The Hindu Business Line : Fusion of energy economics with financial engineering

Before liberalisation, integrated utilities were not exposed to significant financial risks, narrates Pierre Lederer, Chief Operating Officer, EnBW Energie Baden-Württemberg AG, in his foreword to Managing Energy Risk by Markus Burger, Bernhard Graeber and Gero Schindlmayr ( www.wiley.com ).

“Regulated, cost-based tariffs for electricity and gas allowed utilities to pass on all costs incurred to their end customers. Liberalisation has created competition in the energy sector and end user prices have become market based instead of cost based.”

In energy markets, many risks are fundamentally related to underlying cost structures, explains Lederer. “For example, electricity prices are not independent of fuel and CO{-2} prices.”

The book is special, as a ‘fusion of energy economics approaches, including fundamental market models, with the financial engineering approaches commonly used in banks and other trading companies.’

For instance, the SMaPS (spot market price simulation) model uses ideas from the fundamental market models and stochastic time-series theory to model electricity spot prices. “The model can be used in situations where load and prices are considered as stochastic, e.g. full service electricity contracts.”

Electricity is a particular case among commodities because it is hardly storable, the book notes. “An implication of non-storability is that the relationship between spot prices and futures prices cannot be described with cost of carry.”

Marginal costs of the supply side as described in the so-called ‘merit order curve’ determine the price to a large extent. “If total load is low, plants with the lowest variable production costs are used as a priority. When the total load is high, gas or oil fired plants with high fuel costs are utilised.”

A chapter on ‘risk management’ begins with a discussion of ‘risk map’ that depicts price, volume, credit and other risks. First, the position of the entire portfolio has to be determined, the authors instruct.

The ‘energetic position’ is all the more important for ‘market participants with assets such as exploration fields, pipelines, or power plants.’ You’d need to include, in the energetic position: the option delta, the financial leg of indexed contracts, and futures contracts (even if there is no physical delivery).

Among risk measures, the most popular one is VaR (value-at-risk), say the authors. However, while VaR is adequate for short holding periods and for price risks concerning the future market, a liquidity-adjusted VaR can be useful for ‘voluminous portfolios where market risks cannot be eliminated in a short holding period.’

If the energy products cannot be traded on the future market and therefore a market risk exists until delivery, you may resort to measures such as PaR (profit-at-risk), EaR (earnings-at-risk), and CFaR (cashflow-at-risk). These measures ‘integrate spot market prices and give a separate view on the market risk.’

An example given in the book is of hourly profiles in the power market that can be traded on the spot market, but there is no future market for power delivered for one hour only. “Because the distribution of spot prices is often heavy-tailed, the assumption of a log-normal distribution is not adequate.”

In the pre-liberalised era, credit risk was mainly about customers who could not pay for the energy obtained. “Contracts between utilities were not regarded because the risk of a default of a utility seemed to be negligible.” But then came a series of high-voltage hits: “What the collapse of Barings Bank was for financial institutions, Enron was for the energy industry. Additionally, there was the insolvency of US American energy merchants such as Dynegy, Mirant and El Paso…”

Power read.

D. MURALI

http://BookPeek.blogspot.com

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