Energy risk management notes

based on the GARP ERP program

Joao Pedro Pereira
ISCTE-IUL Business School - Lisbon
joao.pereira@iscte.pt
www.iscte.pt/jpsp
May 20, 2012
These notes follow the 2012 Energy Risk Profes-
sional (ERP) Examination AIM Statements. The
++,+, or - next to the reference number in the sec-
tion title denote how clear and correct the paper is
overall, and in particular how clearly it answers the
ERPs learning goals. A paper gets a + if it is
good overall, but either has some fuzzy parts or
does not meet some of the goals. inc means that
I did not nish all learning goals. My own com-
ments and additions are [like this].
Contents
1 Hydrocarbon resources (25%) 2
1.1 Exploration and production . . . . . 2
1.2 Crude Oil and Rening . . . . . . . 3
1.3 Synthetics . . . . . . . . . . . . . . . 6
1.4 Natural Gas, LNG and Shale Gas . . 8
1.5 Coal . . . . . . . . . . . . . . . . . . 15
2 Electricity Production and Distribu-
tion (10%) 16
2.1 Electricity Generation . . . . . . . . 16
2.2 Hydroelectric and Nuclear Power . . 19
2.3 Fundamentals of Electricity Distri-
bution and Trading . . . . . . . . . . 22
2.4 Load Forecasting . . . . . . . . . . . 27
3 Renewable Energy Sources and Car-
bon Emissions (10%) 28
3.1 Economics and Financing of Global
Investment in Renewable Energy . . 28
3.2 Sustainable Energy and Biofuels . . 31
3.3 Current Trends in the Carbon Market 32
3.4 Emissions Trading Models in the Eu-
ropean Union . . . . . . . . . . . . . 32
4 Financial Products and Valuation
(20%) 33
4.1 Forward Contracts and Exchange
Traded Futures . . . . . . . . . . . . 33
4.2 Energy Swaps . . . . . . . . . . . . . 36
4.3 Energy Options . . . . . . . . . . . . 37
4.4 Exotic Options . . . . . . . . . . . . 38
4.5 Option Valuation and Risk Manage-
ment . . . . . . . . . . . . . . . . . . 38
4.6 Real Option Valuation . . . . . . . . 39
4.7 Speculation and Spread Trading . . 39
4.8 Hedging Energy Commodity Risks . 40
4.9 Weather Derivatives . . . . . . . . . 40
5 Modeling Energy Price Behavior
(10%) 40
5.1 Introduction to Energy Modeling . . 40
5.2 Data Analysis and Essential Statistics 41
5.3 Spot Price Behavior . . . . . . . . . 41
5.4 Forward Curve Modeling . . . . . . . 42
5.5 Estimating Price Volatility . . . . . 43
6 Risk Evaluation and Management
(15%) 44
6.1 Value-at-Risk and Stress Testing . . 44
6.2 Credit and Counterparty Risk . . . . 45
6.3 Enterprise Risk Management . . . . 46
6.4 Case Studies in Risk Management . 47
7 Current Issues in Energy (10%) 47
1
1 Hydrocarbon resources
(25%)
1.1 Exploration and production
1.1.1 Hydrocarbon reserves [25, ch3,
++]
Reserves are smaller than Resources due to
technical and economic constraints.
Reserve probabilities are denoted as P90,
P50, P10, etc. Example: P90 = 265 Mbbl
means that Prob[reserves>265] = 0.9. Alter-
native notations for reserves:
1P = proven = P90 or P95
2P = proven + probable = P50
3P = proven + probable + possible = P10
or P5
Nonconventional hydrocarbons are dicult
and costly to produce. Main families are:
Deep oshore. Major reserves in Gulf of
Mexico, Brazil, West Africa, North Sea.
Heavy and extra-heavy oils (< 22

API).
Aka tar sands. Major reserves in Canada,
Russia, Venezuela, US and Indonesia. The
global resources may be four times as large
as the worlds proven reserves of conven-
tional oils. However, today only 5% of
these resources appear to be economically
viable.
Oil shales. Oils that remain in a typically
clayey sedimentary source rock. This rock
needs to be mined, pulverized and pro-
cessed to release oil. The process produces
large volumes of solid waste and CO
2
and
requires enormous quantities of water. Lo-
cated throughout the world; large resource
in the U.S.
Synthetic oils. Oil converted from coal or
gas.
Non-conventional gas. Gas in coal de-
posits (coalbed methane), shales with low
permeability (tight sands), or in solution
in aquifers and zones of geopressure [The
IEA classies unconventional gas as: tight
gas; coalbed methane; shale gas]. Have
low recovery rates.
Polar zones. Large resources in Artic.
Technical progress may lead to more reserves
or accelerated extraction in a oil well.
Location of major oil proven reserves (in
Gbbl):
1. Middle East (743)
2. Former USSR (123)
3. Africa (114)
4. North America (60)
5. South America (104), mostly Venezuela.
1.1.2 Upstream oil and gas operations
[43, ++, inc]
Upstream activities are exploration and pro-
duction; Downstream activities are rening
and distribution. An integrated oil company is
involved in both, whereas an independent com-
pany is involved only in upstream.
To be commercially productive, a petroleum
reservoir must have adequate permeability and
porosity. Porosity is the measure of the open-
ings in a rock in which petroleum can ex-
ist. Permeability measures the connectability
of the pores, which determines the ability of
the petroleum to ow through the rock. If a
reservoir has low permeability, there are pro-
cedures to increase it, such as, fracturing and
acidizing.
Mineral rights refer to the ownership of any
mineral beneath the surface. These can be sep-
arate from ownership of surface rights. When
the owner enters into a lease with an oil com-
pany, mineral interests are created for both
sides:
Royalty interest (RI). The owner receives
a fraction (typically 1/8) of the produc-
tion, free of any operating costs. He is re-
sponsible for his share of production taxes
2
and postproduction costs (transportation,
etc). The RI is also referred to as nonop-
erating or nonworking interest.
Working interest (WI). It is responsible
for the exploration, development, and op-
eration of a property. The company pays
100% of the operating costs and keeps all
revenues after deducting the royalty inter-
est (typically 7/8).
When there are multiple companies, the
working interest can be [does not make
any sense]:
Undivided. Ex: company A sells
50% of its WI on the entire property
to company B.
Divided. Ex: company A sells 100%
of its WI on 50% of the property to
company B.
In the US mineral interests are typically ac-
quired via leasing. Most leases contain the
following provisions: lease bonus, royalty pay-
ments (as dened in RI above), primary term
(time to begin drilling), shut-in payments (if a
capable well is not producing, the lessee may
hold the lease by making shut-in payments to
the lessor), oset clause (requires drilling an
oset well if a neighbor nds a common oil
reservoir).
1.1.3 Accounting for International
Petroleum Operations [43]
The scal system is the set of payments that
the oil company must make to the foreign coun-
try that owns the mineral rights. Major types
of scal systems (distinction not really clear in
practice):
Concessionary systems. Typical in the
US, UK, Norway, and others. Payments
are royalties and taxes.
Contractual systems. Add more pay-
ments. Subtypes:
Production sharing contracts (most
popular). Prot oil (revenues - roy-
alties - production taxes - costs) is
shared between the parties.
Service contracts. The government
allows the contractor to recover costs
and earn a fee. Popular in South
America.
When two or more international parties are
involved in a joint operation they must execute
a joint operating agreement detailing how costs
and revenues are to be shared. This can be one
of the contracts above or can be a separate
agreement.
1.2 Crude Oil and Rening
1.2.1 Nature of oil and gas [24, ch1,
++]
Petroleum = Petro (rock) + oleum (oil). Aka
crude oil. Hydrocarbons include crude oil
(mixture of HC molecules with 5 to 60 carbon
atoms) and natural gas (molecules with 1 to 4
carbon atoms).
English units. Crude oil is measured in bar-
rels (b or bbl). 1 kb = 1 Mbbl = 1 000 bbl,
1 MMbbl = 1 000 000 bbl (M is from the latin
mille), 1 Gb = 1 Gbbl = 10
9
bbl. Natural
gas is measured in cubic feet (cf). A standard
cubic feet (scf) is a cubic feet at 60

