Managing Energy Risk (2^nd Ed.)
An Integrated View on Power and Other Energy Markets
The Wiley Finance Series

As global warming takes center stage in the public and private sectors, new debates on the future of energy markets and electricity generation have emerged around the world. The Second Edition of Managing Energy Risk has been updated to reflect the latest products, approaches, and energy market evolution. A full 30% of the content accounts for changes that have occurred since the publication of the first edition. Practitioners will appreciate this contemporary approach to energy and the comprehensive information on recent market influences.

A new chapter is devoted to the growing importance of renewable energy sources, related subsidy schemes and their impact on energy markets. Carbon emissions certificates, post-Fukushima market shifts, and improvements in renewable energy generation are all included.

Further, due to the unprecedented growth in shale gas production in recent years, a significant amount of material on gas markets has been added in this edition. Managing Energy Risk is now a complete guide to both gas and electricity markets, and gas-specific models like gas storage and swing contracts are given their due.

The unique, practical approach to energy trading includes a comprehensive explanation of the interactions and relations between all energy commodities.

• Thoroughly revised to reflect recent changes in renewable energy, impacts of the financial crisis, and market fluctuations in the wake of Fukushima
• Emphasizes both electricity and gas, with all-new gas valuation models and a thorough description of the gas market
• Written by a team of authors with theoretical and practical expertise, blending mathematical finance and technical optimization
• Covers developments in the European Union Emissions Trading Scheme, as well as coal, oil, natural gas, and renewables

The latest developments in gas and power markets have demonstrated the growing importance of energy risk management for utility companies and energy intensive industry. By combining energy economics models and financial engineering, Managing Energy Risk delivers a balanced perspective that captures the nuances in the exciting world of energy.

