UK capacity markets set to alter hedging patterns

Utilities based in the UK are likely to change how they hedge their forward sales of power following a new type of capacity auction launched last December, according industry sources. A pattern has emerged with a greater focus on the back end of the power curve.

This could provide a boost to flagging liquidity on the forward markets, which has been hit by low prices and regulatory uncertainty.

Concerns over the inability of the electricity market to adjust to spikes in power demand without causing drastic increases in balancing market prices resulted in the Department of Energy and Climate Change (DECC) instituting a capacity auction.

“It all comes down to whether the estimates of required capacity is right,” said one trader from consulting and energy supply firm, referring to the first stage in the process that required predicting the capacity for 2018-2019.

Utilities bid for blocks of generation capacity that could be called upon if necessary during periods of peak demand. The electricity providers bid for a premium on top of the price of the electricity that is sold to end users.

The first round of 49.26GW capacity market auctions closed on the 18 December 2014, with results pointing to significant competition between energy producers keeping pressure on bid prices.

EDF was the ‘big six’ utility that benefitted the most from the auction with its low operating cost nuclear power stations winning bids for blocks of power generation capacity from National Grid. On the other end of the merit order, GDF SUEZ’s Dinorwig pumped storage facility participated in the auction, bringing a windfall of £35m to the firm.

The trader said that despite the benefits covering supply security and the relatively low market price for it due to an open market auction system, “much of the benefit actually accrued is down to whether the utilities priced the value of the premium right.”

Utilities hedge to lock in margins on future sale of power, and the capacity market opens up new potential for sale of electricity in the market and in turn new opportunities to hedge. In pricing their bids, utilities will have to consider their portfolio generation mix and the probability of calling upon the marginal power station for supplying to the grid, in light of forecast wholesale and retail prices.

“Firms can use a combination of long-dated forwards and options on coal, gas and power to mitigate the risk of fluctuation in prices of both input and output,” an industry professional said. “It preserves the premium they may possibly receive if they are called upon to supply.”

In order to hedge out changes in value in the option due to fluctuations in the price of the underlying electricity contract, utilities might eventually buy or sell electricity for delivery at the time when the options are set to expire – generally on the far curve.

“The more auctions take place, we are likely to see liquidity pick up on the back end. We’ve already seen options volumes up since the results of the first auction were announced,” the first trader said.

According to an industry source at a brokerage firm liquidity in 2018 over-the-counter traded options has “doubled” since February.

So far, there has been no noticeable effect on liquidity for the underlying power contracts. Transacted volumes have dropped by approximately 35% on Summer ’18 and Winter ’18 contracts during the same period, according to trade data obtained by ICIS.

But traders think the capacity market could at least offset some of the downward drift in far curve liquidity that has accelerated since the start of the year (see EDEM 21 May 2015).

And some traders agree with DECC’s view that the net benefit of capacity auctions will be significant. The bids in the auctions put a market price on the trade-off between supply security and its cost. This means that power generators can earn money for operating flexible plants that can easily switch on to back up a drop in renewable generation. surya.kanegaonkar@icis.com