U.K. Electricity’s Key Fuel Source: Gas

The principle of electricity generation via a conductor rotating in a magnetic
field totally dominates the industry. Rotating electrical generators are the
core component of thermal and hydro plants and are also fundamental to more
obscure sources such as tidal and geothermal. Within the United Kingdom, a thermal
plant of this type generates the bulk of the national requirement for electricity.
Gas-fired generation constitutes the fastest growing segment of this termal
plant type. The reasons for gas’ recent popularity can be summarized as follows:

• Since deregulation, new entrants have been able to enter the generation
market. Gas-fired plants are optimal, because of quick and (relatively) cheap
construction and the presence of a well-developed gas market that can provide
long-term forward curves. A moratorium on gas generation was withdrawn.
• The Kyoto Agreement and other sources of political pressure have encouraged
the government to support gas, which is a low emission fuel when burned efficiently,
at the expense of coal. Coal emissions can be reduced but the process is expensive.

Converting Gas to Power via Generation

Natural gas is directly related to electricity by conversion via generation.
This conversion (and its rate) is closely observed by generators because it
is key to the profitability of their business. Gas is purchased by and burned
in power stations in order to produce electrical energy that is sold to other
participants in the electricity market. Although the calorific value of 1 Therm
of gas is 29.3071 kWh, a large proportion of this available energy is lost to
entropy. The effective attainable industrial physical exchange is capped, given
current technological constraints, at an electrical efficiency of around 60
percent, which implies a (best attainable) conversion rate of 1 MWh = 56.87
Therms. In financial terms, the conversion is known as the gas spark spread,
which represents the value that derives from the exchange of gas for power at
a given electrical efficiency. This is the operational link between the two
products.

The Substitution Effect

The substitution effect binds gas and power more closely in an economic sense.
Substitutable products perform each other’s functions well. Gas and power are
good physical substitutes because they can both be used to provide economically-viable
space heating. Substitute products are related through a price mechanism. If
one can readily be switched for the other, then their relative prices will be
set by their individual demand and supply. For example, if gas becomes more
expensive relative to power, then some companies and households may switch to
electrical heating. This rise in demand for electrical heating is likely to
cause power prices to rise. Alternatively, a decrease in supply of one product
that would normally lead to a sharp hike in price may be mitigated by the fact
that demand can partially switch to the substitute product (elastic demand).
The substitution effect represents the economic link between gas and power.

The Purposes of Fuel/Power Trading

At the moment that a power station is constructed it immediately represents
an implicit long-term spark-spread transaction whose risk needs to be hedged.
Combined cycle gas turbine (CCGT) plants are usually expected to function for
25 years or more, which exposes the owner(s) to extremely long-term price risks.
Generally, investors require that this risk be hedged in some way by long-term
contracts. In some cases, vertical integration enables the long-term risk to
be offset against a supply portfolio. The end result of the hedging process
is some kind of net exposure that has to be managed on a day-to-day basis. Managing
this requires purchase and sale of the spark-spread constituents in response
to the engineering requirements of the plant and price movements in the forward
curves. This is the risk management situation that faces the typical generator.

Supply companies are only indirectly exposed to fuel prices unless they own
generation (which is now frequently the case in the United Kingdom) Therefore,
although they participate actively in the power market, they tend not to be
involved in fuel trading.
Trading companies that do not have generation provide hedging services to the
generators and the other participants in the power and fuel markets, such as
supply companies. They also take on speculative positions. We might define trading
companies as market participants that neither generate nor supply, but rather
act as intermediaries.

Plant Optimization: The Generator

Most plants attempt to hedge the bulk of their gas/power exposure for at least
the first five years of their functional lives. For example, a 500MW CCGT might
sell 400MW of power forward, while buying the equivalent volume of gas:
If we assume an electrical efficiency for the plant of 50 percent at 100 percent
efficiency, 1 Therm can be converted to 29.3071 kWh, we can derive the following
conversion:

1 MWh = 68.24 Therms.

If the plant runs at baseload (24 hours per day flat output), then of the above
contracted capacity, it will generate:

400 * 24 = 9,600 MWh per day.

