Hedging Option: Power sector moves towards futures and derivatives contracts

Power sector moves towards futures and derivatives contracts

After facing several regulatory delays, the Indian power market may finally be introducing the futures and derivatives contracts mechanism for power trading. This is one of the several power sector reforms that have been carried out over the past few years to improve services, trading and the efficacy of the power supply chain. After years of deliberations, the Central Electricity Regulatory Commission (CERC) and the Securities and Exchange Board of India (SEBI) have arrived at an understanding that futures and derivatives could be a hedging tool against power price volatility.

A futures contract typically involves the exchange of goods or services at a predetermined later date. A key element of these contracts is that the buyer and seller have to carry out the transaction at the price set at the time of entering into the contract, irrespective of the present market price. Prices discovered on the electricity exchanges over the years have varied considerably. From the Rs 3.50 per kWh average price discovered at the exchange in 2014-15 to Rs 2.50 per kWh in 2016-17 and then to Rs 4.26 per kWh in 2018-19, the prices have seen a fluctuating trend. Futures contracts may be able to protect the generator as well as the consumer against uncertainties.

Existing procurement market

Power procurement in India happens via several routes – long-term power purchase agreements (PPAs), short- and medium-term PPAs and exchanges. Over 89 per cent of generation is tied up under long-term PPAs, which typically last 25 years. Discoms have traditionally relied on long-term PPAs to provide electricity to consumers. As a generator, NTPC is primarily reliant on the cost-plus model. NTPC’s average tariff ranged from Rs 3.18 per unit to Rs 3.38 per unit between 2013-14 and 2018-19. At present, discoms are gradually moving away from the long-term PPA mechanism towards short-term PPAs of up to one year and medium-term PPAs of up to five years. The reduced cost of generation, falling renewable energy tariffs, and greater inclusion of renewable-based power have been crucial in bringing about the shift. The recently approved tariffs for several states range from Rs 3.90 per kWh (BEST, Maharashtra) to Rs 5.47 per kWh (Torrent Power, Gujarat). Meanwhile, during November-December 2019, over 12 GW of short-term power transactions were recorded on DEEP at prices ranging from Rs 3.25 per kWh to Rs 5.10 per kWh.

At present, there are two key market segments in both the exchanges – day-ahead market (DAM) and term-ahead market (TAM). Under DAM, auction for the delivery of power is conducted the following day. Under TAM, power can be delivered up to the next 11 days. It comprises intra-day, daily, weekly and day-ahead contingency contracts. DAM accounts for a major share of 94 per cent in terms of electricity volumes traded at the exchanges.

Futures features

Futures contracts may now be added to the list of power procurement methods being used by discoms and other consumers. It is being seen as a major reform in the power trading and procurement segment. While the role of SEBI would be to oversee the trading of futures contracts in the power sector, the CERC will have regulatory powers to settle the physical delivery of power at the stipulated date and price.

In the power sector, a futures contract may function as a PPA with some similarities and some critical differences. A point of similarity between the two contracts is that a specified amount of power is provided by the seller to the consumer. In addition, both contracts specify the duration of power supply. The following are some features of futures contracts for the power sector and their points of differences with traditional PPAs:

  • While a PPA is a complete contract for the transfer of physical power between two parties, a futures contract is a price-based contract with no details about other associated elements such as transmission and distribution charges and routes.
  • A futures contract is a financial-legal entity unlike a PPA, which is a legal entity binding the involved parties.
  • In financial markets, the futures contract is a tool used mostly by speculators and middlemen to take advantage of price fluctuations. However, the same may not be applied to the futures contract in the power sector. There may be some entities engaging in speculation with the help of futures contracts wherein the physical delivery of power may not take place between the two parties, but a cash transaction may be implied.
  • Futures contracts in the power sector may be used by sellers to hedge themselves against the risk of price reduction. For instance, a power generator may enter into a futures contract with an industrial consumer for a specified amount of power at a mutually agreed price for delivery at a later date. At the time of delivery, if the price per unit of power discovered is less than that in the futures contract, then the generator has hedged itself from the fall in prices and stands to make a profit, while the buyer purchases power at a loss. Similarly, if the price is higher than that given in the futures contract, the generator delivers power at a loss while the buyer makes a profit.
  • The futures contract in the power sector could prove to be a tool to decrease price fluctuations as seen on the power exchanges. The exchanges allow power trading through spot markets for a duration of only up to 11 days. The futures market will be pivotal in providing a longer-term mechanism for power trading.
  • With an increasing share of renewables in the power generation mix and falling renewable energy tariffs, it is expected that the overall cost of power procurement may reduce, though not significantly. The uncertainty in pricing may lead to increased volatility. However, analysts may be able to predict the price of power at a later date and futures contracts would insulate the seller and the buyer from the uncertainty of prices on the exchanges.
  • Another interesting aspect of the futures market is that unlike the exchanges or the spot market where the entire amount of the transaction has to be paid in the beginning, the futures market considers a small initial margin to be paid at the time of signing of the contract. This acts as a financial guarantee for the parties involved, which is adjusted at the time of delivery.
  • Futures contracts would also be able to give indications and trends regarding price discoveries at a later date as opposed to spot markets, especially amidst an industrial slowdown and the resultant fall in demand.

The way forward

While the regulatory hurdles seem to have been cleared for setting up the sector-specific futures and derivatives market, there may be certain delays given the current economic slowdown across the country. As the Indian power market matures, a futures market would help the sector improve price discovery on the exchanges and reduce speculation while hedging power generators and consumers. Meanwhile, these contracts will be critical for improving the risk profile of markets by diluting the counterparty risk.

With the introduction of futures contracts in the power sector, the exchanges will be able to offer a larger portfolio of contracts to involved parties. These contracts provide a platform for surplus generators to sell the extra power to consumers anticipating higher requirement at a future point in time. At this point, however, operational challenges are unknown.

Going forward, it is important for the regulators to ensure that the futures market is not limited to a few players that can eventually control the price discovery. Therefore, a strict set of guidelines and regulations will have to be provided to the exchanges, generators and consumers to keep the futures market in the power sector transparent and fair.

Ashay Abbhi