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.

ElectricityPJM Day Ahead Price

050100150200250300

6/1/

2000

8/1/

2000

10/1

/200

0

12/1

/200

0

2/1/

2001

4/1/

2001

6/1/

2001

8/1/

2001

Date

Pri

ce

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 (production-transmission-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

• 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

• 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 ElectricReliability Council

• Private organization• Members are 10 Regional Councils:

– 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

Staff

OperatingCommitteeOperatingCommittee

AdequacyCommittee

Board of Trustees• Board of Trustees– 2 members/Region

– All market segments

– 9 independent members

• Standing Committees– 1 member per Region

– 2 from each market segmentMarket Interface

Committee

NERC I

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

• 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

Sample Hourly Prices 7/5/99-7/11/99

$-

$200

$400

$600

$800

$1,000

Supply & Demand Creates Electric Price Volatility

Hours

Energy Markets - Capacity

Load Duration Curve

0%

20%

40%

60%

80%

100%

% o

f P

ea

k L

oa

d

Base LoadBase Load

IntermediateIntermediate

PeakingPeaking

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

S = St + SZ

Example Continued

• Select a random number from the unit normal distribution

• Compute St+t = St e(t + Z)

– Where Z is t0.5

• 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 = 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.