Financial Contracts

Electricity futures are often financial contracts unlike electricity forwards that are more likely to be regarded as contracts for the physical supply of electricity (the terminology can be vague in business practice, see Sect. 11.2). The party that buys security and sells risk under a futures transaction (the risk shredder) is primarily motivated by security rather than the profit derived from the transaction. The party that buys risk and sells security (the speculator) under a futures transaction is motivated by the profits that are achieved by the successful prediction of price movements.²

Electricity swaps (Sect. 11.5) are an application of futures contracts. Their function is to change the commercial result of the underlying contract without changing its terms as such. This can be illustrated with a forward contract for the physical supply of electricity. If the parties have agreed on a fixed price, an electricity swap can enable the buyer to pay a variable price for the underlying electricity over the contracted time period. If the price of electricity is variable, an electricity swap can enable the buyer to pay a fixed price.

Electricity swaps are typically established for a fixed quantity of power referenced to a variable spot price at either a generator’s or a consumer’s location. Electricity swaps are widely used in providing short- to medium-term price certainty up to a couple of years.³ There are also electricity locational basis swaps (Sect. 11.5.3).

There is a large number of other electricity derivatives such as callable forwards and putable forwards.⁴ Very exotic instruments can resemble betting contracts that may be legally unenforceable in some jurisdictions.⁵

In this chapter, we will focus on electricity derivatives with electricity supply contracts or related assets as the underlying asset. In principle, the underlying could be a spot contract or a futures contract or their auction price. In futures, the underlying can also be an index, such as the “Phelix Base index” or the “APX Power NL index”. The underlying can also be a system price, such as the Elspot system price for the Nordic region. In options, the contract base can be a future that can be assigned. As illustration, there are options on “Phelix Base® Month Futures” (EEX) and “German Electricity Base Year Futures” (Nasdaq Commodities).

There are also financial contracts based on contracts for transmission capacity (Chap. 12), emission allowances, or green certificates (such as Swedish and Norwegian El-Certs).⁶ In addition, electricity firms can use weather derivatives and insurance contracts.⁷

Most electricity derivatives relate to a delivery period during a day. Moreover, the contracts can be contracts for the supply of base load or peak load.

Financial electricity contracts—derivatives—are long-term contracts in the sense that there is a gap of weeks, months, or years between the conclusion of the contract and final settlement.⁸ Generally, they can be used for three purposes. The first is hedging. Financial electricity contracts enable market participants to obtain protection against price volatility—provided that price volatility can be kept within reasonable limits as extreme volatility would make the cost of financial electricity contracts prohibitive.⁹ Financial electricity contracts can also enable electricity producers to stabilise their cash flows. The stability of cash flows can be important for funding reasons as electricity generation is capital intensive. The second purpose is arbitrage (speculating). In addition, financial electricity contracts can be used for basis trading.

In electricity markets, it is particularly important to manage price volatility.¹⁰ It is important for electricity producers, suppliers/distributors, and end consumers alike. (a) Obviously, electricity producers rely on the price of electricity for their profits. (b) An electricity producer may also need to manage price volatility for funding reasons. For instance, it may need debt funding for a new installation. Because price volatility affects its ability to service the debt, banks might not provide the necessary funding unless the firm is able to sell its production at a fixed price. (c) Many industrial production processes require plenty of power. If electricity prices rise too much, the end consumer will not be able to make a profit. For this reason, the end consumer needs to fix the price that it will pay in the future.

There are three ways to use derivatives for hedging: one-on-one hedging; portfolio hedging; and anticipatory hedging.¹⁴

One-on-one hedging means that a market participant merely hedges its existing position in the underlying security or contract.

Portfolio hedging means that firms aggregate their internal exposures and hedge the net exposures as a portfolio.

According to the ISDA, “[h]edges of physical production, physical supply, pricing exposure to movements of benchmarks, arbitrage from one region versus the other and time period hedges form a matrix of positions that are best hedged on a portfolio basis”.¹⁵

Electricity market participants may also need to hedge anticipatory exposures. Anticipatory hedging means hedging prior to the execution of the actual position. To illustrate, they may need to hedge unsold commercial production or anticipated commercial requirements. Generally, electricity producers and suppliers invest in a portfolio of assets to meet anticipated demand, but actual demand depends on many things. Many electricity firms will therefore decide whether financial instruments are needed to mitigate all or a portion of the risk exposure.

