Energy risk management notes

based on the GARP ERP program

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

May 20, 2012

These notes follow the “2012 Energy Risk Profes- 3.3 Current Trends in the Carbon Market 32
sional (ERP) Examination AIM Statements”. The 3.4 Emissions Trading Models in the Eu-
++,+, or - next to the reference number in the sec- ropean Union . . . . . . . . . . . . . 32
tion title denote how clear and correct the paper is
overall, and in particular how clearly it answers the 4 Financial Products and Valuation
ERP’s learning goals. A paper gets a “+” if it is (20%) 33
good overall, but either has some fuzzy parts or 4.1 Forward Contracts and Exchange
does not meet some of the goals. “inc” means that Traded Futures . . . . . . . . . . . . 33
I did not finish all learning goals. My own com- 4.2 Energy Swaps . . . . . . . . . . . . . 36
ments and additions are [like this]. 4.3 Energy Options . . . . . . . . . . . . 37
4.4 Exotic Options . . . . . . . . . . . . 38
4.5 Option Valuation and Risk Manage-
Contents ment . . . . . . . . . . . . . . . . . . 38
4.6 Real Option Valuation . . . . . . . . 39
1 Hydrocarbon resources (25%) 2 4.7 Speculation and Spread Trading . . 39
1.1 Exploration and production . . . . . 2 4.8 Hedging Energy Commodity Risks . 40
1.2 Crude Oil and Refining . . . . . . . 3 4.9 Weather Derivatives . . . . . . . . . 40
1.3 Synthetics . . . . . . . . . . . . . . . 6
1.4 Natural Gas, LNG and Shale Gas . . 8 5 Modeling Energy Price Behavior
1.5 Coal . . . . . . . . . . . . . . . . . . 15 (10%) 40
5.1 Introduction to Energy Modeling . . 40
2 Electricity Production and Distribu- 5.2 Data Analysis and Essential Statistics 41
tion (10%) 16 5.3 Spot Price Behavior . . . . . . . . . 41
2.1 Electricity Generation . . . . . . . . 16 5.4 Forward Curve Modeling . . . . . . . 42
2.2 Hydroelectric and Nuclear Power . . 19 5.5 Estimating Price Volatility . . . . . 43
2.3 Fundamentals of Electricity Distri-
bution and Trading . . . . . . . . . . 22 6 Risk Evaluation and Management
2.4 Load Forecasting . . . . . . . . . . . 27 (15%) 44
6.1 Value-at-Risk and Stress Testing . . 44
3 Renewable Energy Sources and Car- 6.2 Credit and Counterparty Risk . . . . 45
bon Emissions (10%) 28 6.3 Enterprise Risk Management . . . . 46
3.1 Economics and Financing of Global 6.4 Case Studies in Risk Management . 47
Investment in Renewable Energy . . 28
3.2 Sustainable Energy and Biofuels . . 31 7 Current Issues in Energy (10%) 47

1
1 Hydrocarbon resources in aquifers and zones of geopressure [The
(25%) IEA classifies unconventional gas as: tight
gas; coalbed methane; shale gas]. Have
1.1 Exploration and production low recovery rates.

1.1.1 Hydrocarbon reserves [25, ch3, • 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. Alter-
native notations for reserves: 3. Africa (114)
• 1P = proven = P90 or P95 4. North America (60)
• 2P = proven + probable = P50 5. South America (104), mostly Venezuela.
• 3P = proven + probable + possible = P10
or P5 1.1.2 Upstream oil and gas operations
Nonconventional hydrocarbons are difficult [43, ++, inc]
and costly to produce. Main families are: Upstream activities are exploration and pro-
• Deep offshore. Major reserves in Gulf of duction; Downstream activities are refining
Mexico, Brazil, West Africa, North Sea. and distribution. An integrated oil company is
• Heavy and extra-heavy oils (< 22◦ AP I). involved in both, whereas an independent com-
Aka tar sands. Major reserves in Canada, pany is involved only in upstream.
Russia, Venezuela, US and Indonesia. The To be commercially productive, a petroleum
global resources may be four times as large reservoir must have adequate permeability and
as the world’s proven reserves of conven- porosity. Porosity is the measure of the open-
tional oils. However, today only 5% of ings in a rock in which petroleum can ex-
these resources appear to be economically ist. Permeability measures the connectability
viable. of the pores, which determines the ability of
• Oil shales. Oils that remain in a typically the petroleum to flow through the rock. If a
clayey sedimentary source rock. This rock reservoir has low permeability, there are pro-
needs to be mined, pulverized and pro- cedures to increase it, such as, fracturing and
cessed to release oil. The process produces acidizing.
large volumes of solid waste and CO2 and Mineral rights refer to the ownership of any
requires enormous quantities of water. Lo- mineral beneath the surface. These can be sep-
cated throughout the world; large resource arate from ownership of surface rights. When
in the U.S. the owner enters into a lease with an oil com-
pany, mineral interests are created for both
• Synthetic oils. Oil converted from coal or sides:
gas. • Royalty interest (RI). The owner receives
• Non-conventional gas. Gas in coal de- a fraction (typically 1/8) of the produc-
posits (coalbed methane), shales with low tion, free of any operating costs. He is re-
permeability (tight sands), or in solution sponsible for his share of production taxes

2
 and postproduction costs (transportation,
etc). The RI is also referred to as nonop-
erating or nonworking interest.
• Working interest (WI). It is responsible
for the exploration, development, and op-
eration of a property. The company pays
100% of the operating costs and keeps all
revenues after deducting the royalty inter-
est (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 ac-
quired via leasing. Most leases contain the
following provisions: lease bonus, royalty pay-
ments (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 Accounting for International
Petroleum Operations [43]
The fiscal system is the set of payments that
the oil company must make to the foreign coun-
try 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. Add more pay-
ments. Subtypes:
3
– Production sharing contracts (most
popular). Profit oil (revenues - roy-
alties - 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.
1.2 Crude Oil and Refining
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 bar-
rels (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.]
• (Medium?) [Examples: West Texas Sour,
Arab Light.]
• Heavy oils are below 25. Less valuable,
contain considerable asphalt. Tend to be
 sour (above 1% sulfur). [Examples: Arab butane, propane, and ethane that can be re-
Heavy, Venezuelan] moved from natural gas is called natural gas
Benchmark crude oils: liquids (NGL).
• West Texas Intermediate (WTI), 38 to 40 Reservoir hydrocarbons are classified into:
◦ API, 0.3% sulfur, US. • Black oil. Has heavy, nonvolatile
molecules, ◦ API below 45.
• 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
“cuts” (from low to high boiling points): • Retrograde gas. Is a gas in the reservoir
• gasoline under original pressure but liquid conden-
sate forms in the reservoir as pressure de-
• naphtha creases with production.
• kerosene [and jet fuels] • Wet gas. Contains less than 95% methane
• light fuel oils [or diesel fuel oils, heating and more than 5% of heavier molecules
oil, gasoil, or distillate grades] (ethane, propane, and butane). Entirely
as gas in the reservoir, but produces liquid
• heavy fuel oils or heavy gasoil condensate on the surface.
Since gasoline is most valuable, cracking is
• Dry gas. It is pure methane (or more than
used to make gasoline from other cuts. Re-
95% methane in other definitions). Does
fining also produces pure chemicals (3%) that
not produce condensate either in the reser-
are used to make plastics, synthetic fibers, fer-
voir or on the surface.
tilizers, etc.
Natural gas composition:
• Methane, 70-98%, (CH4 ) 1.2.2 Investment Decisions [31]

• ethane, 1-10%, (C2 H6 ) When large quantities of fluids require long-

• 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 hy-
drocarbons occur as a gas. When this gas
comes to the surface, the temperature de-
creases and the liquid hydrocarbons conden-
sate out of the gas. This condensate is almost
pure (low octane) gasoline and costs almost as
much as crude oil. The condensate along with
distance transportation across land, pipelines
are normally the best option based on eco-
nomics, safety, environmental consideration,
and reliability.
Pipeline stakeholders: owners, customers
and shippers, consumers, regulators, landown-
ers, etc.
Decision process for building a pipeline: se-
lect 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).

4
 • Supply driven: new oil fields, refineries, or 1.2.3 Engineering and Design —
tanker terminals. Pipelines and Storage [31]

• Market driven: new resources are discov- Important aspects of pipeline design:
ered (typically natural gas), and new dis- • Safety considerations.
tant markets and connecting pipelines are • Route selection.
developed simultaneously.
• Number and location of stations (com-
The revenue of a pipeline depends on the vol-
pressor or pump stations, delivery sta-
ume transported and on the rate (the amount
tions, storage stations, or interconnecting
shippers pay per unit). Common ways to es-
stations).
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 favor- at 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 de-
ence 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 differ-
ence (supply/demand, transportation al-
1.2.4 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.
pany and manages the pipelines. The rest of Parity pricing: crudes are in parity at a
the MLP units are often traded on exchanges given location if the prices of each produces
and the owners receive periodical cash distri- the same margin for a refiner who purchases
butions. them. The parity conditions for WTI vary
Possible valuation methods for pipelines: through time due to supply/demand in differ-
ent regions. Examples:
• Economic value: NPV or Cash Flow mul-
• US Golf Coast (USGC) parity. West
tiple.
Texas crudes moved south to USGC. WTI
• Comparable sales: does not work well as prices reflected transportation costs and
other pipelines are not directly compara- USGC market prices. (Mostly before
ble. 1986)
• Chicago Parity. When Chicago demands
• Highest and best use: not normally used. more than the available WTI, WTI prices
become related to other crudes delivered
• Reconstruction cost new or replacement
to Chicago by other routes.
cost: ceiling price for buyers.
• Cushing parity. When there are not
• Book value: tells sellers whether they need enough domestic sweets, need to import
to record a financial gain or loss. offshore crudes. Cushing prices are based

