Energy risk management notes

based on the GARP ERP program

Jo
ao Pedro Pereira
ISCTE-IUL Business School - Lisbon
joao.pereira@iscte.pt
www.iscte.pt/jpsp

May 20, 2012

3.3 Current Trends in the Carbon Market

These notes follow the 2012 Energy Risk Profes3.4 Emissions Trading Models in the Eusional (ERP) Examination AIM Statements. The
ropean Union . . . . . . . . . . . . .
++,+, or - next to the reference number in the section title denote how clear and correct the paper is
overall, and in particular how clearly it answers the 4 Financial Products and Valuation
(20%)
ERPs learning goals. A paper gets a + if it is
4.1 Forward Contracts and Exchange
good overall, but either has some fuzzy parts or
Traded Futures . . . . . . . . . . . .
does not meet some of the goals. inc means that
4.2 Energy Swaps . . . . . . . . . . . . .
I did not finish all learning goals. My own com4.3 Energy Options . . . . . . . . . . . .
ments and additions are [like this].
4.4 Exotic Options . . . . . . . . . . . .
4.5 Option Valuation and Risk Management . . . . . . . . . . . . . . . . . .
Contents
4.6 Real Option Valuation . . . . . . . .
1 Hydrocarbon resources (25%)
2
4.7 Speculation and Spread Trading . .
1.1 Exploration and production . . . . .
2
4.8 Hedging Energy Commodity Risks .
1.2 Crude Oil and Refining . . . . . . .
3
4.9 Weather Derivatives . . . . . . . . .
1.3 Synthetics . . . . . . . . . . . . . . .
6
1.4 Natural Gas, LNG and Shale Gas . .
8 5 Modeling Energy Price Behavior
(10%)
1.5 Coal . . . . . . . . . . . . . . . . . . 15
5.1 Introduction to Energy Modeling . .
2 Electricity Production and Distribu5.2 Data Analysis and Essential Statistics
tion (10%)
16
5.3 Spot Price Behavior . . . . . . . . .
2.1 Electricity Generation . . . . . . . . 16
5.4 Forward Curve Modeling . . . . . . .
5.5 Estimating Price Volatility . . . . .
2.2 Hydroelectric and Nuclear Power . . 19
2.3 Fundamentals of Electricity Distribution and Trading . . . . . . . . . . 22 6 Risk Evaluation and Management
(15%)
2.4 Load Forecasting . . . . . . . . . . . 27
6.1 Value-at-Risk and Stress Testing . .
6.2 Credit and Counterparty Risk . . . .
3 Renewable Energy Sources and Car6.3 Enterprise Risk Management . . . .
bon Emissions (10%)
28
6.4 Case Studies in Risk Management .
3.1 Economics and Financing of Global
Investment in Renewable Energy . . 28
3.2 Sustainable Energy and Biofuels . . 31 7 Current Issues in Energy (10%)

32
32

33
33
36
37
38
38
39
39
40
40

40
40
41
41
42
43

44
44
45
46
47
47

Hydrocarbon
(25%)

1.1

resources

in aquifers and zones of geopressure [The

IEA classifies unconventional gas as: tight
gas; coalbed methane; shale gas]. Have
low recovery rates.

Exploration and production

Polar zones. Large resources in Artic.

Technical progress may lead to more reserves
or accelerated extraction in a oil well.
Reserves are smaller than Resources due to
Location of major oil proven reserves (in
technical and economic constraints.
Gbbl):
Reserve probabilities are denoted as P90,
1. Middle East (743)
P50, P10, etc. Example: P90 = 265 Mbbl
2. Former USSR (123)
means that Prob[reserves>265] = 0.9. Alter3. Africa (114)
native notations for reserves:
4. North America (60)
1P = proven = P90 or P95
1.1.1

Hydrocarbon reserves [25, ch3,

++]

5. South America (104), mostly Venezuela.

2P = proven + probable = P50

3P = proven + probable + possible = P10
or P5
Nonconventional hydrocarbons are difficult
and costly to produce. Main families are:
Deep offshore. Major reserves in Gulf of
Mexico, Brazil, West Africa, North Sea.

1.1.2

Upstream oil and gas operations

[43, ++, inc]

Upstream activities are exploration and production; Downstream activities are refining
and distribution. An integrated oil company is
involved in both, whereas an independent company is involved only in upstream.
To be commercially productive, a petroleum
reservoir must have adequate permeability and
porosity. Porosity is the measure of the openings in a rock in which petroleum can exist. Permeability measures the connectability
of the pores, which determines the ability of
the petroleum to flow through the rock. If a
reservoir has low permeability, there are procedures to increase it, such as, fracturing and
acidizing.
Mineral rights refer to the ownership of any
mineral beneath the surface. These can be separate from ownership of surface rights. When
the owner enters into a lease with an oil company, mineral interests are created for both
sides:
Royalty interest (RI). The owner receives
a fraction (typically 1/8) of the production, free of any operating costs. He is responsible for his share of production taxes

Heavy and extra-heavy oils (< 22 AP I).

Aka tar sands. Major reserves in Canada,
Russia, Venezuela, US and Indonesia. The
global resources may be four times as large
as the worlds proven reserves of conventional oils. However, today only 5% of
these resources appear to be economically
viable.
Oil shales. Oils that remain in a typically
clayey sedimentary source rock. This rock
needs to be mined, pulverized and processed to release oil. The process produces
large volumes of solid waste and CO2 and
requires enormous quantities of water. Located throughout the world; large resource
in the U.S.
Synthetic oils. Oil converted from coal or
gas.
Non-conventional gas. Gas in coal deposits (coalbed methane), shales with low
permeability (tight sands), or in solution
2

 Production sharing contracts (most

popular). Profit oil (revenues - royalties - production taxes - costs) is
shared between the parties.
Service contracts. The government
allows the contractor to recover costs
and earn a fee. Popular in South
America.
When two or more international parties are
involved in a joint operation they must execute
a joint operating agreement detailing how costs
and revenues are to be shared. This can be one
of the contracts above or can be a separate
agreement.

and postproduction costs (transportation,

etc). The RI is also referred to as nonoperating or nonworking interest.
Working interest (WI). It is responsible
for the exploration, development, and operation of a property. The company pays
100% of the operating costs and keeps all
revenues after deducting the royalty interest (typically 7/8).
When there are multiple companies, the
working interest can be [does not make
any sense]:
Undivided. Ex: company A sells
50% of its WI on the entire property
to company B.
Divided. Ex: company A sells 100%
of its WI on 50% of the property to
company B.
In the US mineral interests are typically acquired via leasing. Most leases contain the
following provisions: lease bonus, royalty payments (as defined in RI above), primary term
(time to begin drilling), shut-in payments (if a
capable well is not producing, the lessee may
hold the lease by making shut-in payments to
the lessor), offset clause (requires drilling an
offset well if a neighbor finds a common oil
reservoir).
1.1.3

1.2
1.2.1

Nature of oil and gas [24, ch1,

++]

Petroleum = Petro (rock) + oleum (oil). Aka

crude oil. Hydrocarbons include crude oil
(mixture of HC molecules with 5 to 60 carbon
atoms) and natural gas (molecules with 1 to 4
carbon atoms).
English units. Crude oil is measured in barrels (b or bbl). 1 kb = 1 Mbbl = 1 000 bbl,
1 MMbbl = 1 000 000 bbl (M is from the latin
mille), 1 Gb = 1 Gbbl = 109 bbl. Natural
gas is measured in cubic feet (cf). A standard
cubic feet (scf) is a cubic feet at 60 F and 14.65
psi.
The density of crude oil is measured with
the American Petroleum Institute (API) scale
(API decreases with specific gravity; water has
10 API):
Light oils are 35 to 45. Most valuable, rich
in gasoline. Tend to be sweet (less than
1% sulfur). [Examples: Louisiana Sweet,
WTI, Brent.]

Accounting
for
International
Petroleum Operations [43]

The fiscal system is the set of payments that

the oil company must make to the foreign country that owns the mineral rights. Major types
of fiscal systems (distinction not really clear in
practice):
Concessionary systems. Typical in the
US, UK, Norway, and others. Payments
are royalties and taxes.
Contractual systems.
ments. Subtypes:

Crude Oil and Refining

(Medium?) [Examples: West Texas Sour,

Arab Light.]
Heavy oils are below 25. Less valuable,
contain considerable asphalt. Tend to be

Add more pay-

sour (above 1% sulfur). [Examples: Arab butane, propane, and ethane that can be reHeavy, Venezuelan]
moved from natural gas is called natural gas
liquids (NGL).
Benchmark crude oils:
Reservoir hydrocarbons are classified into:
West Texas Intermediate (WTI), 38 to 40
API, 0.3% sulfur, US.
Black oil.
Has heavy, nonvolatile
API below 45.
molecules,
Brent, 38 API, 0.3% sulfur, North Sea.
Volatile oil.
More intermediate size
Dubai, 31 API, 2% sulfur, Middle East.
molecules, API is 40 or above.
Refining separates crude oil into several
Retrograde gas. Is a gas in the reservoir
cuts (from low to high boiling points):
under original pressure but liquid conden gasoline
sate forms in the reservoir as pressure de naphtha
creases with production.
kerosene [and jet fuels]

Wet gas. Contains less than 95% methane

and more than 5% of heavier molecules
(ethane, propane, and butane). Entirely
as gas in the reservoir, but produces liquid
condensate on the surface.

light fuel oils [or diesel fuel oils, heating

oil, gasoil, or distillate grades]

heavy fuel oils or heavy gasoil

Since gasoline is most valuable, cracking is
Dry gas. It is pure methane (or more than
used to make gasoline from other cuts. Re95% methane in other definitions). Does
fining also produces pure chemicals (3%) that
not produce condensate either in the reserare used to make plastics, synthetic fibers, fervoir or on the surface.
tilizers, etc.
Natural gas composition:
1.2.2 Investment Decisions [31]
Methane, 70-98%, (CH4 )
ethane, 1-10%, (C2 H6 )

When large quantities of fluids require longdistance transportation across land, pipelines
are normally the best option based on economics, safety, environmental consideration,
and reliability.
Pipeline stakeholders: owners, customers
and shippers, consumers, regulators, landowners, etc.
Decision process for building a pipeline: select origins and destinations, estimate volumes,
estimate construction costs, estimates rates,
estimate operating costs, calculate economics,
preliminary decision.
The need for a pipeline can be:
Demand driven: consumers need more
fuels or are currently receiving fuels
through more costly alternatives (truck,
rail, barge, or tanker).

propane, 0-5%, (C3 H8 , LPG)

butane, 0-2%, (C4 H10 )
Pipeline natural gas ranges from 900 to 1 200
Btu/cf and is is commonly 1 000 Btu/cf.
The producing gas-oil ratio of a well is the
number of cubic feet of gas the well produces
per barrel of oil. [Note the mixed units: cf per
bbl].
Condensate. In some subsurface reservoirs,
at high temperatures, shorter-chain liquid hydrocarbons occur as a gas. When this gas
comes to the surface, the temperature decreases and the liquid hydrocarbons condensate out of the gas. This condensate is almost
pure (low octane) gasoline and costs almost as
much as crude oil. The condensate along with
4

 Supply driven: new oil fields, refineries, or 1.2.3

tanker terminals.

Engineering and Design

Pipelines and Storage [31]

Market driven: new resources are discov- Important aspects of pipeline design:
Safety considerations.
ered (typically natural gas), and new distant markets and connecting pipelines are
Route selection.
developed simultaneously.
Number and location of stations (comThe revenue of a pipeline depends on the volpressor or pump stations, delivery staume transported and on the rate (the amount
tions, storage stations, or interconnecting
shippers pay per unit). Common ways to esstations).
tablish pipeline rates include:
Storage:
Cost of alternative transportation. Rate
Oil, gasoline, diesel, etc, are normally
set slightly below competition from ship,
stored in aboveground steel tanks, located
barge, rail, or truck. Can be very favorat receipt and delivery points.
able for pipeline owner.
Natural gas - section 1.4.3.
Location differentials. Rate set at differ- Storage must be sized to account for deence between the price of the commodity mand/supply imbalances during the year and
at the origin and the destination. Depend during the day.
on the factors that cause the price difference (supply/demand, transportation al1.2.4 The Role of WTI as a Crude Oil
ternatives) and can thus swing wildly.
Benchmark [36, -, inc]
A Master Limited Partnership (MLP) is a
US legal entity, sold publicly as units of owner- Cushing, OK, is the physical delivery point of
ship. A general partner owns part of the com- the NYMEX Sweet Crude contract.
Parity pricing: crudes are in parity at a
pany and manages the pipelines. The rest of
given
location if the prices of each produces
the MLP units are often traded on exchanges
and the owners receive periodical cash distri- the same margin for a refiner who purchases
them. The parity conditions for WTI vary
butions.
through time due to supply/demand in differPossible valuation methods for pipelines:
ent regions. Examples:
Economic value: NPV or Cash Flow mul US Golf Coast (USGC) parity. West
tiple.
Texas crudes moved south to USGC. WTI
prices reflected transportation costs and
Comparable sales: does not work well as
USGC market prices. (Mostly before
other pipelines are not directly compara1986)
ble.
Chicago Parity. When Chicago demands
more than the available WTI, WTI prices
become related to other crudes delivered
to Chicago by other routes.

Highest and best use: not normally used.

Reconstruction cost new or replacement
cost: ceiling price for buyers.

Cushing parity. When there are not

enough domestic sweets, need to import
offshore crudes. Cushing prices are based

Book value: tells sellers whether they need

to record a financial gain or loss.
5

1.2.6

on the USGC price for sweet crude delivered directly to Cushing. Prices at
other locations would then be based on
the Cushing parity price plus transportation to those other locations.
New pipelines from Canada are likely to create
new parity conditions in the future. Nevertheless, Cushing is still likely to maintain its
status as a key gathering and distribution hub
in the Midcontinent market.
Relation between WTI futures prices and inventories:
Contango (prices increase with maturity)
induces inventory buildup.
Backwardation
crease.
1.2.5

induces

inventory

D2 and No.2 Diesel Fuel [6]

Under the ASTM standard, there are 6 types

of fuel oils. No.13 fuel oils are all called diesel
fuel oils. D2 is the same as No.2 diesel.
Price quotes can be:
Free on board (FOB). Seller provides a
commodity at a specified loading point
within a specified period; buyer arranges
for transportation and insurance.
Cost, insurance, freight (CIF). Price includes FOB value at port of origin plus all
costs of insurance and transportation.
Bunker fuel is a fuel used in the marine industry. No.2 diesel produced in North America
and Europe for inland use in trucks and trains
is also used as marine gasoil.
Refined petroleum products are traded in
cargo markets, such as, Rotterdam, Singapore, New York, and the US Gulf. Bunker
fuels come from blending fuel oils bought in
cargo markets.

de-

Simple and Complex Refineries

[28]

Refining margin = total revenue (gasoline, jet

fuel, distillate fuel, residual fuel, refinery fuel)
- crude cost - operating cost. The margin must
compensate the owner for capital investment.
The margin sets the price in the market.
Types of refineries:
Simple. Crude distillation, cat reforming,
and hydrotreating distillates. Have lower
refining margin. Tend to do better refining (more expensive) light or medium
crudes.

