Nordic electricity hedging: A comparison with other commodity market structures

115 Pages·2013·2.43 MB·English

by  Mattias Andersson;

Nordic electricity hedging

A comparison with other commodity market structures

Mattias Andersson
Ville Nurmos

Master of Science Thesis
KTH School of Industrial Engineering and Management
Energy Technology EGI-2013-093MSC
Division of Applied Thermodynamics and Refrigeration
SE-100 44 STOCKHOLM

Master of Science Thesis EGI-2013-093MSC

Nordic electricity hedging
A comparison with other commodity market structures

Mattias Andersson
Ville Nurmos
Approved Examiner Supervisor
2013-05-31 Per Lundqvist Per Lundqvist
Commissioner Contact person
Vattenfall AB Mats Nilsson

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BSTRACT
This master thesis investigates and answers three fundamental questions regarding structural
changes of a future market. This has been done by analysing and comparing three commodity
markets with the Nordic electricity market. Examined commodity markets are LME steel billet,
CME lean hogs and WTI & Brent crude oil. The report consists of a literature review with a
theoretical background, CATWOE and a case analysis of each commodity market. The markets
are thereafter analysed, compared and discussed regarding the research questions.
It is concluded that the Nordic electricity market is in many ways comparable to other commodi-
ties, although it has some special characteristics. Key factors determining market success have
been identified as (1) correlation between perceived risk and derivative risk, (2) trust for and
experience of trading institutions and trading environment and (3) expectations. Based on the
findings a new conceptual measure for market liquidity, Relative Market Liquidity, is introduced
and discussed. The comparison in this thesis is based on the Nordic electricity market, but much
of the results are applicable to other commodity markets.
The thesis has been written during spring 2013 at the Royal Institute of Technology Department
of Energy Technology in co-operation with Vattenfall AB.
Key words: Nordic electricity, steel billet, lean hogs, crude oil, hedging, future markets, commodi-
ties, market structure.