The use of derivatives to manage electricity price risk can be difficult for several reasons.

First, the existence of products that are traded in the financial electricity market depends on the existence of underlying physical electricity products traded in the physical electricity market. The quality of the financial electricity market depends on the quality and liquidity of the underlying physical electricity market. Second, the simple pricing models used to value derivatives in other industries or other energy industries do not work well in the electricity sector because of the physical characteristics of electricity.¹⁶ Third, problems in price transparency can make it difficult to develop accurate models for pricing derivatives.¹⁷ Pricing transparency would also require information about operational matters relating to production, consumption, transmission, and storage as well as relevant information about other areas.¹⁸

This can give an incentive to use even other instruments. (a) There may be demand for derivatives that are based on something other than the underlying electricity spot price. Such derivatives may include weather derivatives and specialty insurance contracts. (b) For the same reasons, there can be more use of physically-settled forward contracts using increasingly standardised terms as a replacement for futures contracts that are settled financially.¹⁹

In arbitrage, a party (the arbitrageur) capitalises on unjustifiable price differences over space or time.²⁰ Financial electricity contracts can be used on a naked basis without an offsetting position in the underlying reference assets. This reflects an opinion about the outlook of the reference asset. Similar mechanisms are generally used in financial markets regardless of the reference asset.²¹

The third way to use electricity derivatives is basis trading. Financial electricity contracts can be used to replicate the cash flows of underlying physical contracts. Market participants can thus profit from pricing differences between financial electricity contracts and the underlying physical contracts by taking offsetting positions in the two.²³

Financial electricity derivatives are based on relatively standardised terms regardless of whether they are exchange-traded or OTC-traded. Standardisation increases trading liquidity and price transparency and reduces transaction and monitoring costs.

Central counterparties, margin requirements, and daily settlement are common practice for exchange-traded derivatives. There can be more variation in the OTC market, in particular to the extent that the products do not fall within the scope of EMIR and the mandatory clearing obligation.³⁶

Electricity futures are traded on organised venues. They can be exchange-traded or available for clearing as OTC products. The clearing of OTC electricity derivatives is regulated by EMIR.³⁹ Central counterparties can therefore offer to clear OTC-traded futures in addition to exchange-traded futures. We will focus on exchange-traded electricity futures.

Like derivatives in general, electricity futures can be used in various ways. (a) They can be used for risk management (hedging). The risk of falling power prices can be managed by the sale of futures contracts (short hedge) and the risk of increasing power prices by the purchase of futures contracts (long hedge). (b) Electricity futures can also be used for arbitrage or speculation. For instance, there can be price differences between exchange-traded futures and similar contracts traded over-the-counter. In this case, a market participant can buy the cheaper derivatives and sell the expensive derivatives. A speculator may assume risks with a contrary view of the market.⁴⁰

In the following, we will call all financially-settled contracts of this type electricity futures.⁴¹ This reflects European practices. Financially-settled contracts are likely to be called futures in Europe.

The difference seems to be a matter of convention rather than law and depend on the market. Both futures and forwards are contracts for the sale of a certain volume of electricity (the underlying asset) at a pre-defined price at a given time in the future.⁴² Both can be settled physically or financially depending on the contract and the market. Both can be traded in the physical market or in the financial market. In practice, futures and forward contracts can also be regarded as equivalents as far as the hedging result is concerned.

