that are embedded in contracts-- although in practice contracts may have different terms that may make their analysis and valuation more complex.

COMPONENTS OF AN INTERRUPTIBLE BUY-THROUGH CONTRACT

The process of financial engineering involves breaking a compound transaction into its constituent financial instruments, for each of which there are established valuation methodologies. The simplified example of a fixed power sale with an interruptible buy-through feature may be modelled as a:

  • traditional forward agreement with an embedded call option written by the customer (allowing UtilCo to cancel the forward); plus an
  • embedded call option purchased by the customer at a higher strike price (allowing the customer to buy through at a higher fixed price).

The net option premium "received" or "paid" would be embedded in the fixed forward price. Assuming the contract is entered into at rates in line with the market at that time (i.e. at inception, the contract has a fair value of $0), this means that the contract's fixed forward prices are bound to be different from the market price for a plain fixed forward contract (without interruptible or buy-through features). The agreed rate for the fixed interruptible buy-through contract is therefore referred to as an "off-market" rate. The "off" simply means that the rate is above or below the plain forward rate, to the extent of the embedded option premiums that are "paid" by either party. (Presumably it is "on market" relative to other interruptible buy-through deals.)

This may be more clearly understood through a brief analysis of the underlying payoff structures (readers who understood the financial engineering breakdown above may wish to skip the next section).

For the purposes of this example, assume the agreement is not only to buy or sell electricity at a fixed price, but that the quantity is also fixed. Assume that the contract is in effect from January 1, 1997, for a total of 4,896 hours (based on Norh American Electric Reliability Council's accounting practices of on-peak period for utility interchange, the equivalent of one year for the customer) and that all of the hours are priced at a single fixed price. Assume it is now March 25, 1997, and that the contract consists of the following terms (agreed on or before January 1, 1997):

  • Forward sale XYZ Co., a load aggregator, agrees to buy 70,000 kWh per hour for a single hour, 1,115 of the 4,896 total at a cost of 2 cents/kWh, for a total charge of $1,400.
  • Interruptible feature Given the demand characteristics of the hypothetical UtilCo market, UtilCo would choose interruption when the market price is above 2 cents. This would normally not be stated in the contract.
  • Buy-through feature Assume XYZ Co. may elect to override the interruptibility feature at a purchase price of 3.5 cents.

Prior to the start of hour 1,115--with just enough time for a UtilCo manager to make the decision about exercising the interruptible option which UtilCo has previously purchased--the potential range of payoffs on the forward agreement is a listed in Table 2.

Table 2. Range of payoffs on forward contract prior to hour 1,115
Range of potential prices per kWh (cents) Total revenue from sale of 70,000 kWh at current market ($) Actual revenue received by UtilCo ($) Payoff of UtilCo's fixed price forward gain/(loss) ($)
0.5 350 1,400 1,050
1.0 700 1,400 700
1.5 1,050 1,400 350
2.0 1,400 1,400 0
2.5 1,750 1,400 (350)
3.0 2,100 1,400 (700)
3.5 2,450 1,400 (1,050)
4.0 2,800 1,400 (1,400)
4.5 3,150 1,400 (1,750)

Figure 1 is simply the same information in graph form, from UtilCo's point of view.

{figure 1}

THE OPTION TO INTERRUPT

Now consider the potential payoff on the interruptiblilty option which XYZ Co. has sold to UtilCo. When electricity prices are above 2 cents, UtilCo's fixed forward agreement is in a loss position. Cancelling it would erase that loss as UtilCo could then sell electricity at the market price. In financial engineering terms, the contract embeds an instrument that pays UtilCo something when the price is above 2 cents (the strike price of interruptibility), but which is worth nothing when the price is below that level. This, of course, is an option. At expiration, the option will have value if the price of electricity is above 2 cents, because UtilCo will have the ability to cancel the forward at below the market rate of 2 cents, enabling the company to sell in the market at a price above 2 cents. The potential range of payoffs for the option are shown in Table 3.

Table 3. Option payoffs prior to hour 1,115
Range of potential actual market prices per unit (cents) Payoff of UtilCo's purchased call option gain/(loss) ($)
0.5 0
1.0 0
1.5 0
2.0 0
2.5 350
3.0 700
3.5 1,050
4.0 1,400
4.5 1,750

This information is shown in graphical form, from UtilCo's point of view, in Figure 2.

