How carbon-cutting Drax manages currencies and credit

Interview: UK power giant uses option selling – and other tactics – to create hedging headroom

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Lisa Dukes: “Given the size of the portfolio... active management is very important”
Juno Snowdon Photography

There is no obvious connection between the port of Baton Rouge in Louisiana and the town of Selby in Yorkshire, England. But there is a thread – of commerce, carbon dioxide and currency hedging – linking the two.

The fields southeast of Selby are home to the UK’s largest power station. Originally a coal-fired plant, it began transitioning to wood pellets as a fuel source eight years ago, in an attempt to reduce its carbon emissions – the bulk of those pellets are shipped to the nearby Humberside docks from Baton Rouge.

The transformation of the plant has been a big success story – CO2 emissions from the Drax Power Station in 2019 were less than 5% of the level recorded in 2012 – but those pellet shipments have also transformed the company’s foreign exchange exposure and the way it has to be managed. 

“Given the size of the portfolio, the mark-to-market position can be high relative to Drax’s market capital, so active management is very important and can be very valuable,” says Lisa Dukes, deputy group treasurer of Drax.

Today, Drax has a hedging programme that is unusual for a corporate in many ways. It extends out as far as six years, covering up to $5 billion of FX exposures at any one time. Dukes and her colleagues buy options and use structured products to create credit capacity, but will also sell options to monetise entry points for new trades. They have even helped create a brand new hedging product.

For a sterling-denominated company, buying the majority of its fuel in US dollars, the recent collapse in the sterling/US dollar rate on the back of the coronavirus meltdown has made its existing hedges very valuable.

The company is now reassessing which types of hedging strategies make sense going forward, but with its core hedging programme in place and providing protection, it’s also looking for opportunities to lock in some of that value gain.

“Most of our time is spent optimising and adding value, including looking at existing structures in the portfolio to see if it’s an opportune time to restructure and crystallise or add value,” says Dukes.

Buying a Ferrari for £10

When the company started transitioning away from coal, it gained a growing exposure to the GBP/USD rate, and to a lesser extent GBP/EUR, from its pellet purchases. Drax decided to start hedging that risk, but given it had a relatively small FX derivatives book at the time, and collateralisation was not an option, the amount of credit the banks were willing to extend was very limited.

“In terms of the amount of cover we wanted, one of our bankers at the time said it was like walking into a Ferrari garage with a tenner [a £10 note],” says Dukes.

Those limited credit lines meant the team had to find creative ways to get FX derivatives exposure. Early hedges included several structured solutions, such as participating forwards, giving the desired cover for about half of the credit line usage.

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Juno Snowdon Photography
Lisa Dukes

The strike on a vanilla FX forward is a combination of the spot rate and the forward points, the latter of which is a reflection of the interest rate differentials of the two currencies. Participating forwards give a slightly lower forward point, funding the purchase of a call option for 50% of the notional. So, if the GBP/USD spot rate goes above the strike, pushing Drax out-of-the-money, the positive value of the call option offsets half of the credit line usage that would otherwise be generated.

Over time, the derivatives book has grown to cover around £1 billion a year of exposure, and Drax now has the credit lines to hedge the majority of this exposure with vanilla forwards. But not completely – credit line retention is still a key aim and Drax doesn’t want to lock up too much capacity, so the company still uses participating forwards or other products with similar outcomes.

While it seems an unlikely scenario right now, if the company hedged exclusively with vanilla forwards and GBP/USD hit 1.70, it would leave the portfolio a long way out-of-the-money. In this scenario, potential future exposure (PFE) – the measurement on which credit lines are based – would balloon, Drax would rapidly consume its available credit lines and it would be unable to add any new hedges.

“Conceptually, it’s an odd conversation to have with senior management when they ask what we’re worried about. Among other things, we’re worried about sterling going higher. That can be a difficult thing to understand and explain when sterling strength is generally a positive thing for the group,” says Dukes.