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ABLE OF CONTENTS
Abstract ................................................................................................................................................................................... i
Table of contents .............................................................................................................................................................. iii
Table of figures ............................................................................................................................................................... viii
Table of tables ..................................................................................................................................................................... x
Table of equations ............................................................................................................................................................ xi
Acknowledgments ......................................................................................................................................................... xiii
Section 1 – Introduction .................................................................................................................................................. 1
1 Background ............................................................................................................................................................ 1
2 Research problem ............................................................................................................................................... 1
3 Purpose .................................................................................................................................................................... 2
Section 2 - Methodology .................................................................................................................................................. 3
4 Perception of fundamental assumptions ................................................................................................... 3
5 Methods ................................................................................................................................................................... 4
5.1 STEP 1 - System framework .................................................................................................................. 4
5.2 Step 2 – The Nordic electricity market ............................................................................................. 8
5.3 Step 3 – Iterative investigation of commodity markets ............................................................. 8
5.4 Step 4 – Comparison of the Nordic electricity market and the other commodity
markets .......................................................................................................................................................................... 9
6 Limitations and delimitations ..................................................................................................................... 10
7 Main research questions................................................................................................................................ 10
8 Source discussion ............................................................................................................................................. 10
Section 3 – Market dynamics ..................................................................................................................................... 13
9 Market pricing mechanisms ......................................................................................................................... 13
9.1 The demand function ............................................................................................................................ 13
9.2 The supply function ............................................................................................................................... 14
9.3 Market liquidity ....................................................................................................................................... 15
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9.4 Marginal cost ............................................................................................................................................ 15
9.5 Elasticity ..................................................................................................................................................... 15
9.6 Substitutability ......................................................................................................................................... 16
9.7 Price and quantity equilibrium in commodity markets .......................................................... 17
9.8 Impact of taxes ......................................................................................................................................... 18
9.9 Trade tariffs ............................................................................................................................................... 18
9.10 Transportation costs of commodities............................................................................................. 19
10 Hedging ............................................................................................................................................................ 20
10.1 Principles of hedging ............................................................................................................................. 20
10.2 Risk and uncertainty .............................................................................................................................. 20
10.3 Financial contracts ................................................................................................................................. 22
10.4 Future curves ............................................................................................................................................ 25
10.5 Historical futures curves, basis, contango and backwardation ........................................... 26
10.6 Actors on hedging markets ................................................................................................................. 27
Section 4 – The Nordic electricity market ............................................................................................................ 29
11 [C]ustomers on the Nordic electricity market ................................................................................. 29
11.1 Producers ................................................................................................................................................... 30
11.2 Retail companies ..................................................................................................................................... 30
11.3 Consumers ................................................................................................................................................. 30
11.4 Traders ........................................................................................................................................................ 31
12 [A]ctors on the Nordic electricity market .......................................................................................... 31
12.1 Exchanges, contracts and features of trade ................................................................................. 31
12.2 Transmission System Operators ...................................................................................................... 33
12.3 Governments ............................................................................................................................................. 33
12.4 The European Union .............................................................................................................................. 34
13 [W]orld view .................................................................................................................................................. 35
13.1 Transmission congestions ................................................................................................................... 35
13.2 Price areas .................................................................................................................................................. 35
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13.3 Storability of electricity ........................................................................................................................ 37
14 [T]ransformation ......................................................................................................................................... 37
15 [O]wners .......................................................................................................................................................... 40
16 [E]nvironmental constraints ................................................................................................................... 40
16.1 Taxes ............................................................................................................................................................ 40
16.2 Seasons & climate ................................................................................................................................... 40
17 An integrated northern European utility wholesale market ..................................................... 41
Section 5 – Evaluation of commodity markets ................................................................................................... 43
18 Evaluation process ...................................................................................................................................... 43
19 Passed candidates ....................................................................................................................................... 44
Section 6 – Lean hogs .................................................................................................................................................... 47
20 [C]ustomers of lean hogs .......................................................................................................................... 47
20.1 Animal keepers and slaughter houses ........................................................................................... 47
20.2 Traders and consumers ........................................................................................................................ 48
21 [A]ctors on the lean hogs market .......................................................................................................... 49
22 [T]ransformation, lean hogs trading.................................................................................................... 49
23 [W]orld view .................................................................................................................................................. 50
23.1 Storability of lean hogs ......................................................................................................................... 50
23.2 Transportation costs of lean hogs .................................................................................................... 50
24 [O]wners of the lean hogs market ........................................................................................................ 50
25 [E]nvironmental constraints ................................................................................................................... 51
26 A small market transition – changing physical price reference ............................................... 53
27 Summary of key points .............................................................................................................................. 55
Section 7 - Steel billet .................................................................................................................................................... 57
28 [C]ustomers .................................................................................................................................................... 57
28.1 Steel producers ........................................................................................................................................ 58
28.2 Industry ....................................................................................................................................................... 58
28.3 Traders ........................................................................................................................................................ 58
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29 [A]ctors on the steel billet market ........................................................................................................ 59
29.1 London Metal Exchange (LME) ......................................................................................................... 59
29.2 Governments ............................................................................................................................................. 60
30 [T]ransformation and trading of steel billet contracts ................................................................ 61
31 [W]orld view .................................................................................................................................................. 61
32 [O]wners of the steel billet market....................................................................................................... 61
33 [E]nvironmental constraints ................................................................................................................... 62
34 Challenges with liquidity and market function for steel billets ............................................... 63
35 Summary of key points – Steel billet.................................................................................................... 64
Section 8 – Crude oil ...................................................................................................................................................... 65
36 [C]ustomers of the crude oil markets .................................................................................................. 66
37 [A]ctors on the crude oil markets ......................................................................................................... 66
38 [T]ransformation and trading with crude oil ................................................................................... 67
39 [W]orld view .................................................................................................................................................. 70
40 [O]wners of the crude oil markets ........................................................................................................ 70
41 [E]nvironmental constraints ................................................................................................................... 70
42 Recent development on the crude oil markets ................................................................................ 71
43 Summary of key points .............................................................................................................................. 72
Section 9 – Analysis ........................................................................................................................................................ 73
44 three commodity markets – comparison with Nordic electricity............................................ 73
44.1 Lean hogs .................................................................................................................................................... 73
44.2 Steel billet ................................................................................................................................................... 74
44.3 Crude oil ...................................................................................................................................................... 75
45 Solving the hedging issues ....................................................................................................................... 75
45.1 Lean hogs .................................................................................................................................................... 76
45.2 Steel billet ................................................................................................................................................... 76
45.3 Crude oil ...................................................................................................................................................... 77
46 Commodity markets interacting with electricity ........................................................................... 78
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47 Critical analysis of methods and findings .......................................................................................... 81
Section 11 - Discussion & Conclusions ................................................................................................................... 83
48 Pricing on commodity markets .............................................................................................................. 83
49 Implications for the Nordic electricity market ................................................................................ 84
50 Conclusions .................................................................................................................................................... 85
51 Further research .......................................................................................................................................... 86
Section 12 – List of references ....................................................................................................................................... I
Section 13 – Appendices .................................................................................................................................................. i
1 Forward curves for the Nordic system electricity price ...................................................................... ii
2 Future curves for the steel billet price...................................................................................................... iii

