Hedging Strategy and Electricity Contract Engineering - IFOR

2.7 Electricity contracts 27
2.7.2.2. Indexed contract
For many industries the electricity cost makes up a substantial part of the total
costs. An uncertain electricity price thus makes the total costs uncertain.
Further, for many industries the price of sold goods makes up for most of the
uncertainty on the revenue side (together with the amount of sold goods). One
way to hedge against these two risks would be to buy electricity on a fixed price
basis and sell the produced goods on a fixed price basis. This could theoretically
be arranged for by using future contracts. The problem is that the amount
of electricity and sold goods is not exactly known, why a perfect hedge against
the two price risks is not achievable. This volume uncertainty can however be
avoided by linking the electricity price to the output price. The electricity market
offers such so-called indexed products for some industries. The electricity
price that the player pays is determined by an index, based on, for example,
aluminum prices. An aluminum producer could through such an indexed contract
hedge the margin, given by the ratio between costs and revenues to assure
a fixed margin. This is of course a simplification of the reality, since also other
costs may vary, such as personal costs and costs of other input resources. Still
the electricity-output spread will be hedged. An American utility, Bonneville
Power Administration already in 1985 introduced aluminum-linked products.
2.7.2.3. Cross-market contracts
Whereas an electricity consumer may be interested in an indexed contract to
offset some of his risks, a producer may be interested in so-called cross-market
contracts. The fuel costs for a thermal producer makes up the absolute majority
of the variable costs and a substantial part of the total costs. Such a producer
may therefore want to hedge away the fuel price uncertainty. The amount of
fuel to hedge is however unknown, since it depends on the future dispatch, 19
why a normal future or forward hedge will not do the job. Instead, there are
products linking fuel price with electricity price to offset this spread risk. These
cross-market contracts can be a fuel-electricity swap for example, or options on
this swap. A widely used cross-market contract is the spark spread option. 20 A
19 As will be shown in Chapter 4 the future optimal dispatch will for most plants depend
on unknown stochastic factors, such as electricity prices and demand.
20 The spark spread will be discussed more in Chapter 4.