5
 on the USGC price for sweet crude de-
livered directly to Cushing. Prices at
other locations would then be based on
the Cushing parity price plus transporta-
tion to those other locations.
New pipelines from Canada are likely to create
new parity conditions in the future. Never-
theless, 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 in-
ventories:
• Contango (prices increase with maturity)
induces inventory buildup.
• Backwardation induces inventory de-
crease.
1.2.5 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 re-
fining (more expensive) light or medium
crudes.
• 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 pro-
duction. 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.
6
1.2.6 D2 and No.2 Diesel Fuel [6]
Under the ASTM standard, there are 6 types
of fuel oils. No.1–3 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 in-
cludes FOB value at port of origin plus all
costs of insurance and transportation.
“Bunker fuel” is a fuel used in the marine in-
dustry. 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, Singa-
pore, New York, and the US Gulf. Bunker
fuels come from blending fuel oils bought in
cargo markets.
1.3 Synthetics
1.3.1 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 signifi-
cant subsequent upgrading to become a sub-
stitute 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 capabili-
ties.
• Synbit: mixture of bitumen and light SCO
 (becomes fluid). Sent directly to medium- 1.3.2
crude refineries by pipeline.
• 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.
Bitumen reserves:
• Canada: established reserves of 173 billion
barrels, mostly in Alberta. Production
may reach 3 million bbl/d around 2015.
• U.S.: 54 billion bbl (22 billion measured,
32 billion speculative), mostly in Utah.
Bitumen extraction methods:
• Mining. More common today (60% of
Canadian production).
• 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 ex-
traction sites (in-situ is less disruptive
than mining), roads, pipelines, often in
pristine environments.
• Water resources. Extraction requires
much more water than conventional oil
(in-situ requires much less than mining).
• Natural gas prices. Both extraction meth-
ods rely heavily on natural gas: in-situ
methods burn natural gas to generate
steam; mining uses the same amount
[don’t know for what]. By 2015, around
2 Gcf/d will be required, represent-
ing around 10% of Canada’s 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 prod-
ucts.
Coal-to-Liquids Technologies [2,
ch3, ++]
steam and oxygen to produce synthesis
gas (hydrogen and carbon monoxide) and
carbon dioxide.
2. Gas cleaning and preparation. Removes
gaseous molecules that derive from the im-
purities found in coal (sulfur, mercury)
and CO2.
3. FT synthesis. FT reactors convert the
synthesis gas to a mixture of hydrocar-
bons: methane and propane; gasoline,
diesel, and jet fuel; waxes.
4. Product separation. Results in two prod-
uct streams: middle distillates (retail-
ready diesel and jet fuel) and naphtha.
5. Product upgrade. Naphtha is a very low-
octane gasoline that must be extensively
upgraded before it can be used as an au-
tomotive 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 ex-
tremely 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. Pos-
sible solutions are carbon capture and seques-
tration (CCS) and alternative methods (get-
7
ting hydrogen from renewables; averaging CTL
with BTL [sounds like cheating]).
Methanol-to-gasoline (MTG) is an alterna-
tive process to FT. One MTG plant is under
construction in China.
CTL is ready for commercial development in
the US. However, the limited commercial expe-
rience creates uncertainty at many levels: per- cial type of hub where interstate pipelines con-
formance and operational issues, investment
and operating costs, carbon dioxide manage-
ment 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.
1.3.3 Critical Policy Issues for Coal-to-
Liquids Development [2, ch6,++]
Investment in CTL production has been de-
layed due to market and technical uncertain-
ties. It has also been affected by uncertainty
about environmental regulations.
Environmental impacts of CTL production:
• Greenhouse-gas emissions. CTL emits a
lot of CO2 and the viability of large-scale
CCS has not yet been established.
• Air quality. Presumably, CTL would be
subject to regulatory controls on pollu-
tants emissions, like existing coal mining
and coal-fired generation plants.
• Land use, ecological impacts, and water
quality. There are impacts both at the
plant and mining sites.
• Water requirements. High water con-
sumption may be a limiting factor in lo- going long in one security and short in other.
cating CTL plants in arid areas.
1.4 Natural Gas, LNG and Shale
Gas
1.4.1 Natural Gas [15, ch2.1, ++]
Because the composition of natural gas varies,
it is commonly traded in units of energy, like
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 spe-
nect to local distribution networks. Most trad-
ing 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 (differ-
ent from other financial markets):
• Index price: price at Henry Hub. (ex:
$8.52)
• Basis price: spread between the index and
the actual price at a specified location.
(ex: $0.18 for Waha Hub)
• All-in price: price of physical natural gas
at a specified location. (ex: $8.70 for
Waha Hub)
To trade natural gas, traders usually enter
into two trades:
1. a futures trade at the Henry Hub (very liq-
uid, allows bulk of trading done quickly).
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
Examples:
• Location spreads. Speculate on price dif-
ference between two locations. Simulta-
neous buy/sell at different locations with
the same maturity.
• Heat rates. Speculate on the relationship
between natural gas prices and electric-
ity prices. Simultaneous buy/sell of power
8
 and gas matching either the spread trad-
ing in the market or the underlying heat
rate of a physical plant. This is related to
Tolling Agreements.
• 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 con-
tracts with differing maturity dates.
• Swing trades. Pick up inexpensive natu-
ral gas when demand is low (ex: Satur-
day 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 be-
cause natural gas is hard to store. For exam-
ple, traders might buy gas in the summer to
sell during the next winter, but they aren’t go-
ing 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 sum-
mer (for electricity generation for AC).
• Follow a very regular pattern, generally
the same every year.
• Volatility decreases with maturity of the
forward contract (from 1 to 4 months to
expiration)
• Correlated across locations when it is pos-
sible to move gas from one location to an-
other.
Hence, forward prices are highly predictable.
Spot prices:
• Determined by the demand and supply
that is on hand right now.
• Substantially more volatile than forward
prices.
• Price movements in the spot market do
not have a large effect on future prices.
• There is no correlation across locations.
1.4.2 The Basics [9]
Natural gas consists of hydrocarbons that re-
main 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 compo-
nents 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
• Nat gas: 1 cf gas = 1 MBtu or 1 m3 gas
= 35.3 MBtu
Hence,
• 1 boe ≈ 5 800 cf gas ≈ 164 m3 gas
[If prices per energy were the same, 1 bbl of
oil would cost 5.8 times 1 thousand cf of gas.]
Associated gas occurs in the same reservoir
and coexists with crude oil.
1
Though in section 1.2.1 a standard cubic feet of
natural gas is defined at 60◦ F = 15.6◦ C.
9
 Reserves are classified as 1P, 2P, or 3P, like could be built is relatively close to the
oil. Proved (1P) gas reserves worldwide are field.
6 300 tcf, implying a reserves/production ratio • The political situation in the country sup-
of 66 years. ports large-scale, long-term investments.
An oil and gas reservoir may initially pro-
duce high volumes of oil relative to gas, but as • The pipeline would have to cross other
the oil production and reservoir pressure de- countries and the buyer is concerned
cline, the gas/oil ratio of the produced hydro- about security of supply.
carbons may increase. The LNG chain is (cost range in $/MMBtu)
Coal bed methane is methane contained (measurement units):
within coal seams. This is an unconventional • Upstream production. (0.50–0.75) (Vol-
source: though easy to find because coal oc- ume, cf or cubic meters). Similar to tra-
curs close to the surface, it is relatively diffi- ditional gas. Byproducts removed from
cult to produce. Nevertheless, in the US it is a methane (such as ethane, LPG, and con-
significant portion of domestic gas production densate) are sold at market prices and
volumes. contribute to overall LNG project eco-
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- (1.3–1.8) (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 re-
more for longer distances. move all impurities (CO2 and sulfur) and
Liquified Natural Gas (LNG) is a trans- especially water.
portation alternative. Though less than 10%
• Shipping. (0.4–1.0) (Cargo volume, cubic
of gas is transported as LNG, it is growing
meters)
rapidly [section 1.4.9 says it is not growing
due to shale gas]. Methane gas is cooled to • Storage and regasification. (1.0–1.5)
◦ ◦ 3
−161.5 C (−260 F), shrinking 600 ft of gas • Distribution. () (Btu)
to around 1 ft3 of LNG. One ton of LNG con- Gas storage ensures that excess supply pro-
tains 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. Other-
tances 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 deliverabil-
ity for short periods of time.
• Gas contains minimal impurities, such as Structures for storing:
CO2 or sulfur. • Pipeline itself. Simplest form of peak load
• A marine port where a liquefaction plant storage.

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 (in-
jected gas that remains in the reservoir).
• Acquifers. Least desirable and most ex-
pensive. Require whole new infrastruc-
ture, high cushion gas.
• Salt caverns. For peak load. High deliv-
erability with minimal leakage. Small ca-
pacity. Cushion gas requirements are the
lowest.
1.4.4 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 gener-
ate 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 over-
all efficiency around 55%.
Replacing a coal generating unit with a
CCGT plant virtually eliminates SO2 emis-
sions, 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 ef-
ficient 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 efficien-
cies improve and in areas where gas prices are
competitive to other fuels, gas may even re-
place 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-
11
ural gas to liquid fuel. Methane is reacted with
pressurized hot steam to produce syngas (syn-
thesis gas, CO + 3H2 ). Then, syngas is con-
verted to longer-chained hydrocarbons through
the Fischer-Tropsch process. GTL produces:
• Diesel. Represents 60%–85% of the prod-
ucts. Does not contain impurities, thus
being much cleaner burning than conven-
tional diesel.
• Naphtha. Feedstock for petrochemicals.
• Lube oils.
• LPGs.
Despite efforts, it remains an energy inten-
sive process and the number of GTL plants re-
mains limited. For GTL projects to be prof-
itable 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 nat-
ural gas in the transportation sector has been
slow, due in part to the lack of infrastructure.
A Local distribution company (LDC) sup-
plies 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 cus-
tomer base. Deregulation in North America
and Europe has forced LDC to become more
competitive and has brought lower prices for
consumers.
1.4.5 Contracts and Project Develop- ever, the LNG SPA is more complex due to
ment [9]
The pipeline gas sales agreement (GSA) is also
know as gas purchase agreement or a gas sales
and purchase agreement. The contract covers
a number of provisions, including:
• Term. Can be from 1 day to 20 or 30
years.
• Price terms:
– Fixed price. Typically in shorter-
term contracts.
– Fixed price with an escalator:
changes every year by a percentage
determined by an index. The in-
dex may be linked to: inflation; a
published price on the NYMEX; a
combination of substitute fuels, such
as crude oil (most gas contracts in
Europe) or coal. Indexing ensure
gas price competitiveness to alter-
nate fuels and avoids renegotiating
long-term contracts.
– Floating price. Varies every week
or month according to some market
price.
• Delivery obligation. Flexible delivery con-
tracts may be cheaper than firm delivery
because gas supply is interruptible by the
seller.
• Take-or-pay obligations. The buyer is
obliged to pay for a percentage (60–95%)
of the contracted quantity, even if he fails
to take the gas.
• Nominations. The buyer communicates
its weekly (or other period) gas volume
requirements to the seller.
• Force majeure. Events outside the party’s
control. Obligations of all parties must be
clearly stated.
A sales and purchase agreement (SPA) for
LNG is similar to a GSA for natural gas. How-
12
the large capital expenditures, international
nature, and discrete value chain. Important
features of the contract.
• Price. During the first SPAs, Japanese
power plants were able to use either oil
or gas to generate electricity, so the price
of LNG was indexed to a Japan Crude
Cocktail (JCC) price. Since the index-
ing was calculated on a monthly basis,
this made LNG prices less volatile than
crude prices. Today, particularly in North
America, prices are more commonly linked
to natural gas prices (NYMEX or Henry
Hub).
• Take-or-pay.
• Shipping terms. Deliveries can be on a
free-on-board or cost-insurance-freight ba-
sis. Many buyers prefer FOB.
The phases of a gas project development are:
1. Concept and identification. Is the project
realistic and achievable?
2. Feasibility and option selection. Financial
and commercial models are created (esti-
mate NPV and IRR), engineers are en-
gaged, risks are identified, and preferred
technical options are highlighted. Sign
memorandum of understanding or heads
of agreement letters with the resource
holder and the potential customers.
3. Project definition. Critical go/no-go
stage. Key contracts to be secured: GSA,
transportation agreements, environmental
impact studies, permits. Partners should
finalize a joint operating agreement.
4. Project execution. An engineering com-
pany is typically engaged in a engineering,
procurement, construction (EPC) con-
tract or an EPCM contract (adds man-
agement to EPC).
5. Commission and operation.
1.4.6 The Natural Gas Market in the • Coal. There is little price influence. How-
United Kingdom [17, ch36, -, inc] ever there can be fairly high correlation
due to common dependence on oil prices.
Physical and financial gas is traded at the na-
tional balancing point (NBP). NBP does not
have a specific location and gas is neither pro- 1.4.7 Liquefied Natural Gas: Under-
duced nor consumed at the NBP. The Interna- standing the Basic Facts [14, ++]
tional Commodity Exchange acts as the main In the US, natural gas represents 1/4 of pri-
exchange for NBP gas. mary energy. About 90% is produced in the
Consumption: US, the balance is imported by pipeline from
• Power generation. 30% of demand. All Canada. Natural gas demand is expected to
new generation plants are gas-fired. rise, but production in major mature provinces
• Industrial and commercial consumption. in North America is beginning to decline [this
Follows diurnal, working day, and seasonal sounds biased...]. Hence, imports of LNG by
cycles but is not particularly weather sen- ship are expected to increase. One shipload
sitive. (around 3 bcf) provides 5% of US daily de-
mand.
• Domestic consumption. 35% of demand. The international LNG business connects
Very sensitive to weather. natural gas that is stranded — far from any
In the event of a supply shortage, power sta- market — with the people, factories, and
tions and large users are required to self in- power plants that require the energy.
terrupt; domestic users receive priority (due to International LNG trade centers:
lack of relevant safety mechanisms in domes- • Atlantic Basin: Europe, Africa, US.
tic cookers, making gas disruptions potentially
dangerous). – Importers: 33% of global imports.
Relationship to other commodities: – Exporters: 32% of global exports.
• Oil. Long-term gas contracts are com- Algeria is world’s second-largest ex-
monly indexed to oil prices. This improves porter.
hedgeability, cost reflectivity, and reduce • Asia/Pacific Basin: South Asia, India,
contract frustration risk. 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 im-
to 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.
• Power prices in the UK are closely con- Peak shaving. The US has more than 100
nected 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
nuclear better than CCGT. emergencies.