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ABLE OF FIGURES
Figure 1, Illustration of the research process ........................................................................................................ 4
Figure 2, Framework for market analysis ............................................................................................................... 5
Figure 3, CATWOE methodology applied by the authors on commodity markets, originally from
Checkland (1999, pp. 286-288) ................................................................................................................................... 6
Figure 4, Iterative research process ........................................................................................................................... 9
Figure 5, The demand curve ....................................................................................................................................... 14
Figure 6, The supply curve .......................................................................................................................................... 14
Figure 7, Supply- and demand curves for capital intense industries (with inspiration from
Krugman & Wells (2009, p.106) and Radetzki (2008, pp. 61-62)) ........................................................... 17
Figure 8, Welfare effects of a tax introduction .................................................................................................... 18
Figure 9, Example of a simplified future curve where risk aversion changes depending of the
time scope .......................................................................................................................................................................... 21
Figure 10, An example of futures contract ........................................................................................................... 23
Figure 11, A hypothetical future curve .................................................................................................................. 25
Figure 12, Two hypothetical futures price developments compared with the expected spot price.
................................................................................................................................................................................................ 27
Figure 13, Forward contracts on the Nordic electricity market, SYS price (Vattenfall AB, 2013
[4])......................................................................................................................................................................................... 29
Figure 14, CfD prices for SE1-SE4, closing 2013. Daily Power Forward Curve for Nordic SYS
region, Base/Peak (Vattenfall AB, 2013 [4]) ....................................................................................................... 32
Figure 15, The Nordic price areas (Svenska Kraftnät, 2013) ....................................................................... 36
Figure 16, The forward curve of electricity as of mid-march 2013 (Vattenfall AB, 2013 (2)) ....... 38
Figure 17, Front quarter forward curves for Electricity (Vattenfall AB, 2013 (2)) (Nord Pool
Spot, 2013 [5]) ................................................................................................................................................................. 38
Figure 18, Traded volumes on OMX commodities (Vattenfall AB, 2013 [4]) ......................................... 39
Figure 19, Prices of lean hogs future contracts February 1970-2014 (Quandl, 2013) ...................... 47
Figure 20, Forward curves of lean hogs futures contracts (Quandl, 2013 [3]) ..................................... 48
Figure 21, Number of daily traded lean hogs futures with closing february 1970-2014 (Quandl,
2013 [2]) ............................................................................................................................................................................. 50
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