Managing Energy Risk: A Practical Guide for Risk Management in

Managing Energy Risk: A Practical Guide for Risk Management in

Managing Energy Risk
For other titles in the Wiley Finance series,
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Managing Energy Risk
A Practical Guide for Risk Management in
Power, Gas and Other Energy Markets
Second Edition
Markus Burger
Bernhard Graeber
Gero Schindlmayr
This edition first published 2014
© 2014 Markus Burger, Bernhard Graeber & Gero Schindlmayr
First edition published 2007 by John Wiley & Sons, Ltd.
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ISBN 978-1-118-61863-9 (hardback) ISBN 978-1-118-61862-2 (ebk)
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Contents
Preface
Acknowledgements
1 Energy Markets
1.1 Energy Trading
1.1.1 Spot Market
1.1.2 Forwards and Futures
1.1.3 Commodity Swaps
1.1.4 Options
1.1.5 Delivery Terms
1.2 The Oil Market
1.2.1 Consumption, Production and Reserves
1.2.2 Crude Oil Trading
1.2.3 Refined Oil Products
1.3 The Natural Gas Market
1.3.1 Consumption, Production and Reserves
1.3.2 Natural Gas Trading
1.3.3 Liquefied Natural Gas
1.4 The Coal Market
1.4.1 Consumption, Production and Reserves
1.4.2 Coal Trading
1.4.3 Freight
1.5 The Electricity Market
1.5.1 Consumption and Production
1.5.2 Electricity Trading
1.5.3 Electricity Exchanges
1.6 The Emissions Market
1.6.1 Kyoto Protocol
1.6.2 EU Emissions Trading Scheme
1.6.3 Flexible Mechanisms
1.6.4 Products and Marketplaces
1.6.5 Other Emissions Trading Schemes
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Contents
2 Renewable Energy
2.1 The Role of Renewable Energy in Electricity Generation
2.1.1 Historical Development
2.1.2 Political Targets
2.1.3 Forecasts
2.2 The Role of Liquid Biofuels in the Transportation Sector
2.3 Renewable Energy Technologies
2.3.1 Hydropower
2.3.2 Wind Power
2.3.3 Solar Energy
2.3.4 Geothermal Energy
2.3.5 Bioenergy
2.3.6 Not Widespread Renewable Energies
2.4 Support Schemes for Renewable Energy
2.4.1 Feed-In Tariffs
2.4.2 Net Metering
2.4.3 Electric Utility Quota Obligations and Tradable Certificates
2.4.4 Auctions
2.4.5 Subsidies, Investment Grants and Tax Benefits
2.5 Key Economic Factors of Renewable Energy Projects
2.5.1 The Project Developer’s Perspective
2.5.2 The Project Investor’s Perspective
2.6 Risks in Renewable Energy Projects and their Mitigation
2.6.1 Project Development Risks
2.6.2 Construction Risks
2.6.3 Resource Risks
2.6.4 Technical Risks
2.6.5 Market Risks
2.6.6 Regulatory Risks
2.6.7 Other Operational Risks
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3 Risk Management
3.1 Governance Principles and Market Regulation
3.2 Market Risk
3.2.1 Delta Position
3.2.2 Variance Minimising Hedging
3.2.3 Value-at-Risk
3.2.4 Estimating Volatilities and Correlations
3.2.5 Backtesting
3.2.6 Liquidity-Adjusted Value-at-Risk
3.2.7 Profit-at-Risk and Further Risk Measures
3.3 Legal Risk
3.4 Credit Risk
3.4.1 Credit Rating
3.4.2 Quantifying Credit Risk
3.5 Liquidity Risk
3.6 Operational Risk
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4 Retail Markets
4.1 Interaction of Wholesale and Retail Markets
4.2 Retail Products
4.2.1 Fixed-Price Contracts
4.2.2 Indexed Contracts
4.2.3 Full Service Contracts
4.2.4 Partial Delivery Contracts
4.2.5 Portfolio Management
4.2.6 Supplementary Products
4.3 Sourcing
4.3.1 Sourcing Fixed-Price Contracts
4.3.2 Sourcing Indexed Contracts
4.3.3 Sourcing B2C Contracts
4.4 Load Forecasting
4.5 Weather Risk in Gas Retail Markets
4.5.1 Weather Derivatives
4.6 Risk Premiums
4.6.1 Risk-Adjusted Return on Capital
4.6.2 Price Validity Period
4.6.3 Structuring Fee and Balancing Energy
4.6.4 Credit Risk
4.6.5 Volume and Price Profile Risk
4.6.6 Operational Risk
4.6.7 Risk Premium Summary
