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Hedging Using Futures and Options Contracts in the Electricity Market

Conference Paper in Renewable Energy and Power Quality Journal · April 2003
DOI: 10.24084/repqj01.407

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 Hedging Using Futures and Options Contracts in the Electricity Market
Filipe Azevedo1, Zita A. Vale1, António A. Vale2
1
Polytechnic Institute of Porto / Institute of Engineering
Rua Dr. António Bernardino de Almeida, 431 - 4200-072 Porto (Portugal), phone:+351 22 8340500, fax:+351 22 8321159,
e-mail: [email protected], [email protected]
2
Department of Electric and Computer Engineering, University of Porto, Phone: +351 22 5081400, fax: +351 225081441,
e-mail : [email protected]

electricity markets. For example, [1] presents a model for

Abstract. Since the 80’s with the experience of Chile, the the risk management in the valuation of contracts in
electric sector has suffered, in many counties, a process of electricity markets using the concept of efficient frontier
deregulation and liberalization. In almost of the countries, that for the representation of the relation profit vs risk, [2]
process originated the appearance of a Pool where the presents a group of strategies for the use of futures
participants of the market trade the electrical energy on a basis contracts in electricity markets with the objective to
of half-hour or one hour of the next day. However, like the minimize the risk associated to the volatility of electricity
traditional markets, the agents of electricity markets are now price in the spot market. [3] presents a decision support
exposed to the volatility of market price, so far inexistent in model based in the Benders decomposition techniques.
those markets. In some countries, to face that problem and to
turn the market more liquid have been introduced derivatives
markets – futures and options, to negotiate products with
Brokers are too exposed to risks from price variation
underlying active the electrical energy. In this context, there is a once that they sell energy, to the client’s majority, at
need of decision-support tools that allow those agents to use fixed tariffs, while the energy is bought at Pool prices.
derivatives markets with the objective of practicing the hedge However, the risks faces by brokers are substantially
and simultaneously increase their results. In this paper, we superiors to those that producers faces because producers
present a decision model that supports producers in the may decide not to produce if they consider Pool price to
establishment of contracts with the objective to maximize the low, while brokers only could interrupt the energy supply
profit expected utility. The paper presents a group of examples to the consumers when Pool price is to high and if they
of the use of this decision-support system. have interruptible contracts.

Key words
2. Causes for the volatility of energy price
“Risk Management” “Hedge” “Electricity Markets” The fluctuation of Pool energy price is directly dependent
“Contracts” “Decision” of two factors:

• Charge characteristics;
1. Introduction • Producer’s characteristics.

The separation between product – energy – and service – The charge characteristics that have more impact in the
transport and distribution – is the fundamental marginal price of the system are:
characteristic of the recent deregulation of the electric
sector. This deregulation, associated to the liberalization • Seasonality - the charge is not constant, changing
on an unbundled system, allows the free competition in daily, weekly and even annually;
sectors of activity traditionally monopolist. Facing the • Mean Reversion – the demand suffer temporary
new reality, the participants of electricity markets must sudden variations, often associated to extreme
deal with new challenges and new risks. changes in weather conditions, sports or social events
finishing at the demand level of the lasts days;
The volatility of electric energy price in spot markets is, • Stochastic growth – the demand growth of electric
among the risks in a liberalized market, the one that energy is correlated with the country economy
poses major concerns to the agents of the electric market growth, being for that, very difficult to predict her
and, in particular, to the producers. evolution for long periods.

