September 8-12, 2008. 1 Linz Kickoff workshop Power and Gas - PDF document

September 8-12, 2008. 1 Linz – Kickoff workshop

Power and Gas Markets Challenges for Pricing and Managing Derivatives Peter Leoni, Electrabel Linz – Kickoff workshop September 8-12, 2008. 2

Outline � Power Markets: • Spot Market • Forward Market � Gas Markets � Derivatives • Plain Vanilla Products • Exotic Products � Conclusions Linz – Kickoff workshop September 8-12, 2008. 3

September 8-12, 2008. 4 POWER MARKETS Linz – Kickoff workshop

Power Market � Electricity is unique: • cannot be stored (flow commodity) • No flavours • Transport is limited • Production = Consumption (auction) � Trading Power is relatively new � 2 Different Markets • Spot Market • Forward Market Linz – Kickoff workshop September 8-12, 2008. 5

Power Markets – Spot Market � Day-ahead auction per market (~country) • Power supply: – Nuclear Power plants – Gas-fired power plants – Coal-fired power plants – Hydro-power plants – Transport Capacity (import) – … Linz – Kickoff workshop September 8-12, 2008. 6

Power Markets – Spot Market � Day-ahead auction per market (~country) • Power demand: – Transport Capacity (export) – Industrials – Home users – … Linz – Kickoff workshop September 8-12, 2008. 7

Power Markets – Spot Market � Day-ahead auction per market (~country) • Auction for each hour of the next day • Price = (Supply meets demand) • Price is set by marginal cost • Price reflects the consumption pattern Linz – Kickoff workshop September 8-12, 2008. 8

Power Markets – Spot Market � CASE STUDY: NORDIC MARKET • Considered as Very liquid • Hydro-driven (closest to storability) Linz – Kickoff workshop September 8-12, 2008. 9

Power Markets – Spot Market � Day-ahead auction per market (~country) WINTERWEEKDAY WINTERWEEKENDDAY 1.2 1.4 1.2 1.1 1 1 0.8 0.9 0 10 20 30 0 10 20 30 SUMMERWEEKDAY SUMMERWEEKENDDAY 1.2 1.4 1.1 1.2 1 1 0.9 0.8 0.8 0 10 20 30 0 10 20 30 (example: Nordic System Price Pattern) Linz – Kickoff workshop September 8-12, 2008. 10

Power Markets – Spot Market � Intraday Price Pattern • Very weather-dependent • Depends on type of day (weekday/Saturday/Sunday/Holiday) • Depends on Month • Very volatile with respect to the ‘average’ profile • Unpredictable Linz – Kickoff workshop September 8-12, 2008. 11

Power Markets – Spot Market � Time Series of the Spot Price (Nordic) Daily Price Curve Linz – Kickoff workshop September 8-12, 2008. 12

Power Markets – Spot Market � Features: • Very FAT tails • Prices expected to be – Higher in the winter / Lower in the summer – Higher during the Week / Lower during the weekend – Higher During PeakHours / Lower during offpeak (night) • Mean-reversion(?) Linz – Kickoff workshop September 8-12, 2008. 13

Power Markets – Spot Market QQ Plot of Power Returns versus Standard Normal 400 1 1 0.8 0.8 350 0.6 0.6 300 Quantiles of Power Returns Power Returns Quantiles 0.4 0.4 250 0.2 0.2 200 0 0 150 -0.2 -0.2 100 -0.4 -0.4 50 -0.6 -0.6 0 -0.8 -0.8 -1 -0.5 0 0.5 1 -4 -2 0 2 4 -0.1 -0.05 0 0.05 0.1 Standard Normal Quantiles SX5E Returns Quantiles Linz – Kickoff workshop September 8-12, 2008. 14

Power Markets – Spot Market HYDRO SYSTEM NO HYDRO SYSTEM 2500 120 FAT TAILS Hourly Price Curve SPIKES 100 2000 80 1500 60 1000 40 500 20 0 0 0 1 2 3 4 0 1 2 3 4 5 6 7 4 4 x 10 x 10 Linz – Kickoff workshop September 8-12, 2008. 15

Power Markets � The need to manage Risk on the Spot Market led to the development of the Forward Market Linz – Kickoff workshop September 8-12, 2008. 16

Power Markets – Forward Market � Forward Contracts F(t, T 1 , T 2 ): • Price at time t for the commodity to be delivered (in a constant ‘volume’ during the entire period [T 1 ;T 2 ] • [T 1 ;T 2 ] = delivery period • Payment done during the delivery period, usually settled on a monthly basis (swap) • Price is fixed and constant during delivery • Forward price is an estimate of the AVERAGE realised Spot price during delivery period. Linz – Kickoff workshop September 8-12, 2008. 17

Power Markets – Forward Market � Delivery period is bucketed into • Days – Weeks on the short-end of the curve • Months / Quarters • Years � Cascading Mechanism: • 1 Year � 4 Quarters • 1 Q � 3 Months • 1M � 4 Weeks • 1W � WEEKEND + DAYS Linz – Kickoff workshop September 8-12, 2008. 18

