Derivatives are a way to protect players in the electricity sector through contracts for the purchase and sale of energy. With large companies entering to carry out structured operations in the energy market, the expectation is that financial contracts will become increasingly common and more liquid.
Derivatives protect and facilitate the negotiation of the price of electricity. They play a fundamental role as financial instruments. Producers, consumers, and intermediaries in the electricity sector can use derivatives as an effective tool to manage the risks associated with price fluctuations in energy.
Companies depend on electricity as a basic input to maintain their productive capacity. Any sudden variation in the price of energy affects the market, especially energy-intensive industries, which have a greater dependence on business competitiveness in the face of energy prices.
In recent years, the energy market has experienced several fluctuations due to different factors, such as the water crisis, the pandemic, and the shortage of oil production due to embargoes on Russia. Therefore, it is necessary to protect oneself from volatility in the buying and selling of energy, considering the influence of various factors on the price.
The deregulation of the electricity sector, the opening to the free market, and fluctuations in consumption, exchange rates, and water scarcity in the market have driven the structuring of energy as a commodity with greater trading possibilities in the B2B market. This resulted in the emergence of derivatives. The expansion of these derivatives was driven by the free energy market, which facilitates negotiations between agents. In the coming years, retail trade, whether B2C or by load aggregation, will regulate this market.
The Electricity Derivatives Market
Electricity derivatives play an important role in the financial market. These contracts are based on an underlying asset, in this case, the Difference Settlement Price (PLD), which is published by the CCEE (Electric Energy Commercialization Chamber).
The PLD is an indicator of the relationship between supply and demand for energy in the Brazilian market and serves as a reference for prices in the short-term free energy market.
Derivatives are generally linked to financial settlement, but in the case of electricity, they can also be linked to the physical delivery of the commodity. The outcome of the trade is determined by the difference between the agreed price and the market price of the asset.
These derivatives can be traded by traders, generators, and energy consumers. They are tools used to control and protect the market, allowing participants to reduce uncertainties caused by fluctuations in asset prices. This strategy is known as "hedging." In addition, derivatives can also be used to seek profits based on the behavior of asset prices.
Derivatives of Energy Modalities
1. Futures contract
A futures contract represents the commitment to buy or sell an asset for a specified price on a future date. Futures contracts are evaluated daily based on the reference price, known as the daily adjustment price. This means that operations are adjusted daily according to the market's expectations regarding the future price of the underlying asset.
2. "Forward" contract
Forward contracts allow fixing the price of an asset to be settled on a future date. By purchasing a "forward" contract, the buyer agrees to acquire a certain quantity of goods or financial asset at a set price from the moment of negotiation, with settlement occurring on a future date.
3. Options
Options confer the right to trade an asset at a fixed price on a future date. To acquire an option, it is necessary to pay a premium to the seller. This premium is not the price of the asset itself but a value paid to have the possibility of buying or selling the asset in the future.
4. Swap
A swap is a contract used to exchange the profitability between two assets over a certain period. This exchange is based on the comparison between two indexes, such as inflation indices, stocks, interest rates, exchange rates, among others.
Examples of Applied Scenarios
To demonstrate how the derivatives market can be a great option for those who wish to protect themselves from market volatility, we simulated a long-term contract negotiated at the beginning of the hourly PLD (where the market began to price the PLD according to the demand schedule, whereas before this period, it was priced weekly).
In this simulation, we assumed a long-term contract value, the sum of the differences between the contract and the market values for the analyzed period was zero. Thus, the indicated "flat" value of R$ 212,12 represents a loss for the contracting party if the PLD is priced below this value and a profit if it is underpriced compared to PLD.
Scenarios of low volatility and price generally represent the best moment for a Hedge contract, adjusting the predictability of both generators and consumers.
In the exposed graph, FOR EXAMPLE, there were moments of high volatility (R$/MWh) linked to the abrupt rise in price. In this phase, the contracts will attract greater risks to the agents.
Financial Contracts and Physical Contracts in the Derivatives Market
In the derivatives market, settlements can occur in two ways, either through financial settlement or settlement with product delivery, in this case, energy.