F and 14.65
psi.
The density of crude oil is measured with
the American Petroleum Institute (API) scale
(API decreases with specic gravity; water has
10

API):
Light oils are 35 to 45. Most valuable, rich
in gasoline. Tend to be sweet (less than
1% sulfur). [Examples: Louisiana Sweet,
WTI, Brent.]
(Medium?) [Examples: West Texas Sour,
Arab Light.]
Heavy oils are below 25. Less valuable,
contain considerable asphalt. Tend to be
3
sour (above 1% sulfur). [Examples: Arab
Heavy, Venezuelan]
Benchmark crude oils:
West Texas Intermediate (WTI), 38 to 40

API, 0.3% sulfur, US.

Brent, 38

API, 0.3% sulfur, North Sea.
Dubai, 31

API, 2% sulfur, Middle East.
Rening separates crude oil into several
cuts (from low to high boiling points):
gasoline
naphtha
kerosene [and jet fuels]
light fuel oils [or diesel fuel oils, heating
oil, gasoil, or distillate grades]
heavy fuel oils or heavy gasoil
Since gasoline is most valuable, cracking is
used to make gasoline from other cuts. Re-
ning also produces pure chemicals (3%) that
are used to make plastics, synthetic bers, fer-
tilizers, etc.
Natural gas composition:
Methane, 70-98%, (CH
4
)
ethane, 1-10%, (C
2
H
6
)
propane, 0-5%, (C
3
H
8
, LPG)
butane, 0-2%, (C
4
H
10
)
Pipeline natural gas ranges from 900 to 1 200
Btu/cf and is is commonly 1 000 Btu/cf.
The producing gas-oil ratio of a well is the
number of cubic feet of gas the well produces
per barrel of oil. [Note the mixed units: cf per
bbl].
Condensate. In some subsurface reservoirs,
at high temperatures, shorter-chain liquid hy-
drocarbons occur as a gas. When this gas
comes to the surface, the temperature de-
creases and the liquid hydrocarbons conden-
sate out of the gas. This condensate is almost
pure (low octane) gasoline and costs almost as
much as crude oil. The condensate along with
butane, propane, and ethane that can be re-
moved from natural gas is called natural gas
liquids (NGL).
Reservoir hydrocarbons are classied into:
Black oil. Has heavy, nonvolatile
molecules,

