Electricity derivatives markets – what exactly is it?
A steady and secure supply of electricity is taken for granted by many of us. The phone is charged once plugged in, the sauna warms up with a touch of a button and the summer berries are preserved in a cold freezer through the winter, not to mention the need for constant supply of electricity in hospitals and grocery stores. Functioning electricity markets ensure that the demand and supply of electricity are balanced, enabling a steady supply around the clock.
The electricity derivatives market is a place where future electricity production is traded. Whereas the Nord Pool marketplace determines the hourly price of electricity each day, longer contracts are made in the derivatives market, protecting all parties from the fluctuating prices. Also known as electricity financial market and electricity derivatives exchange, the most significant derivatives market in the Nordics is the NASDAQ Commodities exchange.
On this page we will go through what happens on the derivatives market, why are the markets needed and how do they impact the end consumer.
What happens on the electricity derivatives market?
The derivatives market unites electricity producers and buyers. The buyers include electricity companies who provide contracts for end-customers, as well as large industrial companies.
The trading is carried out as an ongoing auction, enabling price transparency for all parties involved. As the derivative, a contract detailing the production of electricity and its price, is agreed upon, a collateral is paid by the electricity producer to a clearing account in the exchange.
The purpose of the collateral is to compensate any costs that follow if the agreed upon transaction i.e., delivery of electricity does not take place. The collateral requirements follow the electricity market price determined in the Nord Pool marketplace and can change daily. This means the producer of electricity must pay to difference of the market price and the previously agreed upon selling price to the clearing account. If the market price is lower than the original selling price, the exchange pays the difference to the clearing account. Once the transaction is complete, the collateral is paid back to the producer.
The increasing price of electricity also increases the required collateral, which are now paid for agreements made in the past. The bigger the electricity producer and the amount of electricity produced, the bigger the collateral needed. If the producer is unable to deliver the collateral, it can result in bankruptcy.
Why are the derivatives markets important?
The electricity derivatives exchange makes it possible to for electricity companies as well as end-customers to predict electricity prices in the form of fixed-price or fixed-term contracts. Just like individual consumers, large industrial and electricity companies want to be able to forecast their operations and the price of electricity they are going to use. Predicting the prices also acts as a barrier against any negative impacts the fluctuating prices may have.
Fixed-price and fixed-term electricity contracts are priced according to the price of the derivatives market. On the market, the electricity producer is agreeing to deliver a certain amount of electricity in a certain period such as two years. The collateral paid to the clearing account secures the transaction for the duration of the contract.
The collateral protects the electricity producer from momentary low prices, as the exchange is obliged to pay the difference of the market and selling price to the clearing account. Simultaneously the collateral protects the buyer from unexpectedly high prices, as existing fixed contracts with end-customers bind the companies to deliver electricity at a previously agreed price. If the electricity is not delivered, the collateral can be used to buy replacement electricity.
Nord Pool vs. NASDAQ Commodities
The above operators will quickly become familiar when reading about the electricity derivatives markets. Most of physical electricity trading will happen in Nord Pool power exchange. Nord Pool determines the hourly price of electricity every day. NASDAQ is the biggest and most significant electricity derivatives exchange, also known as electricity finance market, in the Nordics. The purpose of this exchange is to hedge the price of electricity with contracts called derivatives between the electricity producer and the purchaser. In the physical marketplace electricity moves from the producer to the end-consumer, whereas on the finance market only money is traded.
Ordinarily the derivatives exchange NASDAQ is used to predict the price of electricity for months or even years in advance. When the commerce is busy, each contract and derivative adds to the prediction of future prices. In today’s marketplace more and more producers and purchasers prefer private and bilateral agreements outside the exchange, making predicting future electricity prices even more difficult.
How do the derivatives markets impact individual consumers?
Understanding the difference between different types of electricity contracts helps to understand the impact of derivatives markets on our daily lives. With exchange electricity the consumer themselves covers all the risks caused by the fluctuating prices but is also free to optimize their consumption according to the cheapest hourly prices.
With fixed-term or fixed-price contracts the risk is covered by the electricity company as they need to predict the amount of electricity needed before it is used. If the predictions are wrong, the company faces financial losses either way, while the customer pays the fixed price throughout the contract.
If the company has not bought enough electricity to meet the need of the fixed contracts, additional electricity is needed. This is purchased from the electricity exchange with a higher price than the original. Another extremity is when the company ends up with excess electricity. In this case the excess must be sold in the exchange for cheaper than its original price. Both situations lead to financial loss.
Traditionally electric companies have been able to offer both fixed-term and fixed-price contracts as well as exchange electricity to their customers. The fixed contracts are based on the derivatives market, and as the collateral requirements are high, offering these contracts is a risk. Many electric companies are therefore assessing whether offering different types of contracts is profitable, or if contracts based on exchange electricity are the safer and less risky options.
Key terms
Electricity derivative
An agreement between the electricity producer and purchaser regarding the amount, delivery, and price of electricity in the future.
Electricity derivatives market
A marketplace for trading future electricity. The most significant marketplace in the Nordics is NASDAQ OMX Oslo ASA, also known as NASDAQ Commodities, when referring to electricity derivatives exchange. The agreements made in NASDAQ do not result in the physical trading of electricity.
Nord Pool
Nordic electricity trading place where electricity is sold and bought. Nord Pool operates in Sweden, Norway, Denmark, and Finland. Nord Pool acts as a marketplace for physical electricity.
Collateral
A sum of money paid by the electricity producer to guarantee a successful trade. The amount of the collateral follows the market price of electricity and is returned to the producer after a successful delivery of the electricity.