Our #RegulatoryInsights debate brought together erudite speakers from the Indian energy landscape to discuss the topic of  #ElectrictyDerivatives. The speakers were: Alejandro Hernandez, Director of India and Global Opportunities program, Regulatory Assistance Project; Ajay Pandey, Professor, Indian Institute of Management; Ruchi Shukla, Energy Head, Multi Commodity Exchange of India Ltd.; Rajesh Cherayil, Chief Strategy Officer, PTC; Rohit Bajaj, Executive Director, IEX; RP Singh, Distinguished Fellow, FSR Global and Swetha Ravi Kumar, Executive Director, FSR Global.

The question of introducing energy derivatives within the power sector has been debated for a few years now. The commodities derivatives already exist for other sectors and taking inspiration from them, this debate assesses the crucial role electricity derivatives play in risk management, price discovery as a response to the growing demand for hedging instruments to manage price volatility in the wholesale spot market. Electricity spot prices in the emerging electricity markets are generally volatile due to low liquidity and other dynamic factors such as fuel supply changes, renewable energy intermittency, transmission congestion, and other constraints in generation or distribution. As a risk management tool, hedging instruments through electricity derivatives allows market participants to reduce price risk exposure for market participants, including generators, buyers and distribution entities.  

There are multitudes of risks imbricated within the power sector which need to be addressed through these derivatives such as the absence of capacity during peak hours creating supply risk, price volatility, demand risks in long term borne by utilities, etc. There are multiple instruments which can be utilized to safeguard participants against such risks: options, synthetic PPAs, swaps, futures, CFDs, etc.  

Interestingly, France has a mechanism of capacity credit underlining a regulatory obligation of the off taker to prove their capacity adequacy to meet peak demand to the regulator at the end of a year. In New Jersey, utilities unsure of meeting multi-year demand capacity participate in auctions for 1% bid of the peak demand which can go upto 3% bid by GENCOs to whom the risk and burden is transferred. This reduces the chances of over-contracting of utilities.  

In India, the conversation about lock-in issues of long term PPAs is debated ad nauseam because of which the participation in the different markets (DAM, Intra-Day, RTM, Term-Ahead) account for a meagre. In India, the conversation about lock-in issues of long-term PPAs is debated ad nauseam because of which the participation in the different markets (DAM, Intra-Day, RTM, Term-Ahead) accounts for a meager. In India, the conversation about lock-in issues of long-term PPAs is debated ad nauseam because of which the participation in the different markets (DAM, Intra-Day, RTM, Term-Ahead) accounts for a meager approximation of 3-4% of market dispatch. There has been development and growth of the spot market increasing to 53% during FY 23 from 37% in FY 18 and with the movement towards short term PPAs brings more flexibility to the market. If there exists a liquid market in the electricity market, then the problems of lock-in through long term PPAs, managing counter-party risks, and cost of disputes and contract enforcement can be taken care of through traded derivatives such as futures and options. Plus, with the addition of more renewable players, a higher number of participants have entered the market. As a result of these changes, the time is now ripe to bring in financial instruments for the purposes of risk management.  

From European and Japanese experience, we notice that spot markets have developed further with more liquidity with the introduction of derivatives. Unlike other assets of commodity markets in which derivatives are traded, electricity cannot yet be stored for long-term in large quantities and hence the linkage between spot prices and futures/forward price is not driven by cost-of-carry. In other words, the electricity derivatives may result in price discovery for the prices expected in the future by the market participants which is somewhat delinked with the spot prices. This is useful for generation capacity to ascertain their load profiles as well as consumers. Hence, price discovery mechanism and risk management is a crucial offering of derivatives which we can take as a learning especially for the Indian market.   

Necessary conditions for derivatives in India 

The reference spot market, usually day-ahead, should be liquid for the hedgers (end-users) and speculators to feel confident about the price for settlement. Currently, we don’t have a single market for dispatch even at inter-state level.  A full-fledged Market Based Economic Dispatch (MBED) would provide for a single price at ISTS level, allowing for more liquidity and a single reference price.  

Furthermore, the derivatives to be introduced need to have liquidity so price manipulation can be avoided. This requires large scale participation from a wide variety of players including large financial institutional players who could be speculators as supposed to hedgers. This will not only improve the nature of price discovery, but also act as an informal surveillance mechanism on attempt to manipulate market. Currently, due to low liquidity, there are 8-9 large market players in the spot market who can crowd the market and make profits, leaving high scope for manipulation.  

In the case of India, both SEBI and CERC will jointly oversee electricity derivatives, where in SEBI has experience from financial markets and CERC has the experience of the sector and information on sector-specific manipulation possibilities.  

The regulatory mechanisms should provide clarity on distribution utilities in India not being penalized for using hedging derivatives instruments as the current stance only accounts for the contracted prices for physical delivery as part of the power purchase costs and doesn’t account for hedging costs. In addition to improving spot market liquidity in the most economical way, PPAs with physical delivery obligations could be treated as financial contracts and in parallel open up transmission rights through open access for long-term, medium-term and short-term.  

Lastly, hedgers and speculators in the market are dependent on reliable data to hedge their position which is currently missing in the Indian ecosystem. Information about pertinent data points is essential and the need for it to be recorded in a standardized format and should be made available different market participants to make business decisions.