13
 LNG value chain. See section 1.4.3. Lique- by longer term contracts, as projects with too
faction is the largest cost: capital costs around much uncontracted volume have difficulty se-
$200 per ton of capacity. Total investment for curing project finance.
full LNG chain is very large: $7–10 billion. LNG prices are typically indexed :
Risk is thus minimized with long-term supply • In East Asia, contracts are indexed to
contracts, with take or pay clause. However, crude oil through JCC index. Example:
about 70% of LNG in the US is traded in a LNG price = (gas/oil energy ratio) x JCC
spot market; worldwide, spot market accounts + transport costs.
for 12% of trade.
• In Europe, are indexed to various com-
Units: see table in paper to convert from
modities.
tons of LNG to cubic feet of natural gas, and
corresponding Btu values. • In the US and UK, are indexed to natural
A LNG train consists of the series of linked gas through National Balancing Point and
equipment elements used in the liquefaction Henry Hub indexes.
process. A typical plant includes 3 to 4 trains. This has results in arbitrage spreads between
regions, that have widened in recent years due
1.4.8 Today’s LNG Market Dynamics to index divergence.
[35, +] The current development of standardized
contracts may help to create a more efficient
The geographical mismatch between produc- global market for LNG, help the development
ers (Middle East, West Africa, Indonesia, Aus- of a spot market, and ultimately reduce price
tralia) and consumers (Japan, Europe, North differentials.
America) of LNG has maintained large price
differences between markets (often exceeding
1.4.9 Impact of Shale Gas Develop-
several 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 capac-
tion and regasification plants. ity to North America was expanded. However,
• Development of unconventional gas sup- much of that capacity now sits idle, as shale
plies, such as coal seam methane. gas developments have changed expectations
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 esti-
sites and smaller consumer markets eco- mates point to a North America recoverable
nomically viable. resource around 700 trillion cubic feet.
• Modular liquefaction plants make infras- Implications of this large domestic resource
tructure less costly. base:
Contract term. The number of short-term • Domestic gas prices should remain rel-
contracts (≤ 1 yr) is growing. These contracts atively stable, toward the long-run
tend to cover small volumes. They allow sup- marginal cost of supply (around $6 per
pliers to take advantage of regional price differ- thousand cf at Henry Hub). [An MIT
ences. However, the market is still dominated (2010) study estimates that the breakeven

14
 price for the exploration of shale gas is in world’s reserves), former Soviet Union (23%),
the range of $4 to $8 per thousand cf (2007 and China (11%). Approximately 40% of the
prices)] Earth’s current electricity production is pow-
• A more elastic supply curve will make ered by coal, and the total known deposits re-
it 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.
loose some prominence. [Due to shale gas Coal types (from highest to lowest rank):
supply, since 2005 gas has decoupled and 1. Anthracite (or hard coal). Primarily for
become cheaper than oil (per Btu). This residential and commercial space heating.
shows that gas and oil are not good substi- High percentage of fixed carbon and low
tutes in many applications, such as trans- percentage of volatile matter. Moisture:
ports.] less than 15%. Heat content: 22–28 mil-
lion Btu/ton.
• Since Henry Hub prices are at a discount
relative to other locations (such as the 2. Bituminous coal. Primarily for power gen-
NBP in the UK), LNG supply has been eration, heat and power in manufactur-
redirected from the US to Europe and ing, and to make coke. Moisture: less
Asia, increasing physical liquidity, arbi- than 20%. Heat content: 21–30 million
trage opportunities, and reducing the de- Btu/ton.
mand for pipeline supplies. 3. Subbituminous coal. Primarily for power
• Growth in LNG import reliance is shifted generation. Moisture: 20–30%. Heat con-
by two decades, yielding security benefits. tent: 17–24 million Btu/ton.
If shale gas also grows globally, Europe 4. Lignite (or brown coal). Exclusively for
and Asia will reduce their dependence on power generation. Moisture: sometimes
geopolitically risky sources of supply from as high as 45%. Heat content: 9–17 mil-
the Middle East, North Africa, and Rus- lion Btu/ton.
sia. Important concepts in coal sampling:
However, rapid development of shale gas is • Accuracy: closeness between an experi-
not certain: mental result and the true value. Affected
• Use and contamination of water resources by bias.
remains a major concern.
• Precision: agreement among individual
• Separation of pipeline capacity rights from test results obtained under similar condi-
facility ownership allows entry by small tions. Not affected by bias, hence data can
producers. This market structure was cru- be very precise without being accurate.
cial for shale gas development in the U.S.
• Bias: systematic error that is of practical
In other countries, pipeline transportation
importance.
monopolies may hamper shale gas growth.
There are several coal classification systems
across the world. In the U.S., coal is classi-
1.5 Coal fied according to calorific value and fixed car-
bon (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
rank) to several types of lignite (low rank)
1.5.2 Sampling and Sample Prepara-
tion [39, ch2, -, inc]
The heterogeneous nature of coal complicates
sampling procedures. There is substantial vari-
ation in coal quality and composition across
and unmined bed.
Sampling by increments consists of extract-
ing 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 re-
jection of the largest particles).
Coal washing is a process to remove mineral
matter to leave the coal as mineral-free as re-
quired by the buyer or legislation.
2 Electricity Production and
Distribution (10%)
2.1 Electricity Generation
2.1.1 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
• New England ISO
• SPP RTO
• ERCOT ISO
• California ISO
These are integrated into 3 regional power
grids: Texas, Western, and Eastern Intercon-
nect.
A deregulated market is one where an
RTO/ISO coordinates generation and trans-
mission. Important characteristics:
• Daily power auctions where power produc-
ers submit their supply schedules. It is
a non-discriminatory auction: all winning
bidders get paid the same clearing price.
• Power plants are activated by merit or-
der — from lowest to highest bid — un-
til 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 arbitrar-
ily small sizes for immediate use anywhere
in the country. Types of auctions coordi-
nated by the RTO/ISO:
– Day-ahead auction: sets the price for
the following day in one-hour incre-
ments.
– Real-time auction: is run continu-
ously 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:
– 7×24, power 7 days a week, 24 hours
a day.
 – 5 × 16, weekdays, peak power (7am– nodal price of the electrical bus where they
11pm). deliver power.
– 7 × 8, nighttime off-peak (11pm– • Zone price: average of all nodal prices in
7am). a given area. Customers pay this price.
Standardization makes the contract more • Hub price: (or clearing price) average of
liquid. The forward market doesn’t re- selected nodal prices across several zones.
quire any ability to generate power at all It is the benchmark price for the grid and
— it is possible to trade both physical con- it is used in the forward market.
tracts (requiring delivery of power) and fi- A Financial Transmission Right (FTR) is
nancial contracts (which settle in cash). It a tradable contract between two parties that
is where the bulk of speculative trading pays the difference in price between two nodes.
occurs. It helps to manage the risk of price differences
Elements of the Standard Market Design between a major hub and a specific node due
(SMD) recommended by the Federal Energy to congestion. Can be structured as a forward
Regulatory Commission: or an option.
• The costs of line congestion are paid only The Heat Rate of a given plant is the effi-
by the affected parties rather than be- ciency at which it converts fuel into electricity:
ing shared across the entire grid. This is Fuel used (MMBtu)
achieved by two mechanisms: Heat Rate := (1)
Power produced (MWh)
1. The primary way to solve congestion Typical values range from 7 MMBtu/MWh
is to activate an out-of-merit order (extremely efficient plants) to 10
plant close to the demand area. The MMBtu/MWh (less efficient). [CCGT
higher cost of this producer is paid with 55% efficiency should be closer to 6]
only by the local consumers. Market Implied Heat Rate (MIHR):
2. Producers pay a charge for routing Power price ($/MWh)
power into a high load area over MI Heat Rate :=
Fuel price ($/MMBtu)
congested power lines, and receive a
credit for producing power that by- It is profitable to produce when MIHR ≥ HR.
passes the congestion. 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.
This compensates for line losses. Spark Spread ($/MWh) :=
Hence, implementing SMD requires assign- Power 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 • Postage stamp with market splitting:
to the interconnection of markets and the there are several zones, but they all have
wheeling of power. the same price, unless there is a constraint
• Barriers and constraints. between them. If there is a constraint, the
zone that is a net exporter of electricity re-
• Distance between fossil fuel sourcing, large ceives the clearing price of the zone that
scale production, and consumption. imports from it. This method is used in
• Small scale renewable generation. Germany and Nordpool.
Requirements for locational charging [verba- • Nodal: finer grid, each node (or bus) has
tim from the book; nothing makes sense]: its own price.
• Location signals to generators. 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
and redundancy) requirements. PJM market).

