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.
Mechanism | Payment to Supplier at node a | Payment by consumer at node b |
---|---|---|
Spot Market | ||
F Megawatt Two-Way CFD at strike price p |
||
Total | ||
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:
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 [1] 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.