Topics In Corporate Finance: Energy
Markets and Instruments
• B40.3160.10
• Neal D. Horrell
• Contact Information:
– KMC 9-197
– Hours: Monday 5:00 – 6:00 and by appointment
– Phone: (914) 830-1003 (212) 998-0300
– Email: nhorrell@stern.nyu.edu
• Text:
– Crewlow, Les & Strickland, Chris. Energy Risk
Management: Pricing and Applications. Lacama.
London, England, 2000.
Policies:
• Grading Policy will follow the distribution
typically used within the finance
departments. The components will be:
– One Paper/Study (60%) and
– Class Participation (40%).
Nature of the Energy Markets
• The market for energy derivatives spans a wide
range of physical and financial instruments.
• Multiple commodities: electricity, natural gas,
coal, others
• Characteristics of commodity vary widely with
respect to physical state and storage
• Extends to variables that drive prices including
weather and emissions.
Date
8/1/2001
6/1/2001
4/1/2001
2/1/2001
12/1/2000
10/1/2000
8/1/2000
6/1/2000
Price
Electricity
PJM Day Ahead Price
300
250
200
150
100
50
0
Characteristics of Markets
Immature
Mature
Bid/Ask Spread
Wide
Tight
Liquidity
Limited
Very liquid
Number Participants Few
Many
Forward Curve
N/A
Trading
Clearing
Bilateral
Institutionalized
Energy is Mixed
• Developing markets are electricity,
Weather, Coal, products, emissions.
• Mature Markets exist for Oil and Natural
gas.
• Settlement / clearing is primarily
bilateral (little institutionalized structure)
• Some contracts institutionalized
(NYMEX, IPE).
Electricity: Definitions
• Generation: Supply and Production
• Demand (load requirements on the system)
fluctuates continuously, based on time of
day, season, and the characteristics of the
territory served by the system.
Energy in Matrix
• Electricity (Natural Gas) is embedded in a
generation-transmission-distribution (productiontransmission-distribution) framework and cannot
be separated from this structure.
• While financial instruments are also in a
framework, their fungiblity, ease of transportation
and ease of storage make for a very different
market.
Electricity: A Changing
Environment
• Public Utilities Act & EU Energy Directive
92/96
• Both of these initiatives are aimed at the
disaggregating utilities functions from the
production, transmission and distribution of
energy (and other) products. This reflects the
economic realities that while transmission and
distribution are “natural monopolies”, the
production and sale of energy products can be
more efficiently handled by the marketplace.
Regulatory History
• Energy Policy Act 1992 (EPACT) removed
ownership constraints on generation facilities.
• encouraged increased competition in the
wholesale electric power business.
• any electric utility can apply to the FERC for an
order requiring another electric utility to provide
transmission services (wheeling).
• This change in the law permits owners of electric
generating equipment to sell wholesale power
(sales for resale) to noncontiguous utilities.
April 1996
• FERC Rule 888 provides for equal access to the
transmission grid for all wholesale buyers and
sellers, transmission pricing, and the recovery of
stranded costs
• Rule 889 requires jurisdictional utilities that own
or operate transmission facilities to establish
electronic systems to post information about their
available transmission capacities
Response to Rules
• Independent System Operators (ISOs) to operate
the transmission grid, regional transmission
groups, and open access same-time information
systems (OASIS) to inform competitors of
available capacity on their lines.
• Creation of new participants in the electric power
industry, power marketers and power brokers.
• Power marketers are entities engaged in buying
and selling wholesale electricity (FERC).
• Power brokers, not regulated by the FERC.
major functional areas
• Generation (Production)
• Transmission
• Distribution
Participants in the Market
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•
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National Government
Regional Entities
State Government
Private Sector
The Wholesale Market
Structure of the Market
• FERC Federal Energy Regulatory
Commission
• NERC North American Energy Reliability
Council
The Interconnects
• Texas Interconnected System is an island – not
interconnected with the other two networks
• The other two networks have limited
interconnections to each other.
• Western and the Texas are linked with different
parts of Mexico.
• The Eastern and Western are completely integrated
or linked with most of Canada
• Almost all U.S. utilities are interconnected by
these three major grids
FERC Strategic Plan 2001-2005
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•
•
•
•
Provide Regulatory Framework
Facilitate Development of the market
September 25, 2001 Revision B
Federal Energy Regulatory Commission
Objective 1.1: Remove roadblocks impeding
market investment
• Objective 1.2: Provide clarity of cost recovery to
infrastructure investors
• Objective 1.3: Proactively address landowner,
safety and environmental concerns
North American Electric
Reliability Council
• Private organization
• Members are 10 Regional Councils:
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–
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East Central Area Reliability Coordination Agreement
Electric Reliability Council of Texas
Florida Reliability Coordinating Council
Mid-Atlantic Area Council
Mid-Continent Area Power Pool
Mid-America Interconnected Network
Northeast Power Coordinating Council
Southeastern Electric Reliability Council
Southwest Power Pool
Western Systems Coordinating Council
NERC I
• Board of Trustees
– 2 members/Region
– All market segments
– 9 independent members
• Standing Committees
– 1 member per Region
– 2 from each market segment
Board of Trustees
Staff
Operating
Committee
Adequacy
Committee
Market Interface
Committee
NERC II
• North American Energy Reliability Council
• Overall reliability planning and coordination of
the interconnected power systems
• voluntarily formed in 1968 by the electric
utility industry as a result of the 1965 power
failure in the Northeast.