• Economic treatment of interconnection.

2.1.3 The Essential Aspects of Electric-
• Cost recovery and optimization of spend
by the transmission and system operator.
Loss costs are applied separately to the Functions of the electricity industry:
transmission and distribution sectors. Trans-
mission losses are of the order of 2%–4%
and are relatively low compared to distribu-
tion losses. Losses are handled commercially
through one of the following market model for
losses:
• Marginal losses included in location
marginal prices (eg, New York).
• Average marginal loss factors applied to
generators and loads.
• Average losses netted against load at grid
supply point.
• System administrator buys losses from the
market.
Pricing models. There are alternative meth-
ods for designating the electrical location of
a point on the network, for the purposes of
charging:
• Postage stamp: prices are the same at all
points.
• Zonal: postage stamp pricing within a
zone, where a zone is a group of nodes.
ity [23, ch2, ++]
• Generation or Production. Accounts for
35%–50% of the final cost of delivered elec-
tricity. The development of CCGT in the
1980s showed that economies of scale were
not an inevitable part of electricity pro-
duction and opened the door to competi-
tion in generation.
• Transmission. Electricity is transmitted
from the generators to local distribution
systems. Accounts for 5%–15% of the final
cost of electricity.
The transmission system is quite fragile —
if it overloads it becomes unstable and can
cause widespread blackouts. Hence, the
transmission system requires the constant
attention of a system operator to match
the generation to the load (demand).
• Distribution. Electricity is transported
from the transmission system to cus-
tomers. Accounts for 30%–50% of the fi-
nal cost of electricity. While transmission
works with generation (through the sys-
tem operator), distribution works with the

18
 customer. • Credit risk.
Under regulation, customers take most of the
Commercial functions:
risks; under competition, producers take the
– Retailing: sales to final consumers. risks.
– Wholesale power procurement: when Important technical facts that make electric-
the company chooses which producer ity different from other commodities:
to buy from. In the U.S., a “whole- 1. Electricity cannot be economically stored.
sale sales” means sales for resale. Hence, wholesale price varies tremen-
Wholesale sales are regulated by the dously with the demand/supply balance.
federal government, while sales to fi- The daily load curve is a curve showing de-
nal customers are regulated by the mand across the day. The peak is usually
states. in the afternoon. In hot(cold) areas, sum-
For many years the industry was organized mer(winter) is the peak season. Wholesale
as a vertically integrated monopoly for the fol- hourly prices in competitive markets com-
lowing reasons: monly vary by about 2:1 over the course of
• Natural monopolies (economies of scale) a day in the off-season and by as much as
in transmission and distribution. And 10:1 in the high season (with some spikes
even in generation before smaller plants above this as well).
become economically viable. 2. Electricity takes the path of least resis-
• The coordination of generation and trans- tance. Hence, there is no such thing as
mission is more efficient when both ac- a defined path for delivery.
tivities are in the same firm. Separat- 3. There is a complex series of physical in-
ing the two incurs into transaction costs, teractions in a transmission network.
which are the costs of negotiating, exe- 4. Electricity travels at the speed of light.
cuting, and litigating naturally incomplete Each second, output has to be precisely
contracts. matched to use.
• Long-term planning of transmission and To cope with these facts in a competitive set-
generation benefited from vertical integra- ting trading arrangements should be incentive-
tion. compatible, so that generators will want to
Monopolies have to be regulated to protect obey the system operator. However, note that
consumers. There are two basic models: US there is no physical difference between inte-
and UK. They both: (1) base prices on cost grated and competitive systems: electricity is
and fix them for a period of time; (2) by un- homogenous throughout the grid and there is
hooking prices from actual costs during this no direct connection between a given consumer
window, they provide incentives for efficient and a given producer.
operations.
The main risks are: 2.2 Hydroelectric and Nuclear
• Market demand and prices. Power
• 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
nance, manning, and investment. the electricity.

19
 Top hydroelectric generating countries, from
highest to lowest (capacity, hydro’s % 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 electric-
ity (GWh) in some nonspecified year, which
apparently does not match the ordering on in-
stalled 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 deter-
mined by the volume of waterflow and the
amount of head (the height from the turbines
to the water’s 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 cri-
sis and exposed the risk of a high level of de-
pendence on hydroelectric power (although in-
sufficient growth in supply and transmission in
previous years also contributed to the crisis).
Measures had to be imposed to reduce electric-
ity 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 appli-
cable to the licensing and relicensing of hydro
projects. Some of the main legislation:
• National Environmental Policy Act of
1969: requires assessing the effect of op-
erations on historic structures, water dis-
charge into streams, habitat for plants and
animals.
20
• 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%). Im-
ported oil provides 90% of energy. Hawaii is
developing a mix of renewable resources includ-
ing 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 1–1.5
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 capac-
ity. 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 generat-
ing electricity is [in 2005?]: Europe 28%,
N.America 19%, Russia and Ukraine 18%, Asia
9%. The countries with the highest percent-
age are France and Lithuania (78%), [... list
goes on...], Germany (28%), US and UK (20%),
Canada (15%). The country with more reac-
tors is the US (around 100, of total 439 world-
wide).
Types of commercial nuclear reactors (num-
ber 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
 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). In Japan,
France, and Russia.
• 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 physi-
cally impossible).
Many of the new reactors under construction
are PWRs, while others are pressurized heavy-
water 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. In-
stead, 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).
21
• Potential of catastrophic structural fail-
ure.
The world’s 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 hy-
dropower are (% of total electricity genera-
tion): 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 Construc-
tion Costs [38, +]
Current [2008] estimates of total construction
costs (including escalation and financing) for
new nuclear plants are between 5 500–8 100
$/kW, or 6–9 billion $ per 1 100 MW plant.
Construction costs have increased signifi-
cantly in recent years. This is due to increases
in commodity prices and skilled labor short-
age. Furthermore, there are only two compa-
nies 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 esti-
mated overnight costs once you factor in own-
ers’s costs such as land, cooling towers, etc.,
interest during construction and cost escala-
tion due to inflation and cost overruns. For a
sample of plants that began construction be-
tween 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
overruns are paid by the owners of the plants • Pebble bed reactor. Has been under de-
and their customers. velopment for decades in Germany, then
Consequences of cost overruns: South Africa, and now China and US. The
• Only one-half of projects were actually radioactive fission products are absorbed
built and ratepayers frequently had to pay in the coatings of the fuel pebbles, and the
the sunk costs for abandoned projects. fuel doesn’t get hot enough to melt down
even if there is no coolant. China already
• Cost of power from completed plants be-
has a 10 MW experimental reactor in op-
came much more expensive that initially
eration and is building a 200 MW plant.
expected.
However, pebble bed reactors do not scale
• Some utilities got into severe financial up well: above 600 MW they loose their
problems and some went bankrupt. safety advantage.
Two new reactor designs have been pre-
approved in the US — the Advanced Boiling • Traveling wave reactor. Under develop-
Water Reactor and the Westinghouse AP 1000 ment by TerraPower, a Microsoft spinoff.
— but there is absolutely no construction or There is some conflict about promoting these
operating experience with these designs any- new reactors because utilities and manufactur-
where in the world. ers do not want to imply that the older designs
The nuclear renaissance is heavily depen- now in service are unsafe.
dent on obtaining federal loan guarantees that The failure of Tepco’s Fukushima reactor
would shift the risks of rising plant costs from was in part due to bad management deci-
plant owners onto the federal government. sions. In particular, officials underestimated
the risk that a huge tsunami would overwhelm
2.2.4 The Prospect for Safe Nuclear Fukushima’s defenses. However, it is human
[13, +] nature to lower the probability of catastrophic
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 Dis-
cal parts, and no moving working fluid. For tribution and Trading
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 agree-
water reservoir above the reactor that’s ments between traders and the system oper-
held 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
• Areva’s EPR has four redundant safety be corrected by the system operator in real
systems. time.