1.3
1.3.1

Synthetics
Oil Sands and Synthetic Crude
Oil [41]

Bitumen is a mixture of hydrocarbons that, at

normal temperatures and pressures, is a solid
or semisolid, tarlike substance. Oil sands are
deposits of bitumen in sand or porous rock.
Since bitumen does not flow under ambient
conditions, it is more difficult to recover than
conventional crude oil is and requires significant subsequent upgrading to become a substitute for conventional crude oil.
Bitumen can be processed into:
Synthetic Crude Oil (SCO). Bitumen is
upgraded to either Light, Medium, or
Heavy SCO and then sold to refineries
with corresponding processing capabilities.

Complex. Simple refinery plus a vacuum

flasher, cat cracker, alky plant, and gas
processing.
Very complex. Complex refinery plus a
coker, which eliminates residual fuel production. Have higher refining margin.
Tend to do better refining (cheaper) heavy
crudes because can turn the heavy part of
the crude into light products.
As complexity increases, gasoline yield goes up
(30%, 50%, 60%) and residual fuel yield goes
down.

Synbit: mixture of bitumen and light SCO

6

(becomes fluid). Sent directly to medium- 1.3.2

crude refineries by pipeline.

Coal-to-Liquids Technologies [2,

ch3, ++]

Dilbit: mixture of bitumen and a con- Fischer-Tropsch (F-T) steps for converting
densate, such as naphtha (becomes fluid). coal to liquids (CTL):
Sent directly to heavy-crude refineries by
1. Gasification of coal. Reacting coal with
pipeline.
steam and oxygen to produce synthesis
Bitumen reserves:
gas (hydrogen and carbon monoxide) and
carbon dioxide.
Canada: established reserves of 173 billion
barrels, mostly in Alberta. Production
2. Gas cleaning and preparation. Removes
may reach 3 million bbl/d around 2015.
gaseous molecules that derive from the impurities found in coal (sulfur, mercury)
U.S.: 54 billion bbl (22 billion measured,
and CO2.
32 billion speculative), mostly in Utah.
Bitumen extraction methods:
3. FT synthesis. FT reactors convert the
Mining. More common today (60% of
synthesis gas to a mixture of hydrocarCanadian production).
bons: methane and propane; gasoline,
diesel, and jet fuel; waxes.
In-situ. Preferred for deeper deposits.
Most of the oil-sand reserves (80%) will
require in-situ methods.
Potential constraints on oil-sand production:
Environmental impacts: footprint of extraction sites (in-situ is less disruptive
than mining), roads, pipelines, often in
pristine environments.

4. Product separation. Results in two product streams: middle distillates (retailready diesel and jet fuel) and naphtha.
5. Product upgrade. Naphtha is a very lowoctane gasoline that must be extensively
upgraded before it can be used as an automotive fuel. Alternatively, naphtha can
be converted to chemical feedstocks.
The energy efficiency of FT is close to 50%
(including cogenerated electricity sold to the
grid).
Note that synthesis gas can be produced
from different feeds: coal (CTL), natural gas
(GTL), petroleum coke, and biomass (BTL).
Over the last 15 years, commercial interest has
centered on stranded deposits of natural gas.
Commercial-scale experience with coal is extremely limited.
Transportation fuels produced in an FT
CTL plant have well-to-wheel greenhouse gas
emissions around 2 times higher than fuels
produced by refining conventional petroleum.
This will likely prevent growth of CTL in the
U.S. unless CO2 emissions are managed. Possible solutions are carbon capture and sequestration (CCS) and alternative methods (get-

Water resources.
Extraction requires
much more water than conventional oil
(in-situ requires much less than mining).
Natural gas prices. Both extraction methods rely heavily on natural gas: in-situ
methods burn natural gas to generate
steam; mining uses the same amount
[dont know for what]. By 2015, around
2 Gcf/d will be required, representing around 10% of Canadas production.
However, if natural gas prices increase,
conventional oil prices are also likely to
rise, potentially keeping SCO attractive.
CO2 emissions: life-cycle emissions for
SCO are 20% higher than for sweet light
crude oils. CO2 regulation could influence
the relative economics of the two products.
7

Btu or therms for consumers (1 therm =

100 000 Btu). In North America, natural gas
sold to consumers needs to be in the range of
1 000 Btu 5% per cf at standard temperature
and pressure.
A natural gas hub is the location where two
or more pipelines connect. A citygate is a special type of hub where interstate pipelines connect to local distribution networks. Most trading occurs at either hubs or citygates. The
most important natural gas hub is Henry Hub
in the Gulf Coast. The price at Henry Hub is
used as the benchmark for the whole US. Henry
Hub is the delivery location for the NYMEX
natural gas futures contract.
Terminology for natural gas trading (differ1.3.3 Critical Policy Issues for Coal-toent
from other financial markets):
Liquids Development [2, ch6,++]
Index price: price at Henry Hub. (ex:
Investment in CTL production has been de$8.52)
layed due to market and technical uncertain Basis price: spread between the index and
ties. It has also been affected by uncertainty
the actual price at a specified location.
about environmental regulations.
(ex: $0.18 for Waha Hub)
Environmental impacts of CTL production:
Greenhouse-gas emissions. CTL emits a
All-in price: price of physical natural gas
lot of CO2 and the viability of large-scale
at a specified location. (ex: $8.70 for
CCS has not yet been established.
Waha Hub)

ting hydrogen from renewables; averaging CTL

with BTL [sounds like cheating]).
Methanol-to-gasoline (MTG) is an alternative process to FT. One MTG plant is under
construction in China.
CTL is ready for commercial development in
the US. However, the limited commercial experience creates uncertainty at many levels: performance and operational issues, investment
and operating costs, carbon dioxide management costs. Competitiveness also depends on
crude oil prices staying at least in a $55$65
range. It is not clear how CTL will develop,
but in the U.S. probably not very fast.

To trade natural gas, traders usually enter

Air quality. Presumably, CTL would be
into
two trades:
subject to regulatory controls on pollutants emissions, like existing coal mining
1. a futures trade at the Henry Hub (very liqand coal-fired generation plants.
uid, allows bulk of trading done quickly).
Land use, ecological impacts, and water
quality. There are impacts both at the
plant and mining sites.

2. a basis swap that exchanges the Henry

Hub exposure for an exposure at some
other location.
A spread trade bets on price differences by
Water requirements. High water congoing
long in one security and short in other.
sumption may be a limiting factor in loExamples:
cating CTL plants in arid areas.
Location spreads. Speculate on price difference between two locations. Simulta1.4 Natural Gas, LNG and Shale
neous buy/sell at different locations with
Gas
the same maturity.
1.4.1 Natural Gas [15, ch2.1, ++]
Heat rates. Speculate on the relationship
between natural gas prices and electricBecause the composition of natural gas varies,
ity prices. Simultaneous buy/sell of power
it is commonly traded in units of energy, like
8

 Substantially more volatile than forward

prices.

and gas matching either the spread trading in the market or the underlying heat
rate of a physical plant. This is related to
Tolling Agreements.

Price movements in the spot market do

not have a large effect on future prices.

Time spreads. Speculate on the price

difference between periods of high and
low demand. Example: buy winter gas
and sell spring gas to speculate on a
colder than normal winter causing high
gas prices. Done through simultaneous
buy/sell of future, forward, or swap contracts with differing maturity dates.

There is no correlation across locations.

1.4.2

The Basics [9]

Natural gas consists of hydrocarbons that remain in the gas phase at 20 C and atmospheric
pressure (standard temperature and pressure,
STP).1 See composition in section 1.2.1.
Liquefied natural gas (LNG) is produced by
cooling methane to 161.5 C. This allows for
efficient transport by ships.
Liquefied petroleum gas (LPG) refers to
propane and butane in pressurized containers.
They liquefy at 0 C at 90 psi to 110 psi.
Natural gas liquids (NGL) include components that exist with the gas in the reservoir
but become liquid on the surface. Condensates
are low-density liquid mixtures of pentanes and
other heavier hydrocarbons.
In addition to hydrocarbon components
(methane, ethane, propane, butane, pentane),
natural gas also contains non-hydrocarbon
components: nitrogen (N2 ), Hydrogen sulfide
(H2 S), and carbon dioxide (CO2 ). Gases with
high/low levels of H2 S are called sour/sweet.
Barrel of oil equivalent (boe) for natural gas.
The calorific values are:
Crude oil: 1 bbl oil = 5 800 MBtu

Swing trades. Pick up inexpensive natural gas when demand is low (ex: Saturday night) and resell it when demand is
high (ex: Monday morning). Relies on
the physical ability of the trader to store
natural gas for short periods of time.
Spot and forward markets are separate because natural gas is hard to store. For example, traders might buy gas in the summer to
sell during the next winter, but they arent going to buy gas and hold it for several years as
a long-term investment.
Forward prices:
Determined by seasonal expectations of
demand: highest in winter (for heating),
lowest in spring and fall, increases in summer (for electricity generation for AC).
Follow a very regular pattern, generally
the same every year.

Volatility decreases with maturity of the

Nat gas: 1 cf gas = 1 MBtu or 1 m3 gas
forward contract (from 1 to 4 months to
= 35.3 MBtu
expiration)
Hence,
1 boe 5 800 cf gas 164 m3 gas
Correlated across locations when it is pos[If prices per energy were the same, 1 bbl of
sible to move gas from one location to anoil would cost 5.8 times 1 thousand cf of gas.]
other.
Associated gas occurs in the same reservoir
Hence, forward prices are highly predictable.
and coexists with crude oil.
Spot prices:
1
Determined by the demand and supply
Though in section 1.2.1 a standard cubic feet of
that is on hand right now.
natural gas is defined at 60 F = 15.6 C.
9

could be built is relatively close to the

Reserves are classified as 1P, 2P, or 3P, like
field.
oil. Proved (1P) gas reserves worldwide are
6 300 tcf, implying a reserves/production ratio
The political situation in the country supof 66 years.
ports large-scale, long-term investments.
An oil and gas reservoir may initially pro The pipeline would have to cross other
duce high volumes of oil relative to gas, but as
countries and the buyer is concerned
the oil production and reservoir pressure deabout security of supply.
cline, the gas/oil ratio of the produced hydroThe
LNG chain is (cost range in $/MMBtu)
carbons may increase.
(measurement
units):
Coal bed methane is methane contained
Upstream production. (0.500.75) (Volwithin coal seams. This is an unconventional
ume, cf or cubic meters). Similar to trasource: though easy to find because coal ocditional gas. Byproducts removed from
curs close to the surface, it is relatively diffimethane (such as ethane, LPG, and concult to produce. Nevertheless, in the US it is a
densate) are sold at market prices and
significant portion of domestic gas production
contribute to overall LNG project ecovolumes.
nomics. (LPG sales are also important for
some shale gas projects.)
1.4.3 Transport and Storage [9, +]
Midstream processing and liquefaction.
The cost of transporting 1 energy unit of nat(1.31.8) (Mass, tons. The LNG industry
ural gas via onshore pipeline is 3 to 5 times
uses MT, not MMT, to represent million
higher than oil. This ratio increases to 20 or
tons). Special care must be taken to remore for longer distances.
move all impurities (CO2 and sulfur) and
Liquified Natural Gas (LNG) is a transespecially water.
portation alternative. Though less than 10%
Shipping. (0.41.0) (Cargo volume, cubic
of gas is transported as LNG, it is growing
meters)
rapidly [section 1.4.9 says it is not growing
Storage and regasification. (1.01.5)
due to shale gas]. Methane gas is cooled to
3

161.5 C (260 F), shrinking 600 ft of gas

Distribution. () (Btu)
to around 1 ft3 of LNG. One ton of LNG conGas storage ensures that excess supply protains the energy equivalent of 1 380 m3 of nat- duced during low-demand months or hours is
ural gas.
available to supplement the insufficient supply
LNG is transported by ship over long dis- during high-demand months or hours. Othertances where pipelines are neither economic wise, production and infrastructure would have
nor feasible. LNG could be a viable option to be over-sized to meet the highest demand.
versus pipeline when many of the following are
Base load requirements refer to the seasonal
true:
monthly swings, while Peak load requirements
Gas market is more than 2 000 km from refer to the hourly swings. Base load storage
the field.
needs to be large, but can have low delivery
Production costs are $1/MMBtu or less. rates; peak load storage have high deliverability for short periods of time.
Gas contains minimal impurities, such as
Structures for storing:
CO2 or sulfur.
Pipeline itself. Simplest form of peak load
storage.
A marine port where a liquefaction plant
10

 Depleted gas reservoirs. For base load.

Most common; account for 86% of storage
capacity in North America. Cheaper, well
known, smaller amount of cushion gas (injected gas that remains in the reservoir).

ural gas to liquid fuel. Methane is reacted with

pressurized hot steam to produce syngas (synthesis gas, CO + 3H2 ). Then, syngas is converted to longer-chained hydrocarbons through
the Fischer-Tropsch process. GTL produces:

Acquifers. Least desirable and most expensive. Require whole new infrastructure, high cushion gas.

Diesel. Represents 60%85% of the products. Does not contain impurities, thus
being much cleaner burning than conventional diesel.

Salt caverns. For peak load. High deliverability with minimal leakage. Small capacity. Cushion gas requirements are the
lowest.
1.4.4

Naphtha. Feedstock for petrochemicals.

Lube oils.
LPGs.

Gas Usage [9]

Electricity generation accounts for 25% of all

gas consumption in Europe. In a conventional
power plant, natural gas powers a gas turbine
(or coal or oil power a steam turbine) to generate electricity with an efficiency around 34%.
In a Combined Cycle gas power plant, the first
cycle is a gas turbine, and the second cycle
recovers the heat from the exhaust gases to
power a second steam turbine, with an overall efficiency around 55%.
Replacing a coal generating unit with a
CCGT plant virtually eliminates SO2 emissions, reduces CO2 by 2/3, and reduces N Ox
by 95%. Gas CC plants are cheaper to build,
less noisy, less polluting, and easier to switch
on and off. Can be built in modules and are efficient at smaller sizes. Most new power plants
in North America and Europe are expected to
be gas fired.
Gas has become the fuel of choice for both
intermediate and peak load plants. As efficiencies improve and in areas where gas prices are
competitive to other fuels, gas may even replace other fuels in base load.
A modern CCGT plant can be built at a cost
around $500/kW to $700/kW in about 2 years
(roughly 1/2 the time and cost of coal).
Gas-to-liquids (GTL) processes convert nat-

Despite efforts, it remains an energy intensive process and the number of GTL plants remains limited. For GTL projects to be profitable we need sustained high crude prices and
inexpensive gas. A 2005 study concludes that
GTL has more technical risk, complexity, and
susceptibility to short-term price fluctuations
than LNG.
Transport fuel. Natural gas in the form
of compressed natural gas (CNG), which is
methane pressured to 200 bar to 250 bar, is
a good alternative for spark ignition engines.
It has much smaller emissions than gasoline.
It holds the greatest promise for fleet vehicles
that refuel at a central location. Note: LNG
can also be used. However, the growth of natural gas in the transportation sector has been
slow, due in part to the lack of infrastructure.
A Local distribution company (LDC) supplies residential gas to the end user. Though
they may not face direct competition due to
their exclusive mandate, their end-user energy
prices have to be competitive with electricity,
heating oil, coal, etc, to maintain their customer base. Deregulation in North America
and Europe has forced LDC to become more
competitive and has brought lower prices for
consumers.