US. In the US, the terminology is connected to the division of authority between the CFTC and the SEC. One of the two traditional ways to allocate authority over new financial products is to look at the product and ask whether it meets the definition of a security or a future.⁴³ The Commodity Exchange Act of 1936 (CEA) does not define the term futures contract. Futures are simply customised, exchange-traded forwards. In forwards, the buyer agrees to pay a specified price at a future date, while the seller agrees to deliver an asset.⁴⁴

The terminology is also based on convention. Contracts called futures contracts are often regarded as standardised exchange-traded products that are market-to-marked on a daily basis via a margin account. Contracts called forward contracts are traded over-the-counter and settled at expiration. However, most commodity futures contracts are settled by delivery of the underlying asset.⁴⁵

Auctioning Regulation. The difference between futures and forwards under the EU Auctioning Regulation is that futures are subject to cash variation margining but forwards are variation margined through non-cash collateral.⁴⁶

EEX. On EEX, the main distinction is between futures and options. All unconditional contracts traded on EEX are called futures contracts. Electricity futures are settled either physically or financially depending on the contract terms.⁴⁷

Nasdaq Commodities. In the past, both futures and forwards were defined in the Commodity Derivatives Definitions of NASDAQ OMX Commodities. Both were settled in cash. Electricity forwards could have a longer maturity. The main difference between electricity forwards and electricity futures was that electricity futures were subject to daily market settlement.⁴⁸ On the other hand, allowance contracts traded on NASDAQ OMX Commodities were settled physically. Such contracts included CER forwards (standardised forward contracts for Certified Emission Reduction units) and EUA forwards (standardised forward contracts for European Union Allowance units).

The contract types mentioned in the 2014 NASDAQ OMX Contract Specifications are futures and options.⁴⁹ Forwards are not defined in the NASDAQ OMX Definitions.⁵⁰ On the other hand, the legal framework distinguishes between Futures and DS Futures. Like before, Futures are subject to daily market settlement.⁵¹ Like the earlier Forwards, DS Futures (Deferred Settlement Futures) are not subject to daily market settlement.⁵² Futures, DS Futures, and Options relate to various product types. The offered product types are electricity contracts, natural gas contracts, allowance contracts, Swedish and Norwegian electricity certificates (El-Certs) contracts, and freight and fuel oil contracts. Electricity contracts and allowance contracts are Futures, DS Futures, or Options. El-Certs Contracts are Futures or DS Futures. Natural gas contracts are Futures.

Electricity futures that are settled financially are contracts for difference. What is settled is the difference between the contract price and the market price. Payment obligations under such contracts are unconditional but variable.

In contrast, payment obligations are unconditional and fixed where electricity forwards are settled physically.⁵³

It is, therefore, necessary to define the method of calculating the difference. The market price of the underlying physical electricity contracts cannot be defined without choosing the attributes that are characteristic to electricity supply agreements. These attributes include the delivery period, the load profile, the place of delivery, and the contract volume.⁵⁴

In the EEX Derivatives Market, for instance, the delivery periods that can be traded are weeks (Week Futures), months (Month Futures), quarters (Quarter Futures), and years (Year Futures).⁵⁵ The load profiles which can be traded on EEX are base load, peak load and off-peak load.⁵⁶ The place of delivery depends on the futures product. Depending on the product, the place of delivery can mean the admissible balancing zones of the EEX Spot Market, the balancing zone of the German RWE Transportnetz Strom GmbH, or the balancing zone of the French RTE.⁵⁷ The contract volume means the quantity of power on which the futures contract is based. It is the product of “delivery rate × delivery days × delivery hours/day”. The delivery rate (power volume per hour) of the futures contract is 1 MW.⁵⁸

As both the seller (that has a short position) and the buyer (that has a long position) have obligations that must be settled, both the holder of the long position and the holder of the short position are required to furnish collateral (margins).

Financial electricity futures are customarily settled daily during the term of the contract before final settlement. This means that contract parties either receive payments of money or have to effect payments throughout the entire period until the end of the delivery period or until the position is closed. There are daily margin calls in addition to daily cash settlement.

The customary daily margin calls and daily cash settlement are used on Nasdaq Commodities⁵⁹ and EEX.⁶⁰ There are even other margin calls (Sect. 4.​6.​2).

The amount payable by a party during the term of the contract depends on the change in the value of the position. The change in the value is calculated based on the difference in the daily settlement prices of the current and of the preceding business day. Only net payments will be invoiced.

