Dissertation Report

Mitigating risk exposures of participants in power markets

using derivative instruments

Submitted By:

Yash Prakash Hota

R130219017

MBA Power Management (2019-21)

SoB, UPES Dehradun

Under the mentorship of:

Dr. Anil Kumar Dr. Vipul Sharma

Head of the Department Sr. Associate Professor

(Department of Energy Management) (Department of General Management)

SoB , UPES Dehradun SoB , UPES Dehradun

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 ACKNOWLEDGEMENT

I am highly indebted and owe a sense of gratitude towards Dr. Anil Kumar (HOD –
Department of Energy Management) for facilitating me with all sorts of resources and
knowledge that are essential in completion of the project.

I am very much obliged to Dr. Vipul Sharma (Sr. Associate Professor, Department of
General Management) for mentoring me and keeping the trust in me.

My sincere gratitude to Dr. Mohammad Yaqoot, Dr. Anil Kumar, Mr. Avishek Ghosal at
School of Business, UPES for providing with all the necessary information and encouraging me
to pursue this project.

Finally, I would like to thank my peers in MBA Power Management batch of 21, who helped me
in identifying my core strength and provided me with their profound expertise.

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 DECLARATION

I hereby declare that the dissertation report titled “Mitigating risk exposures of participants in power
market using derivative instruments" is a subtle piece of work carried out with full dedication and
hard work by Yash Prakash Hota, Student of MBA Power Management at UPES, Dehradun. I am
committed to the ethics and values. I have maintained all the standards and restrictions in
successfully preparing the report. All the results and conclusions are the virtue of our precise
calculation and hard work. I ensure that the report is our original work and has not been plagiarized
from any other source. I have put my best endeavor physically, intellectually, and financially in
successful completion of the dissertation.

Yash Prakash Hota

Roll – R130219017

MBA Power Management (2019-21)

School of Business, UPES

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 CONTENTS

Serial Topic/Sub-topic Page

No. Number
1 Introduction 8-14
1.1 Executive Summary 8-9
1.2 Existing short term power market setup in India 9-10
1.3 Major types of risks in energy industry 10-11
1.4 Hedging 11
1.5 Derivative instruments 11
1.6 Major types of Derivative Instruments used across global power markets 12-13
1.7 Status quo of derivative market for electricity in India 13-14
1.7.1 Regulatory setup for derivative markets in Indian power sector 13
1.7.2 Possible outcome from existing state of affairs 14
2 Justification of Project 15-17
2.1 Distinctive attributes of electricity trading 15-16
2.2 Liquidity risks of distribution companies in India 16-17
2.3 Need for work 17
3 Business Problem 18-22
3.1 Hierarchy in a power market 18
3.2 Risks in power sector 19-20
3.3 Business objectives and problems of power market participants 20-21
3.4 Major risk exposures in power sector 22
4 Research Gap 23
4.1 Insufficiency in existing research 23

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 5 Research Problem 24
5.1 Shortfalls in research approaches related to implementation of derivative 24
markets
5.2 Issues in pricing of derivative contracts 24
6 Research Objective 25
7 Research Design and Methodology 26
8 Analysis and Findings 27-33
8.1 Constraints peculiar to various market participants 27
8.2 Favourable market conditions and strategies 28
8.3 Identification of risk associated with market players 29
8.4 Comparative study of derivative markets in USA and Europe 29-30
8.4.1 USA Model 29
8.4.1.1 Exchange based models in USA 29
8.4.1.2 Hedging strategies in derivative markets in USA 30
8.4.2 European Model 31-32
8.4.2.1 European OTC derivative market segment 31
8.4.2.2 European countries with available derivative instruments 32
8.5 Other significant markets 33
8.5.1 Derivative instruments in Nordic power market 33
8.5.2 Derivative instruments in New Zealand electricity market 33
9 Recommendation 34
9.1 Value Proposition of derivative contracts in Indian power markets 34
9.2 Using derivative contracts to strengthen the liquidity of distribution 34
companies
10 Conclusion 35
11 Bibliography 36-37