It may look very odd having the option to sell the currency that we want to buy, but what it does is include participation in the portfolio

With this in mind, the team also buys topside GBP/USD options. It might seem counterintuitive at first glance, given the general goal is to protect against the currency weakening not strengthening, but as a credit-mitigation tool it makes sense: as spot rises towards the strike, the forwards portfolio moves out-of-the money, but the bought topside option gains value and offsets the forwards positions. It also allows the company to benefit from such moves.

“It may look very odd having the option to sell the currency that we want to buy, but what it does is include participation in the portfolio, as well as making sure all the banks are happy and have sufficient lines available to us,” Dukes says.

To keep an eye on credit line usage, Dukes has built a model to estimate its PFE at each dealer. It helps the Drax treasury team understand why its counterparties can have different appetites and credit charges in certain tenors.

“That helps in the discussion. Then, if needed, we can go back and see whether there are ways to cap the PFE, potentially using derivatives, or whether we should focus on a particular term to flatten the exposure,” she says.

The value of indifference

Another key concept in Drax’s hedging policy is what Dukes describes as ‘indifference’. The company doesn’t hedge all its known exposures as they’re identified, because some of its pellet purchase agreements run for longer periods than the available hedging lines and credit management restrictions would not allow it.

The company hedges a minimum of five years of its contracted exposure and a high proportion of its ‘highly probable’ FX exposure in advance. The remainder is done over the passage of time as exposures roll in on a quarterly basis.

Drax is therefore indifferent to when those top-up hedges are put on, giving the team the freedom to cover additional exposure when it suits. This isn’t a new concept to corporate hedging, but capturing the value of this timing flexibility is a big focus for the team.

We can hedge now, we can hedge tomorrow or in a year’s time for a small proportion, or top slice, of our future exposures

In practice, there are several possible benefits. For instance, Drax can use combinations of sold options to improve strikes on the company’s forwards, but require the sale of double the notional amount if spot moves beyond an upside barrier.

So, say a regular forward strike was at 1.35 at the five-year point and Drax needed to sell between £50 millon-200 million for dollars at that tenor over time. Using these options, similar to an extendable forward, the company could instead sell sterling at 1.45. If spot rose through that level, the company would have to sell £100 million at that rate. This wouldn’t be a problem as Drax needed to sell that amount anyway, and the strike is still above what it might have otherwise received. In effect the trade monetises timing flexibility.

“We’ve got very comfortable with this concept over the last three years. We can hedge now, we can hedge tomorrow or in a year’s time for a small proportion, or top slice, of our future exposures. The approach has been very successful, and has been tried and tested in what have been very interesting market dynamics,” says Dukes.

The indifference policy also allows Drax to monetise its trading entry points. For example, say the company was interested in entering a forward but only if the rate hit 1.30. This could be done by placing a conditional sell order, but instead the company looked to sell call options at that strike and collect the premium. If the level was hit, the company can take delivery of the dollars from the call buyer and use them to delta-hedge a forward struck at that higher level.

“If the option lapses, we can choose to sell another one. If it gets exercised, it’s at a higher rate than we would have got if we entered the market at the time. And, in addition, in either eventuality we have captured the premium as value in the wider portfolio,” she says.

Brexit bonus

This flexibility also allows the company to navigate event-driven volatility in a thoughtful way. On the eve of the Brexit referendum vote in June 2016, for example, opinion polls were showing a comfortable victory for the Remain campaign.

Drax chose to ramp up its hedges anyway.

“We evaluated the risk and, ultimately, we were more concerned about a bigger move to the downside, which at the time was lower probability – but would have been more of an issue than a higher probability of a smaller move higher,” says Dukes.

The company opted for products offering some upside participation and reduced credit line usage. One of these is known as the ‘forward-plus’. It gives the hedger protection on the downside with a slightly lower strike. But if spot rises beyond this strike it can sell at the higher rate up to a barrier point. If spot goes beyond the barrier, Drax would sell at the level of a regular forward.