{figure 2}

Combining the option and the forward yields a net result that reflects UtilCo's ability to cancel the forward for hour 1,115. Figure 3 illustrates this combined result in graphical form, while Table 4 shows it in numerical form.

{figure 3}

Table 4. Partially combined instrument payoff profile prior to hour 1,115
Range of potential prices per unit (cents) Payoff of UtilCo's fixed price forward gain/(loss) ($) Payoff of UtilCo's purchased call option gain/(loss) ($) Combined payoff of conpound instrument ($)
0.5 1,050 0 1,050
1.0 700 0 700
1.5 350 0 350
2.0 0 0 0
2.5 (350) 350 0
3.0 (700) 700 0
3.5 (1,050) 1,050 0
4.0 (1,400) 1,400 0
4.5 (1,750) 1,750 0

{table 4}

Obviously, UtilCo pays a premium for this option. If this represented the entire transaction, we would assume that the fixed rate paid by the client was at a rate below the market rate of non-interruptibile power. The difference represents the premium "paid" by UtilCo.

As an aside, Figures 1, 2, and 3 illustrate a parity relationship between put and call options. Selling forward overlaid with a purchased call option yields a payoff identical to that of a purchased put option.

THE OPTION TO BUY-THROUGH THE INTERRUPTION

In our example, the customer also has the ability to buy-through the interruptible feature at a price of 3.5 cents. Of course, the customer will exercise this option to buy through whenever the market price is above 3.5 cents because he would then be purchasing at a below market rate. The buy-through feature therefore represents a call option written by UtilCo to the customer, which goes "in the money" at a price above 3.5 cents. Like the previous car insurance example, "in the money" simply means the option has value because it allows someone to perform a transaction at an off-market favourable price.

The payoff of the entire transaction, representing the amounts in the far right-hand column of Table 4, is shown in Figure 4.

The customer "pays" a premium for this option. The premium is embedded in the negotiated fixed price forward. At inception, whether UtilCo is a net premium payer or not depends on which option is more valuable--the purchased (interruptible) call or the written (buy-through)call. This introduces the notion of fair value at inception.

Table 5. Fully combined instrument payoff profile prior to hour 1,115
Range of potential actual market prices per unit (cents) Payoff of UtilCo's fixed price forward gain/(loss) ($) Payoff of UtilCo's purchased call option gain/(loss) ($) Sub-total (see figure 3) ($) Payoff of written call option to UtilCo (exclusive of premium paid) ($) Combined payoff of conpound instrument ($)
0.5 1,050 0 1,050 0 1,050
1.0 700 0 700 0 700
1.5 350 0 350 0 300
2.0 0 0 0 0 0
2.5 (350) 350 0 0 0
3.0 (700) 700 0 0 0
3.5 (1,050) 1,050 0 0 0
4.0 (1,400) 1,400 0 (350) (350)
4.5 (1,750) 1,750 0 (700) (700)

FAIR VALUE

The payoff diagram in Figure 4 illustrates a combination of three instruments. From UtilCo's point of view they are: a fixed forward sale; a "purchased" option at 2 cents; and a "written" option at 3.5 cents. The fair value of this compound transaction is simply a function of the component transactions described.

For forwards, the fair value represents the discounted present value of the particular payoff scenario in effect at a given moment. It is relatively straightforward to calculate. The variables affecting it are the underlying forward market price and, to a much lesser extent, the interest rate applicable for discounting cashflows.

Options are more complex because they involve rights, not obligations. Their value is a function of variables creating intrinsic value (the payoff scenarios described above) and time value (a probabilistic weighted-average discounted cashflow reflecting the fact that, so long as there is time to expiration, there is ast least a chance that the option may become more valuable). The general variables affecting option fair value are:

  • the spot and forward market price of power (the underlying commodity in this particular contract);
  • the option strike price;
  • the market volatility of the underlying commodity;
  • the probability distribution of market prices;
  • the time to expiration; and
  • the interest rate.