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 LIST OF FIGURES

Figure Figure Title Page

Number Number

1 Types of derivative instruments used across global power sector 12

2 Distinctive attributes of electricity trading 15

3 Key Power Market Participants 18

4 Risks in power sector 19

5 Supply side and Demand side challenges in power sector 20

6 Derivative market arrangement in Europe 31

7 Derivative instruments in European Countries 32

8 Value proposition of derivative trading 34

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 LIST OF TABLES

Table Number Description Page

Number
1 Business objectives and problems 21

2 Constraints in spot power market 27

3 Favourable market condition and strategy 28

4 Identification of risk types 29

5 Hedging strategies in derivative market in USA 30

6 European Model 31

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 1. Introduction

1.1. Executive Summary:

The landscape of global power market is changing. Vertical and horizontal unbundling
introduced competition across electricity markets, changing organizational and economic
strategy for different power market participant. Competition improved the production and
reliability of power utilities, resulting in lower energy costs for customers. Prices in a dynamic
market are dictated by market factors and real-time demand-supply dynamics, which cannot be
predicted in advance, making the market unpredictable.
On top of it, the country is also fostering rapid transition in its energy portfolio mix through
renewable capacity addition in order to achieve the climate goals. But as a consequence of such
expeditious change and increasing demand, the volatility in wholesale electricity price is
becoming very high. There was a stagnant demand of electricity in the summer of 2020 because
of the lockdown resulting in very low prices across different spot exchanges around the world
vis-à-vis the price started to rise gradually with the proportion of relaxations in the lockdown.
But the dynamic market conditions and with the threat of second wave of COVID-19 around the
corner, the uncertainty in price movement is still high. This stimulates financial risk for all the
stakeholders in the power market. Not only the primary value chain of generators, transmission
utilities and distribution companies but all the participants in the market place are exposed to the
risk of price volatility. Extreme volatility is witnessed in a real time market which is difficult to
monetize. (Chawda et al., 2017)
The power sector is marked by a dynamic business environment that is changing rapidly. Global
markets are more interconnected than ever before, modern power transmission lines are being
built between countries and continents, energy capital markets are constantly evolving, and smart
metering technologies will be introduced in the industry. (Pérez-González & Yun, 2013)
Simultaneously, subsidies and carbon policy have a significant effect by encouraging emerging
green technologies to be profitable while removing funding from more polluting technologies.
The increased share of renewables as a result makes demand less predictable and poses
challenges to the power grid.

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The majority of the efficiency benefits from restructuring come from long-run investments in
generating capacity, according to a basic concept behind the global push toward a competitive
energy market. Utility firms were authorized to earn a regulated rate of return over their cost of
capital under the state-ownership or mandated rate-of-return regulatory framework.
Historically, the paradigm of vertically integrated utilities operating as owned (state) monopolies
shielded energy producers and retailers from harm. However, under the current liberalized
paradigm of unbundling and competitiveness, all energy suppliers and consumers must now bear
the full price and uncertainty costs.
Spot rates are extremely unpredictable under optimum generating capacity scenarios due to
factors such as non-storability of electricity, peak demand at specific times, generator outages,
fuel volatility for renewable energy generators (e.g., wind for wind generators and water for
hydro power plants), large investments and time required for generation capacity expansion, and
so on. (Benth & Zdanowicz, 2016)
Entities in the power markets are exposed to a variety of problems that have arisen as a result of
the deregulation. In order to make sound decisions, these organisations must handle these
problems appropriately. The use of risk control tools enables policy makers to train themselves
to bear such reasonable amounts of risk or to benefit from desirable circumstances.
For industry participants, energy policymakers, and institutional investors, a good view of risk
control policies in power markets is very critical. The importance of electricity retail markets to
the global success of the electricity sector would remain unknown in the absence of adequate risk
management instruments.

1.2. Existing short term power market setup in India

India is the world's sixth largest producer and user of energy. According to worldwide estimates,
total worldwide energy trade is approximately $8 trillion, and it is increasing at a fantastic pace
of 30% per year. Energy market dynamics have shifted from a supply market at a fixed price to a
price-sensitive market where energy is sold on exchanges.

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Spot market / Power exchanges aided in the optimization of generation assets across the country,
worked as counter-parties to transactions, and assisted in the absorption of credit risks of
DISCOMS. As trade volume increased, power exchanges using standard contracts were launched
in July 2008. Power exchanges are electronic networks that allow for the anonymous market
exploration of power based on supply and demand.
This has resulted in the creation of an effective power trading, capable of sending market signals
for the sector's development and technology selection. It also aided in the expansion of private-
sector capacity.
But every breakthrough is followed by certain bottlenecks. There are numerous challenges for
the participants in the existing spot market. Some of which are:
 Handling transmission corridor congestion effectively
 creating more goods of longer length and variety to satisfy varied stakeholder needs to
provide timely signals and forecasts for needed capacity additions
 competitiveness of market participants in the medium and long term, given the ongoing
legacy of under-recovery of power cost from customers
 The emergence of a spot market in electricity has raised tariff volatility.
 Price convergence between market segments
 Transmission pricing impacting market price.

Effective risk management through the use of energy derivatives has become critical in India,
where the energy markets are plagued by losses in extraction, conversion, and transmission,
resulting in losses for producers, marketers, and consumers. (Eni & Mattei, 2013)

1.3. Major types of risks in energy industry

Credit Risk: It is the risk of a counterparty failing to execute its contractual obligations. It varies
with various products and is also known as default or counterparty risk.
Market Risk: Market risk is the risk of financial loss as a result of price fluctuations in the
underlying asset/instrument.
Liquidity Risk: Liquidity risk refers to a company's inability to complete a deal at current market
pricing.

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Operational Risk: This type of risk is peculiar to the power industry. It is the deviation in the
operational parameters of the generation stations, transmission lines and power systems etc. For
e.g., increase in Specific Heat rate, specific oil consumption or decrease in plant load factor of
Thermal power plants, instability in grid and transmission lines etc.

