WIND DERIVATIVES: has their time come?

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    WIND DERIVATIVES: has their time come?

    The Internal Energy Agency (IEA) estimates that wind will generate 18% of the world’s power by 2050—equating to approximately 2800 gigawatts (GW) as compared to current generation of about 300 GW.1 This growth in wind power will have a significant impact on the grid infrastructure, power systems, policies and electricity markets. Kevin Casey, Shailesh Joshi and Shahid Intekhab discuss the need for wind-related products/derivatives to manage risk across all aspects of the wind economy, including generation, trading, distribution and project financing.

    How Renewable Power is Changing Electricity Markets

    On Sunday, October 4, 2009, at approximately 3:00 AM, the German Power Exchange (EEX) registered a day-ahead market clearing price of -500.02 € per megawatts per hour (MWh).2 To some, it may have seemed like a technical glitch or an anomaly. But in reality, this was the 71st time that the price of electricity dropped below 0 € per MWh since the EEX removed the price floor in September 2008.

    Since that day, high-variability renewable power (excluding hydro and bio-fuels) has increased from about 400 terawatts per hour (TWh) to 1000 TWh and is projected to grow to 2000 TWh by 2020.3 When that happens, renewable power will be approximately 10% of total electricity production (see Figure 1).

    Fig1

    The Changing Landscape

    In 2008, governments began offering tax breaks and incentives to firms building renewable energy projects. By having a top priority in distribution coupled with the added incentives, renewable energy has become the power of choice for small players, such as financial investors. Today, however, the situation is slowly changing. With reduced incentives, increased regulations and an evolving grid infrastructure, renewable generators will have to evolve from asset developers and investment managers into power market players. To make this shift and to drive profitability, generators will need to invest in production forecast, portfolio optimization, risk management and scheduling.

    This shift will likely change industry strategy by creating opportunities whereby energy utility functions will be offered as services to smaller generators. The big incumbents potentially will become the new traders and the traditional utilities may change their business strategy. For example, on November 30, 2014, E.ON announced its strategy to focus on renewables, distribution and retail solutions and its intent to exit conventional generation.

    Infrastructure

    An integrated grid infrastructure and market coupling, such as integrating electricity markets, are the keys to handling generation variability. Over the last few years, Europe added multiple interconnector capacities and a few remain in the pipeline to build connectivity across the continent. Companies like the European Market Coupling Company (EMCC) are using day-ahead auctions to manage congestion.

    In the United States, the proposed Tres Amigas Superstation that will enable the connection of America’s three primary interconnections—WECC, Eastern and ERCOT—will serve as a renewable energy market hub. Transmission companies and electric utilities will be able to connect to the Superstation and purchase power from, and sell power to, each of the three US power grids.

    Role of Wind—Challenges and Opportunities

    Wind plays a major role in renewable power. In 2013, more than 35,000 megawatts (MW) of new wind power capacity was brought online. In terms of overall investments, the global wind sector saw a small decline to USD 80.3 billion in 2013 from USD 80.9 billion (EUR 59.2 billion) in 2012.5

    Asia was the flag bearer of new wind capacity installations in 2013 and is likely to overtake Europe as the region with the most deployed wind capacity by the end of 2015. China was the primary engine of growth, taking the top spot with 16,088 MW of new capacity. India, the new player, added 1,729 MW.6

    The world is expected to continue pushing for green technologies while the investment trend in wind (and other renewable sources of energy) will continue over the next several years.

    Variability
    The variability in supply from wind leads to uncertainty in the short-term intraday markets for both renewable generators that are unable to accurately forecast the generation, and the conventional generators that are unable to optimize their dispatch. This has led to an increase in short-term trading activities and balancing services. As a result, trading volumes have steadily increased over the past few years.

    Low Marginal Cost

    Wind power has a low marginal cost (zero fuel costs) and therefore enters near the bottom of the supply curve (see Figure 2). Graphically, this shifts the supply curve to the right, resulting in a lower power price depending on the price elasticity of the power demand. In Figure 2, the price is reduced from Price A to Price B when wind power decreases during peak demand. In general, the price of power is expected to be lower during periods with high wind than in periods with low wind. This is called the “merit order effect.”

    Security of Supply
    The power generation from wind is vulnerable to the conditions of weather. To ensure security of supply, wind generation must be augmented by traditional stand-by power generation. This industry model will lead to technological development around grid storage and developments. One example is the new capacity auction market that was recently created in the UK to compensate conventional generators for stand-by power in order to secure a steady rate of supply despite weather conditions.