This principle is shared by Nasdaq Commodities⁶¹ and EEX.⁶²

The amount of collateral calls is reduced by the fact that the futures position is assessed on a “mark-to-market” basis every day and the generated profits and losses are balanced in terms of liquidity. What matters is just the possible price change during the next exchange trading day. The clearing house demands collateral covering the maximum closing-out costs to be expected in the event of the most unfavourable price development during the next exchange trading day.

The settlement method can be complemented by cascading when the delivery period is long, such as a year or a quarter. Cascading means that the contract is replaced with equivalent futures contracts with shorter delivery periods on the last day of trading.

In the EEX Derivatives Market, year futures and quarter futures are fulfilled by cascading. To illustrate, three exchange trading days before the beginning of the delivery period, every position in year futures is replaced by equivalent positions in month futures for January, February and March and quarter futures for the second, third and fourth quarter, whose delivery periods taken together correspond to the year.⁶³

Cascading is also used on Nasdaq Commodities. There is mandatory cascading for open positions in some series. Cascaded series normally spans the same delivery period as the original series. For instance, a year series are transformed to four quarter series spanning the same year.⁶⁴

The final settlement price is the settlement price upon expiry. In the case of futures subject to cascading, the final settlement price defines the value of the position to be cascaded. In the case of futures not subject to cascading because of their shorter delivery period (a week or a month), the final settlement price constitutes the basis for the calculation of the cash settlement.

An option gives a right to buy (call options) or sell (put options) the underlying asset at a fixed price in the future. Depending on the marketplace, the buyer may also be called the purchaser or the option holder, and the seller may also be called the option issuer or option writer.⁶⁵

Electricity call options offer the purchaser the right, but not the obligation, to buy physically settled electricity contracts at a pre-specified price by the option expiration time. Put options offer a similar right to sell physically settled electricity contracts.

In return, the seller of the option (buy/call option or sell/put option) receives the option price (premium) paid by the buyer of the option. Table 11.1 shows the different option rights and duties.

When the option is not in the money on the expiry day, the buyer will not exercise the option but lets it expire. The losses of the buyer are thus limited to the premium. The seller of the option is exposed to the risk that an option which is in the money is exercised by the buyer on the expiry day. In this case, the difference between the exercise price and the market price for the underlying contract means that the seller will make a loss. The option premium is the price of this risk.⁶⁶

These four basic derivatives transactions—buy of a call option, sell of a call option, buy of a put option, sell of a put option—can be combined in various ways.⁶⁷ For example, a market participant may use volatility or investment strategies such as “straddles” and “strangles”.

An option has an intrinsic value and a fair value. (a) An option has intrinsic value when it permits buying or selling of the underlying asset at a favourable price than on the market at the time of the assessment. An option that has an intrinsic value of more than zero is in-the-money. An option without intrinsic value is out-of-the-money. At-the-money means that the exercise price corresponds to the market price of the underlying asset.⁶⁸ (b) Its fair value relates to opportunity and risk. It comprises the possibility that the buyer’s expectations regarding the development of the underlying asset might be fulfilled during the remaining term to maturity.⁶⁹ The fair value therefore depends on the volatility of the price of the underlying asset (the higher the volatility, the higher the fair value). It will also depend on the remaining term (the closer the last day of trading, the lower the fair value). The fair value amounts to zero on the last date the option may be exercised.⁷⁰

The option price (the premium) depends on many things. Generally, the option price (the premium) consists of the option’s intrinsic value (positive or zero) and fair value (positive or zero). Table 11.2 shows the customary factors that increase or reduce the price of a buy (call) option and the customary factors that increase or reduce the price of a sell (put) option.

Electricity options are used for hedging purposes (a) by electricity suppliers and consumers as well as (b) by electricity producers.

Electricity suppliers and end consumers can use them to protect themselves against price changes in the physical market. The option buyer can replace its exposure to price risk by the price that it pays for the option (the premium). (a) Call options enable a party to buy protection against rising electricity prices. Where the price of the electricity future exceeds the contract price and the premium on maturity, the party exercises the option and realises the difference as profit. (b) Put options enable a party to buy protection against falling electricity prices. Where the price of the electricity future falls below the contract price less the premium, the buyer may again want to exercise the option and realise the difference as profit.⁷¹

The use of call options can be illustrated with the following example.⁷² An industrial firm with a base load of 25 MW needs to purchase power for the month of May. To be competitive, the firm cannot pay more than €X/MWh and prefers to pay as little as possible. The firm assumes that the futures price will fall, but its internal risk management guidelines require the firm to cover its energy needs now. By buying a buy option (call), the firm secures both supply and a maximum purchase price (the premium and the exercise price, €X/MWh or less).