22
 2. Congestion management. The system op-
erator has to distribute generation to en-
sure that total electricity flows will not
overload any line.
3. Ancillary services such as operating re-
serves, 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 re-
quires incentive-compatible rules.
Alternative models of trading agreements
differ on the degree to which operation and
commercial arrangements for imbalances, con-
gestion, 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 competi-
tion. Prices are regulated and there is no
spot market. A vertically integrated util-
ity with its own generation runs the trans-
mission and system operation. Provides
access to other traders after it has sched-
uled its own resources, ie, native load gets
priority, and the spare transmission capac-
ity can be used for wheeling. Large loads
such as municipalities arrange for inde-
pendent generators to supply large blocks
of their electricity needs instead of pur-
chasing from the local utility.
2. Decentralized model. Used in California
and Texas. The system operator is inde-
pendent of the generators but its commer-
cial responsibilities are deliberately min-
imized — 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
23
to inefficiencies and arbitrage opportuni-
ties. Typically preferred by marketers and
traders.
3. Integrated model. Used in 3 regions of the
US (eg, PJM, New York) and most mar-
kets abroad. The system operator sched-
ules forward contracts at the request of
traders, but also takes bids from traders
to modify scheduled contracts and to pro-
vide imbalances, congestion management,
and ancillary services. The system oper-
ator runs the spot market using a large
computer optimization program.
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 bene-
fit is that independent generators can find
an outlet for their power without having to
find specific customers, [... which fosters]
real competition in the production mar-
kets.”
The essential feature of the integrated model
is that the system operator administers a spot
market integrated with the pricing of imbal-
ances, congestion management, and the ancil-
lary services. The following mechanisms make
this work:
• The system operator runs an optimiza-
tion program (every 10 minutes) that min-
imizes costs, subject to transmission con-
straints. 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.
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 pro-
duce than to receive MC. Graphically, this
means that the clearing price must inter-
sect the MC curve above the AVC curve.
See p. 217 in Varian, Microeconomic anal-
ysis.]
• 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 optimiza-
tion process.
• Congestion management: traders who
schedule contracts across valuable trans-
mission lines are charged a transmission
usage charge (a bottleneck fee) being
equal to the energy price difference be-
tween the two ends of the transaction.
Main ancillary services:
• Reactive supply.
• Operating reserves: available capacity
that is able to run on short notice. Needs
to be about 7%–10% of load.
• Frequency response (or regulation re-
serve): capacity that continually adjusts
output to exactly match demand.
The total cost of ancillary services is 1%–3%
of total costs.
24
2.3.2 Details of the Integrated Trading
Model [23, ch8, +]
Given that spot prices are set in a nondiscrimi-
natory 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. Cus-
tomers bid for what they want to take and
the price results from the normal intersec-
tion of supply and demand. Demand bid-
ding does two things:
(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 elec-
tric load from demand response can
reduce the price a lot at peak peri-
ods.
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.
2. Capacity payments. Was used in Ar-
gentina 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.
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.
 3. Capacity obligations. All entities that
serve final customers are required to ac-
quire “capacity tickets” to cover the ex-
pected load of their customers plus a re-
serve margin.
In the integrated model, traders can still
make forward contracts in private and bilat-
eral markets, just like they do in the wheeling
and decentralized models. The contract sched-
ule (MW, physical locations, and timing) must
be notified to the system operator only if one
the following holds:
• The contract is inflexible. When all mar-
ket participants are flexible — willing to
modify operations from their contracted
levels if profitable — the system operator’s
dispatch is fully separate from the forward
contracts. The forward contracts then be-
come only financial, providing only price
risk management.
• The contract requires net settlement: im-
balances are calculated and settled by the
system operator as actual metered deliv-
eries net of contract volumes. Contract
schedules are only used for financial set-
tlement, not for physical dispatch. Net
settlement is recommend over gross set-
tlement.
PJM has net settlement, allowing both inflex-
ible and flexible contracts. Forward contracts
are “scheduled” for delivery — but the link be-
tween 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 con-
gestion, plants on the import side of the con-
straint have to increase production, and plants
on the export side of the constraint have to de-
crease 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
25
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 gener-
ators 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 ad-
vance 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 day-
ahead market then become forward contracts
that are settled against spot prices. Benefits:
• Beneficial for generators with high start-
up costs.
• Prevents generators from gaming the mar-
ket by withdrawing capacity at short no-
tice 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 mar-
keter is responsible for supplying fuel to the
plant and selling the resulting electricity into a
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 agree-
ments 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, “What’s the exposure of this power
plant to the price of electricity?” because
there is no single price of electricity (Au-
gust electricity is a fundamentally differ-
ent product than May electricity).
• High volatility in the spread between elec-
tricity and fuel prices increases the value
of the option. Hence, low correlation be-
tween these prices increases the value of
the tolling agreement.
2.3.4 Wheeling Power [15, Ch4.4, ++]
Wheeling is the act of physically transport-
ing electricity from one location to another.
Wheeling trades require a physical transfer of
electricity over power lines rented from a third
party.
Examples of wheeling trades:
26
• 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 nat-
ural gas prices being much more volatile
than coal prices.
• Import hydroelectric power from the Nia-
gara 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 trans-
fer the same amount of power, it is neces-
sary to increase the voltage to reduce the
current. Transformers only work on AC,
which is why AC transmission is the most
used.
• High voltage Direct Current (DC) lines.
They are typically lower cost and lose less
power than AC lines. However, DC power
has to be converted to AC before being
distributed to end users, which has 5%–
10% losses. These conversion losses have
to be weighed against transmission losses.
Furthermore, voltage drops whenever any
energy is removed from a DC line, making
multiple end points problematic. Hence,
HVDC lines are primarily for extremely
 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 trad-
ing 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 liq-
uidated (must be prior to expiration).
2.4 Load Forecasting
2.4.1 Spatial Load Forecasting [15,
ch4.1, ++]
Spatial load forecasting is a prediction of elec-
trical demand within a specified region for a
specific period of time. In the short term, it
is used to schedule power plants; in the long
run, it is used to construct new power lines
and plants.
Factors that go into producing a load fore-
cast:
• Location. Forecasts are made for lim-
ited geographical areas, typically defined
as connecting to the same part of a power model should be: get historical load, look at
grid.
• Type of consumer:
– Residential: higher consumption be- between actual loads and the model’s pre-
tween 6am–9am and 6pm–11pm.
27
– Commercial: offices and retail. Have
standard schedule and moderate de-
mands.
– 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 por-
tion of the variation in demand, at two
frequencies:
– Day-to-day: demand will typi-
cally increase (decrease) with above-
average temperature in summer
(winter) time.
– Month-to-month: demand is typi-
cally higher in summer and winter,
and much lower during spring and
fall.
• Calendar effects:
– Higher demand on weekdays than on
weekends and holidays.
– Typically, in the summer the daily
peak is in the early afternoon (more
AC), while in the winter there is a
peak in the early morning (people
waking up) and another in the end
of the day (people arrive home from
work).
The steps in creating a load forecasting
graphs, develop a preliminary model, expand
the model. It is important to test the model
through error analysis: analyze the differences
dictions. Do it in-sample and out-of-sample.
 death. Costs of electricity production
Check whether the errors correlate with typi-
range from almost zero to 0.15 euros per
cal factors like weather, calendar, etc.
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.
(10%) The attractiveness of investing in renewables
depends on four factors:
3.1 Economics and Financing of • Costs of oil and other fossil fuels.
Global Investment in Renewable • Cost of carbon emissions.
Energy
• Cost of capital.
3.1.1 The Economics of Renewable En-
ergy [21, ++] • Incentives for production of green electric-
ity. US uses production tax credits, but
Contrary to fossil fuel plants, renewable energy this is inefficient for start-ups because it
sources are generally capital intensive and have requires federal tax liabilities. Direct sub-
low or no variable costs. If we build a renew- sidies tend to be more efficient.
able power station, we are effectively prepaying The capacity factor [or load factor] is the ac-
for the next 40 years of electricity. This makes tual output as a fraction of the maximum out-
long-term debt financing seem fair. put that would have been produced if the plant
The Levelized cost of electricity (LCOE) is had operated at maximum capacity. Wind and
the constant price at which electricity would solar are in the 25%–35% range (due to in-
have to be sold for the production facility to termittency), while coal or geothermal reaches
break even over its lifetime, assuming a rea- 90%.
sonable level of capacity utilization. From a Intermittent renewables are only able to
policy perspective, we should add the social bid in the day-ahead electricity market be-
costs. cause they cannot guarantee steady base load
Social costs of using a fossil fuel : power (usually supplied through long-term
• CO2 emissions. Cost estimates range from contracts).
$8 to $85 per ton of CO2. In states with renewable portfolio standards
A large coal-fired power station can use (RPS) there is generally a market in renewable
10 000 tons of coal daily, costing between energy certificates (REC). REC are tradable
50–100 $/t, so that fuel costs can reach certificates proving that 1 kWh of electricity
$1 million per day. Burning 1 t of coal has been generated from renewables. To com-
will produce 1.5–3.5 tons of CO2 [eia.gov ply with the RPS, electricity distributors have
says 2 t, wet basis]. Hence, a CO2 price to own sufficient REC at the end of the year.
of $30/t can double the fuel costs of a Economic viability of major renewables:
coal power station. At the higher price • Wind. Capital costs around $4 000/kW
of $85/t, the LCOE rises from $0.06/kWh for offshore and $2 000/kW for onshore.
to $0.11/kWh. LCOE for onshore in 8-10 cents/kWh.
• Other pollutant emissions, such as SO2, • Solar. PV: capital $7000/kW; LCOE 25–
NOx, PM, are associated with environ- 30 cents/kWh. PV is already competitive
mental damage, poor health, and early in distributed applications where there

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 endan-
gered fish species. Wave and tidal are not
yet at commercial scale, but costs seem
substantially above market rates.
• Carbon capture and storage. Costs in $50–
100 per t of CO2, too high to be com-
mercially attractive. A variant is to cap-
ture CO2 directly from the atmosphere at
a cost of $200/t.
• Biofuels. Sugar-based ethanol is compet-
itive with gasoline at oil prices of $50–60
per barrel. For biodiesel to replace diesel
it will be necessary to develop new tech-
nologies.
For comparison, LCOE for coal is less than 7
cents/kWh, gas and diesel are higher, nuclear
is in 8–10 cents/kWh.
3.1.2 Project Finance Primer [19, +,
inc]
Project Finance is a method of financing in
which the lenders have limited or no recourse
to the assets of the parent company that “spon-
sors” the project. The project is owned by a
special purpose entity, the “project company”.
Lenders will typically demand a secure revenue
stream for the project, which in wind and solar
projects is typically obtained through a power
purchase agreement (PPA) with the local util- through a waterfall with the following order:
ity. Project finance is a way to finance large in- 1. Construction and operating and mainte-
frastructure projects that might otherwise be
too expensive or speculative to be carried on a
corporate balance sheet.
Advantages:
• Debt is held in the project company, not
in the sponsor’s books.
29
• 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 devel-
opment costs at the closing of the project
financing and put their money into new
projects.
• Monetization of tax incentives (see below).
Project finance is a realistic opportunity
when:
• The project is large, with debt above $50
million (project finance is time-consuming
and expensive to consummate).
• The revenue stream will be large enough
to support a highly leveraged debt financ-
ing.
• The power purchaser is creditworthy.
• The physical assets are sufficient to repay
lenders in case of foreclosure.
• The technology can be new, but not
untested.
• Success does not depend only on a few key
individuals who may depart.
• The sponsor must be willing to turn over
the project to lenders if it becomes unable
to service its debt.
• The sponsor is not looking for a quick exit.
• The sponsor is willing to share manage-
ment with lenders.
Project revenues are distributed to investors
nance costs, typically paid to sponsor’s af-
filiates.
2. Fees, interest, and principal to lenders.
3. Reserve accounts and “cash sweep” to
lenders.
 4. Subordinated debt. considered the owner of the project and
can thus claim the ITC. The investor
5. Equity holders.
shares its tax savings with the developer
[Project Finance seems just like Collateral-
in the form of reduced rents. Can be used
ized Debt Obligations...]
for ITC, but not for PTC.
Federal income tax incentives for renewable
energy projects: • Pass-through lease. More complex struc-
• Production tax credits (PTC): around 2.1 ture. Has been used to monetize solar en-
cents/kWh in 2009. ergy credits and Treasury grants. It is
usually preferred by investors who value
• Investment tax credit (ITC): based on the
the credit/grant but place less importance
cost of the qualifying property. Taxpayer
on depreciation.
can choose either PTC or ITC for facilities
that qualify for PTC.
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),
• Accelerated depreciation. +$51 b than in 2009.
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 coun-
biofuels: $1.01/gallon. tries at $72 b overtook developed countries at
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).
ceive value, or “monetize”, the tax incentives Nonetheless, in “total investment” (which
through the intervention of an institutional in- adds R&D and small distributed projects), de-
vestor that can benefit from those tax incen- veloped economies remain well ahead. This is
tives: mainly due to small-scale distributed capacity
• 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.
nership income and tax credits (PTC, Total investment in solar came close to wind
ITC). When the investor’s target return for the first time in 2010. Again, the big chunk
is achieved (the flip point), the investor’s in solar is SDC and the increase is due to falling
allocation is reduced to a small portion. PV prices. Considering only financial new in-
vestment, the decomposition is (in $b):
• Sale-Leaseback. The developer sells the fa-
1. Asset finance: solar 18.9, wind 89.7.
cility to an investor. The investor leases
the project back to the developer for a 2. Public markets new equity: solar 5.3,
term equal to the PPA. The investor is wind 8.2.

