Measuring and managing risks on deregulated electricity markets
EIPM – Archamps, sept. 23, 2005
Pierre Buffière de Lair
Area Manager on European Markets
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Organization of our presentationPresentation of various OTC products
• Standard Products• Options• Indexed Products• Swaps
Using these products for optimal portfolio management
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Standard Products (POWERNEXT)
Bal
an
cin
gS
po
tF
utu
res
½ h
1 h
Day
Week
1 Month
3 Months
Year
- Basis - - Peak -
OT
C
PN
XT
PN
XT
RT
E
1 h
Day
Week
1 Month
3 Months
Year
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Standard products on French OTC marketsThe French Over-The-Counter market is offering products with various deliveries, „base“ and „peak“ (08.00-20.00)
Short-term markets
• Daily intraday market : hours and hourls „blocks“• Whole days + 3 days • Week-ends + 1 week-end• Weeks + 2 to 3 weeks
Futures markets
• Months + 2 to 3 months• Quarters + 2 quarters• Years + 2 years• Occasionally, „industrial year“, as of November 1st.
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Standard products on the French OTC market
With respect to spot markets, short-term products are traded continuously on OTC markets.
• There are arbitrage possibilities between OTC‘s traded in the morning and the clearing of the spot markets
Payment after delivery, no margin calls important credit risk.
Utilization by market actors :
• Short-term : breakeven of energy balance• Long-term : price risk management
Distribution Hedging profit margins in commercial contracts
Producer Hedging a cash flow with respect to production cost
Consumer Hedging supply prices
Speculator Betting on the evolution of product price
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What are the determinants of forward prices?Forward prices should at all times forecast the average level of the spot over the delivery period.
• Arbitrage possibilities
There is very little information available on the physical situation at the time of future delivery.
Thus, one might forecast in terms of:
• Macro-economic situationPrices of fossil fuels (marginal costs)
Growth (GNP, consumption)
• Legal frameworkProduction facilities
Liberalization
Market structure
• Production technologies
Unexpected situations on spot markets are the main elements that can change forward prices.
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Are futures markets able to predict spot prices?
En 2003: no! Unusual conditions (hot summer, et conversely very mild winter)
Since april 04: significant improvement, since conditions were stable and
„normal“
Since feb. 05 : Important volatility, combined with unexpected climatic events
Forward = average value of negociation of one monthe
before maturity.
Spot = average value of all separate days
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Development of forward prices
Increasing by 30 % since the beginning of 2003
„Bulky“ product but time-volatile. Determinants of quotations are varying in
time accoring to expectations of market participnts
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OptionsOption buyers receive the right to either buy or sell electricity at a fixed price defined beforehand, whatever the price of power at the time of delivery.
Importants elements • Various options
Call (Right to buy)Put (Right to sell)European, American, Exotic
• Various time horizons • Option on a standard product - Baseload or annual peak (to hedge against medium-
term volatility)Hourly Option (can be valued on short-term market)
This is an insurance against adverse price variations, with a premium which is a function of:
Price of underlying Exercise (or strike) priceTime and rules for delivery Type of optionVolatility of underlying (in %)Intérest rates
The premium is payable upon conclusion of the contract. If the option is exercised, energy is payable at delivery.
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Payment scheme for buying « Plain Vanilla » options
Price of underlyingin €/MWh
Val
eur
de l’
optio
n en
€/M
W
Call Option
Put Option
Exercise or strike price
Optionpremium
Option premium
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Special options
VPP
• Right of drawing on a contract with a pre-defined marginal cost• Payment of a premium
Swings
• Right of drawing on a contract during a certain number of hours at a pre-defined marginal cost
• With or without premium• Example : « Pumping -Turbining Swing (without marginal cost)»
The buyer has the right to ask for 25 MW during 500 hours between january 1, 2005 and december 31, 2005 and will supply 25 MW during 2000 hours over the same period of time
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EDF’s VPPs : An example of a daily option
VPPs are daily options with a previously known strike : • VPP « Base » : 8 €/MWh, VPP « Peak » : 33 €/MWh
The profitability of a VPP depends upon the price which is reached in the daily auction ( speculation).
In order to maximize the value of a VPP, one has to manage it with respect to the spot market, not with respect to the load.