API below 45.
Volatile oil. More intermediate size
molecules,

API is 40 or above.
Retrograde gas. Is a gas in the reservoir
under original pressure but liquid conden-
sate forms in the reservoir as pressure de-
creases with production.
Wet gas. Contains less than 95% methane
and more than 5% of heavier molecules
(ethane, propane, and butane). Entirely
as gas in the reservoir, but produces liquid
condensate on the surface.
Dry gas. It is pure methane (or more than
95% methane in other denitions). Does
not produce condensate either in the reser-
voir or on the surface.
1.2.2 Investment Decisions [31]
When large quantities of uids require long-
distance transportation across land, pipelines
are normally the best option based on eco-
nomics, safety, environmental consideration,
and reliability.
Pipeline stakeholders: owners, customers
and shippers, consumers, regulators, landown-
ers, etc.
Decision process for building a pipeline: se-
lect origins and destinations, estimate volumes,
estimate construction costs, estimates rates,
estimate operating costs, calculate economics,
preliminary decision.
The need for a pipeline can be:
Demand driven: consumers need more
fuels or are currently receiving fuels
through more costly alternatives (truck,
rail, barge, or tanker).
4
Supply driven: new oil elds, reneries, or
tanker terminals.
Market driven: new resources are discov-
ered (typically natural gas), and new dis-
tant markets and connecting pipelines are
developed simultaneously.
The revenue of a pipeline depends on the vol-
ume transported and on the rate (the amount
shippers pay per unit). Common ways to es-
tablish pipeline rates include:
Cost of alternative transportation. Rate
set slightly below competition from ship,
barge, rail, or truck. Can be very favor-
able for pipeline owner.
Location dierentials. Rate set at dier-
ence between the price of the commodity
at the origin and the destination. Depend
on the factors that cause the price dier-
ence (supply/demand, transportation al-
ternatives) and can thus swing wildly.
A Master Limited Partnership (MLP) is a
US legal entity, sold publicly as units of owner-
ship. A general partner owns part of the com-
pany and manages the pipelines. The rest of
the MLP units are often traded on exchanges
and the owners receive periodical cash distri-
butions.
Possible valuation methods for pipelines:
Economic value: NPV or Cash Flow mul-
tiple.
Comparable sales: does not work well as
other pipelines are not directly compara-
ble.
Highest and best use: not normally used.
Reconstruction cost new or replacement
cost: ceiling price for buyers.
Book value: tells sellers whether they need
to record a nancial gain or loss.
1.2.3 Engineering and Design
Pipelines and Storage [31]
Important aspects of pipeline design:
Safety considerations.
Route selection.
Number and location of stations (com-
pressor or pump stations, delivery sta-
tions, storage stations, or interconnecting
stations).
Storage:
Oil, gasoline, diesel, etc, are normally
stored in aboveground steel tanks, located
at receipt and delivery points.
Natural gas - section 1.4.3.
Storage must be sized to account for de-
mand/supply imbalances during the year and
during the day.
1.2.4 The Role of WTI as a Crude Oil
Benchmark [36, -, inc]
Cushing, OK, is the physical delivery point of
the NYMEX Sweet Crude contract.
Parity pricing: crudes are in parity at a
given location if the prices of each produces
the same margin for a rener who purchases
them. The parity conditions for WTI vary
through time due to supply/demand in dier-
ent regions. Examples:
US Golf Coast (USGC) parity. West
Texas crudes moved south to USGC. WTI
prices reected transportation costs and
USGC market prices. (Mostly before
1986)
Chicago Parity. When Chicago demands
more than the available WTI, WTI prices
become related to other crudes delivered
to Chicago by other routes.
Cushing parity. When there are not
enough domestic sweets, need to import
oshore crudes. Cushing prices are based
5
on the USGC price for sweet crude de-
livered directly to Cushing. Prices at
other locations would then be based on
the Cushing parity price plus transporta-
tion to those other locations.
New pipelines from Canada are likely to create
new parity conditions in the future. Never-
theless, Cushing is still likely to maintain its
status as a key gathering and distribution hub
in the Midcontinent market.
Relation between WTI futures prices and in-
ventories:
Contango (prices increase with maturity)
induces inventory buildup.
Backwardation induces inventory de-
crease.
1.2.5 Simple and Complex Reneries
[28]
Rening margin = total revenue (gasoline, jet
fuel, distillate fuel, residual fuel, renery fuel)
- crude cost - operating cost. The margin must
compensate the owner for capital investment.
The margin sets the price in the market.
Types of reneries:
Simple. Crude distillation, cat reforming,
and hydrotreating distillates. Have lower
rening margin. Tend to do better re-
ning (more expensive) light or medium
crudes.
Complex. Simple renery plus a vacuum
asher, cat cracker, alky plant, and gas
processing.
Very complex. Complex renery plus a
coker, which eliminates residual fuel pro-
duction. Have higher rening margin.
Tend to do better rening (cheaper) heavy
crudes because can turn the heavy part of
the crude into light products.
As complexity increases, gasoline yield goes up
(30%, 50%, 60%) and residual fuel yield goes
down.
1.2.6 D2 and No.2 Diesel Fuel [6]
Under the ASTM standard, there are 6 types
of fuel oils. No.13 fuel oils are all called diesel
fuel oils. D2 is the same as No.2 diesel.
Price quotes can be:
Free on board (FOB). Seller provides a
commodity at a specied loading point
within a specied period; buyer arranges
for transportation and insurance.
Cost, insurance, freight (CIF). Price in-
cludes FOB value at port of origin plus all
costs of insurance and transportation.
Bunker fuel is a fuel used in the marine in-
dustry. No.2 diesel produced in North America
and Europe for inland use in trucks and trains
is also used as marine gasoil.
Rened petroleum products are traded in
cargo markets, such as, Rotterdam, Singa-
pore, New York, and the US Gulf. Bunker
fuels come from blending fuel oils bought in
cargo markets.
1.3 Synthetics
1.3.1 Oil Sands and Synthetic Crude
Oil [41]
Bitumen is a mixture of hydrocarbons that, at
normal temperatures and pressures, is a solid
or semisolid, tarlike substance. Oil sands are
deposits of bitumen in sand or porous rock.
Since bitumen does not ow under ambient
conditions, it is more dicult to recover than
conventional crude oil is and requires signi-
cant subsequent upgrading to become a sub-
stitute for conventional crude oil.
Bitumen can be processed into:
Synthetic Crude Oil (SCO). Bitumen is
upgraded to either Light, Medium, or
Heavy SCO and then sold to reneries
with corresponding processing capabili-
ties.
Synbit: mixture of bitumen and light SCO
6
(becomes uid). Sent directly to medium-
crude reneries by pipeline.
Dilbit: mixture of bitumen and a con-
densate, such as naphtha (becomes uid).
Sent directly to heavy-crude reneries by
pipeline.
Bitumen reserves:
Canada: established reserves of 173 billion
barrels, mostly in Alberta. Production
may reach 3 million bbl/d around 2015.
U.S.: 54 billion bbl (22 billion measured,
32 billion speculative), mostly in Utah.
Bitumen extraction methods:
Mining. More common today (60% of
Canadian production).
In-situ. Preferred for deeper deposits.
Most of the oil-sand reserves (80%) will
require in-situ methods.
Potential constraints on oil-sand production:
Environmental impacts: footprint of ex-
traction sites (in-situ is less disruptive
than mining), roads, pipelines, often in
pristine environments.
Water resources. Extraction requires
much more water than conventional oil
(in-situ requires much less than mining).
Natural gas prices. Both extraction meth-
ods rely heavily on natural gas: in-situ
methods burn natural gas to generate
steam; mining uses the same amount
[dont know for what]. By 2015, around
2 Gcf/d will be required, represent-
ing around 10% of Canadas production.
However, if natural gas prices increase,
conventional oil prices are also likely to
rise, potentially keeping SCO attractive.
CO
2
emissions: life-cycle emissions for
SCO are 20% higher than for sweet light
crude oils. CO
2
regulation could inuence
the relative economics of the two prod-
ucts.
1.3.2 Coal-to-Liquids Technologies [2,
ch3, ++]
Fischer-Tropsch (F-T) steps for converting
coal to liquids (CTL):
1. Gasication of coal. Reacting coal with
steam and oxygen to produce synthesis
gas (hydrogen and carbon monoxide) and
carbon dioxide.
2. Gas cleaning and preparation. Removes
gaseous molecules that derive from the im-
purities found in coal (sulfur, mercury)
and CO2.
3. FT synthesis. FT reactors convert the
synthesis gas to a mixture of hydrocar-
bons: methane and propane; gasoline,
diesel, and jet fuel; waxes.
4. Product separation. Results in two prod-
uct streams: middle distillates (retail-
ready diesel and jet fuel) and naphtha.
5. Product upgrade. Naphtha is a very low-
octane gasoline that must be extensively
upgraded before it can be used as an au-
tomotive fuel. Alternatively, naphtha can
be converted to chemical feedstocks.
The energy eciency of FT is close to 50%
(including cogenerated electricity sold to the
grid).
Note that synthesis gas can be produced
from dierent feeds: coal (CTL), natural gas
(GTL), petroleum coke, and biomass (BTL).
Over the last 15 years, commercial interest has
centered on stranded deposits of natural gas.
Commercial-scale experience with coal is ex-
tremely limited.
Transportation fuels produced in an FT
CTL plant have well-to-wheel greenhouse gas
emissions around 2 times higher than fuels
produced by rening conventional petroleum.
This will likely prevent growth of CTL in the
U.S. unless CO2 emissions are managed. Pos-
sible solutions are carbon capture and seques-
tration (CCS) and alternative methods (get-
7
ting hydrogen from renewables; averaging CTL
with BTL [sounds like cheating]).
Methanol-to-gasoline (MTG) is an alterna-
tive process to FT. One MTG plant is under
construction in China.
CTL is ready for commercial development in
the US. However, the limited commercial expe-
rience creates uncertainty at many levels: per-
formance and operational issues, investment
and operating costs, carbon dioxide manage-
ment costs. Competitiveness also depends on
crude oil prices staying at least in a $55$65
range. It is not clear how CTL will develop,
but in the U.S. probably not very fast.
1.3.3 Critical Policy Issues for Coal-to-
Liquids Development [2, ch6,++]
Investment in CTL production has been de-
layed due to market and technical uncertain-
ties. It has also been aected by uncertainty
about environmental regulations.
Environmental impacts of CTL production:
Greenhouse-gas emissions. CTL emits a
lot of CO2 and the viability of large-scale
CCS has not yet been established.
Air quality. Presumably, CTL would be
subject to regulatory controls on pollu-
tants emissions, like existing coal mining
and coal-red generation plants.
Land use, ecological impacts, and water
quality. There are impacts both at the
plant and mining sites.
Water requirements. High water con-
sumption may be a limiting factor in lo-
cating CTL plants in arid areas.
1.4 Natural Gas, LNG and Shale
Gas
1.4.1 Natural Gas [15, ch2.1, ++]
Because the composition of natural gas varies,
it is commonly traded in units of energy, like
Btu or therms for consumers (1 therm =
100 000 Btu). In North America, natural gas
sold to consumers needs to be in the range of
1 000 Btu5% per cf at standard temperature
and pressure.
A natural gas hub is the location where two
or more pipelines connect. A citygate is a spe-
cial type of hub where interstate pipelines con-
nect to local distribution networks. Most trad-
ing occurs at either hubs or citygates. The
most important natural gas hub is Henry Hub
in the Gulf Coast. The price at Henry Hub is
used as the benchmark for the whole US. Henry
Hub is the delivery location for the NYMEX
natural gas futures contract.
Terminology for natural gas trading (dier-
ent from other nancial markets):
Index price: price at Henry Hub. (ex:
$8.52)
Basis price: spread between the index and
the actual price at a specied location.
(ex: $0.18 for Waha Hub)
All-in price: price of physical natural gas
at a specied location. (ex: $8.70 for
Waha Hub)
To trade natural gas, traders usually enter
into two trades:
1. a futures trade at the Henry Hub (very liq-
uid, allows bulk of trading done quickly).
2. a basis swap that exchanges the Henry
Hub exposure for an exposure at some
other location.
A spread trade bets on price dierences by
going long in one security and short in other.
Examples:
Location spreads. Speculate on price dif-
ference between two locations. Simulta-
neous buy/sell at dierent locations with
the same maturity.
Heat rates. Speculate on the relationship
between natural gas prices and electric-
ity prices. Simultaneous buy/sell of power
8
and gas matching either the spread trad-
ing in the market or the underlying heat
rate of a physical plant. This is related to
Tolling Agreements.
Time spreads. Speculate on the price
dierence between periods of high and
low demand. Example: buy winter gas
and sell spring gas to speculate on a
colder than normal winter causing high
gas prices. Done through simultaneous
buy/sell of future, forward, or swap con-
tracts with diering maturity dates.
Swing trades. Pick up inexpensive natu-
ral gas when demand is low (ex: Satur-
day night) and resell it when demand is
high (ex: Monday morning). Relies on
the physical ability of the trader to store
natural gas for short periods of time.
Spot and forward markets are separate be-
cause natural gas is hard to store. For exam-
ple, traders might buy gas in the summer to
sell during the next winter, but they arent go-
ing to buy gas and hold it for several years as
a long-term investment.
Forward prices:
Determined by seasonal expectations of
demand: highest in winter (for heating),
lowest in spring and fall, increases in sum-
mer (for electricity generation for AC).
Follow a very regular pattern, generally
the same every year.
Volatility decreases with maturity of the
forward contract (from 1 to 4 months to
expiration)
Correlated across locations when it is pos-
sible to move gas from one location to an-
other.
Hence, forward prices are highly predictable.
Spot prices:
Determined by the demand and supply
that is on hand right now.
Substantially more volatile than forward
prices.
Price movements in the spot market do
not have a large eect on future prices.
There is no correlation across locations.
1.4.2 The Basics [9]
Natural gas consists of hydrocarbons that re-
main in the gas phase at 20

