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Energy Market Deals with Trading and Supplying Energy

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Energy Market Deals with Trading and Supplying Energy Financial Risk – MSA400 On the Topic of Energy Risk Management Olof Bjerstaf , Juna Södergren December 3, 2012 Abstract Energy markets are bounded with a set of certain typical features, such as seasonality, mean reversion and storage costs. These attributes make risk management significantly different from the common capital markets, making the day of risk manager just a little bit more problematic. In this paper we give an introduction to the typical risks encountered, along with methods used to overcome and hedge against it. The report was written jointly by the authors in close cooperation. 1. Introduction risk related to these and an overview of how to handle it. There are notably many Energy market deals with the trading of other sources of risk apparent, such as energy, which is an essential importance for functional overload or political risk, that many different companies. This includes could not fit into this report. businesses involved throughout the whole production chain, ranging from oil 2. Energy markets’ characteristics producers like Shell to electricity suppliers as Vattenfall or large energy intensive industries Seasonality in line with Stora Enso. All these industries The demand and supply of energy in general, have a tendency to be sensitive to market and power in particular, tends to be highly risk or more precisely – to price risk, which affected by seasonality. In this way energy is a consequence of high volatility in energy markets are comparable to some other markets. Energy company managers can markets of commodities, such as the more easily deal with other sources of risk, harvesting seasons or likewise. Consider for through up-to-date effective tools, instance the importance of temperature for insurances or similar tools. However, these the demand of heating oil, which drives up tools are not as effective when it comes to prices in winter months whilst lowering managing price risk, particularly with regard them in the summer where there is little to electricity. This assessment deals with need for it. The prices of electricity can be energy market risk in general, with power even far more seasonal, which has since the markets in particular. The latter branch of wave of de-regulation evolved into a highly energy markets inherit a certain set of volatile market (Cartea et al 2005). The interesting characteristics, which make prices depend not only on season, but on handling and hedging of electricity price risk whether it is a working day or holyday. In specifically tough. Pilipovich (2007) lists a some extreme cases one might even couple of these, amplifying the importance experience jumps in prices during the course for the use of different methods for risk of day, making power prices highly sensitive. handling compared to the common capital The importance of seasonality is largely but markets. These are presented in the not entirely dependent on temperatures. The subsequent section. This paper aims to give prices are also affected by severe weather an introduction to energy markets, the price conditions or the amount of rainfall/solar 1 hours, just like in the case of crops and which generally tend to experience few but harvesting seasons. The capital markets are highly persistent price events (Pilipovich on the other hand obviously unaffected by a 2007). The different situation for energy fall in temperature. Seasonality is thereby market can be explained by its sensitivity to one of the most important issues for how to changes in supply and demand. These occur model and understand energy markets. due to some news making events, for example a war, high rainfall or natural Sensitivity to location catastrophes. Trading centers and other financial institutions are usually gathered together in Impact of storage one location, i.e. London/New York, which The energy supplier could manage the price implies that financial markets tend to be risk by producing or purchasing the energy, centralised when it comes to location. Energy e.g. oil/gas/uranium, in the current period suppliers and energy users are in contrast and storing it for later. One disadvantage usually “spread around” with regard to their with this approach is the cost of storage, location, therefore energy markets are said to which drives up the forward/future contract be decentralised. This becomes a problem prices. Another more pressing concern is the because when an energy company signs a inability to store electricity1. The storage future contract in, for example, New York, limitations are thus contributing to the high the energy price is still dependent on the volatility of energy prices. This issue applies location of the energy company. The price distinctively to power, further increasing the can actually be very different from the local level of volatility of prices. In comparison, in market price that we wish to hedge. The fact the money markets you can easily store your that energy markets are decentralized contract, which usually is a piece of paper or introduces us to a new risk – “geographical an electronic document. risk”. In the common capital markets, one unit of some currency holds equal value “Split personality” everywhere, otherwise obvious arbitrage Energy markets can be compared to the opportunities would arise. This is simply not two-faced Janus, one face for the short term possible in energy markets, for numerous perspective and one other for the long term. reasons, like the limits of capacity of the As stated above, energy prices are highly power grid. The price of energy is thereby affected by the storage limitations present relative not only to the model parameters, this underlines the differences between but to the locational one as well. short-term and long-term forward/future prices. The short term forward contracts are Mean reversion concerned with produced energy supply for Energy markets, electricity markets today or up to the next couple of months. especially, are infamous for exhibiting a high Long-term contracts, for more than six degree of mean reversion. Whilst the months or similar has to incorporate the occurrence of price spikes, or price events issue of future possible supply of energy, are common, in contrast to equity markets, which might differ heavily from today or last they also die out quickly. The market moves year. One can thereby argue that there exists around the equilibrium price, but one should a split personality for modeling of forward take further notice of a higher persistence of prices in energy markets. positive events compared to negative ones (Cartea et al 2009). Thus to make things Relatively new market even more complicated we have to deal with A further important discrepancy between an inhomogeneous level of mean reversion, the money and energy markets, are that the differing between spikes and between up-s and down-s. One can compare this 1 Purely theoretically one can of course also store characteristic to other financial markets, electricity, generally however at a cost that does not make it an alternative. 2 latter are relatively newer. The common need is to take into account the mean- financial markets have been around for quite reversion, the sudden jumps in prices and some time, hence there is a lot more the seasonality. Applying the common research done on these compared to the model for equities, which are usually thought other. One can of course argue that the to be log-normally distributed, will therefor world is constantly changing, financial render skewed results (Pilipovich 2007). markets no exception, and there is always Instead consider the fact that there tends to the need and use of improvements. Still the be a large seasonal up-ward jump in winters, strategies for equites/bonds have been we need to keep this in mind when we try to refined for many more years than what is the predict prices. The most common approach case of energy. Whilst many of the would be to include a seasonal component, “mysteries” of energy markets have been obtained from historical data. One should uncovered, there are still a lot of flaws and a though recognize, that this course might be comparatively higher level of uncertainty for problematic for certain electricity markets, modeling purposes than in other markets. such as Nord Pool, where the supply side is Whether or not these comparative issues will heavily dependent on the amount of snow remain even in the future is difficult to tell, fallen in the winter (Cartea et al 2009). given the fact that energy markets are far Likewise markets dependent on fossil fuels more complex. or nuclear power, are highly dependent on prices and availability on other markets too. Complex derivative contracts If we consider the sudden hikes in electricity All financial markets evolve, energy and prices, which might occur for numerous equity markets included. Consistently the reasons (such as technical failure), these hedging, trading and risk quantification should probably be modeled by some jump- abilities have developed to become more diffusion process (Cartea and Figueroa, refined and complex. Whereas the plain 2005). Most commonly one assumes the vanilla options still play a significant part in jumps occur according to some money markets, one might question their homogenous (Geman and Roncoroni, 2006) use for energy. These markets demand a or inhomogeneous Poisson process (Benth more refined sort of derivative, for et al 2007), with an intensity parameter speculative or hedging purposes. The estimated from historical data. An alternative derivatives used might range from more to try and capture the price spikes on commonly known “Asian” or “Barrier” average is proposed by Nomikos and options, to far more complicated weather Soldatos (2008). The authors instead suggest derivatives. With more complex derivatives using a regime-switching model, allowing for come bigger problems of effectively pricing periods of high and low water levels in the these derivatives.
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