Managing Energy Risk

An Integrated View on Power and Other Energy Markets

Markus Burger, Bernhard Graeber, Gero Schindlmayr

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118618585
• Edition: 2
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

An overview of today's energy markets from a multi-commodity perspective

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.

1
Energy Markets

Despite a global sustainability trend including climate protection and more efficient use of energy, worldwide energy consumption will continue to grow over the coming decades (see Figure 1.1). Besides future economic growth, an important driver of global energy demand is policy commitments, such as renewable energy or energy efficiency targets. Depending on scenario assumptions, the average annual growth rate in energy consumption is estimated to be between 0.5% and 1.5% (International Energy Agency, 2012) until 2035, with significant regional differences. Most of the energy demand growth is expected to come from non-OECD countries, with China and India being the largest single contributors.

Figure 1.1 World energy demand. Source: International Energy Agency (2012).

The main primary energy source worldwide is oil, covering 32% of worldwide energy consumption (see Figure 1.2). Second are coal and natural gas, with a share of 27% (respectively 22%). Nuclear energy (6%) and renewables (13%) have a much smaller share. To meet the growing worldwide demand for energy, there will need to be an increase in energy supply from all primary energy sources. However, depending on the scenario, the share of oil and coal will diminish in favour of gas and renewable energy sources (Figure 1.2).

Figure 1.2 World primary energy sources. Source: International Energy Agency (2012).

Not all of the primary sources of energy are used directly for consumption; they may first be transformed into secondary forms of energy, such as electricity or heat. Since part of the primary energy is used for the transformation process, the final consumption is below the primary energy demand. A breakdown of the final consumption into different sectors is given in Figure 1.3.

Figure 1.3 World final energy consumption. Source: International Energy Agency (2012).

The current trends by sector are as follows (International Energy Agency, 2012):

• Industry: The industrial sector accounts for 28% of the total energy consumption and has the highest growth rate among the sectors. The main energy sources are coal (28%), electricity (26%), gas (19%) and oil (13%). It is expected that electricity and gas will gain importance at the expense of coal and oil.
• Transport: The transport sector, which makes up 27% of the energy demand, is strongly dominated by oil (93%). On a worldwide scale, biofuels (2%) and electricity (1%) still play a minor role, but are expected to increase their share to 2% (respectively 6%) in the reference scenario. The actual development will be strongly influenced by future governmental policies.
• Buildings: This sector includes heating, air conditioning, cooking and lighting. It accounts for 34% of the total energy consumption. The energy is delivered mainly in the form of electricity (29%), bioenergy (29%), gas (21%) and oil (11%). There is a clear trend towards a higher share of electricity and gas at the expense of bioenergy and oil.

1.1 Energy Trading

With the development of a global oil market in the 1980s, energy has become a tradable commodity. In the early 1990s, deregulation of the natural gas market in the United States led to a liquid and competitive gas market. In Europe, liberalisation of gas and electricity markets started in the UK in the late 1980s. In the late 1990s, the EU Commission adopted first directives making energy market liberalisation a mandatory target for EU member states along different steps of implementation. Whereas a wholesale market for electricity developed successfully in the early 2000s in some countries (e.g., Germany), a liquid gas wholesale market only existed in the UK. Gas markets in Continental Europe still remained fragmented and dominated by oil-indexed supply contracts. Further consolidation of market areas, easier market access and declining gas demand following the financial crisis in 2008 increased competition and finally led to growing market liquidity for gas markets in Continental Europe and a decoupling of gas and oil prices in the early 2010s.

Besides the commodities coal, oil, gas and electricity, which carry energy directly, the EU introduced carbon emission certificates (European Emission Allowance or EUA) in the year 2005 as part of the EU climate policy. The certificates were designed as tradable instruments for which a liquid market quickly developed. Since carbon certificates are closely related to energy commodities and electricity generation, they will be treated here along with the other energy commodities. Before describing the specific markets for each commodity, the general structure and basic products of commodity markets in general will be introduced. A more detailed description of commodity derivatives products will be given in Chapter 5.

We generally distinguish between over-the-counter (OTC) and exchange-traded markets. The OTC market consists of bilateral agreements, which are concluded over the phone or through Internet-based broker platforms. Such transactions are most flexible since the parties are free to agree individual contract terms. As a main disadvantage, OTC transactions may contain credit risk, meaning that one of the counterparties may not deliver on his contract (e.g., in case of insolvency). As a mitigation, collaterals may be defined to protect the counterparties from losses in such a case. Exchanges provide organised markets for commodities in the form of standardised contracts. In particular, they became popular for derivatives products (futures, options), where the exchange also eliminates credit risk for the market participants.

1.1.1 Spot Market

The spot market is the market for immediate (or nearby) delivery of the respective commodity in exchange for cash. The exact definition depends on the commodity. As an example, the spot market for electri...