To reduce their expose to variations in electricity price in The producer’s characteristics that have a major impact
spot markets, producers and others agents who participate in system marginal price are:
in those markets make extensive use of futures and
options contracts with the objective to practice the hedge. • Technology – the technology used in the production
of electric energy is the principal responsible factor
Some works were realized with the objective to develop for the production costs, having for that a
tools that permit a better management of the risk in fundamental influence in producer’s bids;
• Generators availability – the generators service This payoff is represented in Fig. 1 and it is a result of the
departure due to damage or due to maintenance obligation by the seller to sell and the buyer to buy the
programs, could have a high influence in electric electrical energy negotiated for the value K.
energy price;
• Fuel price – all over the world the major part of
electric energy are of thermal origin, like oil, natural
gas and coal. Variations in fuel prices have a high
Payoff
impact in energy cost and consequently in producers
bids;
• Technical restrictions – the technical characteristics
of generators as operating costs, minimum running
time, minimum shutting time, ramp-rate and K ST
mechanical constraints have a high impact in
producers bids and consequently on the shape of the
supply bid curve;
• Import/Export – producer’s participations in various
electricity markets could influence their bids and
consequently the shape of the supply bid curve. Fig. 1. Payoff at maturity for a long position in a forward
contract

3. Derivatives markets in electric sector

The payoff of a short position is represented in Fig. 2 and
The derivatives markets in electric sector were it is equal to
introduced with the objective to turn the electric market
more liquid and to provide a group of tools that permit to K-ST
the electric energy agents the practice of hedge.
Payoff
They are very similar to those that exist in traditional
markets with the characteristic that negotiate products
with underlying active the electric energy. The
derivatives markets could be organized or not. The
organized markets sell normalized contracts while the not K ST
organized markets, designated for OTC (over-the
counter) markets, sell contracts not normalized.

A. Forward Contracts
Fig. 2. Payoff at maturity for a short position in a
One forward contract is a bilateral agreement where the forward contract
two parts agree mutually the characteristics (price,
quantity, place and date) of one transaction where the
payment and the delivery of the asset only are realized in Where,
a future date, being the price pre-established, been so,
eliminated the risk associated to the price variation. K = Delivery Price
ST = Spot price when the contract rich the maturity
This type of contracts are different from futures contracts
because exist the clear intention for the physical delivery Like in a long position, the payoff of a short position
of the asset and they are normally negotiated in not could also assume positive or negative values, as a result
organized markets (off-exchange). of the price in spot market and the obligation by the seller
to sell the energy at the value K (delivery price)
The realization of a forward contract involve two parts stipulated in the contract.
where the seller assume a short position and the buyer a
long position and the price established in the contract are
designated by delivery price. B. Futures Contracts

Assume that, the spot price per unit of energy in the Futures contracts are very similar to forward contracts.
instant that the contract reaches the maturity is ST and the The characteristics that distinguish them from forward
delivery price, per unit of energy, established in the contracts are:
contract is K. The payoff of a long position is equal to
1. Are normalized contracts and negotiated in organized
ST-K markets, being guaranteed the compliment of the
contracts by the Clearing House;
2. The exercise of that type of contracts could be
financial, in other words, could not contemplate the
 physical delivery of the energy negotiated in the
contract; • In-the-money – if the exercise price is inferior to the
3. The Clearing House as a demonstration of good faith price in the spot market for call options and if the
requires an initial amount of money - Initial Margin - exercise price is superior to the price in the spot
and a maintenance amount – Maintenance Margin – market for put options;
along the life of the future contract. • At-the-money – if the exercise price is equal to the
price in the spot market;
• Out-the-money – if the exercise price is superior to
the price in the spot market for call options and if the
C. Options Contracts exercise price is inferior to the price in the spot
market for put options.

Options contracts are contracts that could be established

in organized markets or not, giving to his owner, in
exchange for a certain monetary quantity (the premium), 4. Decision Process
the right but not the obligation of buy (call option) or sell
(put option) a certain quantity of electrical energy, in a
predetermined data for a pre-established price. One of the biggest problems that a producer faces when
he pretend to practice the hedge is the difficulty that he
Exist two types of options, and the factor that faces to predict the system marginal price for a certain
distinguishes them is the moment that the options are period i in question.
exercised:
So, is fundamental the consideration of a group of
• “American options”, could be exercised at any time scenarios for the system marginal price to the period in
until the expiration date. These types of options are, question and associate to them a certain probability based
however, very expensive due to their versatility; on statistics studies or based on the opinion of an expert.
• “European options”, only could be exercised at their
expiration date. The decision process here presented comprise, for a
certain programmed period, the determination of optimal
In Table I are discriminated the rights and the obligations quantities of energy to negotiate in “financial markets”
of the buyer and the seller of call options and put options and the foresee energy to negotiate in the spot market, in
are discriminated. function of previous contracts established, with the
objective to maximize the profit expected utility.