1.4. Hedging
Hedging is a method of reducing the price risk associated with open holdings. Its objective is to
minimize volatility by lowering risk. Hedging does not imply maximizing return. It simply
indicates that the variance of return has been reduced. It is possible that the return is larger in the
absence of the hedge, but it is also possible that the return is significantly lower.

1.5. Derivative Instruments

Derivative instruments are financial contract that specifies an agreement between two parties that
derives its value from the performance of an underlying commodity (in this case: electricity).
The contract represents the obligation to purchase or sell a fixed quantity of electricity at a pre-
agreed price. The duration of the contracts extends from hours to years. Most of the contracts are
concluded by means of financial settlements based on a certain market price index at maturity,
whereas the rest are resolved by the physical delivery of electricity. It helps investors, traders and
speculators with future price discovery and price certainty in a volatile market. (Power, 2014)

Derivative contracts are used in the scope of energy risk management to hedge against adverse
changes in spot prices that occur throughout the delivery period. Futures contracts attempt to fix
the price of electricity ahead of time in order to manage the expenses of future anticipated
consumptions more efficiently. It facilitates the investor in obtaining a position in the electricity
market while avoiding the issues that come with holding the underlying commodity.

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1.6. Major types of Derivative Instruments used across global power markets

Derivative contracts may be traded over-the-counter (OTC) or on a controlled market. OTC

derivatives account for a larger share of the derivatives market. In general, OTC-traded
derivatives have a higher chance of counterparty risk. This uncontrolled parties deal with two
private parties. On the contrary, derivatives that are exchange-traded, on the other hand, are more
generic and highly supervised. (Deng & Oren, 2006)

Derivative
contracts

Over the Exchange

Counter based

Forward Swap Forward Futures Option

Contracts Contracts options contracts contracts

Swing options
Spark Spread Plain Vanilla
options options

Fig 1

Forward Contracts: A forward contract is an agreement between two parties to do a trade at a

future date at a price and quantity agreed upon today. At the moment the agreement is signed, no
money is exchanged.

Options Contracts : These contracts that grant the buyer with certain rights (the right to purchase
or sell an asset for a certain price on or before a specific date) . The option buyer has the right but
not the duty to execute the option.

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Futures Contracts : A futures contract is an agreement to acquire or sell electricity at a defined
price at a future date. To simplify trading on a futures market, futures contracts are standardized
for quality and quantity.

Swaps : A swap is a financial derivative agreement in which two parties exchange the cash flows
or liabilities of two separate financial instruments.

1.7. Status quo of derivative market for electricity in India

The question of whether electricity should be treated as a utility or as a service has long been
debated in our country, with the prevailing opinion increasingly leaning toward electricity being
treated as a commodity and therefore receiving a comparable treatment.

The jurisdictional dispute between the Securities and Exchange Board of India (SEBI) and the
Central Electricity Regulatory Commission (CERC) is almost resolved. India is soon expected to
start with derivative trading of electricity.

The issue began in 2009, when the Central Electricity Regulatory Commission (CERC) refused
to allow MCX India to launch derivative trading in electricity, claiming that CERC clearance
was required rather than that of the former Forwards Market Commission (FMC). The panel was
given the authority to regulate any future contracts.

The status quo is that Multi Commodity Exchange under the regulatory body SEBI will look
after the financial settlement of contracts and on the other side IEX and hopefully PXIL will be
responsible for physical delivery of electricity.

1.7.1. Regulatory setup for derivative markets in Indian Power sector

Under Electricity Act 2003, Section 66 in conjunction with Section 178(2)(y) empowers CERC
to establish new standards for the development of the electricity market, including trading. The
Electricity Act, on the other hand, does not address a situation involving financial transactions.

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If the expansion of trade in the natural gas industry leads to the growth of trade in the power
industry, it is not realistic to claim that CERC can pass laws affecting the growth of the copper
industry in the name of the growth of the power market under Sections 66 and 178(2). (y).

As a result, the issue stems from the definition of "trading" under Section 2(71) of the Electricity
Act. Although CERC has the authority to issue additional rules in the form of guidance under
Sections 66 and 178(2)(y) of the Electricity Act 2003.

1.7.2. Possible outcome from the existing state of affairs

 If CERC is given the authority to control derivatives in electricity, Sectoral Electricity

Regulators will be given the authority to control derivatives in electricity as well. This
would be a serious violation of the Seventh Schedule, as the legislature intended for this
role to be monitored by the Centre rather than state regulators.
 To avoid the development of Systemic Risk, all traders who engage in the derivatives
market must hold a margin account with the exchange in which they trade for that
specific commodity. As a result, if there is a default, it is unsustainable to argue that
SEBI will oversee all other derivative transactions in commodities on that exchange.
 SEBI controls the derivative market to reduce commodity price volatility and
unpredictability. Preventing it from doing so with energy would be a violation of its
mission as a regulator of the Derivative Market.