Assuming that both this buy-through option and the option purchased by UtilCo at the lower strike (interruptibility) have the same underlying market volatility, and that the other terms are identical, the fair value of the buy-through option at inception (e.g. the premium) would be less than the fair value of the interruptibility option. Hence, we would expect UtilCo to be a net option premium payer, and therefore also expect that the negotiated forward price would be less than the market price for a plain forward.

If one considers the entire transaction, and not just hour 1,115, the entire value of this interruptible buy through contract is a series of the compound instruments described above. At the beginning of the contract, it is 4896 forwards with 4896 purchased and 4896 written options. Each has its own respective forward market, volatility and discount rate. To complicate matters even further, in cases where UtilCo is limited in the mumber of times that it can interrupt the contract (or the total hours it may interrupt over the entire life of the contract, these options are path-dependent. Path dependency implies, for example, that the value of the interruptibility option to UtilCo in hour 1,115 under a scenario in which 45 hours had been previously interrupted would be different from the value of that same option at hour 1,115 when previously only 10 hours had been interrupted. Explaining valuation methodologies for such options is beyond the scope of this chapter, but it is intuitively clear that this path dependency is akin to an "option on an option"--referred to as a compound option--whereby the interruptible call option is valid if certain events in the past have occurred (or not occurred).

No financial engineering analysis is complete without considering the limitations implied by the analysis and its assumptions. In the example above, the largest assumption is that the volume remained constant. In the real world, volumetric variability may greatly affect the potential payoff and value of both price and volume options--for this reason it forms the theme of the second part of this chapter. In addition, we assumed that UtilCo knew the optimal point at which to interrupt service to its customer--in fact, this may be difficult to calculate. We also assumed that the price of electricity was fixed. In reality, the price would be variable for most of these contracts. We also assumed that the market price was observable. And, of course, we looked at only one situation out of 4896 possible scenarios.

We have completed the "easy " part of the financial engineering process. We have broken the instrument into constituent parts that we can understand (see also the summary in Panel 1), and we have considered the variables necessary to value these instruments. While valuing instruments in the illiquid electricity market may be difficult and require numerous assumptions, methodologies do exist to approximate the fair value of all the instrument components identified above. This has an immediate practical implication for utilities as they adapt to the coming competitive markets. The question becomes--have the respective parties been properly compensated for entering into this transaction? Milton Friedman said there is no such thing as a free lunch--by the same token, in an efficient electricity market, there should be no free options. Of course, no market is completely efficient. However, over time, utilities will need to value transactions more precisely and ensure that they are properly compensated. To do this in the real world requires considerable price modelling capability and experience.

Coping with volumetric variability

CATEGORISING ENERGY STRUCTURES

If we take a careful look at the contracts this chapter has analysed so far, a pattern emerges. Most retail electricity contracts are marked by two basic characteristics:

  • the price per kilowatt hour (price): and
  • the number of kilowatt hours they cover (volume

There are generally five prevailing ways of structuring each characteristic. Price can be set as fixed, floating, floating with a cap, floating with a floor, and floating with a cap and floor (collar).

Volume can be set as: fixed, variable , variable with a minimum, variable with a maximum and variable with a minimum and a maximum. Combining these two attributes leads to a total of 25 different types of contracts (5 x 5), as we see in Table 6.

Table 6. Combinations of key contract variables
VOLUME PRICE
Fixed Variable Variable w/ max Variable w/ min and max
Fixed
Floating
Floating w/ cap
Floating w/ floor
Floating w/ cap and floor

For example, the floating price and variable with a minimum volume is a contract under which the customer agrees to purchase electricity at the market rate at the time of delivery, with a variable number of kilowatt hours. Even though the kilowatt hours are variable, there is at least some required minimum which is preset.

In addition to the above 25 types of contracts, there is a 26th type of contract, under which the customer pays a fixed dollar amount for an unlimited number of kilowatt hours. This contract does not fit into the above matrix, but we shall refer to it as the $fixed contract type.

We can also extend each of the 26 contracts so that, instead of delivery taking place at a single date and time, delivery occurs on a series of dates and times in the future.

To understand the 26 types of contracts we should recognise two primary sources of risk that might need to be hedged: price risk and volume risk. To recap, price risk is the risk that each party will make or lose money on a customer contract because the market price of electricity changes. Volume risk arises when the amount of electricity delivered is unexpectedly higher or lower that the amount forecasted.

