Supreme Court is overseeing the issue of electricity futures jurisdiction between SEBI and CERC. SEBI is expected to oversee the functioning of all financially traded electricity forwards while CERC would regulate physically settled forward where electricity is delivered on future date at the contracted price.
Once future trading is started, power exchanges would be in a position to offer derivative instruments to participants. This could be electricity futures with a clear delivery based schedule (delivery at a price on future date) and other derivative instruments such as call and put options. This will help both generators and consumers to mitigate risks by hedging their positions through derivative instruments.
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Derivatives Contracts Electricity India Risk Management
1. Derivatives Contracts in Electricity in India
Amitava Nag, ACE, WBSETCL
There are a large number of factors that can affect energy prices:
Price risk: This is the risk of losing money as a result of price
movements in the energy markets and is sometimes referred to
as market risk. Producers will lose money when prices fall, while
users will find themselves out of pocket when prices increase.
Credit risk: Credit risk is the risk of financial losses arising when
the counterparty to a contract defaults.
Cash-flow risk: This is the risk that an organization will not be
able to produce the cash to meet its obligations.
Basis Risk: In the energy market, these market movements may
be triggered by factors such as poor weather conditions, political
developments, physical events or changes in regulation. These
can lead to basis risk.
Legal risk: This is the risk that contracts may be not being
enforceable in certain circumstances. The most common concerns
in this area surround clauses on netting of settlements, netting of
trade, bankruptcy and the concern that the liquidation of
contracts may be unenforceable.
Operational risk: The risk that may occur through the errors or
omissions in the processing and settlement is known as
operational risk.
Tax risk: Tax risk can occur when there are changes to taxation
regulations that affect physical energy market.
2. Management of price risk is the center of attention for the
majority of energy producers and consumers around the world.
Investors cannot determine the long-term price trends in energy
markets. Admittedly, the relationship between risk and reward is
at the heart of all business. All successful businesses must learn
to assess and manage risk in ways that allow them to exploit
opportunities while limiting their exposure to unpredictable
factors in their operating environment. Energy industry has honed
risk management into a fine art. One of the key concepts in this
fine art is the use of derivatives which are financial instruments
that derive their value from an underlying asset. Derivatives
contracts allow some players in a market to hedge their risks,
while others take advantage of the opportunities that such
hedging provides.
As in other financial markets, the three main tools are (i) futures,
(ii) options and (iii) swaps. A futures contract is a way of
agreeing to buy and sell an asset for delivery at a future date,
while an option is a contract which confers the right but not the
obligation to do so. A swap is an agreement to fix a price in an
otherwise floating market.
• Energy futures contracts are legally binding standardized
agreements on a regulated futures exchange to make or take
delivery of a specified energy product (power, oil, gas), at a fixed
date in the future, and at a price agreed when the deal is
executed.
• Energy swaps represent an obligation between two parties to
exchange — or swap — cash flows, one of which is a fixed price
normally agreed at execution; the other is based on the average
of a floating price index during the contract period. No physical
delivery of the underlying energy takes place; there is only
money settlement.
• Options are agreements between two parties that give the
buyer of the option the right, but not the obligation, to buy or sell
at a specified price on or before a specific future date.
3. Derivatives can be bought and sold in two main ways:-
(i) on-exchange (futures market)
(ii) over-the-counter (OTC)
In India, the existing products of Power Exchanges are all
physical delivery linked products. Going forward, as the market
expands and gains more depth, players would also require
hedging instruments to square off their positions. Currently, in
case of cancelation of contracts before the delivery would impose
penalties to the extent of paying up for overheads like
transmission, scheduling & operating and other charges. In
weekly market, in case of cancellation, the difference of contract
value and spot price is charged to the defaulting party in addition
to above mentioned charges. Though such measure reduces risk
of speculative behaviour by market participants, it does not
safeguard the buyer in case of a non-delivery.
Supreme Court is overseeing the issue of electricity futures
jurisdiction between SEBI and CERC. SEBI is expected to oversee
the functioning of all financially traded electricity forwards while
CERC would regulate physically settled forward where electricity
is delivered on future date at the contracted price.
Once future trading is started, power exchanges would be in a
position to offer derivative instruments to participants. This could
be electricity futures with a clear delivery based schedule
(delivery at a price on future date) and other derivative
instruments such as call and put options. This will help both
generators and consumers to mitigate risks by hedging their
positions through derivative instruments.
In the power sector, a futures contract may function as a PPA
with some similarities and some critical differences. A point of
similarity between the two contracts is that a specified amount of
power is provided by the seller to the consumer. In addition, both
contracts specify the duration of power supply. The following are
4. some features of futures contracts for the power sector and their
points of differences with traditional PPAs:
While a PPA is a complete contract for the transfer of
physical power between two parties, a futures contract is a
price-based contract with no details about other associated
elements such as transmission and distribution charges and
routes.
A futures contract is a financial-legal entity unlike a PPA,
which is a legal entity binding the involved parties.
In financial markets, the futures contract is a tool used
mostly by speculators and middlemen to take advantage of
price fluctuations. However, the same may not be applied to
the futures contract in the power sector. There may be some
entities engaging in speculation with the help of futures
contracts wherein the physical delivery of power may not
take place between the two parties, but a cash transaction
may be implied.
Futures contracts in the power sector may be used by sellers
to hedge themselves against the risk of price reduction. For
instance, a power generator may enter into a futures
contract with an industrial consumer for a specified amount
of power at a mutually agreed price for delivery at a later
date. At the time of delivery, if the price per unit of power
discovered is less than that in the futures contract, then the
generator has hedged itself from the fall in prices and stands
to make a profit, while the buyer purchases power at a loss.
Similarly, if the price is higher than that given in the futures
contract, the generator delivers power at a loss while the
buyer makes a profit.
The futures contract in the power sector could prove to be a
tool to decrease price fluctuations as seen on the power
exchanges. The exchanges allow power trading through spot
markets for a duration of only up to 11 days. The futures
market will be pivotal in providing a longer-term mechanism
for power trading.
With an increasing share of renewables in the power
generation mix and falling renewable energy tariffs, it is
5. expected that the overall cost of power procurement may
reduce, though not significantly. The uncertainty in pricing
may lead to increased volatility. However, analysts may be
able to predict the price of power at a later date and futures
contracts would insulate the seller and the buyer from the
uncertainty of prices on the exchanges.
Another interesting aspect of the futures market is that
unlike the exchanges or the spot market where the entire
amount of the transaction has to be paid in the beginning,
the futures market considers a small initial margin to be paid
at the time of signing of the contract. This acts as a financial
guarantee for the parties involved, which is adjusted at the
time of delivery.
Futures contracts would also be able to give indications and
trends regarding price discoveries at a later date as opposed
to spot markets, especially amidst an industrial slowdown
and the resultant fall in demand.
References
(i) Energy Markets: Price Risk Management and Trading by Tom
James (Wiley) 2008
(ii) Indian Power Market, June 2014 (IEX)
(iii) Energy World, December 10, 2019 (ET)
(iv) Indian Infrastructure, April 2020