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5 Energy Derivatives
5.1 Forwards, Futures and Swaps
5.1.1 Forward Contracts
5.1.2 Futures Contracts
5.1.3 Swaps
5.2 Commodity Forward Curves
5.2.1 Investment Assets
5.2.2 Consumption Assets and Convenience Yield
5.2.3 The Market Price of Risk
5.3 “Plain Vanilla” Options
5.3.1 The Put–Call Parity and Option Strategies
5.3.2 Black’s Futures Price Model
5.3.3 Option Pricing Formulas
5.3.4 Hedging Options: The “Greeks”
5.3.5 Implied Volatilities and the “Volatility Smile”
5.3.6 Swaptions
5.4 American, Bermudan and Asian Options
5.4.1 American and Bermudan Options
5.4.2 Asian Options
5.5 Multi-Underlying Options
5.5.1 Basket Options
5.5.2 Spread Options
5.5.3 Quanto and Composite Options
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5.6
5.7
Modelling Spot Prices
5.6.1 Pricing Spot Price Options
5.6.2 Geometric Brownian Motion as Spot Price Model
5.6.3 The One-Factor Schwartz Model
5.6.4 The Schwartz–Smith Model
Stochastic Forward Curve Models
5.7.1 One-Factor Forward Curve Models
5.7.2 A Two-Factor Forward Curve Model
5.7.3 A Multi-Factor Exponential Model
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6 Stochastic Models for Electricity and Gas
6.1 Daily and Hourly Forward Curve Models
6.1.1 Daily Price Forward Curve for Gas
6.1.2 Hourly Price Forward Curve for Electricity
6.2 Structural Electricity Price Models
6.2.1 The SMaPS Model
6.2.2 The Multi-Commodity SMaPS model
6.2.3 Regime-Switching Models
6.2.4 Virtual Power Plants
6.3 Structural Gas Price Models
6.3.1 Natural Gas Price Models
6.3.2 Swing Options and Gas Storage
6.3.3 Least-Squares Monte Carlo Method
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7 Fundamental Market Models
7.1 Fundamental Price Drivers in Electricity Markets
7.1.1 Demand Side
7.1.2 Supply Side
7.1.3 Interconnections
7.2 Economic Power Plant Dispatch
7.2.1 Thermal Power Plants
7.2.2 Hydropower Plants
7.2.3 Optimisation Methods
7.3 Methodological Approaches
7.3.1 Merit Order Curve
7.3.2 Optimisation Models
7.3.3 System Dynamics
7.3.4 Game Theory
7.4 Relevant System Information for Electricity Market Modelling
7.4.1 Demand Side
7.4.2 Supply Side
7.4.3 Transmission System
7.4.4 Historical Data for Backtesting
7.4.5 Information Sources
7.5 Application of Electricity Market Models
7.6 Gas Market Models
7.6.1 Demand Side
7.6.2 Supply Side
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7.8
7.6.3 Transport
7.6.4 Storage
7.6.5 Portfolio Optimisation
7.6.6 Formulation of the Market Model
7.6.7 Application of Gas Market Models
Market Models for Oil, Coal and CO2 Markets
Asset Investment Decisions
7.8.1 The Discounted Cashflow Method
7.8.2 Weighted Average Cost of Capital
7.8.3 The Capital Asset Pricing Model
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Appendix: Mathematical Background
A.1 Econometric Methods
A.1.1 Linear Regression
A.1.2 Stationary Time Series and Unit Root Tests
A.1.3 Principal Component Analysis
A.1.4 Kalman Filtering Method
A.1.5 Regime-Switching Models
A.2 Stochastic Processes
A.2.1 Conditional Expectation and Martingales
A.2.2 Brownian Motion
A.2.3 Stochastic Integration and Itô’s Lemma
A.3 Option Pricing Theory
A.3.1 Pricing Under the Risk-Neutral Measure
A.3.2 The Feynman–Kac Theorem
A.3.3 Monte Carlo Simulation
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References
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Index
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Preface
Reliable energy supply is essential for our civilised society. With constantly growing worldwide
energy demand it is one of the main challenges for the 21st century to secure sufficient energy
supply at reasonable costs in alignment with environmental and climate protection targets.
