Introduction

In the financial realm, hedging means reducing or if possible, pre-empting the risk of negative movements in the value of financial assets. In other words, it is a kind of preventive mechanism against events that might adversely affect the value of a given set of financial assets and investments. Hedging is not limited to just big corporations and investors but even common people indulge in hedging strategies in varying degrees and forms. For instance, while buying car insurance, one hedges against damages arising due to an accident. In this article, we shall discuss the hedging strategies in energy and electricity contracts.

Why hedging is helpful in Energy & Electricity contracts?

Energy and electricity contracts between large corporations are often based on power purchase agreements between the power producer and the power purchaser. Investors and producers rely on the simple maxim of buying low selling high to make profits. For this, they have to frequently keep a watch over the energy markets so as to know when buying or selling is in their favor. Whereas the producers can be either private or state-run entities or a partnership of both, the purchaser is often a government utility company in many jurisdictions across the world including UAE.

Since worldwide power generation is still by and large based on conventional sources of energy like diesel and coal, Power generating companies are affected by the volatility and risks associated with the global energy supply chain vis-a-vis oil markets. And it’s no secret that global energy and oil supply chain is prone to various natural and geopolitical threats and risks all of which result in price fluctuations.

Different segments of power generation and supply such as production and transmission and distribution have their own risks and uncertainties. To significantly reduce the adverse impact of market fluctuations and price volatilities, parties generally engage in pre-emptive techniques or hedging strategies including customized long-term business transactions, executing several transactions at differing prices, etc.

Different hedging strategies used in power purchase agreements

When it comes to hedging in energy contracts, parties resort to various strategies that include long term and short term contracts, customized power-purchase agreements, dynamic hedging, delta hedging,, hedging tolling contracts, revenue put options, synthetic power purchase agreements, rolling hedges, pure merchant settings, long term and short term hedges in futures contracts, etc. Some of them have been discussed below:

A. Customized Power purchase Agreements (PPA)

This generally applies to power generation and purchase at a very large scale. The purchaser may put such terms and conditions in the power purchase agreement with the producer that may require the latter to pay liquidated damages in case he fails to deliver power as promised on a given schedule.. In certain cases, the producer may be asked to make some security deposits to make the good losses suffered by the purchaser. In big power purchase projects, this serves as a kind of insurance to make the project viable against unforeseeable uncertainties. PPA as a hedging strategy works in the following circumstances-

• Where there is considerable uncertainty with regard to the revenue forecast of the power project and there is doubt about its viability.
• To protect the producer from cheaper or subsidized domestic or international competition where the competitor is generating energy at a cheaper rate.
• Where the power generating company desires some certainty of profits
• Where the purchaser wants to secure the supply against foreseeable failures.

B. Long Term and Short Term Contracts

Investors seek and prefer long term energy contracts due to a greater level of certainty therein as compared to short term contracts. Fluctuations and volatility in the prices of electricity and global energy supply chain primarily result from variations in the demand and supply cycle which are generally contingent on weather. For instance the prices tend to go higher during summers but are relatively cheaper during winters. One should choose the period of the contract wisely taking into account the given facts and circumstances. If you want to stay at a place for more than one year, then it is advisable to choose long term energy contracts because the renewals in case of short term contracts may take a heavy toll on your pockets in case you have to renew them during the most expensive time of the year. However, it doesn’t matter much in many jurisdictions where electricity prices are heavily subsidized.

C. Dynamic Hedging

Dynamic hedging involves reducing price risks by derivative dealers in the securities market by taking various positions in Put Option depending on the changing market conditions. This involves active participation in the short-term market while the approach is of long-term flexibility. This strategy is often relied upon by expert investment managers to mitigate unwanted market crashes or corrections. Using dynamic hedging techniques, the electricity price may be modeled using a deterministic function conditional on joint fuels and demand process.

D. Delta Hedging

The strategy of Delta hedging is often relied upon by expert and professional investors in options trade to reduce the risks associated with the price movements in a given asset and involves the execution of several transactions having equal but opposite delta exposures. Under this, the investor forgoes the directional bias and instead tries to reach a delta neural stage (delta of zero) constant rebalancing of the hedge. This is generally encountered by forwarding trading or future based contracts. However, eliminates price fluctuations by hedging with futures can also limit the scope of future profits in case the prices move favourably. One of the drawbacks of delta hedging is the constant adjustment of positions.

E. Hedging Tolling Contracts

When it comes to energy share-purchase, tolling agreements are based on a historical analysis of the prices of electricity over a period of time wherein the purchaser reserves his right to take the output of the given electricity generation asset by paying a predetermined premium to the asset owner. There is an element of transparency in the tolling method due to the continuous evolution of the energy market and is quite helpful in determining prices in sophisticated transactions.

F. Revenue Put Option

It is a kind of options contract between the concerned power project company and a hedge counter-party (often a bank acting as a financier) in which the parties specify a price floor below. If at any time during the term of the option contract, the revenue falls below this price floor, the opposite party has to pay the difference between the actual revenues from power sale and the pre-determined price floor. It not only ensures that the power project from potential failures but also creates a constant flow of revenue flow during the hedging process.

G. Pure Merchant Setting

Here power investors collect revenue based on spot market trading. Such strategies are not preferred these days as there are a lot of uncertainties about the collections as electricity prices in the spot market are highly volatile and can steadily rise or fall depending on market conditions. Moreover, they have been observed to be not able to sustain investment-grade credit metrics in the long run even if they might seem profitable at times.

H. Rolling Hedges

Rolling hedging involves creating new futures contracts and exchange-traded options to replace the expired ones by awarding the concerned investor a contract with a new maturity date on similar terms as previous ones. This is to ensure a certain percentage of expected cash flow from foreign markets notwithstanding the foreign exchange rate fluctuations. Investors fall back on this hedging strategy when the holding period overshoots the delivery dates of active future contracts.

I. Financial (value-neutral) Hedge

A value-neutral hedge tries to bridge the gap between the value of the Base/Peak contracts and the value of the hourly forecasted load-curve by using an hourly price forward curve (HPFC). HPFC is said to be an abstract forecast of the spot price in the future where the amalgamation of Base and Peak contracts may not correspond to the forecasted demand. This can, however, prove beneficial against proportionate shifts in the price level.

J. Volumetric (neutral) Hedge

In contrast to the previous model, this is used to cut down the differences between the value of the Base/Peak contracts and the value of the hourly forecasted demand and power generation. Such hedges can secure against a drastic rise and fall of price levels between a volatile Base & Peak.

Conclusion

Hedging strategies might prove very useful to investors and developers in highly volatile energy markets. The volatility and the steep rise and fall in electricity prices continent on varied factors such as weather and demand make it quite challenging for the regulators to improve the liquidity of risk management instruments. In such a case a correct application of the hedging strategies as discussed above might reduce the risk if not avert it completely provided one must have an in-depth understanding of these risk management models keeping in mind the overall facts and circumstances and reliable forecasts.