11

Contracts and Project Develop- ever, the LNG SPA is more complex due to
the large capital expenditures, international
ment [9]
nature, and discrete value chain. Important
The pipeline gas sales agreement (GSA) is also
features of the contract.
know as gas purchase agreement or a gas sales
Price. During the first SPAs, Japanese
and purchase agreement. The contract covers
power plants were able to use either oil
a number of provisions, including:
or gas to generate electricity, so the price
Term. Can be from 1 day to 20 or 30
of LNG was indexed to a Japan Crude
years.
Cocktail (JCC) price. Since the index Price terms:
ing was calculated on a monthly basis,
this made LNG prices less volatile than
Fixed price. Typically in shortercrude prices. Today, particularly in North
term contracts.
America, prices are more commonly linked
Fixed price with an escalator:
to natural gas prices (NYMEX or Henry
changes every year by a percentage
Hub).
determined by an index. The index may be linked to: inflation; a
Take-or-pay.
published price on the NYMEX; a
Shipping terms. Deliveries can be on a
combination of substitute fuels, such
free-on-board or cost-insurance-freight baas crude oil (most gas contracts in
sis. Many buyers prefer FOB.
Europe) or coal. Indexing ensure
The phases of a gas project development are:
gas price competitiveness to alter1.
Concept and identification. Is the project
nate fuels and avoids renegotiating
realistic and achievable?
long-term contracts.
2. Feasibility and option selection. Financial
Floating price. Varies every week
and commercial models are created (estior month according to some market
mate NPV and IRR), engineers are enprice.
gaged, risks are identified, and preferred
Delivery obligation. Flexible delivery contechnical options are highlighted. Sign
tracts may be cheaper than firm delivery
memorandum of understanding or heads
because gas supply is interruptible by the
of agreement letters with the resource
seller.
holder and the potential customers.
Take-or-pay obligations. The buyer is
3. Project definition.
Critical go/no-go
obliged to pay for a percentage (6095%)
stage. Key contracts to be secured: GSA,
of the contracted quantity, even if he fails
transportation agreements, environmental
to take the gas.
impact studies, permits. Partners should
Nominations. The buyer communicates
finalize a joint operating agreement.
its weekly (or other period) gas volume
4. Project execution. An engineering comrequirements to the seller.
pany is typically engaged in a engineering,
Force majeure. Events outside the partys
procurement, construction (EPC) concontrol. Obligations of all parties must be
tract or an EPCM contract (adds manclearly stated.
agement to EPC).
A sales and purchase agreement (SPA) for
5. Commission and operation.
LNG is similar to a GSA for natural gas. How1.4.5

12

1.4.6

Coal. There is little price influence. However there can be fairly high correlation
due to common dependence on oil prices.

The Natural Gas Market in the

United Kingdom [17, ch36, -, inc]

Physical and financial gas is traded at the national balancing point (NBP). NBP does not
have a specific location and gas is neither produced nor consumed at the NBP. The International Commodity Exchange acts as the main
exchange for NBP gas.
Consumption:
Power generation. 30% of demand. All
new generation plants are gas-fired.
Industrial and commercial consumption.
Follows diurnal, working day, and seasonal
cycles but is not particularly weather sensitive.
Domestic consumption. 35% of demand.
Very sensitive to weather.
In the event of a supply shortage, power stations and large users are required to self interrupt; domestic users receive priority (due to
lack of relevant safety mechanisms in domestic cookers, making gas disruptions potentially
dangerous).
Relationship to other commodities:
Oil. Long-term gas contracts are commonly indexed to oil prices. This improves
hedgeability, cost reflectivity, and reduce
contract frustration risk.

1.4.7

Liquefied Natural Gas: Understanding the Basic Facts [14, ++]

In the US, natural gas represents 1/4 of primary energy. About 90% is produced in the
US, the balance is imported by pipeline from
Canada. Natural gas demand is expected to
rise, but production in major mature provinces
in North America is beginning to decline [this
sounds biased...]. Hence, imports of LNG by
ship are expected to increase. One shipload
(around 3 bcf) provides 5% of US daily demand.
The international LNG business connects
natural gas that is stranded far from any
market with the people, factories, and
power plants that require the energy.
International LNG trade centers:
Atlantic Basin: Europe, Africa, US.
Importers: 33% of global imports.
Exporters: 32% of global exports.
Algeria is worlds second-largest exporter.
Asia/Pacific Basin: South Asia, India,
Russia, Alaska.

Electricity. The electricity price at the

Importers: Japan, South Korea, and
gate (1 hour ahead of delivery) is related
Taiwan account for 67% of global imto the cost of the marginal plant. Gas and
ports (Japan close to 50%).
power prices are closely related when gas
Exporters: 50% of global exports.
plant is at the margin. As CCGT has also
Indonesia (21%), Malaysia.
been designed to run baseload, long-term
Additionally, Middle Eastern countries ship
baseload power price has also been set by
mostly to Asian countries, but also to Europe
gas.
and US.
Peak shaving. The US has more than 100
Power prices in the UK are closely connected to ETS CO2 prices. Medium CO2 small plants that store LNG. This is used to
prices make CCGT better than coal, but provide extra supply when natural gas demand
very high CO2 prices make renewable and peaks during extremely cold spells or other
emergencies.
nuclear better than CCGT.
13

LNG value chain. See section 1.4.3. Liquefaction is the largest cost: capital costs around
$200 per ton of capacity. Total investment for
full LNG chain is very large: $710 billion.
Risk is thus minimized with long-term supply
contracts, with take or pay clause. However,
about 70% of LNG in the US is traded in a
spot market; worldwide, spot market accounts
for 12% of trade.
Units: see table in paper to convert from
tons of LNG to cubic feet of natural gas, and
corresponding Btu values.
A LNG train consists of the series of linked
equipment elements used in the liquefaction
process. A typical plant includes 3 to 4 trains.
1.4.8

Todays LNG Market Dynamics

[35, +]

by longer term contracts, as projects with too

much uncontracted volume have difficulty securing project finance.
LNG prices are typically indexed :
In East Asia, contracts are indexed to
crude oil through JCC index. Example:
LNG price = (gas/oil energy ratio) x JCC
+ transport costs.
In Europe, are indexed to various commodities.
In the US and UK, are indexed to natural
gas through National Balancing Point and
Henry Hub indexes.
This has results in arbitrage spreads between
regions, that have widened in recent years due
to index divergence.
The current development of standardized
contracts may help to create a more efficient
global market for LNG, help the development
of a spot market, and ultimately reduce price
differentials.

The geographical mismatch between producers (Middle East, West Africa, Indonesia, Australia) and consumers (Japan, Europe, North
America) of LNG has maintained large price
differences between markets (often exceeding
1.4.9 Impact of Shale Gas Developseveral hundred percent of the source price).
ment on Global Gas Markets [30,
However, these gaps may reduce in the future
+]
due to:
Global growth in the number of liquefac- During the early 2000s, the LNG import capaction and regasification plants.
ity to North America was expanded. However,
Development of unconventional gas sup- much of that capacity now sits idle, as shale
gas developments have changed expectations
plies, such as coal seam methane.
about future prices and LNG import require New ships are able to liquefy and regasify ments.
onboard, obviating the need for onshore
The estimates of shale gas resources have
plants and making smaller stranded gas been increasing through time. Current estisites and smaller consumer markets eco- mates point to a North America recoverable
nomically viable.
resource around 700 trillion cubic feet.
Implications of this large domestic resource
Modular liquefaction plants make infrasbase:
tructure less costly.
Contract term. The number of short-term
Domestic gas prices should remain relatively stable, toward the long-run
contracts ( 1 yr) is growing. These contracts
marginal cost of supply (around $6 per
tend to cover small volumes. They allow supthousand cf at Henry Hub). [An MIT
pliers to take advantage of regional price differ(2010) study estimates that the breakeven
ences. However, the market is still dominated
14

price for the exploration of shale gas is in worlds reserves), former Soviet Union (23%),
the range of $4 to $8 per thousand cf (2007 and China (11%). Approximately 40% of the
Earths current electricity production is powprices)]
A more elastic supply curve will make ered by coal, and the total known deposits reit harder to price above marginal cost, coverable by current technologies are sufficient
meaning that oil indexation is likely to for at least 300 years of use.
Coal types (from highest to lowest rank):
loose some prominence. [Due to shale gas
1. Anthracite (or hard coal). Primarily for
supply, since 2005 gas has decoupled and
residential and commercial space heating.
become cheaper than oil (per Btu). This
High percentage of fixed carbon and low
shows that gas and oil are not good substipercentage of volatile matter. Moisture:
tutes in many applications, such as transless than 15%. Heat content: 2228 milports.]
lion Btu/ton.
Since Henry Hub prices are at a discount
2. Bituminous coal. Primarily for power genrelative to other locations (such as the
eration, heat and power in manufacturNBP in the UK), LNG supply has been
ing, and to make coke. Moisture: less
redirected from the US to Europe and
than 20%. Heat content: 2130 million
Asia, increasing physical liquidity, arbiBtu/ton.
trage opportunities, and reducing the demand for pipeline supplies.
3. Subbituminous coal. Primarily for power
generation. Moisture: 2030%. Heat con Growth in LNG import reliance is shifted
tent: 1724 million Btu/ton.
by two decades, yielding security benefits.
If shale gas also grows globally, Europe
and Asia will reduce their dependence on
geopolitically risky sources of supply from
the Middle East, North Africa, and Russia.
However, rapid development of shale gas is
not certain:
Use and contamination of water resources
remains a major concern.
Separation of pipeline capacity rights from
facility ownership allows entry by small
producers. This market structure was crucial for shale gas development in the U.S.
In other countries, pipeline transportation
monopolies may hamper shale gas growth.

4. Lignite (or brown coal). Exclusively for

power generation. Moisture: sometimes
as high as 45%. Heat content: 917 million Btu/ton.
Important concepts in coal sampling:
Accuracy: closeness between an experimental result and the true value. Affected
by bias.
Precision: agreement among individual
test results obtained under similar conditions. Not affected by bias, hence data can
be very precise without being accurate.

Bias: systematic error that is of practical

importance.
There are several coal classification systems
across the world. In the U.S., coal is classi1.5 Coal
fied according to calorific value and fixed carbon (which requires a proximate analysis to
1.5.1 Coal Analysis [39, ch1, +]
determine moisture, ash, volatile matter, and
Global coal reserves exceed 1 trillion tons. fixed carbon by difference). The classification
The largest reserves are in the U.S. (23% of list goes from several types of anthracite (high
15

 New England ISO

rank) to several types of lignite (low rank)

SPP RTO
1.5.2

Sampling and Sample Preparation [39, ch2, -, inc]

The heterogeneous nature of coal complicates

sampling procedures. There is substantial variation in coal quality and composition across
and unmined bed.
Sampling by increments consists of extracting from different parts of a lot a series of
small portions or increments that are combined
into one gross sample without prior analysis.
The precision of sampling improves with the
number of increments (though the size of each
should not be so small as to cause selective rejection of the largest particles).
Coal washing is a process to remove mineral
matter to leave the coal as mineral-free as required by the buyer or legislation.

ERCOT ISO
California ISO
These are integrated into 3 regional power
grids: Texas, Western, and Eastern Interconnect.
A deregulated market is one where an
RTO/ISO coordinates generation and transmission. Important characteristics:
Daily power auctions where power producers submit their supply schedules. It is
a non-discriminatory auction: all winning
bidders get paid the same clearing price.

Electricity Production and

Distribution (10%)

2.1
2.1.1

Electricity Generation
Electricity [15, ch2.2, ++]

The U.S. is split into several regional markets.

Each is coordinated by its own Transmission
Service Operator, which can function as a:
Government-sponsored monopoly.
Independent Service Operator (ISO).
Serve a single state and are exempt from
federal jurisdiction.
Regional
Transmission
Organization
(RTO). Operate across several states and
fall under federal jurisdiction. As ISOs
grow to become RTOs, many still keep
ISO as part of their name.
The main RTO/ISO are:
PJM interconnection.
NY ISO
16

Power plants are activated by merit order from lowest to highest bid until the demand is met. The last is the
marginal producer and its marginal
price of power sets the clearing price.
Electricity trading markets:
Spot market. Trading of power in arbitrarily small sizes for immediate use anywhere
in the country. Types of auctions coordinated by the RTO/ISO:
Day-ahead auction: sets the price for
the following day in one-hour increments.
Real-time auction: is run continuously throughout the actual delivery
day. It is typically bid in five-minute
increments.
Only power plants participate in the daily
auctions.
Foward market. Trading of large blocks
of power at about 20 locations around the
country. Forward contracts are commonly
broken up into day and night power by
month. They are commonly described in
weekdays-by-hours shorthand. Examples:
724, power 7 days a week, 24 hours
a day.

 5 16, weekdays, peak power (7am

11pm).
7 8, nighttime off-peak (11pm
7am).

nodal price of the electrical bus where they

deliver power.
Zone price: average of all nodal prices in
a given area. Customers pay this price.

Standardization makes the contract more

liquid. The forward market doesnt require any ability to generate power at all
it is possible to trade both physical contracts (requiring delivery of power) and financial contracts (which settle in cash). It
is where the bulk of speculative trading
occurs.
Elements of the Standard Market Design
(SMD) recommended by the Federal Energy
Regulatory Commission:
The costs of line congestion are paid only
by the affected parties rather than being shared across the entire grid. This is
achieved by two mechanisms:

Hub price: (or clearing price) average of

selected nodal prices across several zones.
It is the benchmark price for the grid and
it is used in the forward market.
A Financial Transmission Right (FTR) is
a tradable contract between two parties that
pays the difference in price between two nodes.
It helps to manage the risk of price differences
between a major hub and a specific node due
to congestion. Can be structured as a forward
or an option.
The Heat Rate of a given plant is the efficiency at which it converts fuel into electricity:

1. The primary way to solve congestion

is to activate an out-of-merit order
plant close to the demand area. The
higher cost of this producer is paid
only by the local consumers.
2. Producers pay a charge for routing
power into a high load area over
congested power lines, and receive a
credit for producing power that bypasses the congestion.

Typical values range from 7 MMBtu/MWh

(extremely
efficient
plants)
to
10
MMBtu/MWh (less efficient).
[CCGT
with 55% efficiency should be closer to 6]
Market Implied Heat Rate (MIHR):

Heat Rate :=

Fuel used (MMBtu)

Power produced (MWh)

MI Heat Rate :=

(1)

Power price ($/MWh)

Fuel price ($/MMBtu)

It is profitable to produce when MIHR HR.

Spark Spread is a profit estimate for a given
plant from buying gas and selling power at cur There is a penalty for remote generation, rent market prices, excluding operating [and
i.e, producers are only paid for deliverable investment] costs:
power, not power placed onto the grid.
Spark Spread ($/MWh) :=
This compensates for line losses.
Hence, implementing SMD requires assignPower price (Gas price Heat Rate) (2)
ing different prices to different locations on
Dark spread refers to coal-based generation.
a power grid. The price is called Locational
Marginal Price. It has 3 parts: a clearing price,
2.1.2 Location [20, ch7, -, inc]
a congestion charge, and a line loss charge.
Prices are calculated for 3 types of locations: [This chapter is written in some incomprehen Node price: price at the interface (aka sible alien language.]
electrical bus) where power enters or
Location [whatever that means] is important
leaves the grid. Producers are paid the because of:
17

 Commercial complexity of networks due

to the interconnection of markets and the
wheeling of power.
Barriers and constraints.
Distance between fossil fuel sourcing, large
scale production, and consumption.
Small scale renewable generation.
Requirements for locational charging [verbatim from the book; nothing makes sense]:
Location signals to generators.