To run at this level, some equivalent volume of gas must be brought into the
plant (from the above conversion rate):

9,600 * 68.24 = 655,104 Therms per day.

Such a transaction is helpful to the investors in the plant because it enables
them to participate in a certain cashflow during the term of the deal. However,
they will only accept the terms of the contract if the spark spread is sufficiently
positive to cover at least their costs, and as defined above, the spark spread
per 1 MWh of output electricity is the net value of the power to gas conversion
or:

Spark Spread = 1 * power bid price — 68.24 * gas offer
price

The cashflow according to this type of transaction is only accessible to the
plant operators if they manage to keep the plant running consistently. In the
event of plant failure or deviation from expected output, the operator may have
to participate in the spot power and gas markets to cover their contracted volumes.
For example, according to the Balancing and Settlement Code and Grid Trade Master
Agreements that govern the New Electricity Trading Arrangements, if the plant
operators contract to deliver some certain volumes of electricity into the grid,
then they will be “imbalanced” if they fail to deliver those volumes. The result
of such an imbalance is an exposure to the “system buy-or-sell prices” which
are effectively punitive — causing significant losses to those who must
bear them. A similar problem is faced with respect to the gas position. Plant
operators must make every effort to forecast outages accurately and in a timely
fashion. They must buy power and sell gas in order to cover these exposures
if or when they arise.

The only flexibility that the operator has according to this kind of deal is
to switch the plant off completely. This would make sense if it could purchase
the spark spread in the market for less than the contracted spark spread net
of variable costs.

Freedom to Choose: Flexible Contracts

Under these circumstances, the operator works within tight bounds, and is rarely
able to make dynamic decisions regarding the running of the plant. Flexible
gas contracts, such as take-or-pay (TOP) contracts, enable an extra layer of
freedom for plant control.
The terms of a gas take-or-pay contract enable gas purchasers to vary consumption
from one day to the next over the term of the deal, subject to their taking
a certain fixed total quantity. There is a ceiling on day-to-day consumption.
If the purchaser takes less than the total take or pay quantity, then it must
still be paid for anyway.

A gas contract of this type offers a greater level of flexibility than under
the conditions of fixed volume hedges. If day-ahead gas prices are much lower
than the price of gas from the contract, then the operator can buy gas in the
market and not take it from the TOP.
These examples show how important the relative gas/power price can be for a
generator, and how important it is that the generator coordinates the trading
of such products. For example, if the generator has to cover for an outage,
then they are advised to make both sides of the trade at the same time in order
to avoid being front-run by a counterpart on one side of the deal. In some cases,
it may be obvious to market participants that one leg (e.g. the power purchase)
is to be shortly followed by the other (the gas sale).

Risk Management and Speculation:
Trading Companies and the Power Market

Trading companies in the energy industry inevitably get caught up in the physical
side of the business for a number of reasons. This can be a surprise or even
a problem for investment banks that sometimes want to keep their business limited
to financial products.
‘Physicality’ is a particular issue in the U.K. markets for gas and power because
the financial gas market (settled against IPE front-month close) is not well-developed
and there is, as yet, no widely accepted financially settled (index) market
for U.K. power. This means that if you have a position in either of these products
then you will, at some stage, have to physically deliver (or take delivery of)
the product at a specified location. Trading participants are also exposed to
the same imbalanced charges as generators and suppliers. So, trading companies
take on physical obligations irrespective of the fact that they ultimately contribute
no net flow of power to the system.

The trading company takes on straightforward price risk for speculative purposes,
and complex exposures (structured derivatives) in order to provide risk management
services to generators and suppliers. Such companies serve an important function
in the market by facilitating the restructuring and redistribution of risk.
By adding to the total pool of participants that buy and sell, they also add
to liquidity in the sense of available tradable volume.

