AASB139 - Benchmarking Electricity Hedges, 03/06/06
Wed 13 Sep 2006
Electricity Futures Facilitating compliance with Australian Hedge Accounting Standards.
A pdf of this paper is attached at the bottom of this page.
INTRODUCTION
The phase-in of International Financial Reporting Standards in Australia is having a significant impact on the quality of hedge contract reporting in the Australian energy market. The d-cyphaTrade SFE electricity futures products provide an excellent benchmark for hedge contract valuation for reporting purposes. Australian electricity companies have embraced the exchange traded electricity products. Year to date Futures and options turnover (to May 2 2006) equalled 39% of underlying system energy (NSW, VIC, QLD and SA). Specific characteristics of exchange traded electricity settlement prices make them an appropriate benchmark for hedge valuation purposes because they are:
- Consistent with the requirements of neutrality and independence;
- Supported by market makers through live observable markets;
- Not compromised by credit risk factors present in Over the Counter (OTC) energy hedge markets.
This paper examines the benefits of using exchange traded hedge products under the new accounting standards framework.
ELECTRICITY FUTURES AND OPTIONS - OVERVIEW
Exchange traded electricity futures and options contracts trade out to 4 years from the current period in quarterly contracts in QLD, NSW, VIC and SA. During the year ending February 2006, exchange traded volume equalled 22,846 (quarterly equivalent) contracts, equivalent to 42 million MWh. Dedicated market makers provide price support and transparency through the provision of continuous bids and offers and/or market making responses at the request of market participants. Options on year-long futures strips, peak quarter 1 futures and half-hourly cap products provide additional support for the valuation of option hedges.
All Australian energy companies have the ability to execute electricity futures hedges and benefit from the associated compliance and reporting characteristics of exchange traded products. 13 financial intermediaries provide futures execution or clearing support for at least 30 energy trading companies. Open positions (1 MW quarterly contracts) stand at almost 17,000, representing 30.2 million MWh. The face value of all exchange traded volume during the year ending Feb 2006 was approximately $1.77 billion.
NEUTRALITY AND INDEPENDENCE
Exchange traded hedge contracts provide neutrality and independence of hedge valuation in comparison to internal pool price forecasting models or OTC pricing benchmarks that are based on surveys or estimates* rather than verifiable orders or trades. Exchange traded contracts, facilitated through a licensed exchange, provide transparent pricing that is not distorted by the credit quality of energy trading companies.
Futures settlement prices are set daily by the SFE market operator in accordance with stringent protocols using only market prices (derived from bids, offers or trades). Details of price settlement procedures are provided in the August 2004 Energy Focus newsletter, available on the d-cyphaTrade website. Independent daily settlement prices are provided for Base and Peak load Quarter contracts in 4 states over 4 years. From these official prices, precise implicit prices may also be calculated for Off-peak and year-long contracts thereby providing a comprehensive credit-risk-neutral forward curve. Measuring the fair value of exchange traded derivative contracts is simple and facilitated by automated end of day futures account settlement statements issued by (independent) SFE Clearing Participants.
RELEVANCE
Exchange traded futures prices can be dealt by any futures client by placing orders with a registered SFE broker. All futures prices are therefore relevant to all energy companies for valuation purposes.
Many energy companies are unable to trade bilateral hedge contracts with a number of other energy companies due to credit constraints or inability to reach agreement on bilateral trading terms and conditions. Benchmarking using OTC market prices may therefore lack relevance. Embedded contract default risk in bliateral contracts limits the suitability of such benchmarks for valuation purposes. Counterparty identities (and associated credit risk) behind quoted prices are not known to energy companies other than those which actually transact on those price quotes.
FAIR VALUING CREDIT RISK
Futures hedge contracts are automatically marked-to-market without the need for valuations to be discounted to account for the varied (and often dynamic) credit quality of energy trading counterparties. Accurate valuation of futures contract positions is seamlessly provided by the centralised and independent settlement procedures of the exchange and clearing house.
Fair valuing OTC hedge positions may be achieved by adjusting notional MTM values (benchmarked against the futures price curve) by the credit default rate relevant to the credit rating of each OTC counterparty. Fitch Ratings provides credit ratings on Australian energy trading entities and associated credit default rates.
The netting of bought and sold futures positions is seamless due to the novation characteristics inherent in exchange traded products. In contrast a bought and a sold position with even the same OTC counterparty at profitable prices creates a credit risk exposure to that counterparty until the positive cash flows are received (often in several years' time).
HEDGE EFFECTIVENESS , CONTRACT DEFAULT
Energy companies may wish to consider the ramification for deemed �hedge effectiveness� of a significant credit downgrading of one or more bilateral counterparties. The likelihood of contract default should be monitored (and quantified) during the duration of the hedge contract.
RELIABLE SOURCE OF OBSERVABLE MARKET DATA
Futures trading entities including dedicated market makers ensure that exchange traded settlement prices accurately depict the mark-to-market value of hedge positions. Futures traders wishing to obtain up-to-date valuation of open hedge positions may also use the SFE's Request for Quote (RFQ) facility (via their broker) which commits market makers and invites other participants to provide live pricing on request. Energy companies wishing to obtain pricing transparency or liquidity for specific hedges could utilise this function when a tight bid/offer spread is required.
VALUING LARGE HEDGE POSITIONS
Electricity traders often place initial orders in small volumes with broker intermediaries. Order size is regularly increased when counter-pricing emerges. Daily deal flow of up to 925, 1 MW quarter-equivalent futures contracts (1.94 million MWh) has been transacted. It is therefore reasonable to use futures prices initially quoted in 5 MW or 10 MW parcels for the purpose of determining the fair value of larger positions.
The Request for Quote (RFQ) facility enables trading entities to invite large volume bids and offers to be posted for trade execution. Additionally the Block Trade Facility (BTF) enables participants to execute large orders.
OPTIONS CONTRACTS
Options on year-long futures strips and half-hourly caps provide an independent source of hedge valuation for electricity companies. The valuation of OTC options contracts is assisted through benchmarking against exchange traded option volatilities (in similar exercisable option contracts) and against related half-hourly cap products. Half-hourly cap products are available in all state regions out to 2 years. Exercisable calendar option contracts are listed in all state regions, on futures strips out to 4 years. Market makers provide bid/offer pricing support for these products.
VALUATION OF STRUCTURED HEDGE PRODUCTS
Generic hedge contracts, traded through the futures or OTC market make up a significant proportion of intermediated hedge contract volume. A large component of �sculptured load� fixed-volume hedges can be valued using the futures price curve as a benchmark. Accurate partial valuation of sculptured fixed volume hedges is achieved for valuation purposes where the shaped load is broken down into parcels of equivalent futures contracts.
Similarly, a large component of hedge contracts with non-standard start and end dates (not coinciding with a calendar Quarter) may be valued using futures, where the term of the contract encompasses one or more futures Quarter(s). See the illustration below.
OTC contracts that cannot be easily valued through reference to listed exchange traded products include non-firm volume hedges such as �all of meter� hedges or look-back-styled option derivative products, where a minimum contract volume is not known in advance.
PRICE DATA - SOURCES
Electricity futures market data is widely available from several sources including the d-cyphaTrade online Data Centre, SFE website, Reuters, Bloomberg and Futuresource.