Postage stamp with market splitting:

there are several zones, but they all have
the same price, unless there is a constraint
between them. If there is a constraint, the
zone that is a net exporter of electricity receives the clearing price of the zone that
imports from it. This method is used in
Germany and Nordpool.

Nodal: finer grid, each node (or bus) has

its own price.
Financial Transmission Rights or Responsi Medium term incentives to build network bilities? FTRs are called FT-Rights when
infrastructure for base case (transmission, structured as options; FT-Responsibilities
generation, etc) and for variable (capacity when structured as forwards (obligations in
PJM market).
and redundancy) requirements.
Economic treatment of interconnection.

2.1.3 The Essential Aspects of Electric Cost recovery and optimization of spend
ity [23, ch2, ++]
by the transmission and system operator.
Loss costs are applied separately to the Functions of the electricity industry:
Generation or Production. Accounts for
transmission and distribution sectors. Trans35%50% of the final cost of delivered elecmission losses are of the order of 2%4%
tricity. The development of CCGT in the
and are relatively low compared to distribu1980s showed that economies of scale were
tion losses. Losses are handled commercially
not an inevitable part of electricity prothrough one of the following market model for
duction and opened the door to competilosses:
tion in generation.
Marginal losses included in location
Transmission. Electricity is transmitted
marginal prices (eg, New York).
from the generators to local distribution
Average marginal loss factors applied to
systems. Accounts for 5%15% of the final
generators and loads.
cost of electricity.
Average losses netted against load at grid
The transmission system is quite fragile
supply point.
if it overloads it becomes unstable and can
System administrator buys losses from the
cause widespread blackouts. Hence, the
market.
transmission system requires the constant
Pricing models. There are alternative methattention of a system operator to match
ods for designating the electrical location of
the generation to the load (demand).
a point on the network, for the purposes of
Distribution. Electricity is transported
charging:
from the transmission system to cus Postage stamp: prices are the same at all
tomers. Accounts for 30%50% of the fipoints.
nal cost of electricity. While transmission
Zonal: postage stamp pricing within a
zone, where a zone is a group of nodes.
18

works with generation (through the system operator), distribution works with the

customer.
Commercial functions:
Retailing: sales to final consumers.
Wholesale power procurement: when
the company chooses which producer
to buy from. In the U.S., a wholesale sales means sales for resale.
Wholesale sales are regulated by the
federal government, while sales to final customers are regulated by the
states.
For many years the industry was organized
as a vertically integrated monopoly for the following reasons:
Natural monopolies (economies of scale)
in transmission and distribution. And
even in generation before smaller plants
become economically viable.
The coordination of generation and transmission is more efficient when both activities are in the same firm. Separating the two incurs into transaction costs,
which are the costs of negotiating, executing, and litigating naturally incomplete
contracts.

Credit risk.
Under regulation, customers take most of the
risks; under competition, producers take the
risks.
Important technical facts that make electricity different from other commodities:
1. Electricity cannot be economically stored.
Hence, wholesale price varies tremendously with the demand/supply balance.
The daily load curve is a curve showing demand across the day. The peak is usually
in the afternoon. In hot(cold) areas, summer(winter) is the peak season. Wholesale
hourly prices in competitive markets commonly vary by about 2:1 over the course of
a day in the off-season and by as much as
10:1 in the high season (with some spikes
above this as well).
2. Electricity takes the path of least resistance. Hence, there is no such thing as
a defined path for delivery.
3. There is a complex series of physical interactions in a transmission network.
4. Electricity travels at the speed of light.
Each second, output has to be precisely
matched to use.
To cope with these facts in a competitive setting trading arrangements should be incentivecompatible, so that generators will want to
obey the system operator. However, note that
there is no physical difference between integrated and competitive systems: electricity is
homogenous throughout the grid and there is
no direct connection between a given consumer
and a given producer.

Long-term planning of transmission and

generation benefited from vertical integration.
Monopolies have to be regulated to protect
consumers. There are two basic models: US
and UK. They both: (1) base prices on cost
and fix them for a period of time; (2) by unhooking prices from actual costs during this
window, they provide incentives for efficient
operations.
2.2
The main risks are:
Market demand and prices.

Hydroelectric
Power

and

Nuclear

Technology change rendering plants un- 2.2.1 Hydroelectric [8, ch6, +]

competitive.
Worldwide, hydropower plants have a capacity
Management decisions about mainte- around 700 GW and generate around 25% of
the electricity.
nance, manning, and investment.
19

Top hydroelectric generating countries, from

highest to lowest (capacity, hydros % of
national total capacity): Canada (67 GW,
60%), USA (92 GW, 7%), Brazil (?, 90%),
China, Russia, Norway, Japan, India, Sweden,
France. [The ordering is for generated electricity (GWh) in some nonspecified year, which
apparently does not match the ordering on installed capacity (GW). The numbers for the
US are inconsistent throughout the paper.]
Some major plants are: 18.2 GW Three
Gorges Dam in China, 13 GW in Brazil, 7.6
GW Grand Coulee in Washington State.
The amount of power generated is determined by the volume of waterflow and the
amount of head (the height from the turbines
to the waters surface).
Conventional hydropower plants only use
one-way water flow. They can be run-of-river
(do not store water) or storage plants (have
a dam and reservoir). Pumped storage plants
reuse water.
Brazil case study.
Brazil had a severe
drought in 2001, which led to an energy crisis and exposed the risk of a high level of dependence on hydroelectric power (although insufficient growth in supply and transmission in
previous years also contributed to the crisis).
Measures had to be imposed to reduce electricity consumption.
Environmental issues:
current research
on new turbine technology could potentially
achieve a reduction in turbine-passage fish
mortality and maintain a downstream level of
dissolved oxygen consistent with water quality
standards.
There is a huge amount of regulation applicable to the licensing and relicensing of hydro
projects. Some of the main legislation:
National Environmental Policy Act of
1969: requires assessing the effect of operations on historic structures, water discharge into streams, habitat for plants and
animals.

Clean Water Act of 1997: water quality

must be certified.
Wild and Scenic Rivers Act of 1968:
project cannot affect a wild and scenic
river.
Endangered Species Act of 1973: requires
assessing of whether relicensing is likely to
jeopardize endangered species.
Licenses are issued for a period of 30 to 50
years, typically enough to recover investment.
Hawaii case study. Hawaii has several hydro
plants in 3 islands, but they only supply a small
fraction of electricity (from 1.4% to 10%). Imported oil provides 90% of energy. Hawaii is
developing a mix of renewable resources including hydropower, among others.
2.2.2

Nuclear and Hydropower [33,

ch8, +]

A) Nuclear Power
The typical large-sized nuclear power and
coal-fired plants have an output between 11.5
GW. In the US, there are 66 plants of this size
(out of 16 755 units) and they represent 8% of
the 1 031 GW total country nameplate capacity. A 1 GW plant can handle the base-load
needs of a US city of 600 000 people (1 million
people if using world average consumption).
The weight of nuclear power in generating electricity is [in 2005?]: Europe 28%,
N.America 19%, Russia and Ukraine 18%, Asia
9%. The countries with the highest percentage are France and Lithuania (78%), [... list
goes on...], Germany (28%), US and UK (20%),
Canada (15%). The country with more reactors is the US (around 100, of total 439 worldwide).
Types of commercial nuclear reactors (number of operating reactors worldwide):
Boiling water reactor (BWR) (92). The
first reactor was a BWR built for a nuclear
submarine in 1954. A BWR feeds steam

20

directly from the reactor to the turbines.

Pressurized water reactor (PWR) (263).
The first commercial reactor was a PWR
built in 1957. A PWR operates under
higher pressure and temperature making
it more thermally efficient than a BWR.
Gas-cooled reactors (26).
Pressurized heavy-water reactors (19).
Popular in Canada.
Light-water graphite reactors (17). Only
in Russia and Ukraine.
Fast breeder reactors (3).
France, and Russia.

In Japan,

Pebble-bed modular reactor (PBMR) (?).

New technology developed in South Africa
that is attracting attention. Small reactor
of only 110 MW. Has a simple design and
operation, low cost of construction, and
inherent safety (core meltdown is physically impossible).
Many of the new reactors under construction
are PWRs, while others are pressurized heavywater reactors or advanced BWRs.
B) Hydropower
Advantages of hydropower:
Renewable source of energy.
No fuel cost and low operating cost.
Does not pollute.
Provides a way to store energy through
pumped storage plants.
Disadvantages of hydropower:
Are not built where they are needed. Instead, require ample supplies of water plus
favorable geological conditions.
High capital cost.
Environmental concerns (eg, impact on
fish and wildlife) and social issues (eg,
resettlement of people living upstream,
flooding of historical sites).

Potential of catastrophic structural failure.

The worlds largest hydropower producers
(% of total world output) are: Canada (12%),
China and Brazil (little less than 12%), U.S.
(9%), Russia (6%). [Guess the ranking is based
on generated electricity in some non-specified
year.]
The nations with the greatest reliance on hydropower are (% of total electricity generation): Norway (almost 100%); Brazil, Iceland,
and Columbia (over 80%); Venezuela and New
Zealand (65%), Canada (60%). [Year is not
specified.]
2.2.3

Nuclear Power Plant Construction Costs [38, +]

Current [2008] estimates of total construction

costs (including escalation and financing) for
new nuclear plants are between 5 5008 100
$/kW, or 69 billion $ per 1 100 MW plant.
Construction costs have increased significantly in recent years. This is due to increases
in commodity prices and skilled labor shortage. Furthermore, there are only two companies in the world (in France and Japan) that
have the heavy forging capacity to create the
largest components in nuclear plants. Also, the
number of suppliers of nuclear components in
the U.S. has reduced a lot over the last two
decades.
Cost estimates are very uncertain. The all-in
costs can be much higher than the initially estimated overnight costs once you factor in ownerss costs such as land, cooling towers, etc.,
interest during construction and cost escalation due to inflation and cost overruns. For a
sample of plants that began construction between 1966 and 1977, the actual average cost
was 3 times higher than the initially estimated
cost.
Construction firms are unwilling to commit
to fixed price contracts, which means that cost

21

overruns are paid by the owners of the plants

and their customers.
Consequences of cost overruns:
Only one-half of projects were actually
built and ratepayers frequently had to pay
the sunk costs for abandoned projects.
Cost of power from completed plants became much more expensive that initially
expected.
Some utilities got into severe financial
problems and some went bankrupt.
Two new reactor designs have been preapproved in the US the Advanced Boiling
Water Reactor and the Westinghouse AP 1000
but there is absolutely no construction or
operating experience with these designs anywhere in the world.
The nuclear renaissance is heavily dependent on obtaining federal loan guarantees that
would shift the risks of rising plant costs from
plant owners onto the federal government.

Pebble bed reactor. Has been under development for decades in Germany, then
South Africa, and now China and US. The
radioactive fission products are absorbed
in the coatings of the fuel pebbles, and the
fuel doesnt get hot enough to melt down
even if there is no coolant. China already
has a 10 MW experimental reactor in operation and is building a 200 MW plant.
However, pebble bed reactors do not scale
up well: above 600 MW they loose their
safety advantage.

Traveling wave reactor. Under development by TerraPower, a Microsoft spinoff.

There is some conflict about promoting these
new reactors because utilities and manufacturers do not want to imply that the older designs
now in service are unsafe.
The failure of Tepcos Fukushima reactor
was in part due to bad management decisions. In particular, officials underestimated
the risk that a huge tsunami would overwhelm
2.2.4 The Prospect for Safe Nuclear Fukushimas defenses. However, it is human
nature to lower the probability of catastrophic
[13, +]
events when you have no idea about how to
Passive safety features rely on physics instead deal with them.
of active interventions. The best passive safety
measures require no signal inputs, no external
power sources or forces, no moving mechani- 2.3 Fundamentals of Electricity Distribution and Trading
cal parts, and no moving working fluid. For
example, thick concrete walls.
2.3.1 Trading Arrangements [23, ch7,
Examples of safer, next-generation reactors:
+]
Westinghouse AP1000. (AP stands for
Advanced Passive). Has an emergency Trading arrangements are the legal agreewater reservoir above the reactor thats ments between traders and the system operheld back by valves. If the cooling sys- ator and/or the transmission owners.
tem fails, the valves open and water pours
The 4 facts that make electricity different
down to cool the vessel. The water is from other commodities (section 2.1.3) lead,
enough to last for 3 days. Westinghouse respectively, to the 4 pillars of market design:
says the AP1000 is 100 times safer than
1. Imbalances between contracted supply in
current plants.
forward markets and actual demand must
be corrected by the system operator in real
Arevas EPR has four redundant safety
time.
systems.
22

to inefficiencies and arbitrage opportunities. Typically preferred by marketers and

traders.

2. Congestion management. The system operator has to distribute generation to ensure that total electricity flows will not
overload any line.

3. Integrated model. Used in 3 regions of the

US (eg, PJM, New York) and most markets abroad. The system operator schedules forward contracts at the request of
traders, but also takes bids from traders
to modify scheduled contracts and to provide imbalances, congestion management,
and ancillary services. The system operator runs the spot market using a large
computer optimization program.

3. Ancillary services such as operating reserves, reactive power, etc, are necessary
to make the transmission system work,
but these other outputs are dependent on
also producing energy.
4. Scheduling (in advance) and dispatch (in
real time) done by the system operator requires incentive-compatible rules.
Alternative models of trading agreements
differ on the degree to which operation and
commercial arrangements for imbalances, congestion, ancillary services, and scheduling are
integrated with spot markets. From low to
high integration:
1. Wheeling model. Used in many areas of
the US as a first step toward competition. Prices are regulated and there is no
spot market. A vertically integrated utility with its own generation runs the transmission and system operation. Provides
access to other traders after it has scheduled its own resources, ie, native load gets
priority, and the spare transmission capacity can be used for wheeling. Large loads
such as municipalities arrange for independent generators to supply large blocks
of their electricity needs instead of purchasing from the local utility.
2. Decentralized model. Used in California
and Texas. The system operator is independent of the generators but its commercial responsibilities are deliberately minimized the aim is to let traders run
the market. Generators and consumers
trade in bilateral contracts. The system
operator must take the physical origin and
destination of contracts specifically into
account when scheduling. However, this
physical matching is a fiction, and leads

This model is typically preferred by utility

engineers, whose concern is the stability
of the transmission system. [23] strongly
prefers this model: it runs smoothly,
incorporating the necessary complexities
of the transmission system and providing
incentive-compatible rules. A major benefit is that independent generators can find
an outlet for their power without having to
find specific customers, [... which fosters]
real competition in the production markets.
The essential feature of the integrated model
is that the system operator administers a spot
market integrated with the pricing of imbalances, congestion management, and the ancillary services. The following mechanisms make
this work:
The system operator runs an optimization program (every 10 minutes) that minimizes costs, subject to transmission constraints. The output is a merit order
list of generators and the market clearing
price. It is a nondiscriminatory auction:
all plants that bid below the spot price
will be generating and they will all be paid
that same spot price.

23

The incentives are for traders to bid close

to their marginal cost; most of the time
they will be paid more than this, making a

contribution to the investment costs, but

because the software sets the spot price
at the highest bid selected, they do not
need to add in the overhead when making
their bids, and if they do they will not be
selected to run as often.
[They will receive a contribution to the
investments costs only if the price is
greater than average variable costs: pq
V C F C F C p V C/q =: AV C.
(This is a short-run analysis because some
factors are fixed and must be paid even if
output is zero). Unless the AVC is always
zero (like in wind), there is a set of low
quantities where it is better not to produce than to receive MC. Graphically, this
means that the clearing price must intersect the MC curve above the AVC curve.
See p. 217 in Varian, Microeconomic analysis.]

