Thus far, we have seen that temporal risk can be hedged with Contracts for Differences. A one way CFD can basically put a ceiling on the price of electricity. A two-way CFD is essentially identical to a forward contract for electricity at a fixed price. Locational risk can be hedged with Financial Transmission Rights.
In this section, we will see how a combination of CFDs and FTRs can be used to create a "perfect hedge" that shifts all temporal and locational risk. The end result of this perfect hedge is like a fixed-price contract at the strike price of the CFD, as long as the quantities of the CFD and FTR are equal to the amount of power being transferred from the source node to the sink node.
The table below outlines the perfect hedging model. We'll assume that there is a supplier located at node a, and a consumer located at node b. The supplier produces Q MWh in the real-time market and the consumer uses Q MWh. We will let F denote the size of a two-way CFD defined at the customer's node, and M denote the size of the FTR held by the supplier. The FTR is defined such that node a is the source and node b is the sink.
|Payment to Supplier at node a
|Payment by consumer at node b
F Megawatt Two-Way CFD at strike price p
M Megawatt FTR from node a to node b
|Total if F = M
|Total if F = M = Q
Let's walk through the rows of the table:
- The first row shows the spot market revenues and costs for the supplier and consumer.
- The second row shows the payments under the CFD, assuming the strike price is equal to p. Note that if the LMP at node b exceeds p, the generator pays the consumer the difference. If the LMP at node b is smaller than p, the consumer pays the generator.
- The third row shows the sum of payments to the supplier and payments by the consumer from the real-time energy market and the CFD.
- The fourth row shows the FTR payment. This is zero for the consumer because the supplier is assumed to hold the FTR.
- The fifth row shows the total payments for the supplier and consumer if the FTR is the same size as the CFD. Note that because of the CFD defined at node b, and because of the FTR, any payments involving the LMP at node b cancel each other out. This is because the payment stream for the supplier from the FTR and CFD move in opposite directions.
- The sixth row shows the total payments if the FTR, CFD and amount of physical production/consumption at nodes a and b are identical. In this case, all LMP terms cancel out. The supplier is paid the LMP at node a through the real-time market and pays the LMP at node a through the FTR. The consumer pays the LMP at node b and then is paid the difference between the LMP at node b and the CFD strike price p. All that is left is that the supplier earns revenue equal to the CFD strike price times output, while the consumer pays the same amount.
Note that unlike other energy commodities, electricity transportation cost is highly variable. Thus, due to the temporal and locational risks (high volatility over space and time), NYMEX futures contracts don’t add much value to the market, and they are not popular, or the traded volume is very low. Consequently, it’s more efficient to use the mentioned financial instruments and utilize them for the spot market.