Now we will see how locational and temporal risk can be hedged in electricity markets.
Financial Transmission Rights
Financial Transmission Rights (FTRs) are financial instruments that entitle the holder to the difference between LMPs at two defined locations (any two points a and b on the grid). The parameters for an FTR are:
- A "source" node, which we will call node a.
- A "sink" node, which we will call node b.
- A quantity, in MW, which we will call M.
Note that the points do not need to be connected neighbors.
The holder of an M megawatt FTR from a to b at time t receives
FTRs are typically auctioned off quarterly by the RTO, and may have different durations (one-month FTRs versus quarterly FTRs, for example) and market participants bid for quantities, source nodes, and sink nodes. Most FTRs are structured as obligations, which means FTR gives the holder the difference, LMP(sink) – LMP(source). If LMPb > LMPa then the holder of the FTR is paid money by the RTO. If LMPb < LMPa then the holder of the FTR must pay the RTO.
Some FTRs may be structured as options that renew every hour, in which case during a given hour the FTR holder would choose to exercise the option only if LMPb > LMPa, i.e. If the payoff would be positive. The payoff from an M-megawatt FTR option from node a to node b would thus be:
FTRs also obey superposition, just like power flows. An M-megawatt FTR defined from a to b and an M-megawatt FTR from b to a will cancel each other out financially (as long as both FTRs are structured as obligations). An M-megawatt FTR from a to b and an M-2 megawatt FTR from b to a would have identical value as a 2 megawatt FTR from a to b.
As financial instruments, FTRs are very similar to swaps. A swap is an agreement to exchange the closing price of two different financial assets. In this case, the "swap" is between two nodes in the power network, not between two different financial assets.
Contracts for Differences
In conventional financial market analysis, a contract for differences (CFD) is an agreement to exchange the opening and closing prices of some financial asset. In electricity markets, a CFD is a bilateral agreement in which one party gets a fixed price for electric energy (the strike price) plus an adjustment to cover the difference between the strike price and the spot price. This adjustment may be a positive or negative number.
CFDs are different than FTRs in two ways. First, a CFD is usually defined at a specific location, not between a pair of locations. Thus, CFDs are a tool principally for hedging temporal price risk - the variation in the LMP over time at a specific location. Second, CFDs are not traded through RTO markets. They are bilateral contracts between individual market participants.
CFDs may be defined as "one-way" or "two-way" contracts. A one-way CFD can have a couple of different payment mechanisms. First, a one-way CFD can be structured so that if the spot price exceeds the strike price, the seller pays the buyer the difference. Otherwise, there are no side payments. Second, a one-way CFD can be structured so that if the strike price exceeds the spot price, the buyer pays the seller the difference. Otherwise, there are no side payments.
A two-way CFD is just the sum of two one-way CFDs and is basically a forward contract for electric energy. In a two-way CFD, the seller pays the buyer if the spot price exceeds the strike price; and the buyer pays the seller if the strike price exceeds the spot price.
Here is an example. Let's say that a generation company signs a 100 MWh one-way CFD with an electricity consumer. The strike price is $50/MWh, and the CFD is defined at the location of the consumer.
Let's first say that the LMP at the location of the consumer is $75/MWh. In this case, the generator would earn $50*100 = $5,000 in revenue from the CFD, but would then need to pay the consumer 100*($75-$50) = $2,500 under the terms of the CFD. So the generator's net CFD revenue would be $2,500.
Now, let's say that the LMP at the location of the consumer is $40/MWh. In this case, there are no side payments and the generator's CFD revenues are $5,000.