2.3.2

Details of the Integrated Trading

Model [23, ch8, +]

Given that spot prices are set in a nondiscriminatory auction, generators with lower costs will
make a profit from the market prices set at the
marginal cost of the marginal generator. But
how does the marginal generator recover his
investment? Prices need to rise at peak times.
Methods to ensure that prices peak in time
of high demand (from best to worst):
1. Demand bidding. Used in PJM. Customers bid for what they want to take and
the price results from the normal intersection of supply and demand. Demand bidding does two things:

The optimization process outputs a set of

locational prices that differ by the cost of
transport.
All imbalances are traded at the market
spot prices that result from the optimization process.
Congestion management: traders who
schedule contracts across valuable transmission lines are charged a transmission
usage charge (a bottleneck fee) being
equal to the energy price difference between the two ends of the transaction.
Main ancillary services:
Reactive supply.

(a) Raises prices when supplies are tight,

thus inducing new investment.
(b) Stops generators bidding up prices
to excessive levels. Because of the
steepness of the end of the supply
curve, a very small reduction in electric load from demand response can
reduce the price a lot at peak periods.
However, demand response is still very
small in most markets and so demand
curves are nearly vertical. The markets
thus rely on generators bidding above
marginal cost, which has the danger of
them bidding far too high in times of high
demand.

Operating reserves: available capacity

that is able to run on short notice. Needs
to be about 7%10% of load.

2. Capacity payments. Was used in Argentina and the U.K. Pool. Capacity
adders increase the market price. They
are higher when it is more likely that there
will be a shortage.

Frequency response (or regulation reserve): capacity that continually adjusts

output to exactly match demand.
The total cost of ancillary services is 1%3%
of total costs.

This is based on the correct notion that

if generators charge marginal costs at
all hours, they will only break even if
they also charge investment costs at peak
times.

24

3. Capacity obligations. All entities that

serve final customers are required to acquire capacity tickets to cover the expected load of their customers plus a reserve margin.
In the integrated model, traders can still
make forward contracts in private and bilateral markets, just like they do in the wheeling
and decentralized models. The contract schedule (MW, physical locations, and timing) must
be notified to the system operator only if one
the following holds:
The contract is inflexible. When all market participants are flexible willing to
modify operations from their contracted
levels if profitable the system operators
dispatch is fully separate from the forward
contracts. The forward contracts then become only financial, providing only price
risk management.
The contract requires net settlement: imbalances are calculated and settled by the
system operator as actual metered deliveries net of contract volumes. Contract
schedules are only used for financial settlement, not for physical dispatch. Net
settlement is recommend over gross settlement.
PJM has net settlement, allowing both inflexible and flexible contracts. Forward contracts
are scheduled for delivery but the link between producer and consumer is in truth only a
financial one, it could never be a physical one.
There is transmission congestion when the
capacity of one line is filled. To manage congestion, plants on the import side of the constraint have to increase production, and plants
on the export side of the constraint have to decrease production, relative to the production
schedules they would otherwise prefer. Hence,
spot prices will be higher in the import area.
The value of scarce transmission is equal to the
market price of electricity in the import area

minus the price in the export area.

Pay-as-bid
versus
(nondiscriminatory)
marginal bid pricing. Almost all integrated
electricity markets have marginal bid pricing.
The argument for pay-as-bid is that consumers
would pay less because more efficient generators would receive lower prices. However,
evidence shows that generators would quickly
adjust to pay-as-bid auction rules and would
stop bidding at mg cost and would instead
bid at their best guess of the market-clearing
price. If there was perfect information, both
methods would give the same clearing price;
in practice, pay-as-bid creates inefficiencies.
In particular, it increases the risk for efficient
base load generators (if they overshoot, they
do not run), making them less profitable and
less likely to be built.
The day-ahead market operates a day in advance of the spot market. For example, at 2pm
on Wed, an auction is held for energy delivery
for each hour of Thu. Transactions in the dayahead market then become forward contracts
that are settled against spot prices. Benefits:
Beneficial for generators with high startup costs.
Prevents generators from gaming the market by withdrawing capacity at short notice to lift spot prices.
Promotes demand response.
A day-ahead market exists in PJM and NY.
2.3.3

Tolling Agreements [15, ch4.3,

++]

With deregulation, some power plant operators

began to specialize in maintaining the physical
hardware of their plants. Others, called power
marketers, specialize on marketing the power.
A tolling agreement is a contract to rent a
power plant from its owners. The power marketer is responsible for supplying fuel to the
plant and selling the resulting electricity into a

25

competitive market. They take on all of the

economic risks and earn the profits above a
fixed maintenance fee.
Tolling agreements give the renter the option
to convert one physical commodity (fuel) into
a different commodity (electricity). Ignoring
operating costs, the conversion in a gas plant
gives:
Profit ($) =
Dispatch (MWh) Spark Spread ($/MWh)
where the spark spread is defined in (2).
Tolling agreements can be valued through a
real options approach. Each operating decision
(leg) is modeled as a financial option. Each
leg requires electricity and fuel prices and the
right time and location. Since tolling agreements can run for up to 20 or 30 years, there
can be several hundred separate commodities
traded over the lifetime of the contract.
Implications for risk management:
It is meaningless to add up the exposures
of different legs. For example, it is wrong
to ask, Whats the exposure of this power
plant to the price of electricity? because
there is no single price of electricity (August electricity is a fundamentally different product than May electricity).

Building a transmission line to connect the

upper Midwest (where coal is the marginal
fuel) to the southern US (where gas is the
marginal fuel). This trade is a bet on natural gas prices being much more volatile
than coal prices.
Import hydroelectric power from the Niagara Falls region into the New York City
metro area.
Building a nuclear plant a long way from
a population center [and a transmission
line].

Investing in a PV solar installation in New

Mexico and building a long distance high
voltage DC power line to get the power to
the East Coast.
Wheeling trades can be valued as financial
options. The premium is the up-front cost of
building or renting the line. The underlying
asset is the price difference between the two
regions. The strike price is the transportation
cost (line losses and variable expenses).
Long-distance transmission alternatives:
High voltage Alternating Current (AC)
lines. Transmission losses are proportional
to the square of the current. To transfer the same amount of power, it is necessary to increase the voltage to reduce the
current. Transformers only work on AC,
High volatility in the spread between elecwhich is why AC transmission is the most
tricity and fuel prices increases the value
used.
of the option. Hence, low correlation between these prices increases the value of
High voltage Direct Current (DC) lines.
the tolling agreement.
They are typically lower cost and lose less
power than AC lines. However, DC power
has to be converted to AC before being
2.3.4 Wheeling Power [15, Ch4.4, ++]
distributed to end users, which has 5%
Wheeling is the act of physically transport10% losses. These conversion losses have
ing electricity from one location to another.
to be weighed against transmission losses.
Wheeling trades require a physical transfer of
Furthermore, voltage drops whenever any
electricity over power lines rented from a third
energy is removed from a DC line, making
party.
multiple end points problematic. Hence,
HVDC lines are primarily for extremely
Examples of wheeling trades:
26

long distance, point-to-point connections.

Location spread trades are financial trades
made in the futures or forward markets. They
can be done financially with no physical trading capability (this is the primary difference
to a wheeling trade). The trader takes a long
position in one region and a short position in
another. The trades are liquidated before the
physical delivery is required.
Example of a spread trade:
1. Opportunity: expect snow melt earlier
than April this year. This would lead to
cheaper power in the Pacific Northwest
(due to larger hydroelectric production)
than the market is anticipating.
2. Trade March futures for peak power: buy
California (NP-15) and sell Pacific NW
(MID-C).
3. Result will be positive if futures prices
have changed by the time the trade is liquidated (must be prior to expiration).

2.4
2.4.1

Load Forecasting
Spatial Load
ch4.1, ++]

Forecasting

[15,

Commercial: offices and retail. Have

standard schedule and moderate demands.
Industrial: high variation.
Base load demand. Is the minimum level
of demand that must be met at all times.
To be cost effective, should be met by
highly efficient low [fuel] cost base load
power plants that can take advantage of
the fact that they will be able to work
around the clock.
Weather. A lot of electricity is used for
space heating and cooling (AC). Hence,
temperature accounts for a very large portion of the variation in demand, at two
frequencies:
Day-to-day:
demand will typically increase (decrease) with aboveaverage temperature in summer
(winter) time.
Month-to-month: demand is typically higher in summer and winter,
and much lower during spring and
fall.
Calendar effects:

Higher demand on weekdays than on

Spatial load forecasting is a prediction of elecweekends and holidays.
trical demand within a specified region for a
Typically, in the summer the daily
specific period of time. In the short term, it
peak is in the early afternoon (more
is used to schedule power plants; in the long
AC), while in the winter there is a
run, it is used to construct new power lines
peak in the early morning (people
and plants.
waking up) and another in the end
Factors that go into producing a load foreof the day (people arrive home from
cast:
work).
Location. Forecasts are made for limThe
steps
in creating a load forecasting
ited geographical areas, typically defined
as connecting to the same part of a power model should be: get historical load, look at
graphs, develop a preliminary model, expand
grid.
the model. It is important to test the model
Type of consumer:
through error analysis: analyze the differences
Residential: higher consumption be- between actual loads and the models predictions. Do it in-sample and out-of-sample.
tween 6am9am and 6pm11pm.
27

death. Costs of electricity production

range from almost zero to 0.15 euros per
kWh [Paper has references]. Marginal
costs for new capacity in the US are low
3 Renewable Energy Sources
due to high emission standards and a cap
and
Carbon
Emissions
on total SO2 emissions.
The
attractiveness of investing in renewables
(10%)
depends on four factors:
Costs of oil and other fossil fuels.
3.1 Economics and Financing of
Check whether the errors correlate with typical factors like weather, calendar, etc.

Global Investment in Renewable

Energy
3.1.1

The Economics of Renewable Energy [21, ++]

Cost of carbon emissions.

Cost of capital.

A large coal-fired power station can use

10 000 tons of coal daily, costing between
50100 $/t, so that fuel costs can reach
$1 million per day. Burning 1 t of coal
will produce 1.53.5 tons of CO2 [eia.gov
says 2 t, wet basis]. Hence, a CO2 price
of $30/t can double the fuel costs of a
coal power station. At the higher price
of $85/t, the LCOE rises from $0.06/kWh
to $0.11/kWh.

Incentives for production of green electricity. US uses production tax credits, but
this is inefficient for start-ups because it
requires federal tax liabilities. Direct subsidies tend to be more efficient.
The capacity factor [or load factor] is the actual output as a fraction of the maximum output that would have been produced if the plant
had operated at maximum capacity. Wind and
solar are in the 25%35% range (due to intermittency), while coal or geothermal reaches
90%.
Intermittent renewables are only able to
bid in the day-ahead electricity market because they cannot guarantee steady base load
power (usually supplied through long-term
contracts).
In states with renewable portfolio standards
(RPS) there is generally a market in renewable
energy certificates (REC). REC are tradable
certificates proving that 1 kWh of electricity
has been generated from renewables. To comply with the RPS, electricity distributors have
to own sufficient REC at the end of the year.
Economic viability of major renewables:
Wind. Capital costs around $4 000/kW
for offshore and $2 000/kW for onshore.
LCOE for onshore in 8-10 cents/kWh.

Other pollutant emissions, such as SO2,

NOx, PM, are associated with environmental damage, poor health, and early

Solar. PV: capital $7000/kW; LCOE 25

30 cents/kWh. PV is already competitive
in distributed applications where there

Contrary to fossil fuel plants, renewable energy

sources are generally capital intensive and have
low or no variable costs. If we build a renewable power station, we are effectively prepaying
for the next 40 years of electricity. This makes
long-term debt financing seem fair.
The Levelized cost of electricity (LCOE) is
the constant price at which electricity would
have to be sold for the production facility to
break even over its lifetime, assuming a reasonable level of capacity utilization. From a
policy perspective, we should add the social
costs.
Social costs of using a fossil fuel :
CO2 emissions. Cost estimates range from
$8 to $85 per ton of CO2.

28

is no grid connection. CSP: LCOE 11

cents/kWh, 15 cents/kWh with thermal
storage.
Geothermal. LCOE 3.5 cents/kWh.
Water. Hydropower capacity in the US
may actually decrease to protect endangered fish species. Wave and tidal are not
yet at commercial scale, but costs seem
substantially above market rates.

Protection of key sponsor assets, such as

intellectual property, key personnel, and
other assets, in case of project default.
The expected IRR for the equity in a fully
leveraged project can be very high.
The sponsor may be able to recover development costs at the closing of the project
financing and put their money into new
projects.

Monetization of tax incentives (see below).

Carbon capture and storage. Costs in $50
Project finance is a realistic opportunity
100 per t of CO2, too high to be comwhen:
mercially attractive. A variant is to cap The project is large, with debt above $50
ture CO2 directly from the atmosphere at
million (project finance is time-consuming
a cost of $200/t.
and expensive to consummate).
Biofuels. Sugar-based ethanol is compet The revenue stream will be large enough
itive with gasoline at oil prices of $5060
to support a highly leveraged debt financper barrel. For biodiesel to replace diesel
ing.
it will be necessary to develop new technologies.
The power purchaser is creditworthy.
For comparison, LCOE for coal is less than 7
The physical assets are sufficient to repay
cents/kWh, gas and diesel are higher, nuclear
lenders in case of foreclosure.
is in 810 cents/kWh.
The technology can be new, but not
untested.
3.1.2 Project Finance Primer [19, +,
Success does not depend only on a few key
inc]
individuals who may depart.
Project Finance is a method of financing in
The sponsor must be willing to turn over
which the lenders have limited or no recourse
the project to lenders if it becomes unable
to the assets of the parent company that sponto service its debt.
sors the project. The project is owned by a
The sponsor is not looking for a quick exit.
special purpose entity, the project company.
Lenders will typically demand a secure revenue
The sponsor is willing to share managestream for the project, which in wind and solar
ment with lenders.
projects is typically obtained through a power
Project revenues are distributed to investors
purchase agreement (PPA) with the local util- through a waterfall with the following order:
ity. Project finance is a way to finance large in1. Construction and operating and maintefrastructure projects that might otherwise be
nance costs, typically paid to sponsors aftoo expensive or speculative to be carried on a
filiates.
corporate balance sheet.
2. Fees, interest, and principal to lenders.
Advantages:
3. Reserve accounts and cash sweep to
Debt is held in the project company, not
lenders.
in the sponsors books.
29

4. Subordinated debt.
5. Equity holders.
[Project Finance seems just like Collateralized Debt Obligations...]
Federal income tax incentives for renewable
energy projects:
Production tax credits (PTC): around 2.1
cents/kWh in 2009.
Investment tax credit (ITC): based on the
cost of the qualifying property. Taxpayer
can choose either PTC or ITC for facilities
that qualify for PTC.

considered the owner of the project and

can thus claim the ITC. The investor
shares its tax savings with the developer
in the form of reduced rents. Can be used
for ITC, but not for PTC.
Pass-through lease. More complex structure. Has been used to monetize solar energy credits and Treasury grants. It is
usually preferred by investors who value
the credit/grant but place less importance
on depreciation.

