Valuing non-standard load profile products

Load profile products in the European OTC power markets are attracting increasing attention. However, valuations for these non-standard products can be difficult, as Cregor Janssen and Jan Lueddeke discuss

In the current European power market the only forward products listed on the exchanges are base, peak and off-peak contracts. For generators and consumers alike, these contracts are not suitable for effectively hedging a power portfolio. The optimal hedging strategy requires positions to be matched on an hourly profile. The result of the mismatch between hourly portfolio positions and the quoted base, peak and off-peak contracts for hedging is a residual hourly position that has to be taken in delivery. In delivery, these positions are matched by an hourly auction process. This can cause huge exposure to risk for an organisation as the volatility on the spot market can move exponentially, where single hours can settle anywhere between minus €3,000 and plus €3,000.

As a result of this large risk exposure, about five years ago some utility companies started matching hourly positions in the forward market by trading load profiles over-the-counter. A load profile is a strip of hourly positions with different volumes in various hours. By hedging output or consumption with load profiles, companies could significantly decrease their hourly positions and risk by reducing their residual volumes and value in hourly positions, which they take into physical delivery.

A new market

The trading of these tailor-made load profiles, based on single hours, created a very specialised market in non-standard products (not cleared and not traded on any regulated market or multilateral trading facility). Soon some standard products, such as ‘all weekends’ or all the ramping up or down hours of the forward year, were developed. 

Shortly after, the load profile instrument was used to realise various trading opportunities by not only managing and optimising the portfolio in a better way, but also by making it possible to realise the full optionality of virtual power plants, tolling contracts or cross-border capacity. Soon trading houses and banks moved into this market acknowledging these new trading opportunities. The basis of all hourly trading on the forward market is the so-called price forward curve.

Price forward curve

A price forward curve (PFC) is needed to evaluate hourly portfolios and to trade load profiles on the forward market. Every PFC is based on a model taking settlement spot data and historic forward prices into consideration – for example, clustering certain daily price profiles for January and making it arbitrage-free to the exchange-traded January base load. (The average price of all single hours of January must equal the January base load price). In the end, the average of all hourly prices must be arbitrage-free to the month, quarter and calendar product prices traded on the exchange. As every model and every PFC is unique, different PFCs will attribute a different value to the same hour but will maintain the arbitrage-free rule.

Risk premium

An issue regularly identified by market participants is the risk premium on the load profile forward market. As each counterparty uses its own PFC and natural flows are mostly going in one direction, a risk premium needs to be paid in the forward profile market. This is the same as the premium that is paid for a base product traded on an exchange. Some counterparties are under the assumption they have to pay over value, as they would have to pay more than the load profile’s value based on a calculation of their own PFC. What is often neglected is that a risk premium has always to be paid along the whole curve. As a consequence, some parties prefer going into delivery, and do not compare settlement prices with their own forecasts anymore. But more and more market participants are aware that a risk premium will be paid at delivery. By hedging with better instruments and by avoiding taking residual hourly positions into delivery, a bigger incalculable risk can be avoided and perhaps an even higher risk premium is justified to reduce the risk.

Hedging of load profiles

Hedging of load profiles should be done using a value hedge rather than an energetic/dynamic hedge. Every single hour has its own correlation to the peak and off peak. By performing an energetic hedge – for example, selling a yearly profile of 87,600 hours and buying 10 megawatts (MW) of yearly base load – the valuation of these products in a moving market can diverge. While all the hours in a base load will be valued one euro higher after the market moves up one euro, on a single-hour basis some hours move more than a euro, some less. Depending on volumes and hours of the load shape, the change in value of the profile can be different than the change of value of the base load. As a result, the value of a load profile should be hedged rather than the energetic amount, otherwise an exposure against market prices is created.

Optionality

By using load profiles it is not only possible to manage and optimise the portfolio in a better way, but the full optionality of virtual power plants, tolling contracts or cross-border capacity can be realised. Optionality can be used on a single-hour basis where volatility is higher. By trading on a single hour basis in the forward market and not using only base and peak loads, gamma positions¹ can be managed more efficiently. Another advantage of using the forward market is that the optionality can be optimised over and over again until the point where positions are taken into delivery.

Valuation challenges

As every PFC of every market player is unique, positions on an hourly basis can cause valuation differences. This results in differences in margining between the parties.

Bilateral margining agreements

OTC power products (bilateral trade) are traded under master trading agreements developed in the last 10 years, such as the European Federation of Energy Traders (EFET) General Agreement. These agreements have been developed to cater for OTC trading of standard energy products.

The use of an EFET Credit Support Annex (CSA) allows for bilateral margining of excess exposure. Parties agree in advance on their risk appetite by setting out thresholds with regard to their allowed exposure. If the threshold is exceeded, the party that faces the exposure sends out a margin call. Where a trading portfolio would also consists of hourly positions, by definition no matching valuation can exist, as the models used by parties always differ. This could give rise to a margin dispute between parties.

The standard dispute resolution procedure provides for a ‘go into the market’ approach, where the valuation agent (by default, the party making the relevant margin call) selects three leading traders in the power market to obtain quotes. In the that event three quotes cannot be obtained, the eventual fall-back scenario is the valuation agent’s original calculations. One can conclude that the standard dispute resolution process is far from ideal when the subject of the dispute involves the valuation of non-standard products.

Avoiding valuation disputes

One possible approach is to filter out the standard from the non-standard products when calculating the exposure. For example, when a trade is concluded based on hourly positions, parties can agree to filter out the exposure of the specific trade from the general exposure calculations. This could be specified in the relevant trade confirmation or by amending the exposure definitions under the CSA. This solution would however not work effectively if non-standard products dominated the trading portfolio between parties.

Another approach is to set a ‘no-dispute’ buffer upon concluding the CSA. Parties would then agree to a monetary or percentage limit, which would prevent an immediate commencement of the dispute resolution procedure. If the disputed amount is within the comfort limits set out by the parties, the party receiving the margin call will transfer the full (or agreed discounted) margin without starting the dispute resolution procedure.

Furthermore, parties could also choose to compare their PFC models and perform test calculations, prior to concluding the CSA. This would create more trust and transparency between parties and allow for an early check on future valuations. In practice however, this is not an ideal approach, as by its own nature these valuations are model based with no two models ever being the same. 

It is safe to conclude, there is no perfect solution in dealing with these valuation difficulties. Having a smart operational, risk and legal infrastructure will go a long way to avoiding major disputes and at the same time acknowledging the inherent risks when trading non-standard products.

Summary

The non-standard market of load profiles in power is becoming more interesting for utilities, trading houses and financial institutions to manage and optimise their portfolio. The attraction of load profiles is not only that they allow the user to avoid the high volatility and large risk exposures of the spot market, but also that they can be used to continuously realise the full optionality of virtual power plants, tolling contracts or cross-border capacity.

The market participants use a price forward curve, taking settlement spot data and historic forward prices into consideration, to evaluate hourly portfolios and to trade load profiles on the forward market. 

The EFET Credit Support Annex allows for bilateral margining of excess exposure. With regard to hourly positions, valuations differ by definition and no matching valuation can exist, as participants models are incomparable. Non-standard products, by definition, bring along more challenges in terms of valuation. Therefore, it is important market players have access to independent market price information of non-standards products, which offers a proper venue to check if their pricing is
fair and correct.