C and atmospheric
pressure (standard temperature and pressure,
STP).
1
See composition in section 1.2.1.
Liqueed natural gas (LNG) is produced by
cooling methane to 161.5

C. This allows for

ecient transport by ships.
Liqueed petroleum gas (LPG) refers to
propane and butane in pressurized containers.
They liquefy at 0

C at 90 psi to 110 psi.

Natural gas liquids (NGL) include compo-
nents that exist with the gas in the reservoir
but become liquid on the surface. Condensates
are low-density liquid mixtures of pentanes and
other heavier hydrocarbons.
In addition to hydrocarbon components
(methane, ethane, propane, butane, pentane),
natural gas also contains non-hydrocarbon
components: nitrogen (N
2
), Hydrogen sulde
(H
2
S), and carbon dioxide (CO
2
). Gases with
high/low levels of H
2
S are called sour/sweet.
Barrel of oil equivalent (boe) for natural gas.
The caloric values are:
Crude oil: 1 bbl oil = 5 800 MBtu
Nat gas: 1 cf gas = 1 MBtu or 1 m
3
gas
= 35.3 MBtu
Hence,
1 boe 5 800 cf gas 164 m
3
gas
[If prices per energy were the same, 1 bbl of
oil would cost 5.8 times 1 thousand cf of gas.]
Associated gas occurs in the same reservoir
and coexists with crude oil.
1
Though in section 1.2.1 a standard cubic feet of
natural gas is dened at 60

F = 15.6

C.
9
Reserves are classied as 1P, 2P, or 3P, like
oil. Proved (1P) gas reserves worldwide are
6 300 tcf, implying a reserves/production ratio
of 66 years.
An oil and gas reservoir may initially pro-
duce high volumes of oil relative to gas, but as
the oil production and reservoir pressure de-
cline, the gas/oil ratio of the produced hydro-
carbons may increase.
Coal bed methane is methane contained
within coal seams. This is an unconventional
source: though easy to nd because coal oc-
curs close to the surface, it is relatively di-
cult to produce. Nevertheless, in the US it is a
signicant portion of domestic gas production
volumes.
1.4.3 Transport and Storage [9, +]
The cost of transporting 1 energy unit of nat-
ural gas via onshore pipeline is 3 to 5 times
higher than oil. This ratio increases to 20 or
more for longer distances.
Liquied Natural Gas (LNG) is a trans-
portation alternative. Though less than 10%
of gas is transported as LNG, it is growing
rapidly [section 1.4.9 says it is not growing
due to shale gas]. Methane gas is cooled to
161.5