TABLE I. – Rights and obligations of buyers and sellers of The decision process scheme is represented by Fig. 3.
options
Participant Obligation Call Put
/Right
Right Purchase of Sell of the
energy at agreed energy in the Futures and Existent
Buyer conditions agreed Options Quant.
Contracts
conditions
Obligation Payment of Payment of
premium premium Inc/Dec Qifutures, Qishort_call,
Right Receive of Receive of Scenario 1 Qilong_put
premium premium
Seller Obligation Sell of the energy Purchase of Quant.
(in case of at agreed energy in the Qi,1Spot Máx. Expected
exercise) conditions agreed Inc/Dec
conditions Utility (Profit)

Scenario S Inc/Dec
The options could have two forms of exercise:

• Monetary delivery: the buyer of the option demand to Qi,sSpot Quant.

the seller the delivery of an monetary amount equal to
the profit that he have if he buy (call) or sell (put) the
energy at the exercise price and then (call) or after
(put) sell it (call) or buy it (put) in the spot market.
Fig. 3. Decision Model
• Physical delivery: the buyer of the option demand to
the seller the delivery of an amount of energy
established in the contract at the conditions accorded.
5. Mathematical Formulation
Accordingly to the exercise price and the price of the
energy in the spot market, options are grouped in three The mathematical model which translates the optimal
categories: strategy for the optimal energy quantity to negotiate in
forward and options contracts and in the spot market,
with the objective to maximize the profit expected utility • v ishort _ call
Represent the sells that the producer will
,s, E
is given by:
do with the sell of the existent call option with the
quantity Qishort
,E
_ call
at the exercise price
Maximize
short _ call short _ call
S
K and premium P for the period i
∑ U (v futures
i, s, E + vishort
, s, E
_ call
+ vilong
, s, E
_ put
+ vifutures
,s + vilong
,s
_ call
+ vishort
,s
_ put
+ vispot
,s −
i,E i,E
i =1 and scenario s. The amount of money that the
− C (Q ishort _ call + Q ishort _ call
+ Q ilong _ put + Q ilong _ put
+ Q i futures + Q i futures + Q ispot
, s )) × p i , s
,E ,E ,E
producer will do with the sells of the existents call
options is determinate in the same way that the call
options that the producer wants to negotiate.
Subjected to:

• v ilong
,s
_ put
Represent the sells that the producer will
Q short_ call
+Q short_ call
+Q
long_ put
+Qlong_ put
+ Qi futures
+Qfutures
+Q spot
≤Q máx
i i, E i i, E i, E i, s
do if he buy the call option with the quantity
Q short_ call
+Q short_ call
+Q
long_ put
+Qlong_ put
+ Qi futures
+Qfutures
+Q spot
≥ Qmin
i i, E i i, E i, E i, s
Qilong _ put at the exercise price K i
long _ put
and a
Qishort_ call ,Qishort ,s ∈ ℜ
_ call
,E ,Qilong_ put , Qilong
,E
_ put
,Qifutures, Qifutures
,E ,Qispot long _ put
premium Pi for the period i and scenario s.
The sells as a result of the buy option put for the
Where, period i, depends from the considerate scenarios for
the system marginal price, and they are given by:
• pmis represent, for the period i, the marginal electrical
energy price for the scenario s. Q ong _ put × ( K ong _ put − Pi ong _ put ) se pmis ≤ K iong _ put
viong
,s
_ put
=  i ong _ put i
 Qi × ( pmis − Pi ong _ put ) se pmis > K iong _ put
• pis represent, for the period i, the probability of
occurrence of scenario s. In the put options we also admit that the buyer of the
put option only exercise the option if the price in the
• vi,futures Represent the sells of the existent futures spot market will be inferior to the exercise price, and
s
the producer are able to sell the energy negotiated in
futures
contracts for the supply of a quantity Qi , for the the spot market if the buyer don’t exercise the option.
period i and scenario s, at the exercise price Kif. The
sells of futures contracts are given by Qi
futures
* K if . • v ilong
,s,E
_ put
Represent the sells that the producer will
do with the buy of the existent put option with the
long _ put long _ put
• v futures quantity Qi , E at the exercise price K i , E
i , s , E Represent the sells of the existent futures
long _ put
contracts for the supply of a quantity Qi , E
futures
, for the and premium Pi , E for the period i and scenario
period i and scenario s, at the exercise price KifE. The s. The amount of money that the producer will do
sells of existent futures contracts are given by with the sells of the existents put options is
determinate in the same way then the put options that
Qi ,futures
E * K ifE . the producer wants to negotiate.

• v ishort
,s
_ call
Represent the sells that the producer will • v i,spot
s Represent the sells as a result by the sell of the
do if he sell the call option with the quantity spot
quantity Qi , s in the spot market, for the period i and
short _ call short _ call
Q at the exercise price K and
scenario s, and they are given by Qi , s × p mis .
i i spot
short _ call
premium Pi , for the period i and scenario s.
The amount of money that the producer will do with • Qmáx represents the maximum active power that the
the sell of the call option for the period i depends of generator can produce.
considered scenarios and of system marginal price,
and they are given by: • Qmin represents the minimum active power that the
generator can produce.
 Q short _ call × ( pmis + Pi short _ call ) se pmis ≤ K ishort _ call
vishort
,s
_ call
=  shorti _ call
Qi × ( K ishort _ call + Pi short _ call ) se pmis > K ishort _ call • C(.) represent the production costs for a active power
expressed in MW.
We admit that the buyer of the option call only
exercise the option if the price in the spot market will The difficulty to obtain the result of the sells and buys of
be higher then the exercise price, and the producer are the call and put options, as well the combinatory
able to sell the energy negotiated in the spot market if character of this problem to obtain the optimal quantity to
the buyer don’t exercise the option. establish in each contract and to sell in spot market
depending on the scenario, turn impossible the resolution
of this problem for the traditional methods.
 TABLE IVI – Options contracts characteristics for period i
So, to resolve this problem and to overtake to old
problems we use genetic algorithms, particularly the Exercise Premium Quantity/Contract
EVOLVER software. price (€/MWh) (MWh)
(€/MWh)
Call 24.00 1.68 10
Put 24.00 1.12 10
6. Study Case

Let us considering an example with the aim to determine A. Results

the optimal quantity of energy that a producer must
negotiate in futures and options contracts and the energy The results for the example considered are presented in
that he should sell in the spot market, for a certain period Tables VII, VIII and IX.
i1. In this example, we consider the scenarios for
marginal system price for that period presented in Table
II. TABLE VI – Optimal options contracts to realize

Options Short call Long Put

TABLE II - System marginal price scenarios for the period i
Exercise price
24.00 24.00
(€/MWh)
Price 22 27
Premium (€/MWh) 1.68 1.12
Probability 0.4 0.6
Quantity/Contract
10 10
(MWh)
N.º of contracts 4 0
The contracts previously established are presented in
Table III and IV.