• A VPP constitutes a good physical hedging if there is a strong correlation between the load and the spot price
• The strike is quite low, so that the option will almost always be exercized the product is very close to a forward.
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SWAPS
Principle : exchanging (or swapping) some price structure against another one.
The SWAP is the financial part of the transaction. It can either be linked, or not be linked with physical delivery of energy.
Some examples
• Cross Commodity SWAPIndexation of the price of electricity on the price of another commodity
• Fix-for-floating SWAPExchange between a spot indexation and a fixed price
• Geographical SWAPExchange of energy in some price area against another price area
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Principles for evaluation of SWAPS
SWAPS are priced by premiums, whose values depend upon:
• The correlation between prices of the two underlying products• The prices of underlying products at the time of transaction, as well
as their futures prices
Evaluation methods:
• Historical prices • Black-Scholes• Monte-Carlo simulations
Portfolio optimization with OTC products
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Structured products are combinations of various toolsValorization of flexibility
• Selling of daily options by a consumer/distributor, valued by supplier on the spot market or on the « balancing market »
• Type of flexibilitySelf-producer
Flexibility in production process or customers portfolio
Commodity/interest rate indexed products
• Commodity related to the client’s income• Possibility to link energy costs to income and to reduce variations of
margins.
Weather Derivatives
• Weather derivatives (small market)• Possibility to insure against climatic hazards with some impact on
turnover
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Using forwards for optimization of supplies: example
Base load (OTC)
Base load (PNXT)
Peak load (PNXT)
Peak load (OTC)
Total needs
Power [MW]
0 - 24 hours
Individualhours (PNXT)
Cannotbe planified
Can be planified in the short term
Can be planified in themedium/long term
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Portfolio management – Stuctured Puchasing
Possibilities for optimization d’optimisation• Timing of buying • Calendar of buying• Choice of the most liquid products • Dynamic management of positions• Short-term optimization on spot markets• Cross-management with other balancing areas
Contract structure• Contract for balancing services or «hosting in third-party area»• Distinct contracts for access to the network• Framework contracts with OTC counterparties• Participation contracts with Powernext Spot and Futures or « contracts for
access to the market » with third party
Requirements with respect to internal structure• Definition of a long-term strategy (price limits)• Ongoing activity on electricity markets• Information systems for portfolio management• Forecasting and floow-up of load
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Possibility to (voluntarily) reduce consumption is valorized on markets
Liberalization of markets led to a significant decrease in capacities to voluntarily interrupt one’s supplies (EDF’s EJP tariffs and other similar schemes).
Electricity suppliers with access to the market can optimize flexibility by trading on spot and intraday markets, thereby significantly decreasing costs of purchasing.
The value of the possibility to voluntarily interrupt one’s supply is a function of the flexibility of the production unit, in particulier of its
capacity to interrupt supplies :
• At a given time• For several ongoing hours• And as fast in time (real time) as possible
Electricity suppliers thus can make their clients participte in such a value creation, thus decreasing costs of purchasing.
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Valorization of flexibility –« Interruptible contract »Possibilities for optimization
• Timing of purchases• Choice of the most liquid products • Optimization of spot market flexibility and/or on an adjustement
mechanism
Contract structure• Contract for balancing area responsibility or for «balancing area
hosting»• Separate contracts for access to network• Framework contracts with OTC counterparties
Requirements pertaining to internal structure• Elaboration of a medium-term strategy• Ongoing activity on power markets• Mastering of production processes or self-production in order to be
able to sell flexibility
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In order to minimize profit margin risks - «indexed contract»
Possibilities for optimization• Timing of purchases subject to evolution of power and commodity
markets• Choice of the most liquid products
Contract structure• Contract for balancing area responsibility or for « balancing area
hosting»• Separate contracts for access to network• Framework contracts with OTC counterparts (EFET)
Requirements pertaining to internal structure• Elaboration of a medium-term strategy (price limits)• In-depth experience of power markets and of turnover-related
commodity markets• Ability to forecast load curve
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Conclusions
There is a very large number of possibilities for combining products.
The more specific the product is, the less liquid it will be, and the less competitive and transparent its market prices will be.
Every product has its peculiar characteristics, so that it requires highly skilled pricing staff.
The Risk Manager’s advice :
Never work with products that you do not understand, or with risks that you do not know how to manage or cover.
Use expert services !
Thanks for your attention !