C (260

F), shrinking 600 ft

3
of gas
to around 1 ft
3
of LNG. One ton of LNG con-
tains the energy equivalent of 1 380 m
3
of nat-
ural gas.
LNG is transported by ship over long dis-
tances where pipelines are neither economic
nor feasible. LNG could be a viable option
versus pipeline when many of the following are
true:
Gas market is more than 2 000 km from
the eld.
Production costs are $1/MMBtu or less.
Gas contains minimal impurities, such as
CO
2
or sulfur.
A marine port where a liquefaction plant
could be built is relatively close to the
eld.
The political situation in the country sup-
ports large-scale, long-term investments.
The pipeline would have to cross other
countries and the buyer is concerned
about security of supply.
The LNG chain is (cost range in $/MMBtu)
(measurement units):
Upstream production. (0.500.75) (Vol-
ume, cf or cubic meters). Similar to tra-
ditional gas. Byproducts removed from
methane (such as ethane, LPG, and con-
densate) are sold at market prices and
contribute to overall LNG project eco-
nomics. (LPG sales are also important for
some shale gas projects.)
Midstream processing and liquefaction.
(1.31.8) (Mass, tons. The LNG industry
uses MT, not MMT, to represent million
tons). Special care must be taken to re-
move all impurities (CO
2
and sulfur) and
especially water.
Shipping. (0.41.0) (Cargo volume, cubic
meters)
Storage and regasication. (1.01.5)
Distribution. () (Btu)
Gas storage ensures that excess supply pro-
duced during low-demand months or hours is
available to supplement the insucient supply
during high-demand months or hours. Other-
wise, production and infrastructure would have
to be over-sized to meet the highest demand.
Base load requirements refer to the seasonal
monthly swings, while Peak load requirements
refer to the hourly swings. Base load storage
needs to be large, but can have low delivery
rates; peak load storage have high deliverabil-
ity for short periods of time.
Structures for storing:
Pipeline itself. Simplest form of peak load
storage.
10
Depleted gas reservoirs. For base load.
Most common; account for 86% of storage
capacity in North America. Cheaper, well
known, smaller amount of cushion gas (in-
jected gas that remains in the reservoir).
Acquifers. Least desirable and most ex-
pensive. Require whole new infrastruc-
ture, high cushion gas.
Salt caverns. For peak load. High deliv-
erability with minimal leakage. Small ca-
pacity. Cushion gas requirements are the
lowest.
1.4.4 Gas Usage [9]
Electricity generation accounts for 25% of all
gas consumption in Europe. In a conventional
power plant, natural gas powers a gas turbine
(or coal or oil power a steam turbine) to gener-
ate electricity with an eciency around 34%.
In a Combined Cycle gas power plant, the rst
cycle is a gas turbine, and the second cycle
recovers the heat from the exhaust gases to
power a second steam turbine, with an over-
all eciency around 55%.
Replacing a coal generating unit with a
CCGT plant virtually eliminates SO
2
emis-
sions, reduces CO
2
by 2/3, and reduces NO
x
by 95%. Gas CC plants are cheaper to build,
less noisy, less polluting, and easier to switch
on and o. Can be built in modules and are ef-
cient at smaller sizes. Most new power plants
in North America and Europe are expected to
be gas red.
Gas has become the fuel of choice for both
intermediate and peak load plants. As ecien-
cies improve and in areas where gas prices are
competitive to other fuels, gas may even re-
place other fuels in base load.
A modern CCGT plant can be built at a cost
around $500/kW to $700/kW in about 2 years
(roughly 1/2 the time and cost of coal).
Gas-to-liquids (GTL) processes convert nat-
ural gas to liquid fuel. Methane is reacted with
pressurized hot steam to produce syngas (syn-
thesis gas, CO + 3H
2
). Then, syngas is con-
verted to longer-chained hydrocarbons through
the Fischer-Tropsch process. GTL produces:
Diesel. Represents 60%85% of the prod-
ucts. Does not contain impurities, thus
being much cleaner burning than conven-
tional diesel.
Naphtha. Feedstock for petrochemicals.
Lube oils.
LPGs.
Despite eorts, it remains an energy inten-
sive process and the number of GTL plants re-
mains limited. For GTL projects to be prof-
itable we need sustained high crude prices and
inexpensive gas. A 2005 study concludes that
GTL has more technical risk, complexity, and
susceptibility to short-term price uctuations
than LNG.
Transport fuel. Natural gas in the form
of compressed natural gas (CNG), which is
methane pressured to 200 bar to 250 bar, is
a good alternative for spark ignition engines.
It has much smaller emissions than gasoline.
It holds the greatest promise for eet vehicles
that refuel at a central location. Note: LNG
can also be used. However, the growth of nat-
ural gas in the transportation sector has been
slow, due in part to the lack of infrastructure.
A Local distribution company (LDC) sup-
plies residential gas to the end user. Though
they may not face direct competition due to
their exclusive mandate, their end-user energy
prices have to be competitive with electricity,
heating oil, coal, etc, to maintain their cus-
tomer base. Deregulation in North America
and Europe has forced LDC to become more
competitive and has brought lower prices for
consumers.
11
1.4.5 Contracts and Project Develop-
ment [9]
The pipeline gas sales agreement (GSA) is also
know as gas purchase agreement or a gas sales
and purchase agreement. The contract covers
a number of provisions, including:
Term. Can be from 1 day to 20 or 30
years.
Price terms:
Fixed price. Typically in shorter-
term contracts.
Fixed price with an escalator:
changes every year by a percentage
determined by an index. The in-
dex may be linked to: ination; a
published price on the NYMEX; a
combination of substitute fuels, such
as crude oil (most gas contracts in
Europe) or coal. Indexing ensure
gas price competitiveness to alter-
nate fuels and avoids renegotiating
long-term contracts.
Floating price. Varies every week
or month according to some market
price.
Delivery obligation. Flexible delivery con-
tracts may be cheaper than rm delivery
because gas supply is interruptible by the
seller.
Take-or-pay obligations. The buyer is
obliged to pay for a percentage (6095%)
of the contracted quantity, even if he fails
to take the gas.
Nominations. The buyer communicates
its weekly (or other period) gas volume
requirements to the seller.
Force majeure. Events outside the partys
control. Obligations of all parties must be
clearly stated.
A sales and purchase agreement (SPA) for
LNG is similar to a GSA for natural gas. How-
ever, the LNG SPA is more complex due to
the large capital expenditures, international
nature, and discrete value chain. Important
features of the contract.
Price. During the rst SPAs, Japanese
power plants were able to use either oil
or gas to generate electricity, so the price
of LNG was indexed to a Japan Crude
Cocktail (JCC) price. Since the index-
ing was calculated on a monthly basis,
this made LNG prices less volatile than
crude prices. Today, particularly in North
America, prices are more commonly linked
to natural gas prices (NYMEX or Henry
Hub).
Take-or-pay.
Shipping terms. Deliveries can be on a
free-on-board or cost-insurance-freight ba-
sis. Many buyers prefer FOB.
The phases of a gas project development are:
1. Concept and identication. Is the project
realistic and achievable?
2. Feasibility and option selection. Financial
and commercial models are created (esti-
mate NPV and IRR), engineers are en-
gaged, risks are identied, and preferred
technical options are highlighted. Sign
memorandum of understanding or heads
of agreement letters with the resource
holder and the potential customers.
3. Project denition. Critical go/no-go
stage. Key contracts to be secured: GSA,
transportation agreements, environmental
impact studies, permits. Partners should
nalize a joint operating agreement.
4. Project execution. An engineering com-
pany is typically engaged in a engineering,
procurement, construction (EPC) con-
tract or an EPCM contract (adds man-
agement to EPC).
5. Commission and operation.
12
1.4.6 The Natural Gas Market in the
United Kingdom [17, ch36, -, inc]
Physical and nancial gas is traded at the na-
tional balancing point (NBP). NBP does not
have a specic location and gas is neither pro-
duced nor consumed at the NBP. The Interna-
tional Commodity Exchange acts as the main
exchange for NBP gas.
Consumption:
Power generation. 30% of demand. All
new generation plants are gas-red.
Industrial and commercial consumption.
Follows diurnal, working day, and seasonal
cycles but is not particularly weather sen-
sitive.
Domestic consumption. 35% of demand.
Very sensitive to weather.
In the event of a supply shortage, power sta-
tions and large users are required to self in-
terrupt; domestic users receive priority (due to
lack of relevant safety mechanisms in domes-
tic cookers, making gas disruptions potentially
dangerous).
Relationship to other commodities:
Oil. Long-term gas contracts are com-
monly indexed to oil prices. This improves
hedgeability, cost reectivity, and reduce
contract frustration risk.