TABLEVII – Optimal futures contracts to realize

TABLE II – Options contracts previously established
Futures
Options Short call Long Put N.º of contracts 0
Exercise price
22.00 25.00
(€/MWh)
TABLE IX – Spot energy forecast to sell in spot market for
Premium (€/MWh) 1.12 1.40 period i
Quantity/Contract
10 10
(MWh) Spot
N.º of contracts 1 1 Quantity (MWh) 40

TABLE III – Futures contracts previously established Considering that all contracts have to be established in
organized markets, from the results we observe that the
electrical energy producer for the period i mustn’t sell
Futures any forward contract, sell four call options and expect to
N.º of contracts 0 sell 40 MWh in the spot market.

We admit that futures and options contracts will be The producer does not know if the buyer will exercise or
established in organized markets with the characteristics not the options that he purchase and has to decide if
are presented in Tables V and VI. exercise or not the put option previously negotiated for
the same period i.

TABLE V – Futures contracts characteristics for period i To decide that, we calculate for all situations of exercise
for the options the expected profit for period i and the
Quantity (MWh) Delivery Price (€/MWh) standard deviation of the profit considering system
15 24.80 marginal in the interval [20; 30] €/MWh.

Note that, like we consider in the decision model, in all

situations that the options weren’t exercised, the
electrical energy negotiated in those contracts will be
1
We consider that the period i has one hour of duration.
negotiated in the spot market at the considered marginal translate so complex characteristics like the
price. characteristics of the spot market.

The results are presented in Fig. 4 considering the The decision support developed in this work, makes
nomenclature presented in Table X. extensive use of forward and options contracts to permit
to the producers the practice of the hedge against the
TABLE X – Designation for the nomenclature used
volatility of the electricity price in the spot market.

Options in this work reveals extremely useful to reduce

Nomenclature Designation the volatility of the producer’s return and demonstrate
All All options are exercised that derivatives markets introduce extremely powerful
Call+Call_E Only the new call option and the tools for the practice of the hedge and to increase their
previously negotiated call option are results.
exercised
Call Only the new call option is exercised However, the decision support model developed in this
Call+Put_E Only the new call option and the work only looks for the economics aspects. Will be
previously negotiated put option are useful interact this decision support model with technical
exercised validation. The use of a knowledge base that support the
Call_E Only the previously negotiated call decision based in earlier events will be also extremely
option is exercised useful.
Call_E+Put_E Only the previously call option and put
options are exercised
Put_E Only the previously negotiated put References
option is exercised
None None of the options are exercised [1] R. Bjorgan, R. Liu, J. Lawarrée, “Financial risk
management in a competitive Electricity Market”, IEEE
Transactions on Power Systems, 2003 (to be published).
[2] E. Tanlapco, J. Lawarrée, “Hedging With Futures
Contracts in a Deregulated Electricity Industry”, IEEE
Transactions on Power Systems, Vol. 17, N.º 3, August
2002.
[3] M. V. Pereira et al., “METHODS AND TOOLS FOR
CONTRACTS IN A COMPETITIVE FRAMEWORK”,
Task Force 38.05.09, Cigré, Feb. 2001.
[4] C. W. Richter, G. B. Sheblé, “Bidding Strategies that
Minimize Risk with Options and Futures Contracts”,
American Power Conference, 1998.
[5] A. G. Diaz., P. L. Marin, “Strategic Bidding in Electricity
Pools With Short-Lived Bids: An Application to The
Spanish Market”, CEPR Discussion Paper N.º 2567, Sept.
2000.
[6] I. Praça, C. Ramos, Z. A. Vale, “Competitive Electricity
Markets: Simulation to Improve Decision Making”, Porto
Power Tech 2001, Sep. 2001.

Fig. 4 – Expected profit and profit standard deviation

Through the analysis of the results presented in Fig.2 it is

visible that the producer should, in any situation, exercise
the put option previously established, because with this
exercise he can reduce the volatility of the profit.

In situations 1, 2 and 3 the exercise of the put option does

not increase the expected profit but it reduces de
volatility. In situation 4, the exercise of the put option
besides turning the profit bigger, reduces the volatility of
the profit.

7. Conclusion
Beside the works realized to model the spot energy price,
those models are limited and have some difficulties to

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