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 2. Justification of Project

2.1. Distinctive attributes of electricity trading

Electricity has a number of distinguishing characteristics with respect to other commodities:

a) It cannot be stored, once produced it must be delivered to the end user as soon as
possible.
b) Due to lack storage technologies, electricity markets face liquidity crisis (in India).
c) Requirement of balancing market
d) Transmission congestion
e) Operational constraints of generating stations.
f) Price and demand fluctuations in spot market
g) Integration from RE sources
etc.

Fig 2

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Inability to Store: While electricity cannot be stored on any scale, it can be transformed to other
sources of energy that can be stored and later reconverted to electricity on demand.
Transmission Congestion and operational limits: Electricity flows on the basis of Kirchoff’s law.
Hence it is difficult to say where to go or whether or not a line should be overloaded. A single
energy transaction may have an effect on any of all other distribution transactions.
Transmission congestion takes place where there is insufficient transmission capability to meet
all transmission service demands, and in order to ensure continuity, transmission system
operators must re-dispatch generation.
Requirement of Ancillary Service: Ancillary services facilitates grid operators in maintaining a
dependable power infrastructure. Ancillary systems help the grid recover from a power outage by
maintaining the correct distribution and path of energy, addressing supply and demand
imbalances.
Scheduling and Dispatch: Mismatches in supply and demand will always occur due to
complications in the production and delivery processes. It is the responsibility of the System
operator to manage these imbalances.
Contracts are generally ahead of time and System operator combines electricity in real time by
dispatching generation to satisfy demand. (Roy & Basu, 2020)

2.2 Liquidity risks of distribution companies in India

The distribution companies in the country are in distress due to losses and debts. Distribution
companies do not have a liquid alternative market, forcing them to rely on long term PPAs for
the adequacy of capital. This is combined with the difficulty of predicting demand for the next
25 years and the rigidity of payment of capability charges. As distribution companies anticipates
peak load conditions on the basis of its internal analysis and predictions, it enters into pre-
purchase arrangements with power suppliers with final price and quantity obligations. These
deals are either irreversible or have prohibitive costs involved with a situation in which
Distribution companies chooses not to buy the agreed amount of power in the purchase
agreement.

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This is where derivative contracts can be very useful to the distribution companies. One such
scenario is the onset of monsoons earlier than expected, leading to a rapid decrease in demand.
Distribution companies can buy forward contracts for electricity based on projected demand.
And on delivery date based upon the actual demand situation, distribution companies can opt to
easily reverse and close the positions. This not only achieves versatility in forecasts and real
demand management for distribution companies, but also guarantees effective hedging

2.3. Need for the work

The extent of dependence on forward markets is defined by the inefficiency of spot markets in
addressing intertemporal effects such as start-up costs and rampant restrictions, as well as spatial
effects such as transmission line constraints. (De Maere D’Aertrycke & Smeers, 2013)
The foremost intention of introducing derivative contracts in Indian power market is to mitigate
the risk exposures in the energy industry and realizing long term market equilibrium.
Electricity derivatives play an essential role in electricity market restructuring by producing price
signals, offering price discovery, supporting effective risk management, driving capacity
investments in generation and transmission, and enabling capital creation.
Electricity derivatives could address many concerns in the Indian Power Sector.
 DISCOMs have more than 87% of their need tied-up in long-term contracts. The new
market structure will assist distribution firms and open access (OA) players in lowering
their total procurement costs by optimizing their power portfolio, which is now either
prohibitively expensive or impossible due to structural rigidities.
 The Indian spot market remains volatile. Derivative markets will minimize volatility in
the spot market, lowering price risks for players.
 Price convergence across different market sectors will occur as a result of improved
liquidity, improved information, more participation, and re-trade of contracts forward and
derivatives markets. In India, the prices in the bilateral and spot markets continue to
differ.
 Derivative markets will give forward price signals that may be used to evaluate
investment decisions. Buyers will be able to compare their signed purchase agreements to
these costs.

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 3. Business Problem

3.1. Hierarchy in a Power Market

Fig 3

Participants in the electricity market may perform one or more of the following functions:
(1) generate power, (2) transmit/distribute power, (3) market power, and (4) consume power

When energy prices increase, the revenue potential of generators increase, and when energy
prices decrease, the revenue decreases. Meanwhile, price hike increases the risk vulnerability for
utilities and consumers and a decrease in energy price reduces their risk exposures. Consumers,
rather than producers, bore the brunt of the investment risks in producing capacity. As a result,
firms had little incentives to avoid excessive investment costs, and they concentrated on
enhancing and sustaining service quality rather than creating and implementing next-generation
technologies. (Da Fonseca et al., 2016)

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3.2. Risk in power sector

Electricity market changes throughout the world have transferred a large portion of risk away
from consumers and onto producers. Usually, shareholders face all of the liquidity risk and
customers suffer all of the pricing risk, with competitive entry driving generation capacity
toward the intended long-term equilibrium.

Fig 4

The risk would get transferred substantially from the lenders to the consumers. The desired level
of risk allocation in supply side and demand side can be attained by voluntary risk management
practices. Strong regulatory measures assign risks to customers and suppliers by limiting market
price fluctuations and guaranteeing the recovery of investments.