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 in-
ternational politics.
Renewable power, excluding large hydro-
electric, 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 in-
vested in each year, either from internal funds,
debt finance, or equity finance. [If it is re-
ally “all” aren’t they double counting equity
in “financial new investment”?] Asset finance
of new utility-scale projects increased in 2010
to $128 b, distributed through Asia & Ocea-
nia ($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 ac-
counted for 70% of overall financing.
3.2 Sustainable Energy and Biofuels iffs, domestic subsidies, and sustainability reg-
3.2.1 Sustainable Energy [33, ch9, inc] expected to increase due to the comparative
[The paper is interesting but does not add
much to other readings and it is a bit old.]
3.2.2 Biofuels: Markets, Targets and
Impacts [40, ++]
Biofuels are classified into:
1. First-generation. Ethanol produced from
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
crops (e.g., rape seed, sunflower, soybean,
and palm oil).
2. Second-generation. Biofuels produced
from lignocellulosic biomass (e.g., agri-
cultural 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 tech-
nology 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 ac-
counted 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 tar-
ulations have restricted trade. Still, trade is
advantage of some developing countries.
Production costs:
• Ethanol: $0.2/liter ($0.3/liter of gasoline
equivalent) for new plants in Brazil, 50%
more in US, 100% more in EU. Trans-
portation, blending, and distribution adds
$0.2/liter. Cellulosic ethanol, still in
demonstration stage, is about $1/liter.
• Biodiesel: $0.7–$1.0/liter.
substantial government support if oil prices are not clear. The only state more determined
below $70 per barrel. is California. It aims to reduce GHG emis-
Investments in biofuel production plants in sions to 1990 levels by 2020 by: launch-
2008 amounted to $3 billion in Brazil, $2.5 bil- ing cap-and-trade in 2012; requiring 33%
lion in the US, and $1.5 billion in France. The renewable electricity by 2020; cut carbon
worldwide total was around $15 billion. content of fuels by 10% by 2020.
• Australia. Goverment announced plans
3.3 Current Trends in the Carbon for a carbon fixed-price mechanism that
Market will transition into an emissions trading
scheme.
3.3.1 State and Trends of the Carbon
Market [42, +, inc] • China. Aims to reduce carbon intensity
(CO2 emissions per unit of GDP) by 17%
The EU Emissions Trading Scheme (EU ETS) by 2015. May introduce emissions trading
accounted for 97% of the global carbon mar- in 2013.
ket value in 2010 (considering both European The EU ETS has suffered several frauds and
Union Allowances (EUA) and Clean Develop- is undergoing regulatory reform. This has in-
ment Mechanism (CDM)). The growth of the creased interest in OTC spot markets.
global market stalled in 2010. Kyoto Protocols: the uncertainties sur-
To reduce emissions, countries are adopting rounding a post-2012 international agreement
one or several of the following policies: cap- have left Europe alone to absorb the supply
and-trade schemes, baseline and credit mech- of project-based certified emission reductions
anism, renewable energy and energy efficiency (CER) after 2012.
certificates, carbon taxes, subsidies, and emis- Voluntary carbon markets remain tiny (only
sion standards. 0.3% of global volume), but are growing. The
Policies are fragmented across countries: fastest growing product is “Reducing Emis-
• EU. The current goal is to achieve a 20% sions from Deforestation and Forest Degrada-
emissions reduction by 2020 on 1990 lev- tion (REDD)”, in part due to probably becom-
els. But the Roadmap for 2050 aims to ing eligible for offset in California’s cap-and-
reduce emissions by 80–95% by 2050 [rel- trade scheme.
ative to what year?].
During Phase III of the EU ETS that 3.4 Emissions Trading Models in the
starts in 2013, half of the allowances are European Union
expected to be auctioned. During the pre- 3.4.1 Emissions Trading in the Euro-
vious Phase II (2008–12) they were all al- pean Union [17, ch37, ++]
located for free.
[Paper is good, but a bit outdated. This mar-
The EU ETS will include emissions from
ket is changing a lot.]
aviation, but airlines from China and the
The purpose of the European Union Emis-
US 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: In the spot market, delivery and payment are
1. Governments allocate allowances for a done within a few business days. In the forward
trading period (phase I, 2005–07; phase market, December 1st was established as the
II, 2008–12; phase III, 2013–?) to covered delivery date. There is a “banking” arbitrage-
companies. About 57% of allowances were free relationship between the prices:
allocated to the power and heat sector and
43% to industrial installations (which typ- FT = St ei(T −t)
ically do not trade much).
where i is the interest rate. Note that this rela-
The total allocation is below the expected tion only applies to allowances within the same
emissions in a business as usual scenario. trading period because allowances from phase
This scarcity guarantees demand and that I cannot be traded in phase II (it is assumed
the environmental goals are fulfilled. that there will be no restrictions after 2012).
2. Once a year, each installation must re-
deem allowances corresponding to its
emissions.
4 Financial Products and Val-
uation (20%)
3. Each company will have to decide whether
to buy allowances in the market, abate 4.1 Forward Contracts and Ex-
emissions by technical measures, or re- change 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 po-
each phase). sition party either: (1) buys the underlying as-
set for a specified price Ft,T (physical settle-
4. A company that cannot meet its obliga-
ment); 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. How-
ever, exchanges are expected to become more 4.1.1 Behavior of Commodity Futures
important, as they eliminate counterparty risk Prices [16, ch3, ++]
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 de- must affect S and F when there is the
mand. Higher demand is typically met by possibility of storing commodities for de-
sources that emit more CO2. livery against the contract in the future.
• More precipitation means more CO2-free However, the correlation (and therefore
hydroelectric power. hedges) are seldom perfect.

• 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 mo-
ment:

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
Futures prices are usually at a premium it costs $0.015 to finance and store 1 gallon
to cash when there are adequate supplies per month.
in the cash market. This is due to carry- 2. Strategy: buy cash, sell futures.
ing charges: storage, insurance, and inter- 3. 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 usu- be done by either: delivering on the fu-
ally F −S < carrying charge due to a con- tures at F1 ; or settling the futures finan-
venience yield of holding some inventory. cially and selling the oil in the cash mar-
The interest rate is the most volatile of the ket, (F1 − S1 ) + S1 = F1 .
carrying costs. The basis for a given futures contract (usu-
• Backwardation or inverted market: ally the nearby) is:

Basis = Ft,T − St
S > F1 > F2 > . . .
where St is the cash price for a given location
This is caused by a shortage of supply rel- where the commodity is traded. Since there
ative to demand in cash markets. This are typically various such locations, there is a
encourages sales now rather than in the unique basis for each location. Therefore, it is
future and thus discourages storage of helpful to decompose the basis into:
goods.
Basis = (Ft,T − SDt ) + (SDt − St )
Examples: | {z } | {z }
StorageBasis LocationBasis
– In the US, the gasoline or driving sea-
where SDt is the cash price at the delivery
son lasts from Apr to Aug. Hence,
point of the futures contract. While the Stor-
gasoline futures prices are typically
age basis → 0 as t → T , the Location basis typ-
in contango during the early months
ically remains constant. There is also a product
of the season (Mar–May), but are
basis when the cash and futures are not exactly
inverted in the later months (May–
the same commodity (eg, hedging jet fuel with
Aug) when it is expected that gaso-
gasoline futures).
line will be in short supply. [Decreas-
Basis changes. In a full carrying charge mar-
ing F are caused by higher conve-
ket, the basis will decrease systematically at a
nience yields in the later months due
rate approximately equal to carrying costs per
to the chance of shortages.]
unit of time. In an inverted market, S and F
– The NYMEX crude oil futures has still have to converge at expiration, but basis
usually been inverted since 1983. changes are unsystematic and unpredictable.
A cash market arbitrage opportunity occurs
when prices in two different markets for the
4.1.2 Commodity Forwards and Fu-
same commodity differ by more than trans-
tures [29, ch6, -]
portation costs between the markets. Exam-
ple: move heating oil between NY and London. A synthetic commodity position is created by:

