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Energy risk management: settlement or OTC fixation?

By Benedict De Meulemeester

By Benedict De Meulemeester on 17/08/2017

Topics: Energy Trading

Energy risk management operations, the fixing, not fixing or unfixing of forward prices, is part of large end consumers’ daily tasks. Some companies have developed in-house capabilities for trading in the underlying wholesale energy markets. The large majority, however, perform the risk management through the services of their energy suppliers. This means that they make a framework agreement with a supplier that contains the formula to calculate the end price and facilities for performing the forward operations to secure (or not) a price.

There’s a wide variety of terminology to designate such contracts with energy risk management capabilities. Let’s call them ‘flexible contracts’ for simplicity’s sake. When negotiating such a contract, it’s important to carefully analyze and negotiate the process for performing a fixing or unfixing operation. An important aspect is whether the fixings and unfixings can be done based on a settlement value or through an OTC price quote.

Before explaining these options, we should look into what happens when you make a price fixing through such a flexible contract. Let’s say that you make a fixing for 25% of your expected consumption during 2018, e.g. for natural gas in the Netherlands, so we can look at the TTF gas market as our reference. On the ICE Endex exchange, you can find a product called TTF Cal 18. This product can be used to either get 5 MW of natural gas physically delivered on the TTF Hub during each hour of 2018. Or you can use it to just financially secure the price. This means that for every hour of 2018, the fixed price that you secured when buying the TTF Cal 18 future will be netted out against the spot price at that moment. The gains and losses on that netting out will compensate for the opposite price differentials to the fixed price of the gas that you physically buy in the energy spot market.

At the moment of writing this sentence, the TTF Cal 18 is trading at a price of 16,15 EUR/MWh.  Now, let’s say that 25% of your consumption corresponds with a 5 MW average capacity. If the supplier buys the TTF Cal 18 future now and agrees with you that you will pay for the 25% a price that is higher than that, he is sure that he will have a margin. The question is: how can he set up a process that ensures the synchronization of your decision to fix the 25% with his wholesale transaction buying the future?

1. OTC fixation

A first way of doing this is the OTC live price quote. The client sends the supplier a request to fix 25% Cal 18 TTF. The supplier receives this request and based on the price level observed at that moment in the TTF market, the trading room of the supplier provides a price quote that is sent to the client. On this quote, a validity is indicated, e.g. 30 minutes. This means that within that timeframe the client needs to decide whether he fixes or not. If he fixes, the suppliers’ trading room can buy the Cal 18 future and thus secure the price. The short timeframe for the decision is to avoid large increases in price level between the moment of quoting and the moment that the futures contract can actually be bought.

To cover for that short-term price risk, the supplier will often build in a little risk premium. Or a large one. The problem with this set-up is that an end client has no contractual guarantees about the size of that risk premium. This opens the door for abuse, with suppliers adding extra margins disguised as risk premiums every time you make a fixing or unfixing. To solve this, some markets have developed advanced solutions:

  • In the UK and US, some large consumers and consultants have developed so-called “sleeving”. When a client wants to fix, price quotes are asked to different suppliers. In the case that another supplier than the supplier that is contracted has the best quote, the two suppliers are brought in contact so that they can “sleeve” the hedge. This means that the physical supplier takes over the hedge from his better-priced colleague.
  • A more traditional solution is financial hedging. At the moment of fixing a price, the client also asks a quote to a third party, e.g. a bank. They provide swap solutions. If the bank has a better quote than the physical supplier then the client will sign a swap agreement with a bank for that volume. (The volume will almost always be fixed, whereas energy suppliers often give volume flexibility on hedges.) The client will continue to pay the spot price to his supplier for that volume but the bank will net that out over the fixed price. If the spot price is higher than the price fixed in the swap, the bank pays back the difference, if the energy spot price is lower, the client needs to pay to the bank.

These solutions entail a whole range of practical issues that make them difficult to apply for many end consumers of energy. So most of them are just trapped in an endless discussion regarding risk premiums aka extra margins in the price quotes. Many clients only see the price differences when they compare to the settlement values that are published at the end of the trading day. When they see that the prices they fixed are consistently higher than those settlement values, they start up the discussion regarding systematically adding a little extra to price quotes. Other customers have real time information about wholesale prices and see the differences the moment the quote comes in and start up the discussion.

