Hedging Strategy and Electricity Contract Engineering - IFOR

04
04
2.7 Electricity contracts 29
Price
3
Price
3
Price
3
Floa1 ting
2
Time
2
Time
2
Time
With cap With cap and floor
5
Fig. 2.10: Effect of caps and floors.
of geographically distinct spot prices, but all derivatives are based on a fictitious
so-called system price. 22 The spot prices may however differ from the
system price, meaning that if a player hedges the uncertain spot price at one
location through, for example, a future based on the system price (since this is
the only available underlying) he will not be perfectly hedged. The player will
be fully exposed to the difference between the spot price and the system price,
and will carry a so-called basis risk. 23 This is an example of why the contract
for difference was brought to the market. This contract allows players to hedge
against locational price risk and these types of contracts are called locational
spread contracts. The buyer of such contract is obligated to change electricity
at a predefined location A for electricity at another predefined location B at a
given price K . These contract are however often cash settled and the payoff is
naturally given , by S A S B K , where S A denotes the price at location A
-
and S B the price at B.
2.7.2.7. Swing option
The OTC contracts described so far are basically used to, except for delivering
electrical energy, transfer the price risk 24 from one player to another. A user of
electricity may however not know how much electricity he will need and hence
hedge. This uncertainty known as volume risk consequently needs to be managed
as well. Hence many OTC contracts have a flexible underlying volume of
electricity. The buyer of such a contract has the right to swing his load, that is
22 The system price is the price that would apply if there were no transmission congestions.
The Nord Pool system will be discussed further in Chapter 2.8.1.
23 Basis risk and other risks are defined in Chapter 3.3
24 See Chapter 3.3 for more information on the different risks