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Topics In Corporate Finance: Energy Markets and Instruments

B40.3160.10 Neal D. Horrell Contact Information: KMC 9-197 Hours: Monday 5:00 – 6:00 and by appointment Phone: (914) 830-1003 (212) 998-0300 Email: nhorrell@stern.nyu.edu Text:

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Topics In Corporate Finance: Energy Markets and Instruments

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  1. B40.3160.10 Neal D. Horrell Contact Information: KMC 9-197 Hours: Monday 5:00 – 6:00 and by appointment Phone: (914) 830-1003 (212) 998-0300 Email: nhorrell@stern.nyu.edu Text: Crewlow, Les & Strickland, Chris. Energy Risk Management: Pricing and Applications. Lacama. London, England, 2000. Topics In Corporate Finance: Energy Markets and Instruments

  2. Policies: • Grading Policy will follow the distribution typically used within the finance departments. The components will be: • One Paper/Study (60%) and • Class Participation (40%).

  3. Nature of the Energy Markets • The market for energy derivatives spans a wide range of physical and financial instruments. • Multiple commodities: electricity, natural gas, coal, others • Characteristics of commodity vary widely with respect to physical state and storage • Extends to variables that drive prices including weather and emissions.

  4. Electricity

  5. Characteristics of Markets

  6. Energy is Mixed • Developing markets are electricity, Weather, Coal, products, emissions. • Mature Markets exist for Oil and Natural gas. • Settlement / clearing is primarily bilateral (little institutionalized structure) • Some contracts institutionalized (NYMEX, IPE).

  7. Electricity: Definitions • Generation: Supply and Production • Demand (load requirements on the system) fluctuates continuously, based on time of day, season, and the characteristics of the territory served by the system.

  8. Energy in Matrix • Electricity (Natural Gas) is embedded in a generation-transmission-distribution (production-transmission-distribution) framework and cannot be separated from this structure. • While financial instruments are also in a framework, their fungiblity, ease of transportation and ease of storage make for a very different market.

  9. Electricity: A Changing Environment • Public Utilities Act & EU Energy Directive 92/96 • Both of these initiatives are aimed at the disaggregating utilities functions from the production, transmission and distribution of energy (and other) products. This reflects the economic realities that while transmission and distribution are “natural monopolies”, the production and sale of energy products can be more efficiently handled by the marketplace.

  10. Regulatory History • Energy Policy Act 1992 (EPACT) removed ownership constraints on generation facilities. • encouraged increased competition in the wholesale electric power business. • any electric utility can apply to the FERC for an order requiring another electric utility to provide transmission services (wheeling). • This change in the law permits owners of electric generating equipment to sell wholesale power (sales for resale) to noncontiguous utilities.

  11. April 1996 • FERC Rule 888 provides for equal access to the transmission grid for all wholesale buyers and sellers, transmission pricing, and the recovery of stranded costs • Rule 889 requires jurisdictional utilities that own or operate transmission facilities to establish electronic systems to post information about their available transmission capacities

  12. Response to Rules • Independent System Operators (ISOs) to operate the transmission grid, regional transmission groups, and open access same-time information systems (OASIS) to inform competitors of available capacity on their lines. • Creation of new participants in the electric power industry, power marketers and power brokers. • Power marketers are entities engaged in buying and selling wholesale electricity (FERC). • Power brokers, not regulated by the FERC.

  13. major functional areas • Generation (Production) • Transmission • Distribution

  14. Participants in the Market • National Government • Regional Entities • State Government • Private Sector

  15. The Wholesale Market

  16. Structure of the Market • FERC Federal Energy Regulatory Commission • NERC North American Energy Reliability Council

  17. The Interconnects • Texas Interconnected System is an island – not interconnected with the other two networks • The other two networks have limited interconnections to each other. • Western and the Texas are linked with different parts of Mexico. • The Eastern and Western are completely integrated or linked with most of Canada • Almost all U.S. utilities are interconnected by these three major grids

  18. FERC Strategic Plan 2001-2005 • Provide Regulatory Framework • Facilitate Development of the market • September 25, 2001 Revision B • Federal Energy Regulatory Commission • Objective 1.1: Remove roadblocks impeding market investment • Objective 1.2: Provide clarity of cost recovery to infrastructure investors • Objective 1.3: Proactively address landowner, safety and environmental concerns

  19. North American ElectricReliability Council • Private organization • Members are 10 Regional Councils: • East Central Area Reliability Coordination Agreement • Electric Reliability Council of Texas • Florida Reliability Coordinating Council • Mid-Atlantic Area Council • Mid-Continent Area Power Pool • Mid-America Interconnected Network • Northeast Power Coordinating Council • Southeastern Electric Reliability Council • Southwest Power Pool • Western Systems Coordinating Council

  20. NERC I Board of Trustees • Board of Trustees • 2 members/Region • All market segments • 9 independent members • Standing Committees • 1 member per Region • 2 from each market segment Staff Operating Committee Adequacy Committee Operating Committee Market Interface Committee

  21. NERC II • North American Energy Reliability Council • Overall reliability planning and coordination of the interconnected power systems • voluntarily formed in 1968 by the electric utility industry as a result of the 1965 power failure in the Northeast. • NERC's nine regional councils cover the lower 48 contiguous States, part of Alaska, and portions of Canada and Mexico.