Similar Risk Exposures

Due to the types of structured transactions that trading companies take onto
their books, they often share many of the responsibilities and requirements
faced by generators and suppliers. As mentioned above, the physical nature of
the power and gas markets force all participants to actively manage their net
position with the aim of making it flat before gate closure (31/2 hours prior
to actual power flow for electricity positions). If the net position is not
flat by this time, then imbalance costs are incurred. Analogous conditions apply
to a gas position. Some structures make the portfolio behave like that of a
genuine physical participant. An example would be tolling deals, which simulate
the condition of the generator. In that case, the trading company will start
to behave in a similar fashion to a generator in terms of its power and gas
transactions.

Tolling deals are strips of spark-spread options that mimic the conversion process
that happens inside power stations. Although both generators and spark-spread
traders focus on the financial implications of the size of the spark spread,
a tolling transaction is a pure physical deal that is monetized by marking to
market against existing power and gas curves. If a trading company takes on
some tolling, then it obtains the right to swap gas for power at a pre-specified,
fixed conversion ratio that depends on the electrical efficiency of some power
station. (tolling deals are typically sold against assets as a hedge). The optimization
process that is executed with respect to a tolling deal is very similar to the
problem of plant optimization — the risk manager aims to achieve maximum
cashflow for the spark spread and will tend to exercise the spark spread options
only under conditions when the market value is positive and large. A variable
fee that is paid for every exercised MWh simulates the real variable fees that
are faced by a generator. Clearly, the external appearance of a trading company
that is managing this kind of risk will be similar to that of a generator in
terms of the kind of trades that they do.

Bringing the Desks Together

Companies with an energy trading operation may choose to posture themselves
in a way that enables them to benefit from the relationships between fuels and
electricity. From a management standpoint, the first positive action in this
respect is often a desk rearrangement so that the power traders and fuel traders
sit closely together.
A key decision will be whether product synergies (e.g. all European power traders
together) outweigh geographic synergies (U.K. gas traders opposite U.K. power
traders). The above arguments favor the latter strategy. Proximity encourages
uniform information flow with respect to input information (about shared price
drivers) and output information (managing multi-product transactions so that
individual product portfolios are not adversely effected by the activities of
other portfolios).

Origination Versus Trading:
The Role of Structurers in Multi-Asset Trading

The main operational problem with managingmulti-asset risk, such as tolling,
is that it may not be clear where the responsibility lies for hedging and decision-making.
At the origination/marketing and pricing stage, this situation can be mitigated
by the presence of structurers on the trading desk that manage the information
flow between the traders (who will do the hedging) and the originators (who
deal with the customer). The structurer can convert the twin asset information
that is emitted by the originator into the individual risk profiles that are
required by the two trading desks. In order to do so, the structurer must have
access to live and working (tradable) forward and volatility curves for the
underlying commodities.

Day-to-Day Hedging Considerations

Twin asset structures such as tolling products exhibit interdependency between
the assets — a transaction in one asset is contractually linked to a transaction
in the other. This interdependency can be accommodated by housing the combined
risk on one book, where it is managed by a single trader who makes unilateral
decisions on day-to-day optimization strategy. This strategy avoids the risk
of disputes between books regarding how and when to transact according to the
terms of the deals on the book. Secondly, it ensures that associated transactions
are executed in a coordinated fashion.

Conclusion

Many participants in the U.K. energy market have multi-asset portfolios based
on electricity, gas, and other fuels. Generators have a core position that is
based on the conversion of fuel to electricity. After they have executed their
initial hedges against this position, they have a residual position that requires
active management on a day-to-day basis, which requires interdependent transactions
in power and fuel markets. This hedge has often entailed the purchase of supply
portfolios. Trading companies develop their own gas and power portfolios through
customer deals and speculative activity with the result that they have physical
positions that may be similar to those of “true” physical players, such as generators.
Tolling products and other structures enable them to simulate generation portfolios
with varying degrees of precision. In order to optimize various twin or multi-asset
positions, market participants take into consideration the interrelationships
and cross-dependencies between fuel and power. This may be considered at the
economic level — particularly with regard to speculative activity —
but is certainly the case at the operational level, where transactions that
involve both assets need to be managed and coordinated carefully.