3.1.3 Global Trends in Renewable En Treasury grants: cash payment in lieu of

ergy Investment [5, +]
the ITC (and the PTC). The taxpayer
need not have a federal income tax liabil- In 2010, global investment in renewable power
ity to benefit from a grant.
and fuels set a new record at $211 b(billion),
+$51 b than in 2009.
Accelerated depreciation.
Considering only financial new investment
Advanced energy project credit for manu- (venture capital and private equity, public
facturing facilities.
markets, and asset finance of utility scale
Tax credit for the production of cellulosic projects), for the first time developing countries at $72 b overtook developed countries at
biofuels: $1.01/gallon.
Tax structures used to monetize available $70 b. This is mostly due to China at $49
project subsidies. When a developer is not able b, and smaller amounts in South and Central
to benefit from the various tax benefits, the America ($13 b) and Middle East and Africa
following strategies allow the developer to re- ($5 b).
Nonetheless, in total investment (which
ceive value, or monetize, the tax incentives
adds
R&D and small distributed projects), dethrough the intervention of an institutional investor that can benefit from those tax incen- veloped economies remain well ahead. This is
mainly due to small-scale distributed capacity
tives:
Partnership flip. The developer and an (SDC) investments of $60 b, most of which in
institutional investor form a partnership. rooftop photovoltaics (PV) in Europe. Total
In the initial stage, the investor receives investment in the US was $25 b, an increase of
a disproportionate allocation of the part- 58% from 2009.
Total investment in solar came close to wind
nership income and tax credits (PTC,
ITC). When the investors target return for the first time in 2010. Again, the big chunk
is achieved (the flip point), the investors in solar is SDC and the increase is due to falling
PV prices. Considering only financial new inallocation is reduced to a small portion.
vestment, the decomposition is (in $b):
Sale-Leaseback. The developer sells the fa1. Asset finance: solar 18.9, wind 89.7.
cility to an investor. The investor leases
2. Public markets new equity: solar 5.3,
the project back to the developer for a
wind 8.2.
term equal to the PPA. The investor is
30

3. VC/PE: solar 2.2, wind 1.5.

Challenges in renewable energy projects:
Reduction in feed-in tariffs for new
projects and even threats of retroactive
cuts.
Low natural gas prices.
Outside skepticism: clean energy shares
under-performance and cooler mood in international politics.
Renewable power, excluding large hydroelectric, made up 8% of total world electricity
generation capacity in 2010 and 5% of actual
generation. It accounted for 34% of additional
capacity brought online.
Asset finance is defined as all money invested in each year, either from internal funds,
debt finance, or equity finance. [If it is really all arent they double counting equity
in financial new investment?] Asset finance
of new utility-scale projects increased in 2010
to $128 b, distributed through Asia & Oceania ($56 b, mostly in China), Europe ($29 b),
North America ($25 b), and South America
($13 b). Balance sheet finance continued to
be dominant (70%), but non-recourse project
finance increased to 30%. The wind sector accounted for 70% of overall financing.

crops (e.g., rape seed, sunflower, soybean,

and palm oil).
2. Second-generation.
Biofuels produced
from lignocellulosic biomass (e.g., agricultural and forest residues) or from
advanced feedstock (e.g., jatropha and
micro-algae).
While 1st generation biofuels directly compete
with food supply, 2nd generation can produce
both food and fuel together. Unfortunately,
cellulosic biomass is more difficult to break
down than starch, sugar, and oils, and the technology to convert it into liquid fuels is more
expensive.
Leading producers:
Ethanol. US and Brazil accounted for 90%
of the total world production in 2008.

Biodiesel. World production is less than

25% of ethanol production. In addition to
US and Brazil, main producers are in the
EU (Germany, France, Italy).
Despite growth in production, biofuels only accounted for 1% of world road transport fuel
consumption in 2005.
International trade in biofuels is only 10%
of total production. The major importers are
the US and EU (due to blending mandates)
and the major exporter is Brazil. Import tar3.2 Sustainable Energy and Biofuels iffs, domestic subsidies, and sustainability regulations have restricted trade. Still, trade is
3.2.1 Sustainable Energy [33, ch9, inc] expected to increase due to the comparative
advantage of some developing countries.
[The paper is interesting but does not add
Production costs:
much to other readings and it is a bit old.]
Ethanol: $0.2/liter ($0.3/liter of gasoline
equivalent) for new plants in Brazil, 50%
3.2.2 Biofuels: Markets, Targets and
more in US, 100% more in EU. TransImpacts [40, ++]
portation, blending, and distribution adds
$0.2/liter.
Cellulosic ethanol, still in
Biofuels are classified into:
demonstration stage, is about $1/liter.
1. First-generation. Ethanol produced from
Biodiesel: $0.7$1.0/liter.
the sugar or starch portion of plants (e.g.,
sugarcane, sugar beet cereals, and cas- Aside from sugar cane based ethanol in Brazil,
sava) and biodiesel produced from oilseed biofuels are not presently competitive without
31

not clear. The only state more determined

is California. It aims to reduce GHG emissions to 1990 levels by 2020 by: launching cap-and-trade in 2012; requiring 33%
renewable electricity by 2020; cut carbon
content of fuels by 10% by 2020.

substantial government support if oil prices are

below $70 per barrel.
Investments in biofuel production plants in
2008 amounted to $3 billion in Brazil, $2.5 billion in the US, and $1.5 billion in France. The
worldwide total was around $15 billion.

3.3
3.3.1

Australia. Goverment announced plans

for a carbon fixed-price mechanism that
will transition into an emissions trading
scheme.

Current Trends in the Carbon

Market
State and Trends of the Carbon
Market [42, +, inc]

The EU Emissions Trading Scheme (EU ETS)

accounted for 97% of the global carbon market value in 2010 (considering both European
Union Allowances (EUA) and Clean Development Mechanism (CDM)). The growth of the
global market stalled in 2010.
To reduce emissions, countries are adopting
one or several of the following policies: capand-trade schemes, baseline and credit mechanism, renewable energy and energy efficiency
certificates, carbon taxes, subsidies, and emission standards.
Policies are fragmented across countries:
EU. The current goal is to achieve a 20%
emissions reduction by 2020 on 1990 levels. But the Roadmap for 2050 aims to
reduce emissions by 8095% by 2050 [relative to what year?].

China. Aims to reduce carbon intensity

(CO2 emissions per unit of GDP) by 17%
by 2015. May introduce emissions trading
in 2013.
The EU ETS has suffered several frauds and
is undergoing regulatory reform. This has increased interest in OTC spot markets.
Kyoto Protocols: the uncertainties surrounding a post-2012 international agreement
have left Europe alone to absorb the supply
of project-based certified emission reductions
(CER) after 2012.
Voluntary carbon markets remain tiny (only
0.3% of global volume), but are growing. The
fastest growing product is Reducing Emissions from Deforestation and Forest Degradation (REDD), in part due to probably becoming eligible for offset in Californias cap-andtrade scheme.

During Phase III of the EU ETS that 3.4 Emissions Trading Models in the
European Union
starts in 2013, half of the allowances are
expected to be auctioned. During the pre- 3.4.1 Emissions Trading in the Eurovious Phase II (200812) they were all alpean Union [17, ch37, ++]
located for free.
[Paper is good, but a bit outdated. This marThe EU ETS will include emissions from
ket is changing a lot.]
aviation, but airlines from China and the
The purpose of the European Union EmisUS are opposing the inclusion of their
sions Trading Scheme (EU-ETS) is to allow
emissions.
companies to find the cheapest possible CO2 US. Climate policy is uncertain: there are abatement options. It covers activities such
several regional initiatives to reduce CO2 as electricity generation, steel production, and
and increase renewables, but their fate is paper industry.
32

The EU ETS works as follows:

1. Governments allocate allowances for a
trading period (phase I, 200507; phase
II, 200812; phase III, 2013?) to covered
companies. About 57% of allowances were
allocated to the power and heat sector and
43% to industrial installations (which typically do not trade much).
The total allocation is below the expected
emissions in a business as usual scenario.
This scarcity guarantees demand and that
the environmental goals are fulfilled.
2. Once a year, each installation must redeem allowances corresponding to its
emissions.

In the spot market, delivery and payment are

done within a few business days. In the forward
market, December 1st was established as the
delivery date. There is a banking arbitragefree relationship between the prices:
FT = St ei(T t)
where i is the interest rate. Note that this relation only applies to allowances within the same
trading period because allowances from phase
I cannot be traded in phase II (it is assumed
that there will be no restrictions after 2012).

Financial Products and Valuation (20%)

3. Each company will have to decide whether

to buy allowances in the market, abate 4.1 Forward Contracts and Exemissions by technical measures, or rechange Traded Futures
duce production. (But it is unlikely that
a plant will be short in the first years of Terminology. At maturity (T ), the long position party either: (1) buys the underlying aseach phase).
set for a specified price Ft,T (physical settle4. A company that cannot meet its obligament); or, (2) receives a payoff ST Ft,T (cash
tions has to pay a fine and buy the missing
settlement).
allowances on the market.
Currently [2008?], most trade is OTC. However, exchanges are expected to become more 4.1.1 Behavior of Commodity Futures
Prices [16, ch3, ++]
important, as they eliminate counterparty risk
and are reliable sources for market prices. The Relationships between cash (S) and futures (F)
typical size of a deal in both markets is 10 000 prices through time:
allowances, corresponding to 10 000 t of CO2.
1. Parallelism: high correlation between S
Price drivers:
and F. This is because the same factors
Weather is major driver of electricity demust affect S and F when there is the
mand. Higher demand is typically met by
possibility of storing commodities for desources that emit more CO2.
livery against the contract in the future.
However, the correlation (and therefore
More precipitation means more CO2-free
hedges) are seldom perfect.
hydroelectric power.
The relative prices of coal, gas, and crude
oil determine the electricity generation
mix (gas emits less CO2).
Economic growth.
Political and regulatory issues.

2. Convergence of S and F at expiration of

the futures. This is due to the possibility
of physical delivery.
Relationships between cash (S) and futures
(F) prices for several maturities at a given moment:

33

 Contango or carrying charge market:

A cash/futures arbitrage opportunity occurs

when F > S by more than carrying charges.
[aka cash-and-carry arbitrage.] Example:
S < F1 < F2 < . . .
1. Heating oil: S0 = $0.60, F1 = $0.63, and
it costs $0.015 to finance and store 1 gallon
Futures prices are usually at a premium
per month.
to cash when there are adequate supplies
2. Strategy: buy cash, sell futures.
in the cash market. This is due to carrying charges: storage, insurance, and inter3. One month from now: sell at $0.63, for
est costs. The market is at full carry
a profit of +$0.015 per gallon. This can
when F S = carrying charge, but usube done by either: delivering on the fually F S < carrying charge due to a contures at F1 ; or settling the futures finanvenience yield of holding some inventory.
cially and selling the oil in the cash marThe interest rate is the most volatile of the
ket, (F1 S1 ) + S1 = F1 .
carrying costs.
The basis for a given futures contract (usually the nearby) is:

Backwardation or inverted market:

Basis = Ft,T St
S > F1 > F2 > . . .
This is caused by a shortage of supply relative to demand in cash markets. This
encourages sales now rather than in the
future and thus discourages storage of
goods.

where St is the cash price for a given location

where the commodity is traded. Since there
are typically various such locations, there is a
unique basis for each location. Therefore, it is
helpful to decompose the basis into:
Basis = (Ft,T SDt ) + (SDt St )
|
{z
} | {z }

Examples:

StorageBasis

In the US, the gasoline or driving season lasts from Apr to Aug. Hence,
gasoline futures prices are typically
in contango during the early months
of the season (MarMay), but are
inverted in the later months (May
Aug) when it is expected that gasoline will be in short supply. [Decreasing F are caused by higher convenience yields in the later months due
to the chance of shortages.]
The NYMEX crude oil futures has
usually been inverted since 1983.
A cash market arbitrage opportunity occurs
when prices in two different markets for the
same commodity differ by more than transportation costs between the markets. Example: move heating oil between NY and London.

LocationBasis

where SDt is the cash price at the delivery

point of the futures contract. While the Storage basis 0 as t T , the Location basis typically remains constant. There is also a product
basis when the cash and futures are not exactly
the same commodity (eg, hedging jet fuel with
gasoline futures).
Basis changes. In a full carrying charge market, the basis will decrease systematically at a
rate approximately equal to carrying costs per
unit of time. In an inverted market, S and F
still have to converge at expiration, but basis
changes are unsystematic and unpredictable.
4.1.2

Commodity Forwards and Futures [29, ch6, -]

A synthetic commodity position is created by:

34

1. Going long in a forward contract. The [I dont see the point: l is not observable and
cash flows are: CF0 = 0, CFT = ST it has exactly the same interpretation as the
convenience yield see eqn (6.11) and ftn 5
F0,T .
2. Buying a ZCB with cash flows: CF0 = in the paper. Further, the paper does not give
any real life example of l, though Hull [22] says
erT F0,T , CFT = F0,T .
The total CFT = ST . To avoid arbitrage, that gold and silver have lease rates (note that
he considers them investment assets, not inCF0 = S0 or
vestment commodities). This formula still ignores storage costs.]
S0 = erT F0,T
Storage costs (u). Let U denote the present
[Note: this only applies to investment assets, value of storage costs per unit. Then, F0,T =
like stocks, bonds, gold, silver, etc. It does (S0 + U )erT . Alternatively, if u denotes stornot apply to consumption commodities, like age costs that are paid continuously and are
copper, oil, etc. The full equation for a con- proportional to the value of the commodity,
sumption commodity would need to add storF0,T = S0 e(r+u)T
age costs (u) and the convenience yield (c):
S0 = e(r+uc)T F0,T . See Hull [22].]
Using a simple PV relationship for the price Note that u = l. [Equality is only guaranteed
by no arbitrage for investment assets, as shown
of a commodity, we also have
next.]
T
S0 = e
E0 [ST ]
Cash-and-carry arbitrage for both investment assets and consumption commodities:
where is the appropriate discount rate. [Does
it make sense to estimate in the usual way C&C
0
T
(eg, CAPM) for a consumption commodity?]
Borrow $
S0 + U
(S0 + U )erT
Buy asset
S0
+ST
Comparing these two equations, we get
F0,T = e

(r)T

Pay storage
Short Fwd
Payoff

E0 [ST ]

Hence, the forward price is a biased estimate

of the expected spot price. [Downward biased
when the return on the underlying has positive
covariance with the market, as r < F0,T <
E0 [ST ]. Example: stock index. See Hull [22].]
Electricity forward prices can show large
price swings (eg, in day-ahead prices) because
electricity is not storable. Variations in electricity forward prices likely reflect variations
in expected spot prices.
Lease rate (l): l = g, where g is the expected growth rate of the commodity price. l
is the commodity analog to the dividend yield
of a financial asset. If we borrow the asset (in
order to short sell it), we have to pay the lease
rate to the lender. Hence, F0,T = S0 e(rl)T .