After the Leave campaign’s victory in the referendum, GBP/USD slid from around 1.47 to 1.20 in January 2017, dipping again in August last year, but Drax was locked in at close to pre-referendum levels until 2024, according to its 2019 annual report.

“In hindsight it was a very rewarding decision, but the key was making sure we undertook an active decision to provide the additional certainty and downside protection through a particularly risky event,” says Dukes.

The floating spot forward

As all corporate treasurers will know, there isn’t an off-the-shelf hedge for every scenario, but banks will try to come up with something if pushed. And Drax has done its fair share of pushing. As a user of long-dated forwards, the company is most exposed to spot movements, but also to changes in the forward points. Instruments exist to lock in the former, of course, but not the latter – until Dukes and Drax got involved anyway.

Last year, the company noticed GBP/USD forward points were very attractive, but Brexit-related impacts had left the spot level at depressed levels, so the overall forward rate was unattractive.

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Juno Snowdon Photography
Lisa Dukes

“We talked to our banks as we felt there was value in hedging the forward points in isolation, as we were already very well covered for spot. We knew we had long-dated forward exposure that was going to keep rolling in on a quarterly basis, so we challenged them on how we could lock in the record-high forward-point differentials without taking exposure to spot in any way,” says Dukes.

Two banks came back with different answers to that challenge. One of them was NatWest Markets, which developed a product called a floating spot forward, which allowed Drax to fix the value of the forward curve, but leave spot floating for up to six years. If spot rose sufficiently for Drax, it could be locked in, at which point the product converts to a regular forex forward, comprising the new spot rate and the previously fixed forward points.

According to Dukes, Drax is still the only company to have traded the product. She is now looking at other versions of the trade and – extending the indifference principle again – also starting to sell options to enter the floating spot forward to monetise the potential entry point.

The dollars coming in from the hedges are needed to pay for the pellets that are delivered across the Atlantic by ship. Drax has a rough idea, on a quarterly basis, how much foreign currency it will need for these fuel payments, but it cannot say when a ship is going to arrive 30 days out, let alone in six years’ time.

We recognise that some banks tend to have sweet spots… and we can seek to create mutually beneficial execution processes through candid relationships

But with the hedges bringing in dollars on a quarterly basis regardless, Drax has cash-management decisions to make. The company can deposit the currency, for example, or invest it in money market funds.

Drax also makes use of the FX swap market to exchange those dollars for sterling on a short-term basis and avoid a build-up of foreign currency. These trades are mostly done on FXall, as the platform allows Drax to take advantage of straight-through processing.

But, swaps aside, Dukes is not a huge fan of screen-based trading. Maintaining relationships with dealers is a key part of a treasury’s role, she argues, as it allows for open dialogue around everything from new product ideas to potential axes.

“If we know we are restructuring, if we are looking at a less liquid product or if we have a large notional requirement, for example, having an open dialogue is key. The banks could have offsetting flows, which would deliver a better result for us,” says Dukes.

“We also recognise that some banks tend to have sweet spots, including currency, tenor or option positioning, and we can seek to create mutually beneficial execution processes through candid relationships and understanding of our partners’ strengths. We get reverse enquiries most days, which wouldn’t happen if we didn’t have such strong bilateral relationships,” she adds.

And there’s no shortage of relationships to maintain. Drax has more than a dozen banks it can trade over-the-counter derivatives with, along with others offering standby capacity if required.

To benchmark the banks, the company sends around a detailed questionnaire every quarter, asking them to price a credit charge for forwards with tenors from one to six years. This allows the company to create a benchmark credit charge per currency pair, which it uses when evaluating quotes for new trades.

Pips and points

$6 billion: and more. This is the rough amount of FX exposure Drax has hedged at any one time.

$25 million: the typical minimum clip size that Drax will execute in the long-term forwards market.

Six: the longest tenor of the company’s FX hedges.

Two: the number of derivatives specialists in the Drax treasury.

2030: a decade from now, Drax aims to be the world’s first carbon-negative group, removing more CO2 from the atmosphere than it generates from its operations.


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