Published on *EBF 483: Introduction to Electricity Markets* (https://www.e-education.psu.edu/ebf483)

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 CFD 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.