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									Electricity derivatives

The case for financially
settled contracts
Banks and hedge funds have shied away from trading electricity due to fear and
ignorance of the physical nature of the market. But, as Todd Bessemer of Accenture
points out, f inancially settled contracts can avoid the complexity of physical
delivery and could help bring liquidity to power markets
          orward contracts represent an                           variation margin), except the final settle-   eSchedules are a transfer of financial

F         obligation to exchange an
          underlying product at a future
          date, according to pre-agreed
terms. When a forward contract reaches
maturity – in other words, the delivery
                                                                  ment is based on an external reference
                                                                  price, rather than an internally derived
                                                                  settlement price.
                                                                      All things being equal, financial
                                                                  settlement provides a far simpler solu-
                                                                                                                obligation only, and have no direct
                                                                                                                impact on the physical scheduling of
                                                                                                                electricity. Submission of physical
                                                                                                                schedules, along with spot market bids
                                                                                                                and offers, occurs through a totally inde-
period arrives – this obligation is                               tion than physical delivery. However,         pendent set of processes associated with
discharged in one of two ways, depend-                            are all things equal? To address this         unit commitment.
ing on contract specification:                                    question, we look at the specific case of         While participants may choose to
                                                                  Pennsylvania-New       Jersey-Maryland        submit physical schedules that are
● Physical delivery: The seller must                              (PJM) region electricity.                     consistent with their forward contracts,
  deliver the underlying product to the                                                                         they are under no obligation to do so. As
  buyer in the agreed quantity, with the                          Outcomes are unaffected                       a result, for a PJM forward contract the
  buyer making payment at the agreed                              Currently most forward electricity            concept of physical delivery is actually
  price. These contracts are often                                contracts within PJM are deemed to be         a non sequitur, a conclusion that can be
  referred to as ‘physicals’.                                     physicals. However, exactly the same          extended to any electricity market based
● Financial settlement: The seller and                            outcomes – both physical and financial        around a reliable, underlying spot pric-
  the buyer exchange cash payments,                               – can be achieved through the use of          ing mechanism.
  based on the difference between the                             swaps. To understand why, it is impor-            Financially, the process of physical
  agreed contract price and a pre-                                tant to examine how the current delivery      delivery requires the following payment
  defined index price. These contracts                            process works.                                flows:
  are often referred to as swaps or
  ‘contracts for difference’ (CFDs).                              Physical delivery process                     ● Forward contracts: Settled bilater-
                                                                  When a PJM forward contract goes to             ally between the buyer and the seller,
    In electricity markets, physical deliv-                       delivery, the standard procedure is for         at the agreed price and quantity.
ery is by far the more complicated of                             the contract counterparties to lodge an       ● eSchedule: Settled through PJM, for
these two options, particularly in                                eSchedule with PJM, specifying loca-            the quantity specified in the eSched-
commodity markets such as electricity,                            tion, date/time range and hourly quan-          ule, in each hour, multiplied by the
as issues such as transmission service                            tities. This eSchedule results in a             spot market price in that hour, at that
and real-time generation must be                                  transfer of settlement obligation in the        location.
factored into any contract. The delivery                          PJM spot market.                              ● Spot market: Settled through PJM,
process becomes further complicated for                               It is important to emphasise that           for the spot market quantity – which
cleared products, with clearing houses
making use of a number of specialised         Table 1: Example of physical delivery process
delivery processes, including the match-
ing of open positions for delivery, assess-                                 A                    B                C                 D              PJM
ment of delivery margin, verification of      Forward contract: A–B       $4,950              –$4,950
delivery and payment, and so on.              Forward contract: B–D                           $1,700                             –$1,700
    By contrast, financial settlement         Forward contract: D–A      –$1,750                                                 $1,750
only requires the exchange of cash,           eSchedule: A–B             –$6,000               $6,000                                                $0
which in turn depends on the existence        eSchedule: B–D                                  –$2,000                            $2,000              $0
of a reliable, independently determined       eSchedule: D–A             $2,000                                                  –$2,000             $0
index suitable for use as a reference         Spot sales/purchases       $4,800               –$4,000           –$800                                $0
price. For cleared products, contract         Total                      $4,000               –$3,250           –$800              $50               $0
settlement uses exactly the same process                                                                                                     Source: Accenture
used for daily mark-to-market (namely,