In Tabel 6, the amount of electricity to be delivered is not known in advance for 20 out of the 25 contract types. These all incur volume risk. As it turns out, we will usually not be able to effectively hedge away volume risk. This is because, natuarally, there is no instrument traded on the market with a value that is dependent on the volume a particular customer demands. While the volume demanded may be somewhat correlated with the market price of electricity (we might assume demand will be higher when price is higher, since high demand is one signaificant influence that drives the price up in the first place), in general, unknown levels of volume cannot be easily hedged. It is true that a substantial or estimated amount of the volume variability could be hedged using purchased options, but using these instruments extensively to cover unlikely levels of volume exposure may well seem expensive and inefficient.

CONSIDERING VOLUMETRIC VARIABILITY

A useful device for evaluating and communicating volume risk is shown in Figure 5--we will call it the volume risk graph. In Figure 5, the graph represents the volume risk of a fixed price contract with variable volume.

5. Volume risk graph: fixed $/kWh w/ variable volume
S

+

-

-

+

S = contract price
V = expected volume
V

We will also do this within the framework of hedging, which is just the flipside of decomposing a transaction structure (e.g. establishing an instrument with the opposite payoff to neutralise risk). Because unknown volume cannot be hedged, the type of hedge that is put on depends on the type of price built into the contract (fixed, float, float with cap, etc.) and not on the type of volume built into the contract (although the size and nature of the hedge will depend on the type of volume built into the contract). For the 20 contract types where the volume demanded is unknown, this hedge will not be perfect, since it will still be exposed to volume risk.

Figure 5 is drawn form the standpoint of the provider of electricity. The x axis, labelled V, is the actual volume demanded. The y axis, labelled S, is the spot price of electricity at the time of delivery. The intersection of the two axes is where the volume V is exactly as expected and the spot price S is the same as the contract price.

The upper-right quadrant represents the situation in which volume is above expectations, obliging the utility to buy electricity in the spot market. Since the spot price is above the contract price, this situation leads to an unexpected loss for the utility, denoted by a negative sign in the upper-right quadrant of the graph. However, in the lower-right quadrant, the excess demand is met by buying spot electricity at a price that is lower than the customer is paying, leading to a profit, denoted by the plus sign. Similar reasoning leads to a profit in the upper-left quadrant, and a loss in the lower-right quadrant.

We can now construct a table that states the appropriate hedge for each of our 25 types of contract. Since the hedge is independent of the type of volume built into the contract, the table could be construsted using only five rows and one column, instead of five columns. Table 7 shows the volume risk graph for each hedge and offers some brief comments on the position. Note that, in the table, the volume risk graph axes are not labelled; to save space the graph is always read as x = volume, y = spot price, while the 0 point on the x axis always represents the point where volume is equal to expected volume.

Table 7. Hedging strategy and type of risk
Price Hedge Volume risk graph Comments
Fixed Buy forwards S = contract price
+ -
- +
Unexpected volume can be good or bad
Floating Buy spot at delivery S = contract price
0 0
0 0
No hedging done. No volume risk. Spread in contract price leads to profits of unknown size that cannot be hedged.
Floating w/ cap Buy spot at delivery Buy calls S = cap price
+ -
0 0
Volume risk only exists when spot is above the cap.
Floating w/ floor Buy spot at delivery Sell puts S = floor price
0 0
- +
Volume risk only exists when spot is below floor.
Floating w/ cap and floor Buy spot at delivery Buy calls Sell puts S = cap price S = floor price
+ -
0 0
- +
Volume risk only exists when spot is above cap or below floor.

HEDGING THE $FIXED OR "ALL YOU CAN EAT" CONTRACT

For the 26th type of contract, the $fixed contract, there is no perfect hedge. We will instead consider two strategies: buying spot electricity to meet demand, or buying forwards to meet expected demand, and using the spot market to adjust for actual demand when it is time to provide electricity.

In each case, the revenue inflow to the supplier is the dollar amount (x) in the contract. The expected customer volume is V. Finally, S represents the spot price on the delivery date, and F represents the forward electricity price as of today for future delivery.

