What is financial hedging?
Derivative Overlay (financial hedging). A derivative overlay is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate and is often called the “underlying”. They can be held till expiry or can be traded.
What is the purpose of using derivative overlay?
- To hedge a company’s power price exposure risk
- To minimize and diversify the dependence on utility suppliers
- To be able to act quickly in the market when attractive power price opportunities arise
How does power derivative work?
An authorized Treasury Group stakeholder hedges up to several years in advance a fixed price (strike price) for electricity on a given Baseload tranche with a third party. This is a financial agreement amongst the financial community other than the incumbent physical electricity supplier.
Banks usually align their quotes with futures seen on the power exchange. That price will then become a financial commitment for both parties on that given tranche: Bank and Treasury Group. In parallel, the Electricity supplier will deliver physical electricity for the equivalent volume, billed with Day-Ahead market price. The difference between the 2 prices will be borne either by a Bank or a Treasury Group.
If a strike price agreed is higher than the day-ahead electricity market, then the company’s Treasury Group owes money to the Bank and wise versa. If the strike price is lower than the day-ahead price index, Bank owes money to the Treasury Group.
Pros
- Hedging without a supply contract. Financial counterparties make a bet on the out-turn price of a reference index. It is independent of any supplier contract. Anything can be hedged, which is offered by the counterparties. High volumes can be easily hedged. (20MW+ tranches)
- Good liquidity. Financial counterparties are market makers. They can offer reasonable prices. This could allow fixed electricity price visibility up to several years
- Multiple counterparties are available. Treasury already has credit lines set up with some financial counterparties. Position can be taken with multiple counterparties.
- Volume aggregation is possible. Good solution if there are multiple entities with exposure to the same commodity market and priced based on the same index e.g. Brent, ULSD, TTF gas, etc.
Cons
- Supply price and net position are detached. Supplier prices the volumes on day-ahead (DA) price and invoices that. Parallelly financial counterparties issue credit or debit notes based on swap legs. There can be multiple credit and debit notes toward Treasury and from Treasury. Reporting can be complicated.
- Additional audit and reporting requirements. Companies that execute financial hedging must comply with relevant regulations. Hedge books must be created for each counterparty to track net position with them and also to be able to track total net position for a period. Mark-to-market reports should be created.
- Financial exposure. Forward swaps by nature have a higher default risk than futures as there is no centralized cleaning house for those transactions. Positions are settled monthly after maturity and when a floating leg is available.
- Imperfect hedge in terms of price. The floating leg defines the settlement amount between the parties. The average monthly price used by the supplier most probably is different as it’s a volume-weighted average price (WAP). The difference between the simple average and the WAP is an additional risk.
- Imperfect hedge in terms of volumes. Potentially not all volumes can be hedged as financials can be done only for well-defined volumes, not for percentages.
Therefore, although power derivatives can lead to internal operational, accounting, and reporting complexities, this instrument can help protect against future commodity price rises while minimizing supplier dependence.
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