34
 1. Going long in a forward contract. The [I don’t see the point: l is not observable and
cash flows are: CF0 = 0, CFT = ST − it has exactly the same interpretation as the
F0,T . convenience yield — see eqn (6.11) and ftn 5
2. Buying a ZCB with cash flows: CF0 = in the paper. Further, the paper does not give
−e−rT F0,T , CFT = F0,T . any real life example of l, though Hull [22] says
The total CFT = ST . To avoid arbitrage, that gold and silver have lease rates (note that
−CF0 = S0 or he considers them investment assets, not in-
vestment commodities). This formula still ig-
S0 = e−rT F0,T nores storage costs.]
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 stor-
not 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 stor-
age costs (u) and the convenience yield (c): F0,T = S0 e(r+u)T
S0 = e−(r+u−c)T F0,T . See Hull [22].]
Using a simple PV relationship for the price Note that u = −l. [Equality is only guaranteed
of a commodity, we also have by no arbitrage for investment assets, as shown
next.]
−αT
S0 = e E0 [ST ] Cash-and-carry arbitrage for both invest-
ment assets and consumption commodities:
where α is the appropriate discount rate. [Does
it make sense to estimate α in the usual way C&C 0 T
(eg, CAPM) for a consumption commodity?] Borrow $ S0 + U −(S0 + U )erT
Comparing these two equations, we get Buy asset −S0 +ST
Pay storage −U 0
(r−α)T Short Fwd 0 F0,T − ST
F0,T = e E0 [ST ]
Payoff 0 F0,T − (S0 + U )erT
Hence, the forward price is a biased estimate Hence, defining u appropriately, no arbitrage
of the expected spot price. [Downward biased requires
when the return on the underlying has positive F0,T ≤ S0 e(r+u)T
covariance with the market, as r < α ⇒ F0,T <
Reverse Cash-and-carry arbitrage for an in-
E0 [ST ]. Example: stock index. See Hull [22].]
vestment asset. The strategy for the holders of
Electricity forward prices can show large
the asset is
price swings (eg, in day-ahead prices) because
electricity is not storable. Variations in elec- R C&C 0 T
tricity forward prices likely reflect variations Sell asset +S0 −ST
in expected spot prices. Save storage +U 0
Lease rate (l): l = α − g, where g is the ex- Lend $ −(S0 + U ) +(S0 + U )erT
pected growth rate of the commodity price. l Long Fwd 0 ST − F0,T
is the commodity analog to the dividend yield Payoff 0 (S0 + U )erT − F0,T
of a financial asset. If we borrow the asset (in Note that these are incremental payoffs to
order to short sell it), we have to pay the lease the holders relative to doing nothing (keep the
rate to the lender. Hence, F0,T = S0 e(r−l)T . 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, defin-
ing u appropriately, no arbitrage requires
S0 e(r+u)T ≤ F0,T
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 re-
flects the market’s expectations concerning the
future availability of the commodity.]
Reverse Cash-and-carry arbitrage for a con-
sumption commodity. If the holders of the
commodity sell it, they stop receiving the con-
venience yield, hence they only save U − C (if
they lend it to a short seller, they will only
pay him U − C). Replacing U by U − C in the
strategy, and the defining c appropriately, no
arbitrage requires
S0 e(r+u−c)T ≤ F0,T
In summary, for a consumption commodity, panies that need to manage basis risk. Exam-
the no arbitrage region is:
(r+u−c)T (r+u)T
S0 e ≤ F0,T ≤ S0 e
Thus, the convenience yield only explains
anomalously low forward prices.
[Hull [22] and Clewlow and Strickland
[11] define the unobservable c such that
S0 e(r+u−c)T = F0,T .]
Basis risk: the price of the commodity un-
derlying the futures contract may move differ-
ently than the price of the commodity you are
hedging.
4.2 Energy Swaps
Terminology. The swap buyer pays fixed swap in that the fixed price payer is fully pro-
and 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. Exam-
buyer is equivalent to being long in a series of ple: a fuel oil buyer sees the current dip in
forward contracts.
36
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 re-
ceives the fixed leg. Typically, a commod-
ity producer that wants to lock in the sales
price.
• Swap Buyer: (opposite). Typically, a
commodity consumer that wants to sta-
bilise the buying price.
A differential swap exchanges the actual dif-
ferential between two products for a fixed ref-
erence value. Counterparts:
• Swap Seller: pays the actual floating dif-
ferential and receives the fixed differential.
• Swap Buyer: (opposite).
Typical users are refiners that want to hedge
changing margins of refined products and com-
ple: an airline hedges with gasoil futures. To
fix the basis risk, they buy a differential swap
on jet minus gasoil at $36/t. If the average
(jet - gasoil) is above $36 for a given month,
they receive the difference multiplied by the
monthly volume specified in the contract.
A refining margin swap or crack swap allows
the profitability of a refinery to be guaranteed
for a few years forward. In the “crude oil leg”,
the refiner is the fixed-price buyer thus guaran-
teeing the input price; in the “refined-products
leg”, the refiner is the fixed-price seller thus
guaranteing the output price.
A participation swap is similar to a regular
market prices as a good opportunity to hedge
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
pay any upfront premium. The company buys
a 50% participation swap at $80 per ton. If
prices rise to $95 it receives the full $15 differ-
ence. If prices fall to $70, it would only pay $5
rather than the $10 under a regular swap.
Most companies only hedge 40–60% of their
1 or 2 years exposure. Some limiting factors on
the use of swaps are illiquidity and accounting
issues.
Swaps are useful in the following financing
structures:
• Project finance: e.g., to fix the selling
price of an oil field project.
• Pre-export financing: oil-exporting coun-
tries pledge future oil production as col-
lateral against immediate cash. [This is
cash now in exchange for physical oil in
the future — why is it related to swaps?]
• Asset, bond, or equity financing: link cash
flows to fuel prices.
(See pricing in Panel 8, p. 35, of the paper).
4.3 Energy Options
4.3.1 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 equiva-
lent to either:
• Long forward.
• Long call and short put options.
37
Components of an option’s value:
• Intrinsic value: [maximum of zero and
the] amount the option would pay if ex-
ercised immediately.
• Time value: amount due to the possibil-
ity that the intrinsic value may increase.
Time value is highest when the underlying
is trading at the strike.
Types of option exercise:
• American. Can be exercised at any time
up to maturity. Most exchange-traded op-
tions are American, like the energy op-
tions on the NYMEX and IPE.
• European.
• Asian. Settle in cash based upon an aver-
age price. Most OTC energy options.
Greeks:
• Delta: δ := ∂c/∂S
• Gamma: γ := ∂δ/∂S = ∂ 2 c/∂S 2
• Theta: θ := ∂c/∂t
• Vega: v := ∂c/∂σ
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 δ = 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 com-
pensated 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 simulta-
neous purchase of a call and the sale of
 a put, often constructed to have zero up- the assurance of a maximum fixed price,
front cost. If an airline or a gas burning but feel that there is a reasonable prospect
electric utility buys a collar (= long call of a price fall before the expiry of the
and short put), the call strike is the max- swaption.
imum price it will pay for fuel, while the
put strike is the minimum price it will pay 4.4 Exotic Options
for fuel. The advantage is that the pre-
mium from selling the floor subsidises the ..
cost of buying the cap. A collar can be
thought of as a forward (or a swap) with 4.5 Option Valuation and Risk Man-
a band in the middle (the range between agement
the put and the call strikes) where noth-
ing happens. A oil producer would want Put-call parity.
to short a collar (= sell cap and buy floor). • European stock options:

• Participating collars. The company “par- p + S0 = c + Xe−rT

ticipates” in any favourable price move in
the underlying commodity, while still be- • European futures options:
ing fully protected against unfavourable
price movements. The (out-of-the-money) p + F0 e−rT = c + Xe−rT
option bought is for a larger quantity
[the amount that needs to be hedged?] 4.5.1 Overview of option pricing for en-
than the (at-the-money) option sold. The ergies [34, ch9, - -, inc]
strikes are such that the total premiums
paid and received are equal. The cost of [Equation 9-3 is about payoffs; it is not the put-
the “participation” is the less favourable call parity, which is a relation between prices.
placement of the option strike prices. Formula 9-4 is wrong. The terms are not stan-
dard and are just more confusing.]
• Participating swaps. Are like participat-
Parity 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
strike call(put). option’s expiration, but rather on a forward
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 dynami-
cally 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 op-
tion on a forward contract (−δ = −∂c/∂F ).
To delta hedge, we must buy a quantity δ
of the underlying forward. The value of the
hedged portfolio is P = −c + δF , 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 δ
changes faster. Steps:
1. Trade a second option such that the
gamma (γ = ∂ 2 c/∂F 2 ) of the combined
position is zero: γ1 + aγ2 = 0.
2. Since this will have residual delta, neutral-
ize it by taking a position in the underly-
ing 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 com-
bined portfolio; it only changes delta.
This portfolio needs to be rebalanced much less
frequently.
Volatility Hedging is similar to gamma hedg-
ing, replacing gamma with vega (V = ∂c/∂σ).
For delta-gamma-vega hedging, we need even
another hedge option:
1. Simultaneously find quantities a and b
such that γ1 + aγ2 + bγ3 = 0 and V1 +
aV2 + bV3 = 0.
2. Neutralize the residual delta with a posi-
39
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 effi-
ciency, which facilitates hedging.
Position trading speculation consists of out-
right 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 unim-
portant. If the spread X − Y is expected to
widen, buy X and sell Y .
Intermarket spreads trading involve the si-
multaneous 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.
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 8–10 cities.
rel) [the book is from 2002...]. Weather options are written on the cumula-
• A spark spread allows generators to lock tive HDD or CDD over a specified period (typ-
in a margin by purchasing natural gas fu- ically 1 month). One could buy a CDD option
tures and selling electricity futures. for the summer, or a HDD option for the win-
ter.
• Henry Hub natural gas vs. Per- One 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
• NYMEX heating oil vs. IPE gas oil. than the predefined level.

• NYMEX light, sweet crude oil vs. IPE’s

Brent crude oil. 4.9.2 Heating and Cooling Degree
Days [3, +]
• Natural gas vs. propane futures (“frac”
spread). A “degree day” is a measure of the average
temperature’s departure from a human com-
◦ ◦
4.8 Hedging Energy Commodity fort level of 18 C (65 F).
Risks Heating degree days (HDDs) are defined as
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.
NYMEX. Cooling degree days (CDDs) are defined as
Basis or differential risk is the risk due to T − 18. Accordingly, a day with an average
◦
time or location differences. NYMEX futures temperature of 25 C will have 7 CDD.
contracts can be delivered any time during a [In Fahrenheit, the reference temperature is
◦
full month at the seller’s discretion, which cre- 65 F - see Considine [12].]
ates time basis risk for a buyer that needs For both heating and cooling degree days,
prompt barrels today. average temperature of a particular day is cal-
Availability or supply risk. culated by adding the daily high and low tem-
Volume risk is most generally associated peratures and dividing by two.
with extreme temperature deviations. One
way to protect against the possibility of need-
ing greater supply is through buying call op- 5 Modeling Energy Price Be-
tions. When the risk is on the downside and havior (10%)
lower prices, use put options.
5.1 Introduction to Energy Model-
4.9 Weather Derivatives ing
4.9.1 Introduction to weather deriva- 5.1.1 What makes energies so different
tives [12, -] [34, ch2, -, inc]

Weather derivatives are trading OTC since What makes energies so different is the ex-
1997 for most US cities. CME is introducing cessive number of fundamental price drivers,

40
which cause extremely complex price behav-
ior. For example, price depends on location,
which does not happen with traditional finan-
cial products.
Energy prices display spikes and strong
mean reversion. The mean reversion appears
to be a function of either how quickly the sup-
ply 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 limi-
tation (causes high short-term price volatility).where κ is the random jump size and dq is a
Main demand drivers are the convenience
yield and seasonality.
5.2 Data Analysis and Essential jump frequency and jump volatility.
Statistics
5.2.1 Essential statistical tools [34, ch4,
- -, inc]
[The lognormal distribution has positive skew-
ness or is skewed to the right, i.e., the tail is on
the right side. Skewness := E[(X − X̄)3 ]/σ 3 .]
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 val-
ues are uncorrelated.” [Absurd! Ex: AR(1).]
5.3 Spot Price Behavior
5.3.1 Understanding and Analyzing
Spot Prices [11, ch2, ++]
Schwartz (1997) model for a mean reverting
spot price:
dS/S = α(µ − ln S)dt + σdz (3)
The long-term mean is eµ . The half-life is the
time taken for the price to revert half way back
to its long-term level: t1/2 = ln(2)/α. For α =
10, t1/2 = 25 days. Mean reversion rates are
relatively low for most energy prices (except
electricity).
Hull and White (1988), Heston (1993), and
others, model for stochastic volatility:
dSt /St = µdt + σt dz
dσt2 = a m − σt2 dt + ξσt dw