Strategy 1 If no hedge is put in place, and customer demand is met by buying electricity in the spot market, the profit/loss (P/L, dollars taken in minus dollars paid out) is given by:

Spot hedge P/L = X - V × S

because the utility takes in X, and then buy V hours at S per hour.

Strategy 2 If instead the utility hedges by buying VE hours forward at a price F, the profit/loss is given by:

Forward hedge P/L = X - VE × F - (V - VE) × S

This equation arises because the utility takes in X, then pays for the VE forward contracts at F, and then meets excess demand V - VE by paying S in the spot market (if demand is less than expected, V - VE is negative, and the utility actually makes a profit because it can sell the extra hours).

Rearranging this equation, we arrive at:

X - VE × (F - S) - V × S = Spot hedge P/L - VE × (F - S)

This means the forward hedge P/L is the same as the spot hedge P/L when F = S, that is when the spot price ends up being the same as the forward price. But if the spot price ends up being higher or lower than the forward price, there will be unexpected gains and losses. This means that the forward hedge is a riskier position than the spot hedge, and the spot hedge is therefore the best (though far from perfect) hedge of a $fixed contract. In this case, the volume risk profile of $fixed is quite different: there is a profit as long as V × S < X, and a loss whenever X < V × S. The volume risk graph when X = 100 is shown in Figure 6. In the figure, combinations of S and V above the curve represent losses, and below the curve they represent profits.

Conclusion

There is no doubt that the electricity market, and the associated financial risk, is extremely complex. The risk factors identified in this chapter only represent the first steps of any analysis of overall risk. Many other significant factors, such as price modelling, credit risk, operational considerations and understanding all of the related risks, need to be addressed when planning transacting strategies. However, financial engineering, exposure analysis, and volume risk graphs are tools that can be usefully applied to any electricity strategy. The participants who will excel in the power markets will be those who understand, and learn how best to apply , these concepts.

PANEL 1
UNDERSTANDING CONTRACT COMPONENTS

Breaking down compound structures into their components is like riding a bicycle. Once you get the hang of it, you do not forget it. Furthermore, it can be applied to many situations. The table below provides an at-a-glance summary of how the transactions in the power market look to a financial engineer. Note that the first two contracts described are equivalent to the interruptible "buy-through" contract described in detail in the main text.

For any compound instrument, it is important to compare the sum total of the component instruments with that of the contract as a whole to ensure that the analysis is correct. Once the analysis is completed in a portfolio of contracts, it allows the analyst to compare similar financial exposures across markets anf instruments. Furthermore, this kind of financial engineering analysis will help utilities to aggregate value and financial risk into meaningful groups or "buckets" of risk. These risks can then be managed much more efficiently than customised contracts viewed in isolation.

Structure Analysis
Contract to... Is equivalent to...
Deliver electricity at a fixed price on a future date with a provision to interrupt delivery. A forward contract to sell electricity, and a call option bought by the utility to buy the electricity back with a strike price equal to the contract price.
As above with the added ability of the customer to buy through the interruption at a higher price. Same as above, with an additional call option written by the utility with a strike equal to the new price at which the customer can buy through the utility's previously exercised call.
Purchase a fixed amount of electricity at a fixed price on a given future date. A simple forward contract.
Purchase a fixed amount of electricity at a floating price on a given future date. Buying spot on that future date.
Purchase a fixed amount of electricity at a floating price, subject to a maximum price, at a given future date. Buying spot on the future date, and selling a put option on electricity. The strike of the put is equal to the minimum price, and the spot is only purchased if the spot price is above the strike at delivery (expiration). If it is below the strike, the utility will force the customer to take delivery at the strike price.
Purchase a fixed amount of electricity at a floating price, subject to a minimum and maximum price, on a future given date. Buying a call option and selling a put option on electricity. The strike of the put is equal to the minimum price, the strike of the call is equal to the maximum price, and the spot is only purchased if the spot price is between the two strike prices at delivery (expiration). If it is below the strike price, the utility will force the customer to take delivery at the strike price.
 


ABOUT US
| OUR SOFTWARE | TESTIMONIALS | OUR STAFF | WHITE PAPERS
NEWS | STRATEGIC ALLIANCES | SUPPORT | CONTACT US