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I am referring to an electricity production company. Company is located in AsiaPac. The power is generated using Natural Gas fired combined-cycle power plants. Then this electricity is distributed to a main power grid company authorized for delivering the electricity to each house-hold or factory/indutries out there.

The electricity company buys Natural Gas from an authority who exports Liquified Natural Gas and stores in terminal tanks.

Since the electricity futures market is relatively illiquid, these contracts are only traded in OTC market. There are other electricity producting companies who are competitors in the same production space.

As for the search I have done, basic futures contracts this company takes are:-

  1. LNG futures contract with their LNG supplier
  2. Electricity futures contracts with their bidders from industrial players to power ditribution agents who then supply electricity to house-holds etc.

UPDATED AS INITIAL SET OF QUESTIONS WERE VERY BROAD

So it's great if someone could point out,

  • how to diversify a basic electricity portfolio?
  • how does this portfolio differ from any other energy portfolio?
  • how does bidding, hedging and risk is managed for this electricity port?

Given we do not hear much about electricity options in our market, it's great to hear about some effective strategies these companies would use to hedge their over all market risk.

Initial question approach:-

  • how to build a basic portfolio for this company?
  • how does this portfolio differ from any other energy portfolio?
  • how does bidding, hedging and risk is managed?
  • hegding strategies that can be used?
  • how to diversify this basic electricity portfolio?
  • how does speculation and arbitrage opportunities identified

Following are some references I have been reading,

If my question is too broad, please comment so it will help me to break it down to specific parts. :)

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  • $\begingroup$ Whoever down-vote please leave a comment. It says the person down-voted as off-topic, what is the and where is the off topic here when it has specific and relevant tags and title. $\endgroup$
    – bonCodigo
    Dec 17, 2012 at 16:08
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    $\begingroup$ Question's too broad. I sense this is a part of homework assignment. $\endgroup$
    – Rock
    Dec 18, 2012 at 19:28
  • $\begingroup$ There are too many questions. I think you need to narrow it down to one question at a time. Also, you need to be more specific about where this power company is operating. In the U.S.? If so, which state. Is it publicly owned, a co-op, private? If out of the U.S., which country? When you mentioned exporting LNG, is this company buying LNG that was imported, or is the company buying from a company that also exports LNG abroad? I doubt I can answer your final question, but I think you get the idea of how much information is missing. $\endgroup$
    – bill_080
    Dec 18, 2012 at 20:08
  • $\begingroup$ @bill_080 thanks for the helpful comment. The company is a LNG importer and a power retailer. Located in Asiapac. I am trying to imitate a possible fully hedged portfolio for this electricity company. I think I will update the question to more specific and focusing one important part at a time. Which would be : building fully hedged portfolio and difference between an electricity port vs any other energy port. $\endgroup$
    – bonCodigo
    Dec 18, 2012 at 20:18
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    $\begingroup$ I've had some very similar homework assignment problems back in good'o undergrad years. Good luck. $\endgroup$
    – Rock
    Dec 18, 2012 at 23:04

1 Answer 1

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One aspect you seem not to have so far considered is the ability to trade OTC spread options. A gas-fired power plant is naturally exposed to the "spark spread" (the difference between the market price of a unit of power and the cost of the gas required to produce that power).

These are traded OTC between utilities, banks and standalone energy traders and allow a power plant to hedge on a forward basis the exposure to this spread. The reason such spread options come into play is because a power plant does not have to be on. It essentially provides the owner of the plant, the option to collect the payoff

$$(E_i - G_i)$$

i.e. they receive

$$P_i = \max (E_i - G_i )$$

on each hour $i$ that the plant is able to operate. This is an oversimplified view because in reality there are costs associated with turning a power plant on and off that are missed by this framework.

This is not such an issue if the plant is a "base-load" plant (i.e. it is economical to run it 24/7 rather than for only the peak hours during the day). In the case of a baseload plant, the operating company could sell a one month spread option (on the spark spread) for the month ahead.

The value obtained from selling such an option would incorporate the intrinsic value present in the month ahead spark spread, as well as the option value of being able to take advantage of any increases in the power price.

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  • $\begingroup$ Hello Ben, I realise this was posted a long time ago, but do you have any references that I could read that would be of use to me in understanding hedging in fwd markets, specifically for Electricity portfolios? Many thanks $\endgroup$
    – user18399
    Oct 13, 2016 at 13:07
  • $\begingroup$ What aspects are you interested in? The practicalities of what instruments you'd trade etc, or background on how you'd price energy derivatives (e.g. the spark spread options I mentioned above)? $\endgroup$
    – Ben
    Oct 15, 2016 at 17:45

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