U
0
0

0
F0,T ST
F0,T (S0 + U )erT

Hence, defining u appropriately, no arbitrage

requires
F0,T S0 e(r+u)T
Reverse Cash-and-carry arbitrage for an investment asset. The strategy for the holders of
the asset is
R C&C
Sell asset
Save storage
Lend $
Long Fwd
Payoff

0
+S0
+U
(S0 + U )
0
0

T
ST
0
+(S0 + U )erT
ST F0,T
(S0 + U )erT F0,T

Note that these are incremental payoffs to

the holders relative to doing nothing (keep the
commodity stored). Alternatively, these are

35

the payoffs to an arbitrageur that short sells

the asset. He needs to first borrow it from the
holders, which means that the holders pay the
storage costs to the arbitrageur. Hence, defining u appropriately, no arbitrage requires
S0 e(r+u)T F0,T

4.2.1

Energy swaps [27, ch1, ++, inc]

A plain vanilla swap is an agreement whereby a

floating price is exchanged for a fixed price over
a specified period. There is no transfer of the
physical commodity: differences are settled in
cash for specific periods usually monthly, but
sometimes up to annually. Counterparts:
Swap Seller: pays the floating leg and receives the fixed leg. Typically, a commodity producer that wants to lock in the sales
price.

Convenience yield (c). For a manufacturer,

holding physical inventory of a consumption
commodity provides insurance that he can
keep producing. [The convenience yield is the
benefit from holding the physical asset. It reflects the markets expectations concerning the
Swap Buyer: (opposite). Typically, a
future availability of the commodity.]
commodity consumer that wants to staReverse Cash-and-carry arbitrage for a conbilise the buying price.
sumption commodity. If the holders of the
A differential swap exchanges the actual difcommodity sell it, they stop receiving the conferential between two products for a fixed refvenience yield, hence they only save U C (if
erence value. Counterparts:
they lend it to a short seller, they will only
Swap Seller: pays the actual floating difpay him U C). Replacing U by U C in the
ferential and receives the fixed differential.
strategy, and the defining c appropriately, no
Swap Buyer: (opposite).
arbitrage requires
Typical users are refiners that want to hedge
S0 e(r+uc)T F0,T
changing margins of refined products and comIn summary, for a consumption commodity, panies that need to manage basis risk. Examthe no arbitrage region is:
ple: an airline hedges with gasoil futures. To
(r+uc)T
(r+u)T
fix the basis risk, they buy a differential swap
S0 e
F0,T S0 e
on jet minus gasoil at $36/t. If the average
Thus, the convenience yield only explains
(jet - gasoil) is above $36 for a given month,
anomalously low forward prices.
they receive the difference multiplied by the
[Hull [22] and Clewlow and Strickland
monthly volume specified in the contract.
[11] define the unobservable c such that
A refining margin swap or crack swap allows
S0 e(r+uc)T = F0,T .]
the profitability of a refinery to be guaranteed
Basis risk: the price of the commodity unfor a few years forward. In the crude oil leg,
derlying the futures contract may move differthe refiner is the fixed-price buyer thus guaranently than the price of the commodity you are
teeing the input price; in the refined-products
hedging.
leg, the refiner is the fixed-price seller thus
guaranteing the output price.
4.2 Energy Swaps
A participation swap is similar to a regular
Terminology. The swap buyer pays fixed swap in that the fixed price payer is fully proand receives floating. The long/short termi- tected when prices rise above the agreed price,
nology is not clear for swaps, but being a swap but he participates in the downside. Exambuyer is equivalent to being long in a series of ple: a fuel oil buyer sees the current dip in
market prices as a good opportunity to hedge
forward contracts.
36

its budget for the next year. However, it has (Note that this implies that a call and a put
a strong view that prices may go lower and so must have equal value when they are both
it wants an instrument that allows it to bene- struck at the forward price.)
fit from any downside move without having to
Components of an options value:
pay any upfront premium. The company buys
Intrinsic value: [maximum of zero and
a 50% participation swap at $80 per ton. If
the] amount the option would pay if exprices rise to $95 it receives the full $15 differercised immediately.
ence. If prices fall to $70, it would only pay $5
Time value: amount due to the possibilrather than the $10 under a regular swap.
ity that the intrinsic value may increase.
Most companies only hedge 4060% of their
Time value is highest when the underlying
1 or 2 years exposure. Some limiting factors on
is trading at the strike.
the use of swaps are illiquidity and accounting
Types of option exercise:
issues.
American. Can be exercised at any time
Swaps are useful in the following financing
up to maturity. Most exchange-traded opstructures:
tions are American, like the energy op Project finance: e.g., to fix the selling
tions on the NYMEX and IPE.
price of an oil field project.
European.
Pre-export financing: oil-exporting countries pledge future oil production as collateral against immediate cash. [This is
cash now in exchange for physical oil in
the future why is it related to swaps?]

Asian. Settle in cash based upon an average price. Most OTC energy options.
Greeks:
Delta: := c/S

Asset, bond, or equity financing: link cash

flows to fuel prices.
(See pricing in Panel 8, p. 35, of the paper).

4.3
4.3.1

Energy Options
Energy options [27, ch2, +, inc]

NYMEX began trading crude oil WTI options

in Nov 1986. IPE followed with gasoil options
in Jul 1987. The growth of the options market
was spurred by the launch of an OTC market
in swaps from 1986.
In the oil market, while exchange options are
exercised into futures contracts (which result
in physical delivery if held to maturity), OTC
options are generally cash settled.
Any individual settlement period for a swap
buyer (pays fixed, receives floating) is equivalent to either:
Long forward.
Long call and short put options.

Gamma: := /S = 2 c/S 2
Theta: := c/t
Vega: v := c/
Delta hedging. Consider an $18 call on
1 000 000 barrels (1 000 futures contracts) of
crude oil. Assume St = $18 (at-the-money)
and = 0.517. To delta hedge a long call,
a trader would need to sell short 517 futures
contracts at a price of $18 per barrel. If St
changes, the profit/loss in the long call is compensated by the loss/profit in the short futures.
Energy options strategies. Everyone wants
to buy options until they see what they cost.
The following strategies reduce the cost of
hedging by simultaneously buying and selling
options.
Caps, floors, and collars. Caps(floors) are
consecutive series of call(put) options with
the same strike. A collar is the simultaneous purchase of a call and the sale of

37

a put, often constructed to have zero upfront cost. If an airline or a gas burning
electric utility buys a collar (= long call
and short put), the call strike is the maximum price it will pay for fuel, while the
put strike is the minimum price it will pay
for fuel. The advantage is that the premium from selling the floor subsidises the
cost of buying the cap. A collar can be
thought of as a forward (or a swap) with
a band in the middle (the range between
the put and the call strikes) where nothing happens. A oil producer would want
to short a collar (= sell cap and buy floor).
Participating collars. The company participates in any favourable price move in
the underlying commodity, while still being fully protected against unfavourable
price movements. The (out-of-the-money)
option bought is for a larger quantity
[the amount that needs to be hedged?]
than the (at-the-money) option sold. The
strikes are such that the total premiums
paid and received are equal. The cost of
the participation is the less favourable
placement of the option strike prices.

the assurance of a maximum fixed price,

but feel that there is a reasonable prospect
of a price fall before the expiry of the
swaption.

4.4

Exotic Options

..

4.5

Option Valuation and Risk Management

Put-call parity.
European stock options:
p + S0 = c + XerT
European futures options:
p + F0 erT = c + XerT
4.5.1

Overview of option pricing for energies [34, ch9, - -, inc]

[Equation 9-3 is about payoffs; it is not the putcall parity, which is a relation between prices.
Formula 9-4 is wrong. The terms are not standard and are just more confusing.]
Participating swaps. Are like participatParity value [is the same as intrinsic value].
ing collars except that the gap between
Call parity value = max(0, S X).
the call and put strikes is eliminated by
moving the strikes to the same point.
4.5.2 Option valuation [34, ch10, inc]
Bull and bear spreads. A bull(bear) spread
is a call(put) that is partly financed by si- The Black model is used to value options that
multaneously selling back a higher(lower) settle not on the spot price at the time of the
options expiration, but rather on a forward
strike call(put).
price. The spot price is still assumed to fol Swaption. A swaption is an option to buy low GBM and the valuation formulas are very
(or sell) a swap. Compared to a cap cov- similar to Black-Scholes (see formulas in the
ering the same period as the swap, the paper).
call swaption is cheaper because after the
swaption is exercised, there is two-way risk
4.5.3 Risk management of energy
on the swap, while the cap contains no
derivatives [11, ch9, +]
downside risk for the buyer. Swaptions are
typically purchased by clients who need [Greeks are defined in section 4.3.]
38

Delta Hedging an option involves dynamically trading a position in the underlying equal
to the negative of the option delta, such that
the changes in value offset each other.
Example: suppose we have a short call option on a forward contract ( = c/F ).
To delta hedge, we must buy a quantity
of the underlying forward. The value of the
hedged portfolio is P = c + F , which does
not change for small F .
Since delta changes continuously, we should
rebalance continuously; in reality there are
transaction costs, so rebalance only when the
underlying has moved by a significant amount.
Delta for European call options starts at zero
for out-of-the-money, increases to about 0.5 for
ATM, and reaches almost one for in-the-money
options.
Gamma Hedging neutralizes the sensitivity
of our delta hedge to changes in the underlying.
This is important for ATM options where
changes faster. Steps:
1. Trade a second option such that the
gamma ( = 2 c/F 2 ) of the combined
position is zero: 1 + a2 = 0.
2. Since this will have residual delta, neutralize it by taking a position in the underlying equal to the negative of the residual
delta. Note that since forward contracts
are linear, they only have delta and no
gamma. Consequently, this trade does not
mess up the gamma of the overall combined portfolio; it only changes delta.
This portfolio needs to be rebalanced much less
frequently.
Volatility Hedging is similar to gamma hedging, replacing gamma with vega (V = c/).
For delta-gamma-vega hedging, we need even
another hedge option:
1. Simultaneously find quantities a and b
such that 1 + a2 + b3 = 0 and V1 +
aV2 + bV3 = 0.

tion in the underlying.

Note that vegas for puts and calls with the
same strike price are the same (this results
from put/call parity).

4.6

Real Option Valuation

..

4.7

Speculation and Spread Trading

4.7.1

Speculation and Spread Trading

[16, ch4, ++]

Speculation increases liquidity and price efficiency, which facilitates hedging.

Position trading speculation consists of outright positions in futures. If expect price to
increase, take long position (buy) in futures,
for a payoff of Ft+t,T Ft,T . It is difficult to
make money with this strategy because futures
markets are very efficient.
Spread trading speculation consists of both
a long and a short position in different futures
contracts. Absolute price changes are unimportant. If the spread X Y is expected to
widen, buy X and sell Y .
Intermarket spreads trading involve the simultaneous purchase and sale of different but
related commodities that have a reasonable
stable relationship to each other. Examples:
A crack spread creates a paper refinery
by buying crude oil and selling gasoline
and heating oil futures. A crack spread
position would be assumed when refined
product prices are high relative to crude
oil prices and are expected to fall.

2. Neutralize the residual delta with a posi39

To replicate the average refinery, the ratio

is:
Buy 3 crude contracts.
Sell 2 gasoline contracts.
Sell 1 heating oil contract.
The resulting premium ($/barrel) is (H +
2G 3C)/3. A crack spread should be

implemented when this value is above futures and options on futures on HDD and
$4/barrel (reverse crack if below $3/bar- CDD for 810 cities.
rel) [the book is from 2002...].
Weather options are written on the cumulative
HDD or CDD over a specified period (typA spark spread allows generators to lock
in a margin by purchasing natural gas fu- ically 1 month). One could buy a CDD option
for the summer, or a HDD option for the wintures and selling electricity futures.
ter.
Henry Hub natural gas vs.
PerOne can also buy or sell a futures contract,
mian/WAHA Hub natural gas.
such that one counter party gets paid if the
Heating oil vs. gasoline.
degree days over a specified period are greater
than the predefined level.
NYMEX heating oil vs. IPE gas oil.

NYMEX light, sweet crude oil vs. IPEs

4.9.2
Brent crude oil.

Heating and
Days [3, +]

Cooling

Degree

Natural gas vs. propane futures (frac

spread).
A degree day is a measure of the average
temperatures departure from a human com

4.8 Hedging Energy Commodity fort level of 18 C (65 F).

Heating degree days (HDDs) are defined as
Risks
18 T , where T is the average temperature
4.8.1 Different kinds of risk [4, ch3, -] of a given day. Thus, a day with an average

Price or directional risk is movement on the temperature of 10 C will have 8 HDD.

Cooling degree days (CDDs) are defined as
NYMEX.
T
18. Accordingly, a day with an average
Basis or differential risk is the risk due to

time or location differences. NYMEX futures temperature of 25 C will have 7 CDD.

[In Fahrenheit, the reference temperature is
contracts can be delivered any time during a

full month at the sellers discretion, which cre- 65 F - see Considine [12].]
For both heating and cooling degree days,
ates time basis risk for a buyer that needs
average temperature of a particular day is calprompt barrels today.
culated by adding the daily high and low temAvailability or supply risk.
Volume risk is most generally associated peratures and dividing by two.
with extreme temperature deviations. One
way to protect against the possibility of needing greater supply is through buying call op- 5 Modeling Energy Price Betions. When the risk is on the downside and
havior (10%)
lower prices, use put options.

5.1
4.9
4.9.1

Weather Derivatives
Introduction to weather deriva- 5.1.1
tives [12, -]

Introduction to Energy Modeling

What makes energies so different
[34, ch2, -, inc]

Weather derivatives are trading OTC since What makes energies so different is the ex1997 for most US cities. CME is introducing cessive number of fundamental price drivers,
40

which cause extremely complex price behavior. For example, price depends on location,
which does not happen with traditional financial products.
Energy prices display spikes and strong
mean reversion. The mean reversion appears
to be a function of either how quickly the supply side of the market can react to events or
how quickly the events go away.
Main supply drivers are production capacity
(determines long-term prices) and storage limitation (causes high short-term price volatility).
Main demand drivers are the convenience
yield and seasonality.

5.2
5.2.1

Data Analysis
Statistics

and

5.3.1

dSt /St = dt + t dz


dt2 = a m t2 dt + t dw
Model for jumps with mean reversion (good
for electricity):
dS/S = ( ln S)dt + dz + dq

where is the random jump size and dq is a

discrete {0, 1} process.
The following variables may display seasonality: price, volatility, mean reversion rate,
Essential jump frequency and jump volatility.

Essential statistical tools [34, ch4,

- -, inc]

[The lognormal distribution has positive skewness or is skewed to the right, i.e., the tail is on
3 ]/ 3 .]
the right side. Skewness := E[(X X)
The quantile-to-quantile (Q-Q) plot looks
like a diagonal line when the random variable is
normally distributed. [What does 4-13 mean?
It should = 0 (msr 0 set)!!]
If a rv is normally distributed, then the values are uncorrelated. [Absurd! Ex: AR(1).]

5.3

relatively low for most energy prices (except

electricity).
Hull and White (1988), Heston (1993), and
others, model for stochastic volatility:

5.3.2

Shortlist of possible models:

Lognormal price model:

Spot Price Behavior

Understanding and Analyzing
Spot Prices [11, ch2, ++]

Schwartz (1997) model for a mean reverting

spot price:
dS/S = ( ln S)dt + dz

Spot price behavior [34, ch5, -,

inc]

(3)

The long-term mean is e . The half-life is the

time taken for the price to revert half way back
to its long-term level: t1/2 = ln(2)/. For =
10, t1/2 = 25 days. Mean reversion rates are
41

dSt /St = dt + dzt

Famous in nonenergy markets. Guarantees that prices will never be negative.
Width of distribution increases with time
to maturity (T ).
Mean reversion in log of price: developed
by Schwartz and Vasicek - see equation
(3). Spot prices are always positive.
Performs not too badly in capturing the
distribution width [for short horizons], but
does a poor job of capturing the distributions tails. This can be improved with
jumps.
The drawback of this single-factor meanreverting model is that it forces the implied Black-equivalent average volatility of
the price distribution to go to zero over
a long period of time (as the spot price
approaches the immobile long-term mean
level).

