Energy Trading and Risk Management

A Practical Approach to Hedging, Trading and Portfolio Diversification

Iris Marie Mack

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118339343
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

A comprehensive overview of trading and risk management in the energy markets

Energy Trading and Risk Management provides a comprehensive overview of global energy markets from one of the foremost authorities on energy derivatives and quantitative finance. With an approachable writing style, Iris Mack breaks down the three primary applications for energy derivatives markets – Risk Management, Speculation, and Investment Portfolio Diversification – in a way that hedge fund traders, consultants, and energy market participants can apply in their day to day trading activities.

• Moving from the fundamentals of energy markets through simple and complex derivatives trading, hedging strategies, and industry-specific case studies, Dr. Mack walks readers through energy trading and risk management concepts at an instructive pace, supporting her explanations with real-world examples, illustrations, charts, and precise definitions of important and often-misunderstood terms.
• From stochastic pricing models for exotic derivatives, to modern portfolio theory (MPT), energy portfolio management (EPM), to case studies dealing specifically with risk management challenges unique to wind and hydro-electric power, the bookguides readers through the complex world of energy trading and risk management to help investors, executives, and energy professionals ensure profitability and optimal risk mitigation in every market climate.

Energy Trading and Risk Management is a great resource to help grapple with the very interesting but oftentimes complex issues that arise in energy trading and risk management.

CHAPTER 1
Energy Markets Fundamentals

For sake of clarity, we will focus quite a bit of our attention on electricity markets because the generation and transmission of electricity are two of the primary reasons for the existence of energy markets. In addition, I have spent a part of my professional and academic career studying and working in the electricity markets (Mack 1986, 1999). However, please note that other energy products (oil, gas, etc.) will be discussed as well.

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The generation and transmission of electricity are two of the essential reasons for the existence of energy markets.

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Power and energy are two words often confusingly interchanged. These two key terms are summarized in Figure 1.1 and more rigorously defined as follows:

FIGURE 1.1 Power and Energy

• Power is the metered net electrical transfer rate at any given moment. It is measured in megawatts (MW). A watt is equal to one joule per second. The joule is a derived unit of energy, work, or amount of heat in the International System of Units.
• Energy is electricity that flows through a metered point for a given period and is measured in megawatt-hours.
• Electric power is the rate at which electric energy is transferred by an electric circuit. The instantaneous electrical power P delivered to a component is given by

Where P(t) is the instantaneous power (measured in watts)

• V(t) is the potential difference (or voltage drop) across the component (measured in volts)
• I(t) is the current (measured in amperes)
• MWh (megawatt-hour) is a unit of energy
• MW (megawatt) is a unit of power

Consumer energy demand, load profiling and forecasting drive power generation and transmission. Specifically, power transmission patterns are determined by location and size of load. In addition, transmission congestion is responsible for significant price volatility in electricity markets and in fact is a primary market driver.

Electricity derivatives may be structured to protect market participants from exposure to price fluctuations, volume risks, high volatility, and so forth. Some examples of electricity derivatives are options, price swaps, basis swaps, futures, and forward contracts. We will discuss electricity derivatives and their pricing models in great detail in Chapters 3 and 4.

The electricity markets are segmented into the submarkets highlighted in Figure 1.2 (Burger, Graeber, and Schindlmayr 2007).

FIGURE 1.2 Electricity Submarkets

1. Physical forward and futures markets
2. Spot market
3. Intra-Day market
4. Balancing and reserve
5. Congestion revenue rights (CRRs), financial transmission rights (FTRs), and transmission congestion contracts (TCCs)

We will now take a closer look at these segments of the electricity markets.

1.1 PHYSICAL FORWARD AND FUTURES MARKETS

A forward contract is a nonstandardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today. An electricity forward contract can be either a financial contract or a physical contract (Figure 1.3).

FIGURE 1.3 Forward Contract

• If a forward contract is settled before its maturity date, it is a financial forward contract since no electric power is physically delivered.
• A forward contract is a physical contract if the electric power is delivered physically.

The seller of a physical forward contract is obligated to physically deliver power to a location specified in the power contract (the hub). The forward contract does not specify the location at which the power is generated or consumed. However, the power contract states that the seller is responsible for delivering the power from the generator location to the hub, and the buyer is responsible for delivering the power from the hub to the load location. For both counterparties, this may involve purchasing additional transmission contracts, or purchasing/selling power through the spot market (Skantze and Ilic 2000).

A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and qualit...

Table of contents

• Cover
• Series
• Titlepage
• Copyright
• Dedication
• Preface
• Acknowledgements
• About the Author
• About the Contributors
• Chapter 1: Energy Markets Fundamentals
• Chapter 2: Quant Models in the Energy Markets: Role and Limitations
• Chapter 3: Plain Vanilla Energy Derivatives
• Chapter 4: Exotic Energy Derivatives
• Chapter 5: Risk Management and Hedging Strategies
• Chapter 6: Illustrations of Hedging with Energy Derivatives
• Chapter 7: Speculation
• Chapter 8: Energy Portfolios
• Chapter 9: Hedging Nonlinear Payoffs Using Options: The Case of a New Subsidies Regime for Renewables
• Chapter 10: Case Study: Hydro Power Generation and Behavioral Finance in the U.S. Pacific Northwest
• Bibliography
• Index
• Wiley End User License Agreement