20   I May 2003
Electricity derivatives

   may differ from that contracted for in                     the forward market – multiplied by               and not to trade as the delivery period
   the forward market – multiplied by                         the spot market price in that hour, at           approaches. In a financially settled
   the spot market price in that hour, at                     that location.                                   market, however, the trader can
   that location.                                                                                              choose to go through to financial
   This is illustrated by table 1, for a                       As is clear from table 2, this produces         settlement. This encourages non-
single hour of the contract period, where:                 different payment flows, but the same               physical players to stay in longer,
                                                           net financial outcomes.                             knowing that in the worst-case
● A is a net seller in the forward market                      If physical and financial outcomes              scenario they can still cash out through
  and is also selling additional energy                    are the same, why move to financial                 the financial settlement process. The
  into the spot market.                                    settlement? In addition to being a                  resultant increase in the participation
● B is a fully hedged purchaser with                       simpler process, financial settlement               of non-physical players can aid liquid-
  matching forward and spot positions.                     also provides a number of other benefits            ity as the contract develops maturity.
● C is purchasing only in the spot                         compared with physical delivery:                  ● More conducive to shorter-term
  market.                                                                                                      markets: The trading cut-off required
● D is an arbitrageur participating only                   ● Extends trading expiry date: Physi-               for physical delivery – normally
  in the forward market.                                     cally delivered contracts often                   around three business days prior to

   For the sake of simplicity, the differ-
ences between outcomes in the PJM real-
time and day-ahead hourly markets are         The key unresolved issue regarding the design of a financially
not addressed.
                                              settled PJM contract is whether final settlement should be
Financial settlement process                  based on real-time or day-ahead hourly prices
PJM Interconnection calculates and
publishes hourly prices, on both a real-
time and day-ahead basis, for an exten-
sive number of individual and aggregate                      require trading to terminate around                commencement of delivery – is not
points within the PJM market.                                three business days prior to                       conducive to the trading of instru-
    As well as being used by PJM for                         commencement of the delivery                       ments less than a month in duration.
settlement of the spot market, these prices                  period, so that delivery arrangements              By dispensing with this constraint,
also represent a reliable, independently                     can be finalised. Financially settled              financially settled contracts can be
determined reference which may be used                       products allow trading to occur right              offered in smaller time blocks, such
to derive indexes for financially settled                    through until commencement of                      as daily, weekly and rest-of-month.
forward contracts. US regulator the                          delivery. In fact, for contracts based             These products are very important for
Federal Energy Regulatory Commission                         on a monthly average, such as elec-                fine-tuning risk exposure in
obliges all electricity spot markets in the                  tricity, trading could continue right              commodities like electricity, where
US – PJM included – to make this data                        into the delivery month.                           price and demand are heavily depend-
available free of charge.                                  ● Encourages liquidity from non-physi-               ent on near-term factors like weather.
    By their very nature, financially                        cal traders: One of the key fears of
settled derivatives have no direct impact                    non-physical players, such as specula-          Time for a new PJM contract
on the physical scheduling process.                          tors and market locals, is that as the          It is possible to develop financially settled
Financially, the use of swaps involves the                   expiration of trading approaches, they          instruments for PJM Electricity that
following payment flows:                                     will be stuck with open positions in a          achieve exactly the same physical and
                                                             contract that they have no ability to           financial outcomes as the physically
● Forward Contracts: Settled bilater-                        deliver. This is of particular concern          delivered contracts currently in common
  ally between the buyer and the seller,                     in thinly liquid markets such as elec-          use, while providing significant addi-
  for the agreed quantity, multiplied by                     tricity, where reversing a position in a        tional advantages. What, therefore, should
  the difference between the agreed                          short timeframe can be extremely                a redesigned PJM contract look like?
  price and the reference price.                             difficult and expensive. To avoid this               The monthly contract is the basic
● Spot Market: Settled through PJM,                          situation, many of these potential              building block of exchange-traded deriv-
  for the spot market quantity – which                       liquidity providers choose to get out           atives. Risk exposure in the cash market,
  may differ from that contracted for in                     of their positions well ahead of time,          however, occurs on a far shorter time-
                                                                                                             frame. The key to creating a successful
  Table 2: Example of financial settlement process                                                           forward market in electricity is bridging
                                                                                                             this hedging gap, through the availabil-
                                  A                B         C                  D              PJM           ity of shorter duration contracts. But
 Forward contract: A–B         –$1,050           $1,050                                                      these instruments must still relate back
 Forward contract: B–D                           –$300                       $300                            to the more common monthly contracts.
 Forward contract: D–A          $250                                         –$250                                One effective way of achieving this is
 Spot sales/purchases          $4,800           –$4,000   –$800                                  $0          to define a financially settled monthly
 Total                         $4,000           –$3,250   –$800               $50                $0          contract which, as the delivery period
                                                                                         Source: Accenture
                                                                                                             approaches, converts into a strip of daily
                                                                                                             contracts. Rather than the original

