20. Electricity Derivatives

20.1 – Background

MCX just introduced derivatives on a new commodity – electricity. It is a new financial instrument recently launched on MCX and NSE, so it is only natural that we write about it on Varsity. 

Just like you can trade precious metals like gold and silver, and commodities like copper, aluminium, oil, and gas, you can also trade electricity.

Before discussing electricity derivatives, I will first briefly touch upon why and how electricity is traded on the exchange.

Power plants sell most of the electricity they generate to power distribution companies at a fixed price. For instance, NTPC produces electricity and sells it to Tata Power-DDL, which supplies power to North Delhi. They do so in the form of Power Purchase Agreements or PPAs. The PPAs largely mandate fixed quantities for almost fixed prices. The variable component, if at all, is insignificant, and that too for small quantities.

Power distribution companies (discoms) like Tata Power-DDL and others have limitations in how they can price electricity. Owing to price subsidies and state controls, they often sell power to residential users at a price below their cost. They cover some costs by charging higher rates to commercial users, but their profit margins remain volatile. 

For the longest time, discoms took the price shock of any short-term demand spikes or troughs, as they were bound by the PPAs. Electricity prices could rise or fall, but their costs remained rigid. They usually didn’t have the option to buy electricity elsewhere or at a different price. That changed in 2008.

For ad hoc or short-term power transactions, discoms and power generation companies got the option of buying or selling power on the power exchange like IEX or PXIL. I am oversimplifying this, but it works like a stock exchange. Like you buy or sell shares of a company on NSE or BSE, you can trade electricity on the power exchange.

Such buying and selling power on the exchange helped participants in the value chain to get the best price for their trades and improve profitability.

Today, India consumes more than 1700 TWh of electricity annually. It is considered the world’s third-largest power market, but only about 7% of its electricity requirements are met through power exchanges. This could grow much more. Energy exchanges in Europe facilitate almost 50% of their total electricity transactions.

All spot and forward trades on the power exchange are delivery trades. If you have purchased some units of power, you will have to take delivery. If you have sold, you will have to deliver the units. In case of forward contracts, you might have the chance to square off your trade before expiry.

But what if there is extreme price volatility and you want to protect your position? There are no derivative contracts to help you hedge. Well, that was the case until recently. Now you have electricity derivatives. So you can hedge yourself against electricity price volatility.

And that is also the meat of this chapter.

20.2 – What are Electricity Derivatives?

Electricity derivatives are futures or options contracts on electricity. It is just like buying a futures or options contract on a stock, index, or commodity. The underlying for an electricity F&O contract is electricity.

Like the derivatives on gold, silver, natural gas, crude oil, etc, on MCX, you can trade electricity derivatives on MCX from 9:00 AM to 11:30 PM on weekdays. During the US’ daylight saving time, trading hours will be extended to 11:55 PM.

Do note, however, that while electricity derivatives are traded on MCX, their underlying electricity contracts are traded on IEX, India’s largest energy exchange. While MCX could use the electricity contracts traded on PXIL or any other energy exchanges as underlying, the first set of contracts that it launched on 10th July were based on IEX’s Day Ahead Market (DAM) contracts.

The Day Ahead Market (DAM) is IEX’s physical electricity trading market, which allows market participants to buy and sell electricity for the next day.

So why did IEX not launch derivative contracts if it has a ready market for physical electricity trading? Or can MCX launch physical electricity contracts for its derivatives?

Electricity is an essential service/commodity regulated by the Central Electricity Regulatory Commission (CERC). SEBI can only regulate securities, and not commodities. Therefore, energy exchanges where you can actually trade electricity contracts are regulated by CERC. However, derivatives are securities. All securities in India are regulated by SEBI. Therefore, securities exchanges MCX and NSE launched electricity derivatives, while energy exchanges continue to host the underlying electricity contracts of those derivatives.

To begin with, both MCX and NSE have launched only electricity futures contracts. They could soon start offering electricity options contracts, too. The underlying for electricity options will be electricity futures.

20.3 – Who can participate in electricity derivatives?

Practically, anyone. But let’s look at participants more specifically, along with their motives.

• Power generation companies could use derivatives to avoid demand shocks if electricity prices fall.
• Power distribution companies or Discoms, could use derivatives to mitigate costs when they have to sell power to end consumers at a price below their cost.
• Proprietary trading desks of businesses use huge amounts of electricity. They can trade in electricity derivatives to reduce the impact of price volatility on their profitability.
• Institutional investors could see this as yet another avenue to trade and make money from.
• HNI investors and professional investors can use electricity derivatives contracts as a tool of diversification and risk management in their portfolios.

