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original version of the final published article in EPRM Dec 2002 issue.
"That Option Called Power" by Anne Ku
As a derivative of other fuels, electricity is an exotic option. Despite the current downturn in energy trading activity, such complex options continue to be structured and embedded in power contracts. Anne Ku surveys both sides of the Atlantic.
Power is complex and exotic. By definition, anything other than a plain vanilla European or American call or put option is exotic. Electric power is a compound option, for energy from a power plant is an option on the capacity, which itself is an option on the input fuels. A power plant is a spread option, for the plant is profitable to run if the output power is more valuable than the input fuel and operating costs.
"Everything in power is exotic," declares Chris Strickland, Director of Lacima Group, who is based in Sydney, Australia. Some typical examples include a capacity option on a facility with path-dependent type characteristics, swing contracts, gas storage and gas supply agreements, fuel supply contracts, and long-dated tolling agreements.
What makes such kinds of options exotic? Strickland points to numerous assumptions about forward curves, volatility, and jump parameters in their valuation. Douglas Coyne, Energy Consultant at The Oxford-Princeton Programme, notes that many exotic options do not have valuation formulas and must be priced through one of several estimation techniques.
One way to initially identify and quantify the optionality found in power contracts and fixed assets is to ask a series of questions (column panel). Exotic options mentioned in this article are explained in greater detail in table 1.
Barry Trayers, options trader at Tractebel USA, Houston, Tx., sees financial options coming back only when a reliable and independent index is produced. The demise of NYMEX electricity futures, recent controversy over certain traders rigging Platts gas prices, and the shift back to voice brokering and bilateral contracts all serve to dampen this price transparency. Without financials, power options have high transaction costs related to the manpower involved in scheduling physical delivery. People are expecting published indices to come out of the formation of Regional Transmission Organisations (RTO). "Once you get indices, options can get more exotic," he says.
Christophe Chassard, VP, Head of Structured Products, RWE Trading, London says that the biggest impact on their business has been the departure of American energy merchants from Europe, leaving fewer counterparties to trade with. "Most of the remaining (especially energy end users) have been reluctant to enter into exotic transactions because they are less transparent, more complicated to understand and/or value. However, as a group, RWE Trading is prepared to do more exotic trades and has, indeed, experienced a noticeable increase in the volume of exotic transactions it has entered into since the beginning of the year."
While the better credit-rated banks may have picked up some good people from energy trading, they still need the underlying physical liquidity. E-lecTrade's president Anil K. Suri sees energy transactions going back to the slow way of doing business, via Request for Proposals (RFP) for the moment. The RFP process allows a case by case arrangement of credit and removes the potential for round-trip trading. As the market recovers, it would look for solutions that provide credit support along with transparency, sort of a modified RFP process. Suri is sure that exotics will stay, given the complexity of serving electricity as a commodity, but they will be largely unhedgeable.
The way out
Trading oil, gas, coal, and power options, Fanis operates in several markets. Cross-commodity options convert the risk of electricity into another commodity that is more suitable and understandable for the customer. For example, an aluminium producer has an electricity contract tied to the price of aluminium rather than power. Because of the synergies between various commodities, you can apply the same pricing and risk management philosophy across different commodities.
With less liquidity, it is more difficult to hedge or lay off risk. Most merchant power assets have lives of 20 plus years, but a majority of these assets are hedged for only the first couple years. A liquid long-dated market doesn't exist. David Goodman, Director of Power Trading for Entergy Koch Trading (EKT) in Houston believes that companies which divest themselves of their trading and marketing capability will still have this risk on their books. "When you take on a physical asset, such as a power plant, you inherently have risk. Trading allows you to hedge out near term risk, while origination (marketing) allows you to hedge out the long term risk, which is less liquid."
awareness of risk
This greater awareness of risk has brought new business to A3-rated EKT, whose exotic portfolio includes precipitation-dependent options, weather-sensitive strike calls, and multiple strike options.
Exotic options embedded in insurance products have also appeared on the scene. Swiss Re's forced outage insurance (ELPRO - Electricity Price and Outage Solutions) behaves like a contingent call option, as the payoff is above a strike price and the call is available only if there is a forced outage or forced derating. ELPRO protects generating units from the operational risks associated with the price of electricity.
Exotic needs of end users
Utilities often give discounts to large customers for the right to interrupt service in periods of extreme prices. Such call options on power prices can be physical, where the end user must curtail consumption, or be financial, where the end user can continue their consumption but must pay the hourly spot price. For many large consumers, the risk and inconvenience of curtailment is well worth the savings.
Similarly, some end users are able to "fuel switch" when it is economically advantageous. They switch diesel or gas for electricity at facilities with on-site power generation capabilities. Others have industrial processes that allow switching. Fuel switching is an option on the spread between power and another source of fuel.
Third party power marketers often exercise "rainbow" options in transitional markets by annually choosing to physically serve or financially serve their long-term customers. To physically serve their customer, they schedule customer load, procure wholesale power and transmit to a utility distribution company. To financially serve, they get service through the utility and pay for the service on customer's behalf.
Victor Belyaev, Quantitative Analyst at PG&E National Energy Group, Bethesda, Md. explains that a power plant's flexibility affects its option value. Although combined cycle units are more efficient than peakers, their slower response to market signals means that they should be modeled as options with continuous daily path-dependent payoff. Plant features that reduce their option value include minimum up and down times, contractual restrictions, and limits imposed on the total number of starts. Features that increase option value include fuel switching capability (rainbow optionality), duct firing capability, and ability to sell power into different pools in the absence of transmission constraints.
"Nobody thought thoroughly about how to manage risk along the supply chain of a vertically disintegrated electricity industry," observes Shmuel Oren, Professor of Operations Research at UC Berkeley, whose research work has been motivated by options in contracts, such as interruptibility of service. "The way to do it is through a variety of financial instruments tailored to specific hedging needs. A forward contract, for example, is not a good hedge for a generator selling its power output. A better hedge is selling a spark spread put option, which accounts for the generator's 'real option' of shutting down when it is not economical."
E-lecTrade's Suri agrees
that such structures are sorely needed. However, he cautions that the high volatility
of electricity may not be hedgeable just by financial instruments or even physical
instruments if the underlying design of the power supply chain is flawed. "The
supply chain of risk has to mirror the physical reality of electricity supply.
End users vary their electricity usage at will, and that variable usage shock
is felt all the way back at the generating station. Unless the industry finds
a way to rationalise that risk in a deregulated environment, history will repeat
itself, leading to more financial losses. Over the next few years, innovative
1 December 2002
column panel: determinants of exoticity