• NERC's nine regional councils cover the lower
48 contiguous States, part of Alaska, and
portions of Canada and Mexico.
NERC III
• overall coordination of bulk power
policies
• exchange operating and planning
information among their member utilities
• The boundaries of the NERC regions
follow the service areas of the electric
utilities in the region.
Networks (Power Grids)
Dispatch Center
• dispatch center must coordinate its
responsibilities so that the peak load highest
level of demand placed on the system can
be met at any given time.
• The center must also ensure that the flow of
electricity does not surpass the carrying
limits of transmission lines.
Transactions 1
• Purchase transactions involve buying
electricity from electric utilities and
nonutility power producers.
• Sales for resale transactions refer to
electricity sold by one electric utility or
power marketer to other electric utilities for
distribution.
Transactions 2
• Exchange transactions involve the availability of
excess generating capacity or diversity in load
requirements. For instance, an electric utility with
low winter load may offer excess capacity in
exchange for additional capacity to meet its high
summer load.
• Wheeling transactions are the movements of
electricity from one utility to another over the
transmission facilities of one or more intervening
utilities
Generating Units
• A base load generating unit is normally used to
satisfy all or part of the minimum or base load of
the system and, as a consequence, produces
electricity at an essentially constant rate and runs
continuously.
• A peak load generating unit, (aka peaker) is used
to meet requirements during the periods of
greatest or peak load on the system.
Types of Units
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•
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Steam-Turbine Generating Units
Gas Turbine Generating Units
Internal-Combustion Engines
Hydroelectric Generating Units
Other Generating :geothermal, solar,
wind, biomass
Electric Power v Energy
• Electric power is the rate at which electricity
does work-measured at a point in time (no
time dimension) unit of measure for electric
power is a watt).
• Electric energy is the amount of work that
can be done by electricity. The unit of
measure for electric energy is a watthour.
Electric energy is measured over a period of
time and has a time dimension as well an an
energy dimension.
Changing Energy Marketplace: Today
Supply & Demand Creates Electric Price Volatility
Sample Hourly Prices 7/5/99-7/11/99
$1,000
$800
$600
$400
$200
$-
Hours
Energy Markets - Capacity
Load Duration Curve
100%
Peaking
% of Peak Load
80%
60%
Intermediate
40%
20%
Base Load
0%
Supply & Demand
• Generation and Load
• Supply Determinants
– Installed capacity
– Congestion (use of transmission and
distribution lines)
• Demand Determinants
– weather
Short Term Supply
Short Term Demand
• Demand (Load or Consumption)
• Inelastic
– Seasonal Effects
– function of weather
– electricity heating/cooling
• Daily and Hourly Effects
– on peak 16 hours from 7AM to 10PM local time
excluding Sundays / Holidays
– off peak
• 8 hours 10PM local to 7AM local Sundays / Holidays
– Flat weighted average of peak and off-peak full
calendar month
Market Clearing
Resources
• General Information
– Energy Information Agency
http://www.eia.doe.gov/
– Report on Utility Industry
Valuation Tools
• Objective is to solve a partial differential
equation. The methods that are used
include:
• Monte Carlo Simulation
• Lattice Methods
• Analytic (Closed Form) Models
• Each as advantages and disadvantages.
Valuation Tools
• Use primarily Numerical techniques:
– Monte Carlo
– Lattice Methods
• Required “Inputs”
– Probability function(s)
– Specify form of PDE
– Payoff function
Monte Carlo
• Numerical Technique
• Advantages
– Easy to implement
– Can readily value any non-path dependent
derivative
• Disadvantages
– Not useful for American Style derivatives
– Time to obtain price and ‘greeks’
Lattice Methods
– Several types: binomial, trinomial, finite
difference grid.
• Advantages
– Relatively Easy to obtain ‘Greeks’
– Can value any path dependent derivative
• Disadvantages
– More difficult to implement than Monte Carlo
Example: GBM
• Geometric Brownian Motion.
• SDE (stochastic differential equation)
– dS = Sdt + SdZ
–  is the drift term
–  is the standard deviation
• This is in continuous time
• Changes in price are proportional to price level
• Convert to finite difference equation
 DS = SDt + SDZ
Example Continued
• Select a random number from the unit
normal distribution
• Compute St+Dt = St e(Dt + DZ)
– Where DZ is Dt0.5 e
• Compute value of derivative security
• Repeat simulation
• Compute average prices of simulations
Example: Numerical Results
• Suppose we want to value a call option on this
instrument. Boundry C = Max[S(T)-X;0].
• Parameter and Market Values
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–
–
–
 =0
 = 0.45
S0 (spot price) = 18
Risk free interest rate 3%.
• Contractual Values
– X (strike) = 20
– T (time to expiration) = 0.5 years.
– European Style Option
Example: Numerical Results
• Below are the results of a simulation
with n = 20
– Black Model 2.271162
– Monte Carlo 2.266716
• What are some issues concerning this
result?
• How can results be improved?
Example Continued
• Binomial Lattice
– Contruction of a “tree” that replicates the
parameters of the distribution.