Power Markets – Forward Market Forward Curve 74 72 70 68 66 64 62 60 58 56 54 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 Linz – Kickoff workshop September 8-12, 2008. 19

Power Markets – Forward Market � Seasonality is very obvious in the Forwards � Forward Market Organised in • Exchange (Futures) • Brokered OTC Market (very liquid and transparant) Linz – Kickoff workshop September 8-12, 2008. 20

Power Markets – Forward Market � Some numbers on the Nordic Market: • First liberalised Market in Europe • About 150 players in the Forward Market • About 15 (active) players in the Vol market • About 3-5 option trades per day Linz – Kickoff workshop September 8-12, 2008. 21

September 8-12, 2008. 22 GAS MARKETS Linz – Kickoff workshop

Gas Markets � Gas is storable to some extent • Pipelines • Day-storages � No Hourly market � No spike-behaviour � Still seasonal, still very fat tails, very physical as well Linz – Kickoff workshop September 8-12, 2008. 23

PLAIN VANILLA DERIVATIVES September 8-12, 2008. 24 Linz – Kickoff workshop

Derivatives: Plain Vanilla Products � Option Expires before delivery period starts � Power: • Options on Futures (Exchange) • Swaptions: Options on the ‘Forward’ (OTC) • ‘Liquid’ Markets: Nordpool, Germany � Gas: • Options on Summer/Winter Forwards • Strip of Options on Summer/Winter (most liquid) Linz – Kickoff workshop September 8-12, 2008. 25

Derivatives: Plain Vanilla Products � Study (Koekebakker and Ollmar, 2005): • Multifactor (geometric Brownian) forward dynamics • 2 factors � explain 75% of volatility of the forward curve • 10 factors � capture 95% • Low correlation between short-end and long-end Linz – Kickoff workshop September 8-12, 2008. 26

Derivatives: Plain Vanilla Products � Typically only a few expiries per product � Volatility ‘Term Structure’ refers to underlying forward curve • Short-end of the forward curve: HIGH VOL • Long-end of the forward curve: LOW VOL � Seasonality in Volatility • Winter Vol (relative) high • Summer Vol (relative) low Linz – Kickoff workshop September 8-12, 2008. 27

September 8-12, 2008. 28 Derivatives: Plain Vanilla Products Linz – Kickoff workshop

Derivatives: Plain Vanilla Products � Challenges for the ‘Plain Vanilla Options’ • Option market is thin (implied vol quotes not always reliable) • Implied Vol quoted according to bad model (model for forwards rather than swaptions) • Bid/Offer spreads in the underlying (hedging cost) • Fat tails (as any market) • Liquidity Linz – Kickoff workshop September 8-12, 2008. 29

Derivatives: Plain Vanilla Products � Bid/Offer spreads for Forwards: • Days: 0.75% - 5% (sometimes even 15%, for SUN) • Weeks: 1.25% - 6% • Months: 0.5% - 2% - 5% • Quarters: 0.10% - 3% • Cals: 0.25% - 2% Linz – Kickoff workshop September 8-12, 2008. 30

Derivatives: Plain Vanilla Products � Liquidity in Forwards: • Can dry up easily and fast • Risk premium: implied vol is much higher than realised vol (difference about 10%) Linz – Kickoff workshop September 8-12, 2008. 31

Derivatives: Plain Vanilla Products � Underlying does not (yet) exist • Strip of Options on Winter/Summer products • 6 Options each expiring right before Monthly- Forward goes into delivery • Monthly forwards may not be traded at the time of writing the option • Basis Risk: “Hedging of Untradable Assets,” N. Vandaele, P. Leoni and M. Vanmaele (in preparation) Linz – Kickoff workshop September 8-12, 2008. 32

Derivatives: Plain Vanilla Products Q4-2008 Nordic Q1-2009 Nordic 0.524 0.495 0.523 0.49 0.522 0.521 0.485 0.52 0.48 0.519 0.518 0.475 0.517 0.516 0.47 0.7 0.8 0.9 1 1.1 0.8 1 1.2 1.4 � Skew is rather small � About 15 players in the vol market Linz – Kickoff workshop September 8-12, 2008. 33

EXOTIC DERIVATIVES September 8-12, 2008. 34 Linz – Kickoff workshop

Derivatives: Exotic Products � 2 Examples and their risks: • Hourly Option (power) • Swing Option (gas) Linz – Kickoff workshop September 8-12, 2008. 35

Derivatives: Exotic Products: Hourly Option � Specifications • Strip of options expiring on the SPOT market • For each hour of the day, for each day over the period (typically 3 years), the owner has a right: • Call/Put • Fixed strike (can be floating as well) • For each hour: ‘nomination’ or exercise has to be decided on a day-ahead basis • Settlement can be financial or physical Linz – Kickoff workshop September 8-12, 2008. 36