  22. NERC III • overall coordination of bulk power policies • exchange operating and planning information among their member utilities • The boundaries of the NERC regions follow the service areas of the electric utilities in the region.

  23. Networks (Power Grids)

  24. Dispatch Center • dispatch center must coordinate its responsibilities so that the peak load highest level of demand placed on the system can be met at any given time. • The center must also ensure that the flow of electricity does not surpass the carrying limits of transmission lines.

  25. Transactions 1 • Purchase transactions involve buying electricity from electric utilities and nonutility power producers. • Sales for resale transactions refer to electricity sold by one electric utility or power marketer to other electric utilities for distribution.

  26. Transactions 2 • Exchange transactions involve the availability of excess generating capacity or diversity in load requirements. For instance, an electric utility with low winter load may offer excess capacity in exchange for additional capacity to meet its high summer load. • Wheeling transactions are the movements of electricity from one utility to another over the transmission facilities of one or more intervening utilities

  27. GeneratingUnits • A base load generating unit is normally used to satisfy all or part of the minimum or base load of the system and, as a consequence, produces electricity at an essentially constant rate and runs continuously. • A peak load generating unit, (aka peaker) is used to meet requirements during the periods of greatest or peak load on the system.

  28. Types of Units • Steam-Turbine Generating Units • Gas Turbine Generating Units • Internal-Combustion Engines • Hydroelectric Generating Units • Other Generating :geothermal, solar, wind, biomass

  29. Electric Power v Energy • Electric power is the rate at which electricity does work-measured at a point in time (no time dimension) unit of measure for electric power is a watt). • Electric energy is the amount of work that can be done by electricity. The unit of measure for electric energy is a watthour. Electric energy is measured over a period of time and has a time dimension as well an an energy dimension.

  30. Changing Energy Marketplace: Today Supply & Demand Creates Electric Price Volatility Hours

  31. Energy Markets - Capacity Peaking Intermediate Base Load

  32. Supply & Demand • Generation and Load • Supply Determinants • Installed capacity • Congestion (use of transmission and distribution lines) • Demand Determinants • weather

  33. Short Term Supply

  34. Short Term Demand • Demand (Load or Consumption) • Inelastic • Seasonal Effects • function of weather • electricity heating/cooling • Daily and Hourly Effects • on peak 16 hours from 7AM to 10PM local time excluding Sundays / Holidays • off peak • 8 hours 10PM local to 7AM local Sundays/ Holidays • Flat weighted average of peak and off-peak full calendar month

  35. Market Clearing

  36. Resources • General Information • Energy Information Agency http://www.eia.doe.gov/ • Report on Utility Industry

  37. Valuation Tools • Objective is to solve a partial differential equation. The methods that are used include: • Monte Carlo Simulation • Lattice Methods • Analytic (Closed Form) Models • Each as advantages and disadvantages.

  38. Valuation Tools • Use primarily Numerical techniques: • Monte Carlo • Lattice Methods • Required “Inputs” • Probability function(s) • Specify form of PDE • Payoff function

  39. Monte Carlo • Numerical Technique • Advantages • Easy to implement • Can readily value any non-path dependent derivative • Disadvantages • Not useful for American Style derivatives • Time to obtain price and ‘greeks’

  40. Lattice Methods • Several types: binomial, trinomial, finite difference grid. • Advantages • Relatively Easy to obtain ‘Greeks’ • Can value any path dependent derivative • Disadvantages • More difficult to implement than Monte Carlo

  41. Example: GBM • Geometric Brownian Motion. • SDE (stochastic differential equation) • dS = Sdt + SdZ •  is the drift term •  is the standard deviation • This is in continuous time • Changes in price are proportional to price level • Convert to finite difference equation • DS = SDt + SDZ

  42. Example Continued • Select a random number from the unit normal distribution • Compute St+Dt = St e(Dt + DZ) • Where DZ is Dt0.5e • Compute value of derivative security • Repeat simulation • Compute average prices of simulations

  43. Example: Numerical Results • Suppose we want to value a call option on this instrument. Boundry C = Max[S(T)-X;0]. • Parameter and Market Values •  = 0 •  = 0.45 • S0 (spot price) = 18 • Risk free interest rate 3%. • Contractual Values • X (strike) = 20 • T (time to expiration) = 0.5 years. • European Style Option

  44. Example: Numerical Results • Below are the results of a simulation with n = 20 • Black Model 2.271162 • Monte Carlo 2.266716 • What are some issues concerning this result? • How can results be improved?

  45. Example Continued • Binomial Lattice • Contruction of a “tree” that replicates the parameters of the distribution.

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