Preface xi

Acknowledgements xiii

1 Energy Markets 1

1.1 Energy Trading 3

1.1.1 Spot Market 3

1.1.2 Forwards and Futures 4

1.1.3 Commodity Swaps 6

1.1.4 Options 6

1.1.5 Delivery Terms 6

1.2 The Oil Market 7

1.2.1 Consumption, Production and Reserves 7

1.2.2 Crude Oil Trading 10

1.2.3 Refined Oil Products 11

1.3 The Natural Gas Market 12

1.3.1 Consumption, Production and Reserves 13

1.3.2 Natural Gas Trading 15

1.3.3 Liquefied Natural Gas 19

1.4 The Coal Market 21

1.4.1 Consumption, Production and Reserves 21

1.4.2 Coal Trading 23

1.4.3 Freight 26

1.5 The Electricity Market 27

1.5.1 Consumption and Production 27

1.5.2 Electricity Trading 31

1.5.3 Electricity Exchanges 38

1.6 The Emissions Market 42

1.6.1 Kyoto Protocol 42

1.6.2 EU Emissions Trading Scheme 45

1.6.3 Flexible Mechanisms 46

1.6.4 Products and Marketplaces 48

1.6.5 Other Emissions Trading Schemes 51

2 Renewable Energy 55

2.1 The Role of Renewable Energy in Electricity Generation 55

2.1.1 Historical Development 55

2.1.2 Political Targets 58

2.1.3 Forecasts 59

2.2 The Role of Liquid Biofuels in the Transportation Sector 60

2.3 Renewable Energy Technologies 61

2.3.1 Hydropower 61

2.3.2 Wind Power 66

2.3.3 Solar Energy 69

2.3.4 Geothermal Energy 71

2.3.5 Bioenergy 73

2.3.6 Not Widespread Renewable Energies 77

2.4 Support Schemes for Renewable Energy 78

2.4.1 Feed-In Tariffs 80

2.4.2 Net Metering 83

2.4.3 Electric Utility Quota Obligations and Tradable Certificates 83

2.4.4 Auctions 85

2.4.5 Subsidies, Investment Grants and Tax Benefits 86

2.5 Key Economic Factors of Renewable Energy Projects 87

2.5.1 The Project Developer’s Perspective 87

2.5.2 The Project Investor’s Perspective 88

2.6 Risks in Renewable Energy Projects and their Mitigation 90

2.6.1 Project Development Risks 90

2.6.2 Construction Risks 93

2.6.3 Resource Risks 93

2.6.4 Technical Risks 96

2.6.5 Market Risks 97

2.6.6 Regulatory Risks 99

2.6.7 Other Operational Risks 100

3 Risk Management 101

3.1 Governance Principles and Market Regulation 102

3.2 Market Risk 104

3.2.1 Delta Position 104

3.2.2 Variance Minimising Hedging 110

3.2.3 Value-at-Risk 111

3.2.4 Estimating Volatilities and Correlations 120

3.2.5 Backtesting 123

3.2.6 Liquidity-Adjusted Value-at-Risk 123

3.2.7 Profit-at-Risk and Further Risk Measures 127

3.3 Legal Risk 130

3.4 Credit Risk 134

3.4.1 Credit Rating 137

3.4.2 Quantifying Credit Risk 140

3.5 Liquidity Risk 144

3.6 Operational Risk 146

4 Retail Markets 151

4.1 Interaction of Wholesale and Retail Markets 151

4.2 Retail Products 155

4.2.1 Fixed-Price Contracts 155

4.2.2 Indexed Contracts 156

4.2.3 Full Service Contracts 157

4.2.4 Partial Delivery Contracts 157

4.2.5 Portfolio Management 158

4.2.6 Supplementary Products 159

4.3 Sourcing 160

4.3.1 Sourcing Fixed-Price Contracts 160

4.3.2 Sourcing Indexed Contracts 161

4.3.3 Sourcing B2C Contracts 162

4.4 Load Forecasting 163

4.5 Weather Risk in Gas Retail Markets 165

4.5.1 Weather Derivatives 168

4.6 Risk Premiums 172

4.6.1 Risk-Adjusted Return on Capital 174

4.6.2 Price Validity Period 174

4.6.3 Structuring Fee and Balancing Energy 175

4.6.4 Credit Risk 176

4.6.5 Volume and Price Profile Risk 177

4.6.6 Operational Risk 181

4.6.7 Risk Premium Summary 182

5 Energy Derivatives 185

5.1 Forwards, Futures and Swaps 186

5.1.1 Forward Contracts 186

5.1.2 Futures Contracts 189

5.1.3 Swaps 191

5.2 Commodity Forward Curves 192

5.2.1 Investment Assets 194

5.2.2 Consumption Assets and Convenience Yield 194

5.2.3 The Market Price of Risk 196

5.3 “Plain Vanilla” Options 197

5.3.1 The Put–Call Parity and Option Strategies 198

5.3.2 Black’s Futures Price Model 200

5.3.3 Option Pricing Formulas 200

5.3.4 Hedging Options: The “Greeks” 202

5.3.5 Implied Volatilities and the “Volatility Smile” 208

5.3.6 Swaptions 210

5.4 American, Bermudan and Asian Options 212

5.4.1 American and Bermudan Options 212

