Session 5

Question 1

What is hedging?

Answer 1

An insurance: realize expected margins of assets as cash flow

(strategy to reduce risk)

Question 2

Hedging vs speculation: which is which?

Answer 2

Hedging:
- Goal: Risk mitigation to stabilize cash flow
- e.g. who ever wants to be insured for whatever

Speculation:
- Goal: Risk-taking to make a profit
- e.g.: insurance company

Question 3

What price risk do power producers face (considering selling on the foreward-, day-ahead-, or intraday-market)?

Answer 3

Generators could sell all output day-ahead. This would, on average, maximize their profits

Problem: Liquidity squeeze if revenues decline suddenly, but costs remain the same.

Solution: Sell some production on forward market to ‘lock in’ revenues.

Question 4

Hedging spreads:
What is it? + general formula
Which ones are there?
Specific formulas

Answer 4

A “spread” refers to the price difference of two or more underlying assets.
Spread = P output - (P input / Efficiency)

Clean dark spread (CDS): The (theoretical) gross margin of a coal-fired power plant.
CDS = P power - ((P coal + P carbon)/0.4)
Pcoal = coal price / MWh thermal energy per ton coal
Pcarbon = (CO2 price * t carbon emitted per ton coal) / MWh thermal energy per t coal
Ppower = €/MWh electricity

Clean spark spread (CSS): Margin of a natural gas CCGT.
CSS = P power - ((P gas + P carbon)/ 0.6)

Question 5

Windfall profits in the energy crisis

Answer 5

Many assumed power generators would make huge profits in the energy crisis (due to a higher clearing price) and that those could be easily calculated by spot price - var. cost

But that’s not the case: Profits had been largely locked in through previous hedging decisions.

Question 6

(High) Risk of hedge when plants are unavailable: What happened to EdF in 2022?

Answer 6

• Sold output in forward markets at low prices.
• Plants broke down right during the crisis
• EdF had to compensate / buy the sold energy at much higher prices at the market

Question 7

What is a side effect of hedging?

Answer 7

Reducing market power
If capacity is scarce, generators can withhold capacity (e.g. fake unavailability) to inflate wholesale prices.
–> when hedged, this gets unattractive, as the provider then faces imbalance settlement duty

Question 8

PPA vs forward market

Answer 8

Purchasing power agreement:
- tailored contracts
- linked to a physical asset
- often 7-15 years of duration

Organized forward markets:
- standardized contracts
- not linked to any asset
- maturities of a few days up to a few years

Question 9

What are derivatives?

Answer 9

Different types of contracts.
Value is dependent on (derived from) an underlying asset (e.g. MWh of electricity).

Question 10

Derivative settlement (2)

Answer 10

Physically settled:
- a contract about selling a good for money
- transfer of ownership of the underlying asset
- actual delivery of the good

Financially settled:
- net payment of cash
- a contract-for-difference
- a contract about cash payments, depending on the (spot) price of the underlying

Question 11

Types of derivative contract (2)

Answer 11

1. Physical futures / Forward contracts:
- A sales contract signed today for delivery of MWh of electricity in exchange for EUR at a future point in time
- Right to withdraw electricity from the grid at a specific date/time

2. Option contracts:
- The right to buy or sell an asset at a certain price
- Right to buy: call option
- Right to sell: put option

Question 12

Financial power future: what payments are there, when and what’s the formula to estimate the payment?

Answer 12

Payment from seller or buyer to equalize the difference between spot market price and pre-set price (in financial forward)
Payment after pre-set time, so when the spot price is known.

Payment for difference = ∑ (𝑃 𝑠𝑝𝑜𝑡 − 𝑃 𝑓𝑢𝑡𝑢𝑟𝑒)
Net revenue: forward price

Question 13

What does “buying on forward markets” actually mean?

Answer 13

Receiving a payment worth the spot price and use that payment to physically buy power on spot markets.

Question 14

What does “selling on forward markets” actually mean?

Answer 14

Engaging in an obligation to pay the spot price, then sell the power physical on spot markets and use the proceeds to make the payment.

Question 15

Is hedging distortive (= ± verzerrend)?

Answer 15

Heding is non-distortive.
It doesn’t alter spot market behavior and asset dispatch:
Even if you ‘sold’ electricity forward, you will still turn off your generator if spot prices fall below your var. cost.

Question 16

Where are Futures and forwards traded?

Answer 16

Futures:
Traded on PX, standardized products

Forwards:
Traded OTC, individually degotiated contracts

Question 17

Minimal trade size at different platforms (2)

Answer 17

Smallest product at EEX (a PX) is 1 MW.

OTC trade is possible for fractions of a MW

Question 18

What are/ why are there proxy hedges?

Answer 18

Often, the commodity you would like to hedge is not traded in sufficient liquidity.

Proxy hedge:
- Trade a commodity that is highly correlated instead.
- (Only) basis risk remains on the books (the risk resulting from imperfect correlation)

Question 19

Different types of proxy hedges

Answer 19

• Geographic: trade on a neighboring, more liquid market
• Commodity: trade another energy commodity (gas, carbon, coal)
• Time: trade a more near-term contract (front-year)

Question 20

What is clearing?

Answer 20

• all activities between trade and settlement
• in particular: Managing pre-settlement credit exposures to ensure that trades are settled in accordance with market rules, even if a buyer or seller should become insolvent prior to settlement

Question 21

What’s margining?

Answer 21

Counterparty risk in financial contracts: If the seller goes bankrupt, the buyer must buy electricity at current prices

Question 22

Margining requirements:
1. What determines margins?
2. Types of margins
3. Price movements

Answer 22

1.:
- Current price level relative to contract price (=expected settlement payouts as of today)
- Price volatility

2.:
- Initial margin (pay when trading)
- Variation margins (pay when prices move or valitility changes)
- Margin call: deposit fresh money at the end of a trading day

3.:
- Increasing market: Sellers (open long positions) have to increase margins
- Falling markets: Buyers (open short positions) have to increase margins

Question 23

What’s a margin call?
Who gets margin calls?

Answer 23

Sellers have to provide enough liquidity to potentially compensate their failing delivery (to be able to buy the sold electricity at the spot market)

Who gets margin calls:
- Price increase -> sellers (long positions) have to provide more cash
- price fall -> buyers (short positions) have to provide more cash

Question 24

What if you cannot pay your margin call?

Answer 24

Your assets are liquidated:
- you realize any loss that you may have at this moment
- no chance to recover

Question 25

Hedging and the risk triangle

Answer 25

You will have to face one of the risks, you can’t avoid all of them:

1. Market / price risk
2. Funding / liquidity risk
3. Counterparty (credit) risk

Question 26

Is the future price the expected spot price?

Answer 26

Initially: Yes. At any moment in time, the current futures price is the predictor for the day-ahead prices during settlement.

It could be seen as discounted & inflation-adjusted expected spot price

Preferences for hedging is not symmetric: Generators tend to hedge more & earlier than consumers. Consequently, electricity futures prices tend to be lower than spot prices (“forward discount”).