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Once regulatory bodies authorized the construction expenses of a power producing facility, the
expenses would be passed on to customers through regulated electricity rates during the life of
the investment, regardless of the variation in market value over time owing to changing energy
prices, increasing technology, and developing supply and demand situations. (Skouloudis et al.,
2012)
There are challenges in both supply side management as well as demand side management in the
power sector.

• Increasing fuel costs ( coal and gas)

• Increasing surcharges in importing
fuel and raw materials
• Volatility in tariff of mecrchant power
Supply Side Management plants.
Challenges • Must-run status of Renewable energy
impacting trade volumes in RE based
market segments like GTAM, REC
etc.
• Inadequate infrastructure for
evacuation of coal as well as power

• Lack of prepaid metering

• Error in billing
Demand Side Management • Shortage in revenue realization due to
Challenges collection inefficiency.
• Improper utilization of demand response

Fig 5

3.3 Business Objectives and problems of power market participants

In the table further, a probe has been made into the business objectives of various market
participants and the problem / hurdles to the key stakeholders in achieving these business
objectives.

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 Market Business Objective Business Problems
Participants
Generation i. Producing power at optimal cost. i. Intermittency
Companies ii. Procurement of resources and factors of ii. Scheduling
production at reasonable cost. iii. Absence of Ancillary
iii. Profit maximization service market
iv. Maintaining emission
standards/ procuring carbon
emission certificates
System i. Ensuring grid reliability during events like i. Large scale renewable
Operators / outages, load variation, curtailment from integration
Transmission renewable sources and other ii. Volatility in electricity
Licensee contingencies. demand
ii. Offset demand with supply of electricity. iii. Volatility in Ancillary
iii. Accurate Load forecasting service price
Distribution i. Reducing line losses i. High AT&C losses.
Companies ii. Reducing commercial losses ii. Inefficiency in Metering,
iii. Procurement of electricity from generators Billing and Collection.
at cheaper cost. iii. Subsidy regime
iv. Supply electricity to consumers at a price iv. Gap in Annual Cost of
that ensures a significant profit margin. Supply and Annual
Revenue Realized (ACS >
ARR)
v. Burden of Straining Power
Purchase Agreements.
Retail i. Procurement of electricity from at cheaper i. Purchase allocation
Consumer cost from wholesale market. ii. Negotiation & Bidding on
ii. Energy Savings bilateral contract.
iii. Reduction in electricity bills. iii. Scheduling of self-
generation

Table 1

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3.4. Major risk exposures in power sector
The power market is susceptible to these major changes and risks associated with it:
 Dynamics of market structure and changing policies in the past couple of years. However,
the development seems to be proceeding at a steady rate, allowing for more liberalization
and the creation of new business frameworks. Adapting to these developments would be
critical for potential growth.
 Leveraging renewable energy through incentives and introducing policies catering to
climate change.
 With a variety of climate policies in place in the majority of nations, the energy market is
heavily dependent on existing policies at all times. A change in a tax or a subsidy could
completely turn the market toward alternative energy sources.
 High volatility in energy prices and change in electricity demand with the advancements of
technology like Electric Vehicles, Battery Storage etc.
 Today's trend is increasing electricity demand, but stable energy demand, which results in
more unpredictable consumption during the day.
 Market behaviour is expected to respond to rising energy costs as smart metering schemes
are implemented. Initiatives such as the pledge of origin would also have a greater effect
on consumers.
 Financial uncertainties like interest rate risk, exchange rate risk etc. have a significant
effect on profitability. Around the same time, these are the dangers that businesses are
most familiar with and where the most hedging instruments are available.
 Downtime in the electrical grid or in manufacturing is critical for both utilities and power
producers. The growing share of renewables and changing user behaviour make grid
balancing more difficult.
 Power generation and transmission are being increasingly reliant on advanced ICT
systems. The amount of personal information that must be addressed will escalate as smart
metering schemes become more prevalent. Both the possibility of technological errors and
security violations must be carefully handled.

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 4. Research Gap

4.1. Insufficiency in existing research

There are certain insufficiencies or rather areas requiring further attention and improvements in
the existing derivative market models across different countries. Most of these are related to the
precise estimation of energy prices and discernment of the factors that co-relate to these price
movements. (Nossa et al., 2016)

 In most cases, wholesale price discovery method devised considering oligopolistic

market condition but the nature of the electricity market differs across the countries.
 Electricity market remains far less liquid than other commodity markets. Electricity is a
complex asset and traditional derivative pricing methods are ineffective.
 Electricity market remains far less liquid than other commodity markets. Due to its
complexity, traditional derivative pricing methods are ineffective.
 In power markets, distinguishing between on-peak and off-peak electricity prices, or
between pricing corresponding to distinct time periods, such as seasons, is critical.
 Instantaneous fluctuations in the spot market could result in less precise estimation of
consumer price.
 Electricity's non-storability is also anticipated to have a considerable impact on derivative
pricing, particularly on the form and behaviour of the forward curve.
 Volatile market conditions drive the market participants to take rational decisions for risk
mitigation and obtaining optimal results by reducing the possibility of losses by taking
complexity into account.
 Due to transmission constraints across long distances, dependency on local grids or State
transmission utilities increases. And simultaneously off-takers had to rely on local
generating units and power stations despite the electricity price. Hence at such times
derivative contracts would mainly facilitate financial settlement rather than physical
delivery.

