Instrument

Definition

Examples

Swap

"fixing the uncertainty"

An exchange of cashflows or physical delivery. Most common is the "fixed for floating," enabling a counterparty to lock-in the exposure to floating prices.

Contracts for Differences (CFD) in the UK power market. The Electricity Forward Agreement (EFA) in the UK is effectively a swap that indexes off the UK Pool which is responsible for physical delivery of power. Both CFDs and EFA’s are financially settled.

Plain vanilla option

"insurance policy"

"the ability but not the requirement"

Call options: the right but not the obligation to purchase the underlying product at a fixed price

Put options: the right not the obligation to sell the underlying product at a fixed price.

Unlike a swap, an option allows you to benefit if the uncertain situation turns in your favor.

Buy a call option if you need to buy more power. Buy a put option if you need to sell more power.

Capacity is equivalent to a call on the generation process (i.e. power plant, etc.). Energy is a call on the fuel - concept of converting one type of energy into another.

Strip of calls or puts

A series of call options: cap

A series of put options: floor

Capacity reservation: the right to have access to capacity on a daily basis for a month translates to a strip of daily calls.

A floor ensures generators can sell at a given price in the future without being obliged to do so.

Spread option

"power station"

"oil refinery"

Option on the difference (in price) between two underlying products. Can also be thought of as "giving" one product and "taking" the other. Give or take a spread. One product is the input, the other is the output.

Anything that converts one form of energy into another, in which one can decide when to do it. A power station is a call option on the difference between power and gas. A spark spread is an option on gas and power price. If price of power in the market is more expensive than converting gas into power, then burn your gas and sell your power.

Crack spread: oil refinery produces a higher quality fuel (gasoline, heating oil, etc) from crude.

Asian option

Option on the average of prices over a period of time. It is a cheaper form of hedging as it is not sensitive to short term price fluctuations.

An inflexible power plant such as that used for baseload generation can’t be switched on and off in a day, but can be turned on one week and off the next. The decision to run it depends on average power price for the week.

Swaption

Option on a swap: the right but not the obligation to enter into a swap.

EFA option: when you exercise this option, you enter into a swap.

Boption

Basis option: option on the transmission of power.

If power is more expensive in one region than another (including transmission cost), then exercise this option.

Best Of option

Choosing the best out of a set in which all are similar in some way: types of fuels, sources, transmission criteria, etc.

You choose the cheapest of different types of fuels to convert into electricity. An aluminium producer has a Best Of option on its fixed price electricity contract and its workers. When power prices are high, it shuts down operation and sells the power. When power prices are low, its workers produce aluminium.

Extendible swap

Called a swap, but this is actually an option at the end of the swap. It is exercised close to the end of the swap.

Do a one month transaction. At the end of it, you have the right to extend for another month.

Barrier option:
knock-in, knock-out.

A contract that causes an option to come into existence (knock-in). A trigger event such as some preset price level kicks the deal into effect or terminates (knock-out) the deal.

Knock-in call: You have the right to buy power if the price falls to a preset price.

Knock-out call: You have the right to buy power at $10/MWh, but if it moves above $20/MWh then the deal falls apart. These types of options are embedded in contracts, not traded.

Swing

Option on volume: most important of all. There are two types of exercise.

Non-ruthless exercise by consumers who simply use power whenever needed.

Ruthless exercise by utilities who "swing" for profitability reasons, symbolic of wholesale market.

Non-ruthless exercise:

Utility sells a contract to a large industrial end-user. Classic is the aluminium smelter plant which either uses all or nothing.

Ruthless exercise:

Utility A trading with utility B in the same city in the same market. The amount traded depends on price of power at the time.

"Rock and bop swing swap"

Basis swing option: Swing option between two locations

A buyer takes a contract between two regions – but can change volume during the period.

Embedded swing option

"interruptible power"

Sale of a swap simultaneous with purchase of a swing option from the same party.

Load curtailment contract: utility sells industrial users a lower priced (i.e. discounted) swap but utility gets the right to not deliver power fixed number of times in the period. This parallels what’s called a "range forward" in the foreign exchange market.

Compound option

Option on an option

Instead of building new power plant, a utility buys a compound option from a power marketer which gives the ability to call on a second option some time in the future. The utility thus has access to power if needed without the risks of building or owning a power plant.