Electricity trading viability in Indian electricity exchange: A case of seasonal option strategies

Abstract

Commodities generally fall into three categories as Soft commodities[1], Metals[2] and Energy commodities[3]. With the taxonomy in Commodities risks in commodities also vary and which will adversely affect business’s financial performance or position with more volatility in price. Producers of commodities, for example in the minerals, agricultural and energy sectors, are primarily exposed to price falls, which will receive less revenue, contrary Consumers of airlines, transport companies, clothing manufacturers and food manufacturers, are experiencing rising prices, which will increase the cost of the commodities they purchase. In the same category under Electricity market the most sensitive issues are spot prices are volatile due to the unique physical attributes of electricity such as no storability, uncertain and inelastic demand and a steep supply function. Uncontrolled exposure to market price risks could lead to devastating consequences. With the increase of volatility in financial markets and leading to financial risk and corporate failures, organizations are showing keen interest in managing financial risk, one of the most commonly used technique to minimize financial risk is hedging (Hanly & Morales, 2015). Financial risk managers are busy in saving the industries from expected risk and volatility in electricity prices through hedging[4]. In India, there is huge demand supply gap in the electricity market at geographical level i.e. power deficit (Northern, Western and Southern) in certain regions and power surplus in other regions (Eastern and North Eastern). Hence the need of power trading is inevitable. With reforms and advent of Power Trading as a distinct activity, although there is decrease in the power deficit from 7.7% in January, 2006 to 0.9 % in July, 2017(Tongtao & Cunbin, 2014), still the market is not mature enough in comparison with the global electricity markets. India has two power exchanges: Indian Energy Exchange (IEX) and Power Exchange India Limited (PXIL) which started their operations in 27th June, 2008 and 22nd October, 2008 respectively (IEX and PXIL site)(Clark, Davis, Eberhard, Gratwick, & Wamukonya, 2005). Between the two exchanges, IEX is a dominant player; hence the prices of IEX are taken for analysis. IEX trades in four major products such as Day-Ahead Market(DAM), Term-Ahead Market(TAM), Renewable Energy Certificates (REC) and Energy Saving Certificates (ESCerts).The DAM contract is entered into one day before the actual execution of the contract. Since DAM captures the major portion of IEX and trading takes place in 15 minute time blocks in 24 hours of next day starting from midnight, therefore, conducting volatility analysis is easier in comparison with other products. This paper aims to examine the conditions of the Indian electricity trading market in the mid of 2008- 2017 for the establishment of an options and future market of electricity. It also estimates and applies a risk management strategy for electricity spot exposures using futures hedging. (Weron, 2000)Electricity options the power industry had been utilizing the idea of options through embedded terms and conditions in various supply and purchase contracts for decades, without explicitly recognizing and valuing the options. (Tongtao & Cunbin, 2014) Options are further categorized into call and put options, electricity call and put options offer their purchasers the right, but not the obligation, to buy or sell a fixed amount of underlying electricity at a pre-specified strike price by the option expiration time. They have similar payoff structures as those of regular call and put options on financial securities and other commodities. The majority of the transactions for electricity call and put options occur in the OTC markets. Electricity call and put options are the most effective tools available to merchant power plants and power marketers for hedging price risk because electricity generation capacities can be essentially viewed as call options on electricity, particularly when generation costs are fixed.

Then the progression of spot prices in one specific year Mar 2016 to Feb 2017 was analyzed to check the conclusion alignments with previous data. The analysis was mainly based on the spot price evolution and in the evaluation of an equivalent contract to some already existing. The equivalent contracts are some synthetic transactions consisting of four different (seasonal) and one short term yearly option contracts both call and put premiums are analyzed, which reproduced the original contract and reflects the cost of hedging. The outcome of the paper depicts the seasonal variation in cost associated with hedging also it shows contract between 135-270 days is considered to be advantageous for Indian Electricity market traders. For seasonal contracts winter is consider to be the best session for contracting for contract maturity more than 30 days. The seasonal contracts as summer, Rainy, autumn and winter were replicated in terms of a set of call and put option contracts. The evaluation of forward contracts by means of surrogated option transactions based on electricity gave quite acceptable results. Electricity trade can benefit from applying strategies with derivatives that reduce significantly the costs of hedging if a market for derivatives on electricity exists. Moreover, the strategies can be varied easily and given place to revision of decisions. Allocation of resources through time requires a system of signals. The roles of signals, in electricity should be by the spot, futures, and option prices. Price volatility in the spot market keeps in acceptable levels, in the short term volatility behaves as a stochastic variable. However, this variation has bounds and for long term operations the assumption of constant volatility, Scholes formula, seems adequate. There is evidence that the electricity price follows a random walk process. There are specific time duration are a part of strategy to decide the maturity of option contracts if it comprises seasonal impact or if the contract is of relatively lengthier or after integrating various sub contracts if trading is performed then a part of strategy to choose another time maturity to gain optimum premium. This paper finally gives green signal to Indian electricity market on the ground of maturity of contracts and volatility in price that IEX day ahead market can bring benefits to traders if the proper strategy is planned to invest in that market.