Model for jumps with mean reversion (good
for electricity):
dS/S = α(µ − ln S)dt + σdz + κdq
discrete {0, 1} process.
The following variables may display season-
ality: price, volatility, mean reversion rate,
5.3.2 Spot price behavior [34, ch5, -,
inc]
Shortlist of possible models:
• Lognormal price model:
dSt /St = µdt + σdzt
Famous in nonenergy markets. Guaran-
tees 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 distribu-
tion’s tails. This can be improved with
jumps.
The drawback of this single-factor mean-
reverting model is that it forces the im-
plied 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).
41
 • Mean reversion in price. (Pilipovic
model). The spot price is assumed to
mean-revert toward an equilibrium price
level, which is itself lognormally dis-
tributed. The volatility of the spot price
never goes to zero. [See paper for eqns.]
Energy markets require mean-reverting
models. Both models give negative autocor-
relation for the changes in spot prices, which
is important for energy markets, particularly
electricity.
[Box at the end explains reasonably well Lo-
cational Marginal Pricing in electricity mar-
kets.]
5.4 Forward Curve Modeling
5.4.1 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 esti-
mated 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 for-
ward price.
• Spot price modelling approach. Forward
prices are derived from assumptions about
the stochastic processes for the spot en-
ergy 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,
is: ++, inc]
Ft,T = St e(r+u−c)(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 for-
ward curve can be in contango or backwarda- dF (t, T )/F (t, T ) = σ(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 pat- A 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 σ(t, T ) =
complicated forward curves, with seasonal, σe−α(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
Since most electricity contracts are illiquid, X
dF (t, T )/F (t, T ) = σi (t, T )dzi (t)
other methods are used to construct the for-
i=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
 Since S(t) = F (t, t), we can derive a process
for the spot price from the process for the for-
ward price. [See the paper for equations.] One
important result is that the simple model in
(4) with σ(t, T ) = σe−α(T −t) implies the mean-
reverting spot price in (3), albeit with a time
dependent drift term. If α = 0, we obtain the
Black (1976) model.
Seasonality for gas and electricity can be in-
corporated by
Xn
dF (t, T )/F (t, T ) = σS (t) σi (T − t)dzi (t)
i=1
where σS (t) is the time dependent spot volatil-
ity.
[See the paper for option pricing formulas.]
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 produc-
tion processes and/or consumption goods;
they are not investments assets. For ex-
ample, 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 Vasicek’s (1977) may not perform well
because:
– The speed of mean reversion may be
different below and above the mean.
43
– In many markets, especially electric-
ity, departures to the upside are more
likely than to the downside.
– A price spike is frequently neutral-
ized by a following spike of opposite
sign.
• Prices of energy commodities behave dif-
ferently during different periods of their
lives. Eg, the volatility of forward con-
tracts increases as they get closer to their
maturity.
If the underlying price follows a GBM (re-
turns are iid), volatility can be estimated from
historical data as follows:
1. Calculate [daily] logarithmic price returns
[continuously compounded returns]: St =
St−1 er ⇒ r = ln(St /St−1 ). Note that
r0,T := ln(ST /S0 ) = r1 + r2 + . . . + rT .
2. Calculate standard deviation of daily se-
ries, σd .
√
3. Annualize: σy2 = 250σd2 ⇒ σy = 250σd
If the underlying price follows a mean-
reverting Ornstein-Uhlenbeck process, dS =
α(S̄ − S)dt + σdz, volatility can still be esti-
mated from historical data by considering an
AR(1) discretization. [See formulas in the pa-
per].
A leptokurtic distribution has fat tails, ie, its
kurtosis is higher than in the normal distribu-
tion. 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 depen-
dent volatility, be it deterministic or random.
Models for stochastic volatility. Assume re-
turns are rt = k +ut , where k is a constant and
ut = σt εt , with εt ∼ N (0, 1). Alternatives for
the variance:
1. ARCH(q): σt2 = a0 + a1 u2t−1 + . . . + aq u2t−q
GARCH(p,q): σt2 = a0 + pi=1 bi σt−i 2 +
P
2. P
q 2
i=1 ai ut−i
5.5.2 Volatilities [34, ch8, - -, inc] follow a random walk):
The volatility of a price process is always as- rt = µt + σt 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 struc- Volatility estimation:
ture of implied volatilities from several options • Simple Moving Average:
on the same underlying. Suppose we have two v
options on the same 3-month futures:
u
u1 X N

1. Option 1 expires in 1 month, has implied σ̂ = t (ri − µ)2

N
volatility σ0,1 . i=1

2. Option 2 expires in 2 months, has implied • Exponentially Weighted Moving Average:

volatility σ0,2 . v
We can then estimate σ1,2 from u N
u 1 X
2 2 2
σ̂ = t PN λi−1 (ri − µ)2
i−1
σ0,2 = (σ0,1 + σ1,2 )/2 i=1 λ i=1

Referring to the same 3 models of section
5.3.2:
• Single-factor lognormal price model
(GBM). Volatility is the same for spot
and all forward prices. Spot and all
forward prices are perfectly correlated The corresponding formulas can be used to es-
with each other. None of this is consistent timate covariances.
with real energy prices.
• Single-factor log-of-price mean-reverting
model. The volatility of the forward price
goes to zero as the maturity date goes to
infinity. Correlations remain perfect be-
cause it is still a single-factor model.
• Two-factor mean-reverting model.
(Pilipovic model). Correlations be-
tween spot and forward prices are less
than one.
6 Risk Evaluation and Man-
agement (15%)
6.1 Value-at-Risk and Stress Testing
6.1.1 Value-at-risk [11, ch10, +, inc]
The basic VaR model assumes that market
variable returns are normally distributed (or
The decay factor is typically 0.9 < λ <
1.0. Older returnsP get exponentially less
weight. Note that N i−1 ∼ 1 , as in
i=1 λ = 1−λ
the RiskMetrics formula (but not good for
λ close to 1!!!).
VaR methodologies:
1. Variance-Covariance or Delta VaR. As-
sumes that returns are normally dis-
tributed. Derivatives are represented in
terms of a Delta equivalent position in the
underlying asset, ie, the weights in the
∂Vi
portfolio are modified to w̄i = ∂S i
wi (for a
basic instrument that is not a derivative,
∂Vi
∂Si = 1). The variance of the portfolio is
the usual σp2 = w̄0 Σw̄. Hence,
V aR = z × σp$
z is the critical level for a given con-
fidence level. For example, z(95%) =
1.65, z(99%) = 2.326.
Examples:
• 100 M$ spot crude oil position. Stan-
dard deviation of daily returns of
crude oil price is 2.5%. The 1-day

44
 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 +2ρV aR1 V aR2
2. Delta-Gamma VaR. The change in value
of derivatives are approximated with more
terms: δ, γ = ∂ 2 V /∂S 2 , and also θ =
∂V /∂t. The portfolio distribution is no
longer normal [see paper for formula], so
the VaR calculation becomes more com-
plicated. The main point of this approach
is to compute the change in value of an op-
tion without having to use the full option
pricing model. This can be integrated in
the Monte Carlo method to speed up the
simulations.
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, stochas-
tic volatility, or knowledge of future events
(eg, changes in the operation of a market)
can be easily incorporated.
4. Historical simulation. Good alternative if not fulfil his contractual obligations. Credit
returns are not well described by the nor- risk exposure results from:
mal distribution or other tractable alter-
natives, as is likely for energy markets.
VaR estimates should be backtested : check
how often the actual returns exceed the VaR
forecast.
6.1.2 Incorporating stress tests into
market risk modeling [1, +]
Stress tests are exercises to determine the
losses that might occur under unlikely but
plausible circumstances, i.e., under rare or ex-
treme events. Stress tests respond to VaR ex-
cessive dependency on history or unrealistic
statistical assumptions.
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. How-
ever, 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.
6.2.1 Credit risk management [7, ch6.3,
-, inc]
Credit risk is the risk that a counterparty can-
• Settlement risk: the possibility that a
counterparty cannot pay the obtained
benefits, e.g. the delivered energy
amount.
Example: at some point before the matu-
rity of a forward contract, the risk is the
present value of the terminal payoff, as-
suming that ST is the current spot price.
• Replacement risk: the possibility that a
new replacement contract will have to be
entered into, under potentially worse mar-
ket conditions.
Credit risk can be quantified through:
• Risk-at-Default. [= EAD x LGD ?]
45
 • Expected loss.
• Potential exposure: maximum credit loss
to a given counterparty with a given confi-
dence level. Obtained by generating mar-
ket prices scenarios. Useful for setting
credit limits.
• Credit VaR.
Credit risk can be reduced through:
• Margining agreements. Most powerful
method. [Works like in exchange-traded
products.] 6.2.3 Mitigating counterparty credit
• Transfer an OTC transaction into an regu-
lar exchange-traded futures contract. The Termination gives the possibility that an in-
European 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 counter-
party in an OTC derivatives transaction will
default prior to expiration of a trade and will
not therefore make the current and future pay-
ments required by the contract. Since the fu-
ture value of the derivative contract is uncer-
tain, each counterparty has risk to the other.
Traditionally, credit risk has been associated
only with lending risk. This is the risk that
we don’t 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.
• Expected MtM is the expected value of a
transaction for some future time. ..
46
• Expected Exposure is the average of pos-
itive MtM values at some future time.
Note that E[M tM ] < E[E].
• Potential Future Exposure is the worse ex-
posure distribution for a given confidence
level (similar to a VaR).
• Effective Expected Exposure is a nonde-
creasing time series of E[E].
risk [18, ch3, ++, inc]
counterparty going bankrupt. It may exist as
an option or be conditional on certain condi-
tions 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 nega-
tive. However, they may still be worth putting
under a netting agreement to offset negative
MtM of other instrument within the same net-
ting 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 Enterprise Risk Management
6.4 Case Studies in Risk Manage- by rail and sea. Transport is expensive, repre-
ment senting 50–60% of the final price. During 2009,
it was cheaper to import coal from Indonesia,
6.4.1 The collapse of Amaranth Advi-
Australia, 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
losses in natural gas futures and options. since recovered and the import window began
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, China’s will-
referred 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]

6.4.2 The Case for Enron [37, +, inc]
Enron’s 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 accountabil-
ity.
7 Current Issues in Energy
(10%)
7.0.3 The World’s Greatest Coal Arbi-
trage: China’s Coal Import Be-
havior 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 be-
tween rapid growth in oil demand in emerg-
ing economies and the downshift in oil supply
trend growth.
Real oil prices have not trended persistently
up or down in 1875–2010. 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, technol-
ogy, 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 mod-
erate increases in oil scarcity may not present
a major constraint on global growth in the
medium to long term.

47
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