Incidents like increasing oil prices, climate change, the Fukushima nuclear accident or shale
gas production have attracted a high degree of public, international media and political attention
in the energy sector. However, suggested answers for safe future energy supply differ broadly
in international comparison.
Until the mid-20th century, energy demand was almost exclusively met by domestic energy
sources. Since then fossil fuels have become traded internationally and interconnected markets
for electricity have evolved. Liberalisation of energy markets in many regions of the world led
to new electricity and gas markets with increasing trading volumes. With the introduction of
emissions trading for sulphur dioxide (SO2 ) in the United States and for carbon dioxide (CO2 )
in Europe, new markets with specific characteristics have been created.
Besides energy companies, large consumers and emitters, banks and other traders participate in growing energy markets. Commodities are also increasingly recognised as an important
asset class in fund management that can improve the portfolio risk profile. However, energy and
emissions markets are often described as unstable and erratic. They are characterised by a multitude of complex products, high price volatility and changing correlations between each other.
The financial crisis of 2007/8 has shown that for market participants, adequate risk management is essential. Risk management must cover all aspects – such as market, credit, liquidity
and operational risk – and has to reflect the specifics of the relevant markets adequately. Such
specifics also include the interaction between different energy markets. This book pursues a
multi-commodity approach and addresses electricity, gas, coal, oil and CO2 emissions.
Since the financial crisis, increased regulation of energy markets has broken the earlier trend
of market liberalisation in many countries. On the one hand, this is caused by the interaction of
financial markets and energy markets in terms of products and market participants. As a result,
energy traders now have to comply with new regulatory requirements originally targeted at
financial institutions. On the other hand, different political views on how to achieve ambitious
renewable energy targets led to new market interventions and regulations. Furthermore, public
concerns about the influence of speculators on commodity prices have fed discussions on
further regulation. Increased regulation and market interventions provide new challenges for
the energy industry that need to be taken into account in the risk management process.
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One speciality of this book is to cover both energy economics approaches, including fundamental market models, and the financial engineering approaches commonly used in banks
and other trading companies. One example of the combination of these approaches is the
SMaPS electricity price model described in Chapter 6. This builds on stochastic price models
similar to those used for financial markets but reflects the specific characteristics of electricity
markets by using a merit order approach commonly found in fundamental electricity market
models. As a consequence, this book addresses researchers and professionals from a technical
background in energy economics as well as those with experience in financial mathematics
or trading. Although the book introduces a wide range of theoretical concepts, its main focus
is on applications within the energy business. As the best choice of model depends on the
specific purpose, advantages and disadvantages of different modelling and risk management
approaches are discussed throughout the book.
This second edition contains substantial new material to meet the requirements of the recent
developments in energy markets. The main changes include:
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The structure of the book has been altered to offer a more intuitive approach for readers with
different interests. Chapters 1 and 2 give an overview and explain the fundamental principles
of energy markets. Chapters 3 and 4 describe risk management and customer-oriented retail
processes for energy companies. These chapters are particularly focused on practical use.
Chapters 5 and 6 cover the valuation of derivatives and structured energy products. They
require basic knowledge of financial mathematics, some of which is summarised in the
Appendix. An alternative for the valuation of real assets is the use of fundamental models
as explained in Chapter 7.
The growing influence of renewable energy is given much more space and a new and
comprehensive chapter on renewable energy has been added (Chapter 2). This contains
energy economic principles, value drivers and risks related to hydro, wind, solar, bio and
further renewable energy sources.
The growing gas markets and their modelling approaches are described in more detail.
Specific topics added to this second edition are how to build a price forward curve for
natural gas, stochastic modelling of gas prices and valuation of gas storage and swing
options.
The chapter on retail markets (Chapter 4) now contains a description of weather derivatives
and their use for hedging gas retail contracts.
To meet new requirements after the financial crisis, extended risk management processes
are discussed in more detail.
Acknowledgements
The realisation of this second edition involved inspiring teamwork, which we really enjoyed.
Besides the authors, a number of people provided valuable contributions to this book for which
we want to express our gratitude. First of all, we thank Guido Hirsch for his contributions
regarding gas price models and weather derivatives. Guido is Head of Market Risk and
Valuation Models at EnBW and thanks to Guido’s expertise the book could be expanded with
respect to the recent developments in natural gas markets. Jan Müller has added a description
of the multi-commodity SMaPS model, which formed part of his PhD thesis. Sven-Olaf Stoll
has added refinements to the price forward curve for electricity. Both Jan and Sven-Olaf are
experts in stochastic modelling at EnBW.