Did you know discoms often incur losses in supplying power to agriculture and domestic consumers? These losses and any impact of price volatility are recovered by charging a hefty price to industrial and commercial consumers. 

Thanks to electricity derivatives, those industrial and commercial users of electricity now have an avenue to hedge themselves against the price volatility passed down to them by the discoms.

20.4 – Contract Specifications of Electricity Futures

Just like F&O on NSE and BSE stocks, electricity derivatives will also have contracts at any point – near month, next month, and far month. These are the first set of contracts at the time of launch by MCX.

Like you have lot sizes for stocks, indices, and commodities, electricity futures will also have a lot size of 50 MWh. You can trade a minimum of 1 lot and a maximum of 50. Tick size is ₹1 per MWh. Meaning, the price of 1 MWh can move from, say, 4000 to 4001, and not 4000.5. Since one lot has 50 units, your contract position will move by ₹50 for every ₹1 movement in the futures price.

The initial margin to enter the contract is 10% or based on SPAN, whichever is higher.

All electricity derivatives will be cash settled only. If you were long a futures contract and the electricity price upon expiry is more than your contract price, you will earn the difference. If the electricity price is less than your contract price, you will lose the difference.

If your broker offers trading in MCX commodity contracts, it will offer electricity derivatives contract too. Brokerage, stamp duty, transaction charges, transaction tax, and income tax applicable will be the same as what are applicable on other derivatives contracts. 

20.5 – Illustration of a sample electricity futures contract

Let’s say you want to go long 1 lot of near-month electricity futures at ₹3000/MWh. 

The lot size is 50MWh. Hence, the contract value is – 

> ₹3000/MWh * 50 MWh

>  ₹1,50,000/-

Considering a margin of 10%, your broker will block ₹15,000/- towards 1 lot long. Each tick results in ₹50 profit or loss. So, for example, if after you you go long, the futures move to ₹3010, then you make – 

> 50*10 = 500

Likewise, you will lose ₹500 if the Electricity futures move to ₹2990.

The broker will block 10% or SPAN, whichever is higher of the two, as margin. So always check the margin before you take a trade. 

Note that I did not account for brokerage and other transaction costs in this illustration. If you trade with Zerodha, you can check the charges here. 

20.6 – Are there any risks in electricity derivatives?

Like any financial instrument, electricity derivatives also carry some risk.

• Derivative trading is a cost. Hedging using derivatives must help you cover for price risk after covering for those costs. Otherwise, hedging will largely be pointless.
• Because electricity derivatives are cash-settled, excessive speculation or investor euphoria could detach the derivative prices from its underlying, especially on days far away from expiry.
• The divergence between spot and futures prices can remain even at expiry. This is possible because these contracts are cash-settled. Physical delivery, on the other hand, forces convergence of the futures price with the physical asset’s price.
• Time basis risk – if an electricity consumer’s billing cycle does not match with the contract expiry date, which might be the case mostly, it could have days when its exposure is unhedged. Fluctuations in these days could amplify both gains and losses.
• Location basis risk – The spot price in a trader’s region could be vastly different from the spot price at the exchange. Such differences could throw your hedging strategies off guard.
• Quantity basis risk – Large consumers of electricity trying to hedge their exposure have to correctly estimate their consumption. An estimate far below the actual consumption could render the hedging activity ineffective and pointless. An estimate far in excess of actual consumption could unnecessarily add costs.

Electricity derivatives are a new instrument. There might be initial excitement around it due to its novelty factor. However, before you consider trading electricity derivatives, do understand the electricity markets and factors influencing power prices before you dabble in it 🙂. 

This chapter is authored by Vineet Rajani from Zerodha Varsity.

Key Takeaways

1. Electricity trading on energy exchanges like IEX, PXIL, and others help value chain participants reduce price volatility in their short term electricity purchases.
2. Electricity derivatives add another layer of helping reduce price volatility by bringing more participants to the market.
3. Electricity derivatives will be offered by securities exchanges like MCX and NSE, and not energy exchanges like IEX and PXIL. This is also why electricity derivatives will be cash-settled.
4. Power generators, distributors, institutional investors, retail investors, businesses, etc., can all participate in electricity derivatives.
5. For now, electricity futures have been introduced. Electricity options might soon follow suit.
6. Electricity futures will trade in lot sizes of 50 MWh. You can trade a minimum of 1 lot and a maximum of 50. Tick size is ₹1 per MWh.
7. Like any financial instrument, electricity derivatives carry risk. Be cognizant of those risks and have guardrails if you intend to participate in electricity derivatives.