Electricity producers may use electricity options even to optimise production and increase revenue. Where the production costs at a plant exceed the physical market price, the generator does not use the plant. However, it can increase revenue by selling a buy option (call) with its generation costs as the exercise price. The buy option (call) will not be exercised, if the exercise price is higher than physical market prices. But the firm has already received the premium and may still sell power in the physical market due. The buy option will be exercised, if physical market prices are higher than the exercise price. In this case, the firm’s profit is limited to the premium.⁷³

Electricity suppliers may need options even because of customer preferences. Many customers prefer supply contracts that include a flexible volume term and a fixed rate per kWh/MWh regardless of actual consumption. However, a supplier must try to balance the load in advance. Where the supplier uses forward contracts (or physically settled futures contracts) with fixed volume terms, there can be a difference between the volume purchased by the supplier and the customer’s actual load. The supplier can mitigate risk by buying an option to purchase additional electricity at a fixed price.⁷⁴

The underlying asset customarily consists of exchange-traded electricity futures or physical electricity.⁷⁵ One can distinguish between electricity options that are contracts for difference and electricity options that are settled physically. This section focuses on financial electricity options that are contracts for difference. There are also particular spread options (Sect. 11.4).

There are different kinds of spreads and spread traders in the energy markets. One can distinguish between temporal spread traders (that try to take advantage of the differences in prices of the same commodity at two different dates in the future), locational spread traders (that try to hedge transportation/transmission risk exposure from futures contracts on the same commodity with physical deliveries at two different locations), and particular spread traders that deal with at least two different physical commodities.⁷⁶

Financial electricity options can be traded on an electricity exchange or OTC. In Europe, cash-settled options on futures are traded on electricity exchanges. Other kinds of cash-settled electricity options can be OTC traded.

Exchange-traded financial electricity options can be created by using exchange-traded electricity futures as the underlying asset. Trading participants hold positions on the option market by buying and selling options. Positions in options can be “long” (buyer) or “short” (seller). They can be closed out by means of a matching transaction in the same option contract. A buy position is thus closed out by a corresponding sell position.⁷⁷ Closing out is not the same thing as fulfilment. Exchange-traded options are fulfilled by booking in the corresponding futures position at the exercise price when the option is exercised.⁷⁸

Both exchange-traded and OTC-traded options can be cleared in the same way. Clearing is mandatory under EMIR for all standardised options.⁷⁹

The power options that could be traded in the EEX Power Derivatives Market in 2014 were options on Phelix base-load futures with a maturity of 1 month, 3 months, or 1 year.⁸⁰ OTC transactions in these option contracts and/or in similar contracts can be submitted to ECC for clearing. Exchange-traded and OTC-traded options are cleared in the same way. Consequently, an option position can be opened on the exchange and closed out over the counter, or vice versa.⁸¹

On Nasdaq Commodities, Nordic Electricity Base DS Future Year Options are based on the Nordic Electricity Base Year DS Future contract,⁸² and Nordic Electricity Base DS Future Quarter Options are based on the Nordic Electricity Base Quarterly Electricity DS Future contract.⁸³ NASDAQ OMX Clearing AB, the clearing house of Nasdaq Commodities, provides even OTC clearing.⁸⁴

The duty to make margin payments is one-sided in option contracts. The buyer has no duty to furnish margins, because the buyer has already fulfilled its side of the deal by paying the premium. On the other hand, the seller of the option must furnish margins, because the seller has to make payments in the event that the buyer chooses to exercise the option.⁸⁵

