Integration of Power and Gas Trading by Chris Trayhorn, Publisher of mThink Blue Book, January 15, 2002 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 A moratorium on gas generation was withdrawn.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. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.