5.4.2 Asian Options 213

5.5 Multi-Underlying Options 216

5.5.1 Basket Options 216

5.5.2 Spread Options 218

5.5.3 Quanto and Composite Options 221

5.6 Modelling Spot Prices 224

5.6.1 Pricing Spot Price Options 226

5.6.2 Geometric Brownian Motion as Spot Price Model 231

5.6.3 The One-Factor Schwartz Model 237

5.6.4 The Schwartz–Smith Model 241

5.7 Stochastic Forward Curve Models 246

5.7.1 One-Factor Forward Curve Models 247

5.7.2 A Two-Factor Forward Curve Model 249

5.7.3 A Multi-Factor Exponential Model 251

6 Stochastic Models for Electricity and Gas 253

6.1 Daily and Hourly Forward Curve Models 253

6.1.1 Daily Price Forward Curve for Gas 255

6.1.2 Hourly Price Forward Curve for Electricity 257

6.2 Structural Electricity Price Models 265

6.2.1 The SMaPS Model 266

6.2.2 The Multi-Commodity SMaPS model 269

6.2.3 Regime-Switching Models 272

6.2.4 Virtual Power Plants 278

6.3 Structural Gas Price Models 281

6.3.1 Natural Gas Price Models 281

6.3.2 Swing Options and Gas Storage 286

6.3.3 Least-Squares Monte Carlo Method 291

7 Fundamental Market Models 301

7.1 Fundamental Price Drivers in Electricity Markets 301

7.1.1 Demand Side 302

7.1.2 Supply Side 306

7.1.3 Interconnections 313

7.2 Economic Power Plant Dispatch 313

7.2.1 Thermal Power Plants 315

7.2.2 Hydropower Plants 322

7.2.3 Optimisation Methods 325

7.3 Methodological Approaches 335

7.3.1 Merit Order Curve 335

7.3.2 Optimisation Models 347

7.3.3 System Dynamics 353

7.3.4 Game Theory 357

7.4 Relevant System Information for Electricity Market Modelling 366

7.4.1 Demand Side 366

7.4.2 Supply Side 367

7.4.3 Transmission System 370

7.4.4 Historical Data for Backtesting 371

7.4.5 Information Sources 371

7.5 Application of Electricity Market Models 372

7.6 Gas Market Models 374

7.6.1 Demand Side 375

7.6.2 Supply Side 376

7.6.3 Transport 379

7.6.4 Storage 379

7.6.5 Portfolio Optimisation 382

7.6.6 Formulation of the Market Model 383

7.6.7 Application of Gas Market Models 385

7.7 Market Models for Oil, Coal and CO2 Markets 386

7.8 Asset Investment Decisions 387

7.8.1 The Discounted Cashflow Method 387

7.8.2 Weighted Average Cost of Capital 389

7.8.3 The Capital Asset Pricing Model 390

Appendix: Mathematical Background 393

A.1 Econometric Methods 393

A.1.1 Linear Regression 393

A.1.2 Stationary Time Series and Unit Root Tests 395

A.1.3 Principal Component Analysis 397

A.1.4 Kalman Filtering Method 398

A.1.5 Regime-Switching Models 399

A.2 Stochastic Processes 402

A.2.1 Conditional Expectation and Martingales 402

A.2.2 Brownian Motion 402

A.2.3 Stochastic Integration and Itô’s Lemma 403

A.3 Option Pricing Theory 405

A.3.1 Pricing Under the Risk-Neutral Measure 405

A.3.2 The Feynman–Kac Theorem 408

A.3.3 Monte Carlo Simulation 410

References 413

Index 419

DR MARKUS BURGER ­(Karlsruhe, Germany) is Director of Risk Manage­ment at EnBW Trading (­Energie Baden-Württemberg AG) a company specialising in ­energy ­trading, optimization and risk management. Markus has more than fifteen years’ experience in Commodity ­Trading, Finance and Risk Management. He has a PhD in mathematics from ­Karlsruhe Institute of Technology (KIT).

DR BERNHARD GRAEBER (Karlsruhe, Germany) is Head of Infrastructure Investments at ­Talanx Asset ­Management. Prior to that he was head of Renewable Energies and International ­Climate Projects at EnBW AG and was res­ponsible for the coordination of all renewable ­energy ­activities within the EnBW group. Bernhard has a PhD in Energy Economics from Stuttgart ­University.

DR GERO SCHINDLMAYR (Essen, Germany) is Head of Risk Control for asset-related trading at RWE ­Supply & Trading GmbH. Over the last fifteen years, Gero held various positions in the finance and energy industry in the area of quantitative modelling and risk management and is author of several ­research publications. He holds a PhD in mathematics from RWTH Aachen, University of Technology.