Controlling market risk creates counterparty risk. This may be mitigated in turn by clearing. Nevertheless, clearing is not standard conduct in the energy derivative market. Important motivations for not clearing are clearing fees and possible liquidity risks.
Energy derivative contracts may control market risk for a hedger, but may depending on the price developments lead to credit risk (Box 4.1 provides a full overview of risks and risk management). This credit risk, is the risk that a counterparty cannot meet its obligations. This may be quantified as the difference between the actual value of the contract and the initial price of the contract. If an industrial consumer buys electricity for € 50/MWh for delivery one year later, the price of electricity and therefore the value of the contract may have risen to € 60/MWh.
Counterparty credit risk in this case is equal to the difference between these prices, namely €10/MWh.23
Box 4.1 Hedging, speculation and risk management
To understand the risk management of energy companies it is essential to acknowledge that market risk, credit risk and liquidity risk are closely intertwined. As a natural part of their business operations – the production and/or retail supply of energy – energy companies face market risk. Hedging via derivative trading is aimed to reduce this market risk but brings along a credit risk on the derivative counterparty. This risk on its turn can be hedged by means of clearing or bilateral margin agreements. Whether, and to what extent, this is necessary depends on the (net) position against a counterparty and its financial position. Evidently, this must be based on sound upfront and continuing counterparty analysis. For non-cleared OTC contracts this, in turn, results in liquidity risk as both parties in the deal may have insufficient cash-potential to post required (future) margins.24 Even if liquity risk can be handled, this comes at a price in the form of capital costs. Liquidity risk (costs) can be so substantial, that there exists a trade-off with market risk. Energy companies constantly analyze positions, counterparties and clearing costs in order to achieve an optimal risk position at lowest costs. This process of taking and managing risks based on the company’s risk attitude and related costs is illustrated in Figure 4.2.
Hedging via derivative trading is thus regareded as part of the core business of energy companies and necessary to carry out the physical side of the market: production and retail supply of energy. In the process of managing their risks energy companies also obtain positions which are indirectly but not directly connected with their physical operations. This occurs when firms trade on own account in order to arbitrage between different products or engage in speculation. Speculation is indeed profitable for the company but also aids the hedging task: trading on own account masks their (intended) hedge positions and thus allows traders to secure better deals for their hedging needs.25 Risks taken as part of derivative trading are mostly managed through internal procedures and tools, like maximum Value at Risk.
Figure 4.2 Clearing restricts options in risk management
Source: SEO Economic Research, based on interviews and sector analysis
23 Interest rates are not taken into account in this example.
24 In theory, also cleared deals might pose credit risks. For now, it is assumed that CPs will be properly regulated to prevent this.
25 Other benefits of proprietary trading, mentioned during interviews, were e.g. enhanced market liquidity, improved internal knowledge and management of commodity derivative trading, and higher returns.
Market risk
Liquidity risk Credit risk
Counterparty risk may in turn be mitigated by clearing. A clearing house acts as a central counterparty for both sellers and buyers of the future and guarantees delivery or payment according to the contract. Instead of one contract between buyer and seller, both the buyer and the seller have a contract with the central counterparty or with a clearing member of the clearing house. Margins are paid over outstanding net positions and fees are paid based on transaction volume. Clearing members pay margins in cash or accepted securities to the central counterparty. Non clearing members have in turn to pay margin to the clearing members. Both initial and variation margins have to be paid for power and gas futures. Variation margin is settled daily and is used to secure meeting obligations of open positions. The buyer of a future has to pay variation margin if the price of the future decreases, because there is a bigger difference between the agreed price in the contract and the price in the market. In volatile markets, both buyers and sellers may have to put up variation margin at some point.
Trade in futures on power exchanges is automatically cleared as clearing is an inherent part of exchange trade. Future contracts in OTC trade are not automatically cleared, but the contracting actors may decide to do so. Currently, depending on the market, between 10% and 30% of all derivative contracts is cleared. Whether they choose to do so depends on several factors, an important one being the necessity to bring down exposure to a specific counterparty. This could be the case if relatively high volumes are traded with one counterparty or when the trading partner has a low credit rating. Clearing may also be beneficial if actors know little about each other, for example when they have little experience dealing with each other. Another advantage of clearing is that energy firms can net all their outstanding positions.
Disadvantages of clearing are clearing fees and potential liquidity problems. Liquidity problems could especially arise at smaller asset based energy firms, because these firms hold mainly non liquid assets. Such a firm may want to hedge the risk of decreasing energy prices. If prices increase however, the difference between the value of the contract and the agreed price of the contract is positive. The energy producer would have to put up variation margin in order to cover this difference. Clearing houses would only accept cash and possibly government bonds as collateral, but not underlying production capacity or letters of credit from banks, which is currently common practice. As price fluctuations may force actors to credit their margin account, clearing also counteracts ‘the initial reason for trade, smoothing cash flows’ (Alexander et al. 2011, 43). Here we may again point to the mechanism to manage risk and liquidity positions, explained in Box 4.1.
As explained above, circa 70% to 90% of traded OTC contracts in the energy derivative markets is not cleared. Instead, firms use their own credit risk management, monitoring the creditworthiness of their counterparties. Generally, no collateral is paid until a threshold determined by the firms themselves. If trading exposure with a firm exceeds the threshold, only the loss-making side of the transaction has to put up margin. This margin is held by either the seller or the buyer of the contract. This means that the actors involved are more concerned with counterparty credit risk than the risk that the counterparty cannot deliver. In contrast with exchanges, in OTC markets collaterals are not automatically settled daily. They may however be settled if the value of the future contract decreases. Whether this happens depends again on volumes and perceived risk. According to information from the sector, most OTC markets
actually use collaterals to settle variation margins at a daily basis. Variation margins are constantly monitored and paid out to the counterparty if a predetermined threshold is surpassed.