The ECC Clearing Conditions set out in detail how margins are established. Margins are based on net positions in all option series and futures contracts.⁸⁶ There is a premium margin (for the costs of potential closing out at the settlement price)⁸⁷ and an additional margin (which covers the changes in the close-out costs for all option positions in case the most unfavourable price development until the next calculation of margins established by ECC occurs).⁸⁸

Similar principles are applied on Nasdaq Commodities. There are daily margin calls⁸⁹ according to the general terms of the clearing rules.⁹⁰

The settlement of financial electricity options has its particular characteristics. (a) One can distinguish between the settlement of the premium and the settlement of other aspects of the financial electricity option. (b) One can also distinguish between the financial and physical settlement of financial electricity options. (c) Settlement depends on whether the option is exercised or expires. (d) Moreover, there is a difference between American-style settlement and European-style settlement.

The premium is payable after closing. The option is settled later.⁹¹

In the EEX Derivatives Market, the premium is payable on the first trading day after closing.⁹²

On Nasdaq Commodities, the premium settlement is included in the daily cash settlement amount on the first bank day following the day on which the option is registered as a clearing transaction.⁹³

There is no daily settlement of the value of the option. However, there may be daily margin payments.

There is no daily settlement of the change in the value of the option on EEX.⁹⁴ There are nevertheless margin payments that depend on the costs of potential closing out at the settlement price.⁹⁵

On Nasdaq Commodities, open positions in options will be settled at the option exercise time.⁹⁶ There are margin calls according to the general terms of the clearing rules.⁹⁷

In principle, financial electricity options could be settled in three different ways depending on the terms of the option. (a) They could be settled in cash through the payment of the difference between the agreed price and value of the underlying futures contract (contracts for difference). (b) Where the options are exchange-traded, one could open futures positions for the parties (a long position and a short position). (c) The futures positions could lead to the physical delivery of power when the futures positions are settled, or be settled in cash.⁹⁸

One can therefore distinguish between financial electricity options settled: (a) in cash; (b) by registering underlying contract positions and settling the underlying position in cash; or (c) by registering underlying contract positions and settling the underlying position by physical delivery.

On Nasdaq Commodities, financial electricity options are settled by registering new clearing transactions. The exercise price of the option is registered as the contract price for the underlying forward contract.⁹⁹ The financial electricity options are nevertheless contracts settled “financially”, because the forward positions are settled in cash only.¹⁰⁰

On EEX, the clearing house opens futures positions for the parties. The futures positions can lead to the physical delivery of power when the Phelix Futures are settled physically.¹⁰¹ The trading participant can combine the financial fulfilment of its positions in Phelix Futures with a physical delivery or partial delivery.¹⁰²

An electricity option expires unless it is exercised. Whether the option is exercised in fact depends on its intrinsic value.

The fact that electricity options can have intrinsic value influences the way electricity options are exercised. The exercising of options can be organised in various ways depending on the marketplace. In principle, options could be exercised on every trading day or the last trading day, and the exercising of electricity options could be automatic or explicit.

There is a difference between American-style options and European-style options as regards the point in time when the option may be exercised. If the option is an American-style option, the buyer can exercise the option right on every exchange trading day until the last trading day. Such options can thus be exercised in a flexible way according to price changes in the wholesale market.¹⁰³ If the option is a European-style option, the buyer can exercise it only on the last trading day.¹⁰⁴

Options traded on the EEX Derivatives Market are European-style options exercised on the last day of trading.¹⁰⁵ Options traded on Nasdaq Commodities are exercised on the expiration day.¹⁰⁶ Physically-settled American-style electricity options can be traded in the OTC market.¹⁰⁷

Moreover, electricity options could be exercised expressly or automatically. (a) One alternative would thus be to require express notification of the exercise of the option. (b) On the other hand, the exercising of options could also be automatic as the clearing house can determine their value. If the rules of the marketplace provide for automatic exercising, the default rule is that the clearing house exercises the option on behalf of the buyer where the option has positive intrinsic value. (c) Automatic exercising can be combined with an opt-out rule. In this case, the buyer may choose not to exercise the option whether it has value or not.

On Nasdaq Commodities, option exercise takes place either by Standard Exercise or by Manual Exercise. (a) Standard Exercise is the default rule.¹⁰⁸

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