 Mean reversion in price.

(Pilipovic
model). The spot price is assumed to
mean-revert toward an equilibrium price
level, which is itself lognormally distributed. The volatility of the spot price
never goes to zero. [See paper for eqns.]
Energy markets require mean-reverting
models. Both models give negative autocorrelation for the changes in spot prices, which
is important for energy markets, particularly
electricity.
[Box at the end explains reasonably well Locational Marginal Pricing in electricity markets.]

5.4
5.4.1

Forward Curve Modeling

Energy forward curves [11, ch4,
++]

tained via:
Power price = Fuel price Heat Rate
where the heat rate is defined in (1).
Econometric approach. Prices are estimated with econometric models based on
key variables such as fuel cost, weather
patterns, etc. But note that the output
is a forecast of spot prices; it is not a forward price.
Spot price modelling approach. Forward
prices are derived from assumptions about
the stochastic processes for the spot energy price and other key variables (eg, the
long-term price, the convenience yield, or
interest rates). This approach is similar to
interest rate models.

The full cost of carry relationship for an energy 5.4.2 Forward curve models [11, ch8,
++, inc]
is:
Ft,T = St e(r+uc)(T t)
Forward curve models represent all the forward
prices simultaneously rather than just the spot
Depending on the relative size of storage costs
price. A simple model is:
(u) and convenience yield (c) the resulting forward curve can be in contango or backwardadF (t, T )/F (t, T ) = (t, T )dz(t)
(4)
tion. [See section 4.1 for more details.]
Oil can be in contango sometimes and in There is no drift because futures and forwards
backwardation at other times. The natural gas have zero initial investment.
forward curve typically displays a seasonal patA simple specification that ensures that
tern (higher prices in winter).
short-dated forward returns are more volatile
Electricity forward prices exhibit the most than long-dated forwards is (t, T ) =
complicated forward curves, with seasonal, e(T t) .
daily, and hourly patterns. These complicated
However, the real behaviour of the curve is
patterns arise because electricity is not storable more complex and we need more factors:
and because electricity markets are segmented.
n
X
Since most electricity contracts are illiquid,
dF (t, T )/F (t, T ) =
i (t, T )dzi (t)
other methods are used to construct the fori=1
ward curve:
Arbitrage approach. Although electricity These risk factors can determined by principal
cannot be easily stored, the fuel used to components analysis (PCA). Typically, there
generate electricity can be stored. Hence, are n = 3 risk factors, which act to shift, tilt,
a basic electricity forward curve can be ob- and bend the curve.
42

 In many markets, especially electricity, departures to the upside are more

likely than to the downside.
A price spike is frequently neutralized by a following spike of opposite
sign.

Since S(t) = F (t, t), we can derive a process

for the spot price from the process for the forward price. [See the paper for equations.] One
important result is that the simple model in
(4) with (t, T ) = e(T t) implies the meanreverting spot price in (3), albeit with a time
dependent drift term. If = 0, we obtain the
Black (1976) model.
Seasonality for gas and electricity can be incorporated by

Prices of energy commodities behave differently during different periods of their

lives. Eg, the volatility of forward contracts increases as they get closer to their
n
maturity.
X
dF (t, T )/F (t, T ) = S (t)
i (T t)dzi (t)
If the underlying price follows a GBM (rei=1
turns are iid), volatility can be estimated from
historical data as follows:
where S (t) is the time dependent spot volatil1. Calculate [daily] logarithmic price returns
ity.
[continuously compounded returns]: St =
[See the paper for option pricing formulas.]
St1 er r = ln(St /St1 ). Note that
r0,T := ln(ST /S0 ) = r1 + r2 + . . . + rT .

5.5

Estimating Price Volatility

5.5.1

Volatility Estimation in Energy

Markets [11, ch3, ++]

GBM is not a good model for energy prices

because:
Energy commodities are inputs to production processes and/or consumption goods;
they are not investments assets. For example, electricity prices may be negative,
which is not allowed in GBM.
Seasonality.
Jumps.
Mean reversion. Prices may depart from
the cost of production in the short term
due to abnormal market conditions, but in
the long term, the supply will be adjusted
and the prices will revert to the cost of
production.
However, a simple mean-reversion process
like Vasiceks (1977) may not perform well
because:
The speed of mean reversion may be
different below and above the mean.

2. Calculate standard deviation of daily series, d .

3. Annualize: y2 = 250d2 y = 250d

If the underlying price follows a meanreverting Ornstein-Uhlenbeck process, dS =
(S S)dt + dz, volatility can still be estimated from historical data by considering an
AR(1) discretization. [See formulas in the paper].
A leptokurtic distribution has fat tails, ie, its
kurtosis is higher than in the normal distribution. Eg, electricity prices have fat tails due
to jumps. Time varying parameters can also
cause the unconditional distribution to look
leptokurtic.
An heteroskedastic process has time dependent volatility, be it deterministic or random.
Models for stochastic volatility. Assume returns are rt = k +ut , where k is a constant and
ut = t t , with t N (0, 1). Alternatives for
the variance:
1. ARCH(q): t2 = a0 + a1 u2t1 + . . . + aq u2tq
P
2 +
2. P
GARCH(p,q): t2 = a0 + pi=1 bi ti
q
2
i=1 ai uti

43

5.5.2

follow a random walk):

Volatilities [34, ch8, - -, inc]

The volatility of a price process is always asrt = t + t t , t iidN (0, 1)

sumed to represent the annualized standard
deviation of returns.
where rt is a log return.
We can back out a rudimentary term strucVolatility estimation:
ture of implied volatilities from several options
Simple Moving Average:
on the same underlying. Suppose we have two
v
u
N
options on the same 3-month futures:
u1 X
t

=
(ri )2
1. Option 1 expires in 1 month, has implied
N
i=1
volatility 0,1 .
2. Option 2 expires in 2 months, has implied
volatility 0,2 .
We can then estimate 1,2 from
2
2
2
0,2
= (0,1
+ 1,2
)/2

Exponentially Weighted Moving Average:

v
u
N
u
X
1
i1 (ri )2

= t PN
i1
i=1
i=1

Referring to the same 3 models of section

The decay factor is typically 0.9 < <
5.3.2:
1.0. Older returnsP
get exponentially less
i1 1 , as in
weight. Note that N
Single-factor lognormal price model
= 1
i=1
the RiskMetrics formula (but not good for
(GBM). Volatility is the same for spot
close to 1!!!).
and all forward prices. Spot and all
forward prices are perfectly correlated The corresponding formulas can be used to eswith each other. None of this is consistent timate covariances.
VaR methodologies:
with real energy prices.
1.
Variance-Covariance or Delta VaR. As Single-factor log-of-price mean-reverting
sumes
that returns are normally dismodel. The volatility of the forward price
tributed. Derivatives are represented in
goes to zero as the maturity date goes to
terms of a Delta equivalent position in the
infinity. Correlations remain perfect beunderlying asset, ie, the weights in the
cause it is still a single-factor model.
Vi
portfolio are modified to w
i = S
wi (for a
i
Two-factor
mean-reverting
model.
basic instrument that is not a derivative,
Vi
(Pilipovic model).
Correlations beSi = 1). The variance of the portfolio is
tween spot and forward prices are less
the usual p2 = w
0 w.
Hence,
than one.
V aR = z p$

Risk Evaluation and Management (15%)

6.1

Value-at-Risk and Stress Testing

z is the critical level for a given confidence level. For example, z(95%) =
1.65, z(99%) = 2.326.
Examples:

6.1.1

Value-at-risk [11, ch10, +, inc]

The basic VaR model assumes that market

variable returns are normally distributed (or
44

100 M$ spot crude oil position. Standard deviation of daily returns of

crude oil price is 2.5%. The 1-day

VaR with a confidence level of 95%

is
V aR = 1.65 0.025 100 M $
For a portfolio with 2 underlying
market variables,
V

aRp2

=V

aR12 +V

aR22 +2V

aR1 V aR2

2. Delta-Gamma VaR. The change in value

of derivatives are approximated with more
terms: , = 2 V /S 2 , and also =
V /t. The portfolio distribution is no
longer normal [see paper for formula], so
the VaR calculation becomes more complicated. The main point of this approach
is to compute the change in value of an option without having to use the full option
pricing model. This can be integrated in
the Monte Carlo method to speed up the
simulations.

Types of stress tests:

1. Uses scenarios from recent history.
2. Uses predefined scenarios that have
proven to be useful in practice. Eg, fall
in stock index of x standard deviations.
3. Mechanical-search stress tests.[?]
Problems with stress tests:
Choice of scenarios is subjective.
Results are difficult to interpret and to act
on because there is no probability for the
event concerned.
VaR and Stress Tests are often presented
as two separate measures of risk. However, the two methods can be integrated
by assigning (subjective) probabilities to
the stress scenarios.
Stress tests often ignore the correlation
between the stressed prices and other
prices.

These methods up to here do not provide

the accuracy required for energy markets. 6.2 Credit and Counterparty Risk
3. Monte Carlo simulation. Jumps, stochas6.2.1 Credit risk management [7, ch6.3,
tic volatility, or knowledge of future events
-, inc]
(eg, changes in the operation of a market)
can be easily incorporated.
Credit risk is the risk that a counterparty can4. Historical simulation. Good alternative if not fulfil his contractual obligations. Credit
returns are not well described by the nor- risk exposure results from:
Settlement risk: the possibility that a
mal distribution or other tractable altercounterparty cannot pay the obtained
natives, as is likely for energy markets.
benefits, e.g.
the delivered energy
VaR estimates should be backtested : check
amount.
how often the actual returns exceed the VaR
forecast.
Example: at some point before the matuIncorporating stress tests into
market risk modeling [1, +]

rity of a forward contract, the risk is the

present value of the terminal payoff, assuming that ST is the current spot price.

Stress tests are exercises to determine the

losses that might occur under unlikely but
plausible circumstances, i.e., under rare or extreme events. Stress tests respond to VaR excessive dependency on history or unrealistic
statistical assumptions.

Replacement risk: the possibility that a

new replacement contract will have to be
entered into, under potentially worse market conditions.
Credit risk can be quantified through:
Risk-at-Default. [= EAD x LGD ?]

6.1.2

45

 Expected Exposure is the average of positive MtM values at some future time.
Note that E[M tM ] < E[E].

Expected loss.
Potential exposure: maximum credit loss
to a given counterparty with a given confidence level. Obtained by generating market prices scenarios. Useful for setting
credit limits.

Potential Future Exposure is the worse exposure distribution for a given confidence
level (similar to a VaR).

Credit VaR.
Effective Expected Exposure is a nondeCredit risk can be reduced through:
creasing time series of E[E].
Margining agreements. Most powerful
method. [Works like in exchange-traded
6.2.3 Mitigating counterparty credit
products.]
risk [18, ch3, ++, inc]
Transfer an OTC transaction into an regular exchange-traded futures contract. The Termination gives the possibility that an inEuropean Energy Exchange allows this.
stitution can terminate a trade prior to their
Additional collateralization.
Countertrade.
Price adjustment [?].
6.2.2

Defining counterparty credit risk

[18, ch2, ++, inc]

Counterparty risk is the risk that a counterparty in an OTC derivatives transaction will
default prior to expiration of a trade and will
not therefore make the current and future payments required by the contract. Since the future value of the derivative contract is uncertain, each counterparty has risk to the other.
Traditionally, credit risk has been associated
only with lending risk. This is the risk that
we dont get our money back. It applies to
loans, bonds, mortgages, credit cards, and so
on. Only one party takes lending risk and even
the amount is fairly predictable.
Metrics for credit exposure:
Exposure is the maximum between zero
and the current Mark-to-Market(MtM) of
the position.

counterparty going bankrupt. It may exist as

an option or be conditional on certain conditions being met (e.g., ratings downgrade).
Close-out allows the unilateral termination
of all contracts with the insolvent counterparty
without waiting for the bankruptcy process to
be finalized. It is often combined with netting
into a single contract.
Netting is the ability to offset amounts due
at termination of individual contracts between
the same counterparties when determining the
final obligation. Netting comes into force in
the event of a bankruptcy. Can be contracted
bilaterally or multilaterally. Long options with
upfront premiums do not give any benefit from
netting because their MtM will never be negative. However, they may still be worth putting
under a netting agreement to offset negative
MtM of other instrument within the same netting set in the future.
Collateral is an asset supporting a risk in a
legally enforceable way. Typical assets: cash
(most common), bonds, equity.

6.3

Expected MtM is the expected value of a

..
transaction for some future time.
46

Enterprise Risk Management

6.4

Case Studies in Risk Manage- by rail and sea. Transport is expensive, representing 5060% of the final price. During 2009,
ment

it was cheaper to import coal from Indonesia,

The collapse of Amaranth AdviAustralia, and Russia. Hence, Chinese imports
sors [10, ++, inc]
accounted for 15% of all globally traded coal
Amaranth Advisors was a large-sized hedge in 2009, despite China still being the largest
fund that failed in September 2006 due to coal producer. International coal prices have
since recovered and the import window began
losses in natural gas futures and options.
They made a general bet that winter natural to close by summer 2010.
gas prices would rise, while nonwinter natural
This highlights the fact that, since China has
gas prices would increase to a lesser degree, a massive domestic coal market, Chinas willreferred to as the long winter, short non-winter ingness to import when international prices are
spread trade.
lower than domestic prices will move these two
Their trades had high levels of market and prices closer to parity.
liquidity risk, and also funding risk. Their
VaR numbers underestimated the risk. Some
of their traders were in a different city than 7.0.4 Oil Scarcity, Growth and Global
risk managers.
Imbalances [26, +, inc]
6.4.1

6.4.2

The Case for Enron [37, +, inc]

Enrons Board of Directors failed to monitor

... ensure ... or halt abuse. Sometimes the
Board chose to ignore problems, other times
it knowingly allowed Enron to engage in high
... risk practices.
At Enron, risk management neither provided
accurate information nor ensured accountability.

Current Issues in Energy

(10%)

7.0.3

The Worlds Greatest Coal Arbitrage: Chinas Coal Import Behavior and Implications for the
Global Coal Market [32, -]

[They do not use arbitrage in the usual sense.

The paper simply says that Chinese consumers
buy coal from the cheapest source: domestic or
international.]
Coal is produced in the North of China and
moved to the consumption centers in the South

Oil is considered scarce when its supply falls

short of a specified level of demand, over a long
period. Oil scarcity is reflected in the market
price, relative to the price of other goods.
Scarcity arises from continued tension between rapid growth in oil demand in emerging economies and the downshift in oil supply
trend growth.
Real oil prices have not trended persistently
up or down in 18752010. Instead, prices have
experienced slow-moving fluctuations around
long-term averages. This suggests that periods
of oil scarcity have been long lasting but have
come to an end, and that investment, technology, and discovery are eventually responsive to
price signals.
Energy consumption will depend largely on
GDP growth. However, the relation differs
across countries: linear for emerging markets,
but flatter for high-income countries.
The paper concludes that gradual and moderate increases in oil scarcity may not present
a major constraint on global growth in the
medium to long term.

47

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