Strategies and Costs of Hedging: Successfully Navigate the European Power Markets

Strategies and Costs of Hedging: Successfully Navigate the European Power Markets
Blog January 23, 2019

Power traders and portfolio managers leverage hedging as a risk management strategy to safeguard themselves from the losses that derive from market volatility. Genscape’s EPSI platform, a powerful data platform that provides supply curves and demand estimates, can help traders effectively hedge exposure.

In energy commodities, hedging helps manage spot market price volatility for both generators and electricity purchasers. This activity is much like an insurance policy against price movements. Hedges are either agreed upon directly between the parties involved as an over-the-counter (OTC) agreement or purchased as derivatives on the European Energy Exchange (EEX) electricity futures market. It works on the principle of offsetting, which takes both an opposite and equal position in two different markets. Market participants hedge one investment by investing in another.

Because power traders or portfolio managers build the hourly supply stack at a forward date, they can estimate future price developments to get an edge when hedging exposure.

Schematic Representation of Hedge Payouts
Figure 1: Schematic representation of hedge payouts between market buyers and sellers. Click to enlarge

In 2018, European utilities incurred major losses due to the opportunity costs associated with their hedging behavior. Companies generally sell more of their power output in advance if they expect prices to fall and cut back hedging if prices rise. An example of payouts from hedges are shown in Figure 1.

On November 16, 2018, Montel reported Uniper posted a current loss of 730 million EUR due to adverse effects of previous hedges while they froze their current hedging activity to catch an expected rise in power price. As a result, their 2021 outright portfolio is less than 5 percent hedged. Montel also reported RWE lowered its hedge price for 2020 due to strong declines of dark and spark spreads since the beginning of 2018. Vattenfall stopped its price hedging activity across Europe due to changed risk exposure following the divestment of their German lignite operations.

As a “rule of thumb”, the hedging positions of market players include:

  • Generators hedge all but one of the total number of generating units in their portfolio. This allows them to generate enough power to cover a contract even if one generating unit goes offline or is otherwise constrained.
  • Utilities traditionally hedge majority of their forward generation on the far curve to lock in profit margins and insulate themselves against potential declines in wholesale prices, as well as against general uncertainty and volatility closer to the delivery date.
  • Retailers follow different strategies, including fully hedging their position to holding a minimal hedging position.
  • Speculators that are not involved in generating or retailing electricity, enter the market if they think the electricity derivatives are mispriced. While commercially motivated, their presence provides liquidity to the market.

Industry players such as generators, hedge their natural long power position to receive market advantages including stable earnings or cash flow visibility. This strategy comes at a cost when the market moves against them. The ability to dynamically hedge a position by unwinding or increasing their current position can palliate this problem. To forecast future market moves and adopt the right hedging strategy, EPSI can help model the evolution of the stack and forecast price levels. Figure 2 represents the supply stack evolution for the next five years in the UK. The crossing line with the demand curve shows a price for UK baseload power in the calendar year 2023 at 48 EUR/MWhr.

Genscape EPSI Platform
Figure 2: Supply stack evolution and driver in the UK in 2023

At Genscape, we are continuing to watch the market as it evolves and the EPSI platform can be leveraged to inform industry players with price forecasts and supply-stack evolution. Knowing which plant is the marginal one helps to gain an edge and improve hedging strategies. Discover a different and more efficient way of analyzing European power markets with EPSI today