    Fig2

    Time to Think about Wind Derivatives

    The increase in wind’s share of electricity generation has increased the risks associated with its inherent high variability and low marginal cost. The risk not only affects electricity producers, but also reverberates throughout the value chain.

    The History of Wind Derivatives
    Wind-related products are available today; however, they are mostly tailor-made to manage specific risks. Typically, these over-the-counter (OTC) products have been used for project financing and insurance. A reason often cited by generators is the basis risk between the actual wind farm location and the index.

    In May 2011, Galileo Weather Risk (acquired by Endurance Re), a provider of weather risk protection products, announced WindLock, which it described as “the first financial products designed to assist the wind power industry in hedging the financial risk of wind variability.”7 The contracts, transacted either as derivatives or (re)insurance, were based on an index of modeled output from a wind farm, driven by average or hourly wind speed.

    In 2007, the US Futures Exchange announced that it would offer wind futures. Seven contracts from wind farm regions in Texas and New York were to be traded with monthly expiries.

    The Dimensions of Wind Derivatives

    The increased contribution of wind generated power, availability of data, models and an increased need to manage the volume risk indicate that it is the perfect time to start thinking about wind derivatives.

    At a fundamental level, wind derivatives can be structured using two dimensions: wind speed and wind power.

    Wind Speed
    Wind speed products will be defined based on the daily average wind speed as measured by a predefined meteorological station over a specified period. The inherent problem with such products is the basis risk which can now be minimized by data provided by companies like 3TIER, who provide very comprehensive data at the installed wind capacity location. The product can be similarly structured to temperature products with average speed and high wind and low wind steps. These products will be of particular interest to producers as they can hedge the expected dispatch.

    Wind Power
    Wind power products will be defined based on power generated by the installed wind capacity in a particular region over a specified period. The European Energy Exchange (EEX) is planning to launch a product based on Deutsche Börse’s Wind Power Indicator, which provides the daily expected wind power generation normalized to available capacity (MWh per available MW) for Germany, Austria, the UK and Denmark. Conventional power generators will find this product key to hedge the price risk because the product is based on the market area and pricing region.

    Looking Ahead

    Both wind speed and wind power can be structured as standardized products to create a wind derivatives market. It’s a market that will provide the right hedging tool to generators and other participants in the value chain, and will eventually replace the current “kitchen sink” approach to hedge variability due to wind generators.

     

    References

    1. International Energy Agency (IEA), Technology Roadmap, Wind Energy, 2013.
      http://www.iea.org/publications/freepublications/publication/Wind_2013_Roadmap.pdf
    2. EEX, Market Data, October 4, 2009.
      http://www.eex.com/en/market-data/power/spot-market/auction” \l “!/2009/10/04” http://www.eex.com/en/market-data/power/spot-market/auction#!/2009/10/04
    3. International Energy Agency (IEA), Technology Roadmap, Wind Energy, 2013.
      http://www.iea.org/publications/freepublications/publication/Wind_2013_Roadmap.pdf
    4. CAPP, Crude Oil Forecast, Markets & Transportation, June 2014
    5. Global Wind Energy Council, The Global Wind Report, Annual Market Update, 2013
    6. IBID.
    7. Reuters, Insurance-like Product Protects Power Developers from Windless Days, June 12, 2011. http://www.reuters.com/article/2011/06/12/idUS255181882020110612
    The Authors
    Kevin Casey

    Kevin Casey
    is a Director of Business Consulting based in Houston, Texas. With more than 30 years of experience in commodities trading, Kevin has been instrumental in the research and development of crude oil, natural gas, heating oil, gasoline and electricity futures contracts traded on the NYMEX. He has served on the Board of Directors of the New York Mercantile Exchange (NYMEX), the Commodity Floor Brokers and Traders Association (CFBTA) and the European Federation of Energy Traders (EFET). Prior to joining Sapient Global Markets, Kevin worked for some of the top firms in energy and commodities trading.

    Shailesh Joshi

    Shailesh Joshi
    is a Director of Business Consulting with more than 17 years of experience working as a technology and business consultant in the energy industry. His experience includes engagements that range across the entire energy business value chain. Shailesh is currently responsible for setting up the commodities consulting business for Sapient Global Markets in Europe and leading key projects.

    Shahid Intekhab

    Shahid Intekhab
    is a Dusseldorf-based Senior Manager at Sapient Global Markets. He has over 11 years of experience in consulting and system integration for large-scale energy utilities with upstream, midstream and downstream assets. He is currently one of the leads on a greenfield product implementation project.

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