The problem with that discussion is that it often leads to nothing and keeps the client from making fixings at good moments. The quote has only a limited validity, making the timeframe for negotiation or discussion regarding price fixings very short. This problem is exacerbated by the fact that in many cases there is a middle man in the shape of the client’s account manager. Larger clients are sometimes given direct access to a trader in the trading room. But many clients are frustrated by a non-discussion with an account manager claiming that “this is the price my trading room gave me, and there’s nothing I can do about it”. Or even – this is a literal quote from a conversation I once had – “I know my trading room isn’t performing very well on these price quotes, but there is nothing I can do about it”.

When confronted with a price quote that is half a euro or more expensive per MWh than the price that you see at that moment in the market, and a supplier that isn’t willing to lower it, most clients take the decision not to fix. And often see the market increasing the next day, get a bad quote again at an even higher level, don’t fix it again, and so on until the opportunity is completely lost.

It is clear that performance on OTC price quotes should be a key element in your selection of a supplier. But we’ve seen cases of suppliers that were always giving very good price quotes changing their behavior. If a supplier is going through a rough time, it must be very tempting to prop up the results a bit by asking your traders to be very risk-averse, i.e. charge high premiums, in the price quotes. To avoid these issues, buyers should look at settlement fixings.


2. Settlement fixings

When electricity markets in continental Europe were deregulated, we saw the rapid development of power exchanges. These function as any other exchange, e.g. for trading stock or currency. There are two main characteristics of exchanges that are of interest to the energy end consumer:

  1. The exchange is linked to a clearing house that functions as a central counter party. The buyer of energy pays to the clearing house, the seller gets paid by it. This makes trading through an exchange anonymous. And it reduces the credit risk in the case of derivatives such as our Cal 18 TTF future. To cover that risk, the clearing house will ask members of the exchange to deposit collateral. Such obligations are difficult to comply with for an end consumer. Hence, the interest of making your energy price fixings and unfixings through the services of an energy supplier.
  2. There is a trading board on which you can see the prices at which the different products are traded. This promotes transparency. Some exchanges, such as EEX, are very transparent and give information on the deals that are going on (although this is delayed). In all cases, exchanges are publishing at the end of the trading day the settlement value, which represents the value of the last trade or trades executed on that day.

In the continental European retail electricity markets, it’s become customary for price fixings to be executed based on that settlement value. Supply contracts contain a certain procedure for executing such a fixing (or unfixing) on settlement value, e.g. before 14:30 of day D, you have to communicate your wish to fix (or unfix) on that day D’s settlement price.

The advantage of settlement fixings is clear. There is no more discussion regarding the value that is fixed. It is the settlement value that everyone can see on the website of the exchange. There are some variations on this, e.g. in the UK, where it’s not an exchange but a price reported by a data company such as Heren, Platt’s or Argus that is used. But the principle is the same: no more discussions regarding the level of the price quote, the wholesale value that is fixed. The price that you see at the end of the day on the exchange’s price screen or in the data providers’ newsletter, is the value that is plugged into the price formula that you agreed contractually. No risk premiums or sneaky extra margins. Settlement fixing is therefore the best guarantee of avoiding paying extra on your price fixings.

Some buyers of energy hold on to OTC live price quoting because they believe that it allows them to make sharper pricing. We don’t see this. Unless you roll out the complicated sleeving or financial hedging techniques, the risk premiums aka extra margins will make you fix a price that is on average higher than what you could have fixed on the settlement values of those same days you chose for fixing. And that doesn’t even account for the large loss that can occur when not fixing because of an unresolved discussion regarding a quote. When fixing and unfixing, the OTC live price problems are twice as high, as you pay the bid – ask spread plus risk premiums on both sides.

Others think that they will lose money on the settlement fixings as they tend to fix in rising markets, which means that the market is lower when you fix OTC during the morning or afternoon. We can show them many trading days on which the highest price level intraday was reached during the morning.

In the end, the ideal contract allows you to choose the best of both worlds. It has an OTC live price quote option and a settlement option. If you decide to fix, you ask for the quote. If you’re satisfied, you fix it. If you think it is too high above what you can see in the market at that moment, you decide to drop it and ask the supplier to fix at settlement value. Fortunately, more and more suppliers are willing to make such a contract.

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