In financial contracts, physical delivery of energy is not required, and the negotiation is settled by the difference between the fixed price and the negotiated price. It is carried out in the market administrator and takes place at the time of negotiation, and the risk is bilateral. Since they are financial contracts, it is not necessary to register with the CCEE; negotiations can take place through the over-the-counter market as well as on the stock exchange.
For physical contracts, physical delivery of energy is necessarily involved, and the negotiation is settled for the full value of the contract. All must be registered with the CCEE, and registration must take place by the sixth business day of the following month of generation or consumption. Credit risks are bilateral and involve other risks associated with the MCP (GSF, lack of ballast, sharing of default).
Short-term Market
Known as MCP or 'spot' market, it is the moment when consumers and generators make adjustments and strategies to achieve the monthly energy balance, either by buying or selling energy. This period occurs between the 1st and the 6th business day of each month and is a time of adjustment between the available and necessary energy to close the month to carry out its operations. The MCP is based on the trading value of the PLD plus an operation fee. Exposure can be a strategy, but it is subject to market vagaries. It is important to note that short-term consumption occurs when there is excess or lack of energy.
Long-term Market
In the Free Contracting Environment, it is possible to buy energy from one or more agents, either for a few months or years, this contract modality guarantees more stable conditions in relation to (costs) and adjustments to the price of electricity, that is, greater cost predictability. A good energy management strategy integrates good load sizing with the negotiation period.
In the derivatives market, settlements can occur in two ways, either through financial settlement or settlement with product delivery, in this case, energy.
In financial contracts, physical delivery of energy is not required, and the negotiation is settled by the difference between the fixed price and the negotiated price. It is carried out in the market administrator and takes place at the time of negotiation, and the risk is bilateral. Since they are financial contracts, it is not necessary to register with the CCEE; negotiations can take place through the over-the-counter market as well as on the stock exchange.
For physical contracts, physical delivery of energy is necessarily involved, and the negotiation is settled for the full value of the contract. All must be registered with the CCEE, and registration must take place by the sixth business day of the following month of generation or consumption. Credit risks are bilateral and involve other risks associated with the MCP (GSF, lack of ballast, sharing of default).
Short-term Market
Known as MCP or 'spot' market, it is the moment when consumers and generators make adjustments and strategies to achieve the monthly energy balance, either by buying or selling energy. This period occurs between the 1st and the 6th business day of each month and is a time of adjustment between the available and necessary energy to close the month to carry out its operations. The MCP is based on the trading value of the PLD plus an operation fee. Exposure can be a strategy, but it is subject to market vagaries. It is important to note that short-term consumption occurs when there is excess or lack of energy.
Long-term Market
In the Free Contracting Environment, it is possible to buy energy from one or more agents, either for a few months or years, this contract modality guarantees more stable conditions in relation to (costs) and adjustments to the price of electricity, that is, greater cost predictability. A good energy management strategy integrates good load sizing with the negotiation period.
Trading derivatives requires having an account with a brokerage firm. These institutions carry out the intermediation of operations on the B3 trading floor. For the specific case of this market, it is worth considering some special aspects.
Check the trading fees charged by the brokers you are evaluating.
Also evaluate the analysis and trading systems provided by the broker. Brokers may also make specific requirements for those trading certain categories of derivatives, such as margin deposits. Check the conditions they establish for these services.
To open an account with a broker, it is usually necessary to submit copies of some documents and fill out certain forms. Once the account is active, simply transfer funds to the broker and start trading.
Why Derivatives Are the Future of the Electricity Market?
International experience shows that derivatives provide greater liquidity to the energy market, which is a fundamental element to add value and provide security in the operations of all involved in the chain, from consumption to generation.
The practice is common in several countries; the use of derivatives contributes to improving risk management, price formation, and expanding competition in the market, attracting resources, especially from financial agents interested in energy products. In the case of Germany, the volume of energy traded is eleven times greater than consumption.
What we can perceive is that electricity derivatives are another solution to increase the liquidity of the electricity market, protection of agents, but mainly attraction of new stakeholders who do not want to be involved with the physical delivery of energy, such as banks and large funds.
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