Electricity Derivatives

Context:

The National Stock Exchange (NSE) has received in-principle approval from the Securities and Exchange Board of India (SEBI) to launch electricity derivatives. The announcement was made during the NSE’s fourth-quarter earnings analyst call.

Key Features of Electricity Markets and Derivatives

This chapter outlines the unique characteristics of electricity, the structure of electricity markets, and introduces market-specific derivatives, focusing on features that directly affect pricing and trading.

Key Properties of Electricity Affecting Markets

• Non-Storability
  • Electricity cannot be stored economically at scale.
  • This makes real-time balancing of supply and demand crucial.
  • Strongly influences market volatility and price formation.
• Transport Constraints
  • Electricity is location-specific due to transmission limitations.
  • There is no truly global or regional electricity market.
  • Markets are fragmented: each country (or even sub-region) has its own localized market.

Electricity Market Microstructure

• Fragmentation
  • Unlike gas or oil markets, electricity markets lack international homogeneity.
  • Every country has a distinct market design, regulatory framework, and pricing mechanism.
• Common Structural Features
  • Despite fragmentation, most electricity markets share:
    • A day-ahead market (based on forecasts)
    • Intraday and real-time balancing markets
    • Use of merit-order dispatch and marginal pricing

Electricity Derivatives

• Purpose and Use
  • Used for hedging price risk due to high volatility.
  • Commonly used by:
    • Utilities (both generators and retailers)
    • Large consumers (e.g., manufacturers)
• Types of Derivatives
  • Futures and forwards: Lock in prices for future delivery
  • Options: Offer flexibility with the right but not the obligation to trade
  • Contracts for difference (CfDs): Common in regulated markets for stabilizing revenue
  • Spread contracts: Hedge price differentials between locations or time periods
• Market Participants
  • Varying strategies depending on:
    • Size of the utility (large vs. small)
    • Nature of business (generation vs. retail)
    • Risk tolerance and access to capital markets

How Derivatives Exchanges Work

• Market Mechanism: Continuous auction where prices are set via supply-demand bids.
• Benefits:
  • Price transparency.
  • Predictability for producers and consumers.
• Participants: Mostly large corporations, banks, and trading firms.
• Barriers to Entry:
  • High capital requirements.
  • Daily financial reporting and transaction capabilities.

Trading Electricity vs. Financial Markets

Understanding the electricity wholesale market requires recognizing how electricity trading differs from traditional financial asset trading.

Key Differences Between Electricity and Financial Market Trading

• Instant Production and Consumption
  • Electricity must be produced and consumed in real-time.
  • Unlike commodities (e.g., oil) or financial assets (e.g., stocks, bonds), electricity cannot be stored efficiently at the wholesale level.
• Real-Time Market Balance
  • Continuous balancing of supply and demand is essential to maintain grid stability.
  • Market design is based on immediate delivery, not future settlements.
• Market Design
  • Electricity markets operate on a day-ahead or intraday basis, requiring precision forecasting.
  • Pricing reflects real-time constraints such as demand spikes, generation failures, or weather variability.

BS