22   I May 2003
 monthly contract settling against the                                     physical dispatch. As a result, forward          There is no consensus amongst
 cash market index, each of the daily                                      contracts based on real-time prices          industry players regarding the better
 contracts would cash out separately.                                      provide a better hedge against actual        approach to take. Current practice for
 These dailies would also continue to                                      physical exposures. Day-ahead prices do      physically delivered contracts, however,
 trade into the delivery month, right up                                   not take account of on-the-day demand        is to lodge eSchedules based on real-
 until the day-ahead hourly market                                         fluctuations or any operator recommit-       time prices. The minimalist solution,
 commenced for that day. Daily contracts                                   ment of units for reliability reasons.       therefore, would be to replace the exist-
 could trade both individually and as                                                                                   ing physical contract with an analogous
 strips, allowing short-term and rest-of-                                  Day-ahead prices                             financially settled instrument based on
 month exposure to be hedged.                                              The bulk of physical electricity in PJM      real-time prices. Another potential solu-
     The key unresolved issue regarding                                    is currently scheduled through the day-      tion that has been suggested is to list two
 the design of a financially settled PJM                                   ahead market. While not providing a          separate contracts, based on real-time
 contract is whether final settlement                                      perfect hedge against physical outcomes,     and day-ahead prices respectively. The
 should be based on real-time or day-                                      day-ahead prices provide a better indica-    market could then make its own deci-
 ahead hourly prices. Strong arguments                                     tion of the actual prices paid for most      sion, through uptake. EPRM
 exist for both points of view:                                            physical/cash market purchases.
                                                                               Financial Transmission Rights (FTRs),     Todd Bessemer is a senior manager in
 Real-time prices                                                          PJM’s in-built instruments for managing       the Competitive Energy Markets practice
 The real-time market is the true spot                                     locational basis risk, are based around       at Accenture.
 market, with prices based on the actual                                   prices in the day-ahead market.               e-mail:

Financial flows for cleared products

The physical and financial outcomes for cleared              market – multiplied by the spot market price        house on a daily basis, based on mark-to-
products are identical to those for non-cleared,             in that hour, at that location.                     market against that day’s settlement price
though there are some differences in financial                                                                   for all open positions.
flows – a result of clearing house processes               The physical delivery process is shown in         ■   Forward contract (final settle): Settled
such as variation margining and final                   table 3, for a single hour of the contract               between each counterparty and the clearing
settlement/delivery. The financial flows for both       period. In this particular case, it is assumed           house, based on a final mark-to-market of
physically delivered and financially settled            that Nymex is the clearing house for all                 all open positions against the contract’s
cleared products are shown below.                       contracts. A and B are matched for delivery,             external index price.
                                                        as they are the only parties with net open           ■   Spot market: Settled through PJM, for the
Physical delivery process                               positions at the expiry of trading.                      spot market quantity – which may differ
The process of physical delivery for cleared                                                                     from that contracted for in the forward
forward contracts requires the following                Financial settlement process                             market – multiplied by the spot market price
payment flows:                                          Financial settlement for cleared forward                 in that hour, at that location.
                                                        contracts requires the following payment flows:
■   Forward contracts (variation margin):                                                                       Table 4 uses the same example as table 3.
    Settled between each counterparty and the           ■    Forward contract (prior to delivery): Settled   This produces different payment flows but the
    clearing house on a daily basis, based on                between each counterparty and the clearing      same net financial outcomes as physical delivery.
    mark-to-market against that day’s
    settlement price for all open positions.
■   Forward contracts (delivery payment):
                                                            Table 3: Example of physical delivery process for cleared products
    Settled bilaterally between the
                                                                                                    A           B         C        D       PJM     Nymex
    counterparties matched for delivery by the
                                                        Forward contracts (variation margin)      –$200        $150               $50                $0
    clearing house, based on the delivery
                                                        Forward contracts (delivery payment)     $3,400      –$3,400
    quantity (that is, net open position)
                                                        eSchedule                                –$4,000      $4,000                        $0
    multiplied by the last-day settlement price
                                                        Spot sales/purchases                     $4,800      –$4,000   –$800                $0
    (that is, the price on the final day of trading).
                                                        Total                                    $4,000      –$3,250   –$800      $50       $0        $0
■   eSchedule: Settled through the
                                                                                                                                                  Source: Accenture
    Pennsylvania-New Jersey-Maryland (PJM)
    operator, for the quantity specified in the
    eSchedule in each hour, multiplied by the               Table 4: Example of financial settlement process for cleared products
    spot market price in that hour, at that
    location. We should note that, for cleared                                                      A           B         C        D       PJM     Nymex
    contracts, the eSchedule quantity equals the         Forward contracts (prior to delivery)    –$200       $150                $50                $0
    net position for delivery – whereas uncleared        Forward contracts (final settle)         –$600       $600                                   $0
    trading requires an eSchedule for each trade.        Spot sales/purchases                     $4,800     –$4,000   –$800                $0
■   Spot market: Settled through PJM, for the            Total                                    $4,000     –$3,250   –$800      $50       $0         $0
    spot market quantity – which may differ                                                                                                       Source: Accenture
    from that contracted for in the forward

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