Electricity. The electricity price at the
gate (1 hour ahead of delivery) is related
to the cost of the marginal plant. Gas and
power prices are closely related when gas
plant is at the margin. As CCGT has also
been designed to run baseload, long-term
baseload power price has also been set by
gas.
Power prices in the UK are closely con-
nected to ETS CO2 prices. Medium CO2
prices make CCGT better than coal, but
very high CO2 prices make renewable and
nuclear better than CCGT.
Coal. There is little price inuence. How-
ever there can be fairly high correlation
due to common dependence on oil prices.
1.4.7 Liqueed Natural Gas: Under-
standing the Basic Facts [14, ++]
In the US, natural gas represents 1/4 of pri-
mary energy. About 90% is produced in the
US, the balance is imported by pipeline from
Canada. Natural gas demand is expected to
rise, but production in major mature provinces
in North America is beginning to decline [this
sounds biased...]. Hence, imports of LNG by
ship are expected to increase. One shipload
(around 3 bcf) provides 5% of US daily de-
mand.
The international LNG business connects
natural gas that is stranded far from any
market with the people, factories, and
power plants that require the energy.
International LNG trade centers:
Atlantic Basin: Europe, Africa, US.
Importers: 33% of global imports.
Exporters: 32% of global exports.
Algeria is worlds second-largest ex-
porter.
Asia/Pacic Basin: South Asia, India,
Russia, Alaska.
Importers: Japan, South Korea, and
Taiwan account for 67% of global im-
ports (Japan close to 50%).
Exporters: 50% of global exports.
Indonesia (21%), Malaysia.
Additionally, Middle Eastern countries ship
mostly to Asian countries, but also to Europe
and US.
Peak shaving. The US has more than 100
small plants that store LNG. This is used to
provide extra supply when natural gas demand
peaks during extremely cold spells or other
emergencies.
13
LNG value chain. See section 1.4.3. Lique-
faction is the largest cost: capital costs around
$200 per ton of capacity. Total investment for
full LNG chain is very large: $710 billion.
Risk is thus minimized with long-term supply
contracts, with take or pay clause. However,
about 70% of LNG in the US is traded in a
spot market; worldwide, spot market accounts
for 12% of trade.
Units: see table in paper to convert from
tons of LNG to cubic feet of natural gas, and
corresponding Btu values.
A LNG train consists of the series of linked
equipment elements used in the liquefaction
process. A typical plant includes 3 to 4 trains.
1.4.8 Todays LNG Market Dynamics
[35, +]
The geographical mismatch between produc-
ers (Middle East, West Africa, Indonesia, Aus-
tralia) and consumers (Japan, Europe, North
America) of LNG has maintained large price
dierences between markets (often exceeding
several hundred percent of the source price).
However, these gaps may reduce in the future
due to:
Global growth in the number of liquefac-
tion and regasication plants.
Development of unconventional gas sup-
plies, such as coal seam methane.
New ships are able to liquefy and regasify
onboard, obviating the need for onshore
plants and making smaller stranded gas
sites and smaller consumer markets eco-
nomically viable.
Modular liquefaction plants make infras-
tructure less costly.
Contract term. The number of short-term
contracts ( 1 yr) is growing. These contracts
tend to cover small volumes. They allow sup-
pliers to take advantage of regional price dier-
ences. However, the market is still dominated
by longer term contracts, as projects with too
much uncontracted volume have diculty se-
curing project nance.
LNG prices are typically indexed:
In East Asia, contracts are indexed to
crude oil through JCC index. Example:
LNG price = (gas/oil energy ratio) x JCC
+ transport costs.
In Europe, are indexed to various com-
modities.
In the US and UK, are indexed to natural
gas through National Balancing Point and
Henry Hub indexes.
This has results in arbitrage spreads between
regions, that have widened in recent years due
to index divergence.
The current development of standardized
contracts may help to create a more ecient
global market for LNG, help the development
of a spot market, and ultimately reduce price
dierentials.
1.4.9 Impact of Shale Gas Develop-
ment on Global Gas Markets [30,
+]
During the early 2000s, the LNG import capac-
ity to North America was expanded. However,
much of that capacity now sits idle, as shale
gas developments have changed expectations
about future prices and LNG import require-
ments.
The estimates of shale gas resources have
been increasing through time. Current esti-
mates point to a North America recoverable
resource around 700 trillion cubic feet.
Implications of this large domestic resource
base:
Domestic gas prices should remain rel-
atively stable, toward the long-run
marginal cost of supply (around $6 per
thousand cf at Henry Hub). [An MIT
(2010) study estimates that the breakeven
14
price for the exploration of shale gas is in
the range of $4 to $8 per thousand cf (2007
prices)]
A more elastic supply curve will make
it harder to price above marginal cost,
meaning that oil indexation is likely to
loose some prominence. [Due to shale gas
supply, since 2005 gas has decoupled and
become cheaper than oil (per Btu). This
shows that gas and oil are not good substi-
tutes in many applications, such as trans-
ports.]
Since Henry Hub prices are at a discount
relative to other locations (such as the
NBP in the UK), LNG supply has been
redirected from the US to Europe and
Asia, increasing physical liquidity, arbi-
trage opportunities, and reducing the de-
mand for pipeline supplies.
Growth in LNG import reliance is shifted
by two decades, yielding security benets.
If shale gas also grows globally, Europe
and Asia will reduce their dependence on
geopolitically risky sources of supply from
the Middle East, North Africa, and Rus-
sia.
However, rapid development of shale gas is
not certain:
Use and contamination of water resources
remains a major concern.
Separation of pipeline capacity rights from
facility ownership allows entry by small
producers. This market structure was cru-
cial for shale gas development in the U.S.
In other countries, pipeline transportation
monopolies may hamper shale gas growth.
1.5 Coal
1.5.1 Coal Analysis [39, ch1, +]
Global coal reserves exceed 1 trillion tons.
The largest reserves are in the U.S. (23% of
worlds reserves), former Soviet Union (23%),
and China (11%). Approximately 40% of the
Earths current electricity production is pow-
ered by coal, and the total known deposits re-
coverable by current technologies are sucient
for at least 300 years of use.
Coal types (from highest to lowest rank):
1. Anthracite (or hard coal). Primarily for
residential and commercial space heating.
High percentage of xed carbon and low
percentage of volatile matter. Moisture:
less than 15%. Heat content: 2228 mil-
lion Btu/ton.
2. Bituminous coal. Primarily for power gen-
eration, heat and power in manufactur-
ing, and to make coke. Moisture: less
than 20%. Heat content: 2130 million
Btu/ton.
3. Subbituminous coal. Primarily for power
generation. Moisture: 2030%. Heat con-
tent: 1724 million Btu/ton.
4. Lignite (or brown coal). Exclusively for
power generation. Moisture: sometimes
as high as 45%. Heat content: 917 mil-
lion Btu/ton.
Important concepts in coal sampling:
Accuracy: closeness between an experi-
mental result and the true value. Aected
by bias.
Precision: agreement among individual
test results obtained under similar condi-
tions. Not aected by bias, hence data can
be very precise without being accurate.
Bias: systematic error that is of practical
importance.
There are several coal classication systems
across the world. In the U.S., coal is classi-
ed according to caloric value and xed car-
bon (which requires a proximate analysis to
determine moisture, ash, volatile matter, and
xed carbon by dierence). The classication
list goes from several types of anthracite (high
15
rank) to several types of lignite (low rank)
1.5.2 Sampling and Sample Prepara-
tion [39, ch2, -, inc]
The heterogeneous nature of coal complicates
sampling procedures. There is substantial vari-
ation in coal quality and composition across
and unmined bed.
Sampling by increments consists of extract-
ing from dierent parts of a lot a series of
small portions or increments that are combined
into one gross sample without prior analysis.
The precision of sampling improves with the
number of increments (though the size of each
should not be so small as to cause selective re-
jection of the largest particles).
Coal washing is a process to remove mineral
matter to leave the coal as mineral-free as re-
quired by the buyer or legislation.
2 Electricity Production and
Distribution (10%)
2.1 Electricity Generation
2.1.1 Electricity [15, ch2.2, ++]
The U.S. is split into several regional markets.
Each is coordinated by its own Transmission
Service Operator, which can function as a:
Government-sponsored monopoly.
Independent Service Operator (ISO).
Serve a single state and are exempt from
federal jurisdiction.
Regional Transmission Organization
(RTO). Operate across several states and