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 5. Research Problem

5.1. Shortfalls in research approaches related to implementation of derivative market

Participants across the power market value chain seek predictability in their costs and profits
through hedging strategies, contracts, and active trading as the competitive but unpredictable
energy markets mature. Hedging is necessary due to the unpredictable value of commodity
markets, such as power and natural gas, and the direct effect on income. However, most
businesses will discover that natural hedges occur within their activities that manage a portion of
the risks. (Singh et al., 2019)

5.2. Issues in pricing of derivative contracts

Pricing of derivative contracts is a challenging aspect considering the uniqueness of the

commodity. In-order to mitigate transmission constraints, power generation and consumption
must be in balance at all times, which is a noteworthy feature of electricity derivatives pricing.
Furthermore, the no-arbitrage paradigm does not apply to commodities futures pricing.

Pricing of electricity derivative contracts are based on fundamental and technical indicators. The
fundamental method depends on modelling of system and market operation to arrive at market
prices, whereas the technical method aims to describe directly the stochastic behaviour of market
prices using historical data and statistical analysis. While the first technique gives more realistic
system and transmission network modelling under certain circumstances, the huge number of
possibilities that must be examined makes it computationally costly. As a result, the second
approach would be leveraged for pricing power derivatives. (Benth & Zdanowicz, 2016)

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 6. Research Objective

6.1 Research goals and objectives

The primary aim of risk management is the desire to maximize the firm's value. Hedging adds
value by lowering the chance of financial hardship and the expenses associated with it, or by
lowering the variation of taxable revenues and the corresponding present value of future tax
liabilities.
The research primarily focuses on fundamentals of electricity derivatives and their scope in
India.

The primary objectives behind the research work are:

 To deeply scrutinize the short-term power market in India

 To study various risk management tools that could be introduced in the Indian power
market
 To evaluate the risk exposures of participants in spot market for electricity.
 To study existing derivative market models existing in different countries
 To analyze the feasibility of such market models in Indian scenario.
 To analyze different derivative instruments – Forward, Futures, Options and Swaps
 To critically analyze the function of derivatives across the value chain of the power
industry.
 To evaluate the appropriate approach for pricing of derivative contracts.

The research can also be used by power companies to establish new power trading and load
dispatch strategies in the changing dynamics of power market.

Another goal of derivative contracts can also be to strengthen the relationship between the
different participants in the power market.

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 7. Research Design and Methodology

7.1. Method approached for the research

One major conundrum is to decide the appropriate hedging techniques (forward/future, options,
swap) for a specific market participant. A cautious approach is to analyze the trading constraints
in the existing spot power market for various participants and reciprocatively taking the right
decisions.

The method approached in this particular study is based on a qualitative model and a multi-step
process. Although there are lot of large and small participants in the electricity market but in this
study, we are dealing with the four primary market players – Generating companies, System
Operators / Transmission licensees, Distribution companies and consumers.

In the very first step, the constraints in the existing spot markets for all the major participants is
evaluated. The equilibrium of demand and supply in electricity spot market indicates the clearing
price and volume at which the trade is to be settled. Sellers with offers below this clearing price
and buyers with bids higher than the clearing price are the ones that could participate in that
particular trade. It is not appropriate to say if the spot market is more of a buyer centric or a
seller centric, it doesn’t favour any particular group of stakeholders. But the market dynamics
sometimes favours the producers and at other instances it favours the off-takers. Hence the
favourable market conditions and the strategies adopted by the market participants is probed.

Just like the favourable market dynamics, the kind of risk exposures for individual market
participant will also vary. So, in the next step the types of risk associated with different market
players is scrutinized. Now, in the final phase of the analysis, a comparative study of the existing
models of derivative markets in US and Europe is carried out and their feasibility in Indian
scenario is scrutinized.