fall under federal jurisdiction. As ISOs
grow to become RTOs, many still keep
ISO as part of their name.
The main RTO/ISO are:
PJM interconnection.
NY ISO
New England ISO
SPP RTO
ERCOT ISO
California ISO
These are integrated into 3 regional power
grids: Texas, Western, and Eastern Intercon-
nect.
A deregulated market is one where an
RTO/ISO coordinates generation and trans-
mission. Important characteristics:
Daily power auctions where power produc-
ers submit their supply schedules. It is
a non-discriminatory auction: all winning
bidders get paid the same clearing price.
Power plants are activated by merit or-
der from lowest to highest bid un-
til the demand is met. The last is the
marginal producer and its marginal
price of power sets the clearing price.
Electricity trading markets:
Spot market. Trading of power in arbitrar-
ily small sizes for immediate use anywhere
in the country. Types of auctions coordi-
nated by the RTO/ISO:
Day-ahead auction: sets the price for
the following day in one-hour incre-
ments.
Real-time auction: is run continu-
ously throughout the actual delivery
day. It is typically bid in ve-minute
increments.
Only power plants participate in the daily
auctions.
Foward market. Trading of large blocks
of power at about 20 locations around the
country. Forward contracts are commonly
broken up into day and night power by
month. They are commonly described in
weekdays-by-hours shorthand. Examples:
724, power 7 days a week, 24 hours
a day.
16
5 16, weekdays, peak power (7am
11pm).
7 8, nighttime o-peak (11pm
7am).
Standardization makes the contract more
liquid. The forward market doesnt re-
quire any ability to generate power at all
it is possible to trade both physical con-
tracts (requiring delivery of power) and -
nancial contracts (which settle in cash). It
is where the bulk of speculative trading
occurs.
Elements of the Standard Market Design
(SMD) recommended by the Federal Energy
Regulatory Commission:
The costs of line congestion are paid only
by the aected parties rather than be-
ing shared across the entire grid. This is
achieved by two mechanisms:
1. The primary way to solve congestion
is to activate an out-of-merit order
plant close to the demand area. The
higher cost of this producer is paid
only by the local consumers.
2. Producers pay a charge for routing
power into a high load area over
congested power lines, and receive a
credit for producing power that by-
passes the congestion.
There is a penalty for remote generation,
i.e, producers are only paid for deliverable
power, not power placed onto the grid.
This compensates for line losses.
Hence, implementing SMD requires assign-
ing dierent prices to dierent locations on
a power grid. The price is called Locational
Marginal Price. It has 3 parts: a clearing price,
a congestion charge, and a line loss charge.
Prices are calculated for 3 types of locations:
Node price: price at the interface (aka
electrical bus) where power enters or
leaves the grid. Producers are paid the
nodal price of the electrical bus where they
deliver power.
Zone price: average of all nodal prices in
a given area. Customers pay this price.
Hub price: (or clearing price) average of
selected nodal prices across several zones.
It is the benchmark price for the grid and
it is used in the forward market.
A Financial Transmission Right (FTR) is
a tradable contract between two parties that
pays the dierence in price between two nodes.
It helps to manage the risk of price dierences
between a major hub and a specic node due
to congestion. Can be structured as a forward
or an option.
The Heat Rate of a given plant is the e-
ciency at which it converts fuel into electricity:
Heat Rate :=
Fuel used (MMBtu)
Power produced (MWh)
(1)
Typical values range from 7 MMBtu/MWh
(extremely ecient plants) to 10
MMBtu/MWh (less ecient). [CCGT
with 55% eciency should be closer to 6]
Market Implied Heat Rate (MIHR):
MI Heat Rate :=
Power price ($/MWh)
Fuel price ($/MMBtu)
It is protable to produce when MIHR HR.
Spark Spread is a prot estimate for a given
plant from buying gas and selling power at cur-
rent market prices, excluding operating [and
investment] costs:
Spark Spread ($/MWh) :=
Power price (Gas price Heat Rate) (2)
Dark spread refers to coal-based generation.
2.1.2 Location [20, ch7, -, inc]
[This chapter is written in some incomprehen-
sible alien language.]
Location [whatever that means] is important
because of:
17
Commercial complexity of networks due
to the interconnection of markets and the
wheeling of power.
Barriers and constraints.
Distance between fossil fuel sourcing, large
scale production, and consumption.
Small scale renewable generation.
Requirements for locational charging [verba-
tim from the book; nothing makes sense]:
Location signals to generators.
Medium term incentives to build network
infrastructure for base case (transmission,
generation, etc) and for variable (capacity
and redundancy) requirements.
Economic treatment of interconnection.
Cost recovery and optimization of spend
by the transmission and system operator.
Loss costs are applied separately to the
transmission and distribution sectors. Trans-
mission losses are of the order of 2%4%
and are relatively low compared to distribu-
tion losses. Losses are handled commercially
through one of the following market model for
losses:
Marginal losses included in location
marginal prices (eg, New York).
Average marginal loss factors applied to
generators and loads.
Average losses netted against load at grid
supply point.
System administrator buys losses from the
market.
Pricing models. There are alternative meth-
ods for designating the electrical location of
a point on the network, for the purposes of
charging:
Postage stamp: prices are the same at all
points.
Zonal: postage stamp pricing within a
zone, where a zone is a group of nodes.
Postage stamp with market splitting:
there are several zones, but they all have
the same price, unless there is a constraint
between them. If there is a constraint, the
zone that is a net exporter of electricity re-
ceives the clearing price of the zone that
imports from it. This method is used in
Germany and Nordpool.
Nodal: ner grid, each node (or bus) has
its own price.
Financial Transmission Rights or Responsi-
bilities? FTRs are called FT-Rights when
structured as options; FT-Responsibilities
when structured as forwards (obligations in
PJM market).
2.1.3 The Essential Aspects of Electric-
ity [23, ch2, ++]
Functions of the electricity industry:
Generation or Production. Accounts for
35%50% of the nal cost of delivered elec-
tricity. The development of CCGT in the
1980s showed that economies of scale were
not an inevitable part of electricity pro-
duction and opened the door to competi-
tion in generation.
Transmission. Electricity is transmitted
from the generators to local distribution
systems. Accounts for 5%15% of the nal
cost of electricity.
The transmission system is quite fragile
if it overloads it becomes unstable and can
cause widespread blackouts. Hence, the
transmission system requires the constant
attention of a system operator to match
the generation to the load (demand).
Distribution. Electricity is transported
from the transmission system to cus-
tomers. Accounts for 30%50% of the -
nal cost of electricity. While transmission
works with generation (through the sys-
tem operator), distribution works with the
18
customer.
Commercial functions:
Retailing: sales to nal consumers.
Wholesale power procurement: when
the company chooses which producer
to buy from. In the U.S., a whole-
sale sales means sales for resale.
Wholesale sales are regulated by the
federal government, while sales to -
nal customers are regulated by the
states.
For many years the industry was organized
as a vertically integrated monopoly for the fol-
lowing reasons:
Natural monopolies (economies of scale)
in transmission and distribution. And
even in generation before smaller plants
become economically viable.
The coordination of generation and trans-
mission is more ecient when both ac-
tivities are in the same rm. Separat-
ing the two incurs into transaction costs,
which are the costs of negotiating, exe-
cuting, and litigating naturally incomplete
contracts.
Long-term planning of transmission and
generation beneted from vertical integra-
tion.
Monopolies have to be regulated to protect
consumers. There are two basic models: US
and UK. They both: (1) base prices on cost
and x them for a period of time; (2) by un-
hooking prices from actual costs during this
window, they provide incentives for ecient
operations.
The main risks are:
Market demand and prices.
Technology change rendering plants un-
competitive.
Management decisions about mainte-
nance, manning, and investment.
Credit risk.
Under regulation, customers take most of the
risks; under competition, producers take the
risks.
Important technical facts that make electric-
ity dierent from other commodities:
1. Electricity cannot be economically stored.
Hence, wholesale price varies tremen-
dously with the demand/supply balance.
The daily load curve is a curve showing de-
mand across the day. The peak is usually
in the afternoon. In hot(cold) areas, sum-