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 8. Analysis and Findings

8.1 Constraints peculiar to various market participants in existing spot market

Market Constraints in existing spot market

Participants
a) Maintaining reserves and regulation.
b) Intermittency in renewable sources like wind and solar makes it
difficult for round the clock trading in spot market.
c) Leveraging contribution of renewable energy through recently
Generating launched trading mechanism like GTAM, GDAM could rise
Companies uncertainty in price movement in the existing trading mechanism of
Day Ahead Market, Real Time Market which could be a possible threat
for merchant power plants (thermal – based).
d) Constant ramp up/down of load at conventional generation stations in
order facilitate integration / curtailment of power from RE sources
could increase operational costs of conventional power plants.
e) Fulfilment of Renewable Generation Obligation (RGO).
f) Forced Outage
System Operators / a) Transmission Congestion
Transmission b) Available Transmission Capacity < demand in peak hours
licensees c) Management of Day Ahead schedules along with intraday / Real time
schedules
d) Maintaining of active and reactive power
e) Frequency regulation
Distribution a) Price rise in spot trading which increases procurement cost of power
Companies b) Variation in electricity demand. When distribution companies schedule
their energy supply, they are ignorant of the current demand of their
customer base.
c) Fulfilment of Renewable Purchase Obligation (RPO).
Retail Consumers a) Self-generation forced outage charges
b) Fluctuations in consumption (Large scale consumers)
Table 2
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8.2 Favourable market condition and strategies
Market Favourable Market Condition
Participants
Rise in clearing price at spot market
Generating would increase potential revenue for
Companies generators.
The System Operator is subjected to
various uncertainties in terms of
System electricity demand, generation, etc.
Operators / Hence, a common co-occurrence of
Transmission fluctuations in demand and supply can
licensee assist the system in maintaining
imbalances and provide an incentive.
Distribution Decrease in clearing price at spot
Companies market would reduce the procurement
cost of electricity and simultaneously
the margin between supply cost and
procurement cost would increase.
Retail Consumers' ability to reduce
Consumer consumption enable them to lower
electricity charges
Table 3
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Strategies
a) Optimum offer price
b) Optimum bidding volume
c) Monitoring competitors’ behaviour.
d) Deviation charges on account of demand
fluctuation.
a) Congestion Management
b) Maintaining spinning reserve
c) Separate balancing market / Ancillary
Service market.
a) Hedging against price rise through
financial contracts.
b) Accuracy in price forecasting.
c) Estimating optimum bid price.
d) Allocating appropriate volumes while
procuring power from different modes
(Long term PPAs, bilateral contracts,
OTC, Power Exchanges etc.
i. Optimized generation schedule
ii. Better use of Demand Side Management
in order to reduce the total cost.
iii. Assessment of consumption pattern.
iv. Selling of surplus power
v. Demand Response
8.3. Identification of risk types for various market players

Participants Risks involved

IPPs/ GENCOS Credit Risks, Operational Risk

Transmission licensee / System Operators Congestion, Load balancing, Maintaining reserve,

Grid stability

Distribution utilities Liquidity risk, price and volumetric risk

Table 4

8.4. Comparative study of derivative markets in USA and Europe

8.4.1. USA Model

In the United States of America, market players employ electricity derivatives to cover all
wholesale sales and purchases with or without retail competition. However, whether utilities
participate in forward transactions will be determined in part by how they are regulated. Utilities
will have few alternatives for hedging under rate-of-return legislation and the fuel/purchased
adjustment clause (FAC /PPAC).

Typically, FACs conduct automated rate modifications. This approach ensures that utilities
recoup all power and energy expenses incurred, regardless of intra-rate variation. As a result of
this assurance, regulated utilities have no motive to defend themselves, as long as they are
assured cost recovery and incur no danger if the prices of their imported energy or fuel change.

8.4.1.1 Exchange based models in USA

Various derivative products are offered to market participants on exchanges other than those
controlled by Independent System operators, such as ICE and NYMEX. Both markets provide
peak, off-peak, real-time, and day-to-day futures and options for timeframes specific to the
control zones. Any complaints about customer behaviour in exchanges, such as independent
market monitor, monitoring analytics, real-time power, and so on, will be handled by the Federal
Energy Regulatory Commission.

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8.4.1.2. Hedging Strategies in derivative markets in USA

Participants Derivative Hedging Strategy

instruments
Trading futures, fixed price swaps, and power call options might
benefit a generator with a set per unit rate. If the forward/swap rate
Swap Contracts or the strike price of the call options is more than the fixed cost, the
generator's earnings are guaranteed. (Da Fonseca et al., 2016)
The thermal power plant's operating performance is characterized
by its Station heat rate. In such a circumstance, spark spread calls
will be the ideal instrument for protecting the generator's income
Generating Spark Spread call stream for a particular time period. The financial benefit of holding
Companies (IPPs) options a portfolio of spark spread calls with strike heat rates comparable to
the plant's running heat rate is the same as owning a power plant
throughout the optional maturity period.
If the energy forward market at the generator site is not liquidly
Forward Contacts for traded, electricity forwards from neighbouring trading hubs or even
cross – hedging liquidly traded futures to input fuel can be utilized to cross-hedge
the price of power generation. (Njoh, 2007)

The nodal price differential between the locations of withdrawal

and injection is paid for a 1-MW bilateral exchange between two
Financial transmission network locations. At the same time, a 1 MW FTR
Transmission Rights between two locations is responsible for the difference in nodal
Transmission (FTRs) pricing at the withdrawal and injection nodes. A 1 MW FTR
licensee / System between two nodes is an excellent buffer against unanticipated
Operators congestion charges.

The values of the flow gate rights can be estimated through

auctions conducted by the ISOs. The real-time shadow pricing for
Flow Gate Rights the relevant restricted product, as determined by the Independent
(FGRs) system operator’s security limited economic dispatch method, is
utilized to generate the spot price on which flow gate rights are
centred.
Distribution Forward / Futures Commonly suggested hedge options include low volatility hedge by
companies Contracts buying electricity forwards and futures contracts.

Table 5

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8.4.2. European Model

Model Market Arrangement Countries

The electricity dispatch of the generating Ireland (SEM),
stations is scheduled by the system operator Greece, Most of the
Gross Pool based on least marginal cost of production. In evolved markets in
this type of market arrangement, the generating Europe, Scandinavian
station bid its price and loads are allocated on countries
least cost method.
The off-takers indulges in PPA (Power Croatia, Cyprus
Single buyer model Purchase Agreements) with buyers that Malta and other
provides contractual obligations related to price emerging markets
and volume of electricity to both the parties.
Net Pool Physical contracts are made in advance and are Eastern European
(Vertically Integrated) generally long-term bilateral physical contracts countries
are made within vertically integrated parties

Table 6

8.4.2.1. European OTC derivative market arrangement

Fig 6 Source: The evolution of electricity markets in Europe (book by Edward Elgar)

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An exchange facilitates trading by employing standardised contracts whereas in case of Over-
the-counter market participants conduct bilateral transactions. (Author et al., 2018)

Energy costs are negotiated by bidding zone, which in most cases overlaps with national borders.
A bidding zone is seen by the market as a benchmark for the pricing of contracts in derivative
markets. (Economic Consulting Associates Limited, 2015)

8.4.2.2. European countries with available derivative instruments

Fig 7

(Economic Consulting Associates Limited, 2015)

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8.5. Other significant markets

8.5.1. Derivative instruments in Nordic power market

In Norway derivative contracts are sold both by NASDAQ commodities exchange as well as in
the OTC segment. The price of energy and the volume of supply on all markets are determined
by supply and demand dynamics. Nasdaq Commodities sells electricity futures from the Nordic
countries. Majorly used hedging tools are -: Baseline and peak load futures, Delayed Settlement
Futures (DS Futures), options, and Energy Market Area Differentials (EPAD).

The Swedish Financial Supervisory Authority, is the clearing house and contractual counterparty
in all contracts traded on the financial market of NASDAQ OMX Commodities Europe. The
financial settlement is guaranteed by the clearinghouse. Cash settlement is automated and is
handled by a number of global settlement institutions. (Economic Consulting Associates
Limited, 2015)

8.5.2. Derivative instruments in New Zealand electricity market

In New Zealand, there are two principal markets for derivative tradin: over-the-counter (OTC)
and exchange-traded markets (using the Australian Stock Exchange, ASX).

CfDs, FPFV (Fixed price, fixed volume), FPVV (Fixed price, variable volume), futures, and
options are examples of OTC hedge products.

The following are the characteristics of the New Zealand hedge market:

 Contracts are standardized and transferable

 A clearing house to operate as a counter-party to all trades
 Minimal entry barriers and transaction costs
 Market makers to offer liquidity

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 9. Recommendation

9.1.Value proposition of derivative contacts in Indian power markets

Fig 8

9.2. Using derivative contracts to strengthen the liquidity of distribution companies

Distribution companies are the most important stakeholders in the Indian power sector. The price
at which PPAs are signed appears to be on the higher side. But the distribution companies also
don’t have that many alternatives. In order to ensure and stable supply of energy, distribution
companies end up in long term agreements, despite the fact that the price at which power is
available is very high. However, with the help of financial and derivative contracts, Distribution
companies could sell the forward contracts in return and reverse the position as the physical
supply of electricity takes place. In such a situation, the distribution companies will in effect
have known the selling price of power prevailing when the actual procurement of electricity
exists and not when the PPA has been signed.

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 10. Conclusion

Electricity has become a traded commodity as a result of the reorganization of the power sector.
As a result, power prices became extremely erratic, creating a need for hedging solutions similar
to those seen in other commodity markets. Even while the quantum of transactions on Power
Exchanges has increased since the sector's reform began, electricity remains much less liquid
than other commodity markets. Liquidity is critical in financial markets since it allows for big
order volumes and ensures the ability to buy/sell huge amounts of assets fast without
significantly impacting prices. (Weber et al., 2019)
In most competitive electricity markets, a considerable amount of the energy traded is hedged.
Forward and futures contracts are typically the most important hedging vehicles.
Thus, it can be summarized that businesses that use market risk control techniques backed by a
sound hedging strategy understanding cost effectiveness of derivative contracts end up lowering
their overall costs in the process. In the long run, it would revolutionize the sector by broadening
market access to a wider range of products. Currently, majority of western markets have shifted
to derivatives and spot exchanges, with just a few nations still engaging in long-term bilateral
power trading. With the commencement of derivative trading, the power markets would benefit
from transparent and efficient price discovery for longer-term contracts along the same lines as
the much shorter-term contracts traded on power exchanges.

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