mer(winter) is the peak season. Wholesale
hourly prices in competitive markets com-
monly vary by about 2:1 over the course of
a day in the o-season and by as much as
10:1 in the high season (with some spikes
above this as well).
2. Electricity takes the path of least resis-
tance. Hence, there is no such thing as
a dened path for delivery.
3. There is a complex series of physical in-
teractions in a transmission network.
4. Electricity travels at the speed of light.
Each second, output has to be precisely
matched to use.
To cope with these facts in a competitive set-
ting trading arrangements should be incentive-
compatible, so that generators will want to
obey the system operator. However, note that
there is no physical dierence between inte-
grated and competitive systems: electricity is
homogenous throughout the grid and there is
no direct connection between a given consumer
and a given producer.
2.2 Hydroelectric and Nuclear
Power
2.2.1 Hydroelectric [8, ch6, +]
Worldwide, hydropower plants have a capacity
around 700 GW and generate around 25% of
the electricity.
19
Top hydroelectric generating countries, from
highest to lowest (capacity, hydros % of
national total capacity): Canada (67 GW,
60%), USA (92 GW, 7%), Brazil (?, 90%),
China, Russia, Norway, Japan, India, Sweden,
France. [The ordering is for generated electric-
ity (GWh) in some nonspecied year, which
apparently does not match the ordering on in-
stalled capacity (GW). The numbers for the
US are inconsistent throughout the paper.]
Some major plants are: 18.2 GW Three
Gorges Dam in China, 13 GW in Brazil, 7.6
GW Grand Coulee in Washington State.
The amount of power generated is deter-
mined by the volume of waterow and the
amount of head (the height from the turbines
to the waters surface).
Conventional hydropower plants only use
one-way water ow. They can be run-of-river
(do not store water) or storage plants (have
a dam and reservoir). Pumped storage plants
reuse water.
Brazil case study. Brazil had a severe
drought in 2001, which led to an energy cri-
sis and exposed the risk of a high level of de-
pendence on hydroelectric power (although in-
sucient growth in supply and transmission in
previous years also contributed to the crisis).
Measures had to be imposed to reduce electric-
ity consumption.
Environmental issues: current research
on new turbine technology could potentially
achieve a reduction in turbine-passage sh
mortality and maintain a downstream level of
dissolved oxygen consistent with water quality
standards.
There is a huge amount of regulation appli-
cable to the licensing and relicensing of hydro
projects. Some of the main legislation:
National Environmental Policy Act of
1969: requires assessing the eect of op-
erations on historic structures, water dis-
charge into streams, habitat for plants and
animals.
Clean Water Act of 1997: water quality
must be certied.
Wild and Scenic Rivers Act of 1968:
project cannot aect a wild and scenic
river.
Endangered Species Act of 1973: requires
assessing of whether relicensing is likely to
jeopardize endangered species.
Licenses are issued for a period of 30 to 50
years, typically enough to recover investment.
Hawaii case study. Hawaii has several hydro
plants in 3 islands, but they only supply a small
fraction of electricity (from 1.4% to 10%). Im-
ported oil provides 90% of energy. Hawaii is
developing a mix of renewable resources includ-
ing hydropower, among others.
2.2.2 Nuclear and Hydropower [33,
ch8, +]
A) Nuclear Power
The typical large-sized nuclear power and
coal-red plants have an output between 11.5
GW. In the US, there are 66 plants of this size
(out of 16 755 units) and they represent 8% of
the 1 031 GW total country nameplate capac-
ity. A 1 GW plant can handle the base-load
needs of a US city of 600 000 people (1 million
people if using world average consumption).
The weight of nuclear power in generat-
ing electricity is [in 2005?]: Europe 28%,
N.America 19%, Russia and Ukraine 18%, Asia
9%. The countries with the highest percent-
age are France and Lithuania (78%), [... list
goes on...], Germany (28%), US and UK (20%),
Canada (15%). The country with more reac-
tors is the US (around 100, of total 439 world-
wide).
Types of commercial nuclear reactors (num-
ber of operating reactors worldwide):
Boiling water reactor (BWR) (92). The
rst reactor was a BWR built for a nuclear
submarine in 1954. A BWR feeds steam
20
directly from the reactor to the turbines.
Pressurized water reactor (PWR) (263).
The rst commercial reactor was a PWR
built in 1957. A PWR operates under
higher pressure and temperature making
it more thermally ecient than a BWR.
Gas-cooled reactors (26).
Pressurized heavy-water reactors (19).
Popular in Canada.
Light-water graphite reactors (17). Only
in Russia and Ukraine.
Fast breeder reactors (3). In Japan,
France, and Russia.
Pebble-bed modular reactor (PBMR) (?).
New technology developed in South Africa
that is attracting attention. Small reactor
of only 110 MW. Has a simple design and
operation, low cost of construction, and
inherent safety (core meltdown is physi-
cally impossible).
Many of the new reactors under construction
are PWRs, while others are pressurized heavy-
water reactors or advanced BWRs.
B) Hydropower
Advantages of hydropower:
Renewable source of energy.
No fuel cost and low operating cost.
Does not pollute.
Provides a way to store energy through
pumped storage plants.
Disadvantages of hydropower:
Are not built where they are needed. In-
stead, require ample supplies of water plus
favorable geological conditions.
High capital cost.
Environmental concerns (eg, impact on
sh and wildlife) and social issues (eg,
resettlement of people living upstream,
ooding of historical sites).
Potential of catastrophic structural fail-
ure.
The worlds largest hydropower producers
(% of total world output) are: Canada (12%),
China and Brazil (little less than 12%), U.S.
(9%), Russia (6%). [Guess the ranking is based
on generated electricity in some non-specied
year.]
The nations with the greatest reliance on hy-
dropower are (% of total electricity genera-
tion): Norway (almost 100%); Brazil, Iceland,
and Columbia (over 80%); Venezuela and New
Zealand (65%), Canada (60%). [Year is not
specied.]
2.2.3 Nuclear Power Plant Construc-
tion Costs [38, +]
Current [2008] estimates of total construction
costs (including escalation and nancing) for
new nuclear plants are between 5 5008 100
$/kW, or 69 billion $ per 1 100 MW plant.
Construction costs have increased signi-
cantly in recent years. This is due to increases
in commodity prices and skilled labor short-
age. Furthermore, there are only two compa-
nies in the world (in France and Japan) that
have the heavy forging capacity to create the
largest components in nuclear plants. Also, the
number of suppliers of nuclear components in
the U.S. has reduced a lot over the last two
decades.
Cost estimates are very uncertain. The all-in
costs can be much higher than the initially esti-
mated overnight costs once you factor in own-
erss costs such as land, cooling towers, etc.,
interest during construction and cost escala-
tion due to ination and cost overruns. For a
sample of plants that began construction be-
tween 1966 and 1977, the actual average cost
was 3 times higher than the initially estimated
cost.
Construction rms are unwilling to commit
to xed price contracts, which means that cost
21
overruns are paid by the owners of the plants
and their customers.
Consequences of cost overruns:
Only one-half of projects were actually
built and ratepayers frequently had to pay
the sunk costs for abandoned projects.
Cost of power from completed plants be-
came much more expensive that initially
expected.
Some utilities got into severe nancial
problems and some went bankrupt.
Two new reactor designs have been pre-
approved in the US the Advanced Boiling
Water Reactor and the Westinghouse AP 1000
but there is absolutely no construction or
operating experience with these designs any-
where in the world.
The nuclear renaissance is heavily depen-
dent on obtaining federal loan guarantees that
would shift the risks of rising plant costs from
plant owners onto the federal government.
2.2.4 The Prospect for Safe Nuclear
[13, +]
Passive safety features rely on physics instead
of active interventions. The best passive safety
measures require no signal inputs, no external
power sources or forces, no moving mechani-
cal parts, and no moving working uid. For
example, thick concrete walls.
Examples of safer, next-generation reactors:
Westinghouse AP1000. (AP stands for
Advanced Passive). Has an emergency
water reservoir above the reactor thats
held back by valves. If the cooling sys-
tem fails, the valves open and water pours
down to cool the vessel. The water is
enough to last for 3 days. Westinghouse
says the AP1000 is 100 times safer than
current plants.
Arevas EPR has four redundant safety
systems.
Pebble bed reactor. Has been under de-
velopment for decades in Germany, then
South Africa, and now China and US. The
radioactive ssion products are absorbed
in the coatings of the fuel pebbles, and the
fuel doesnt get hot enough to melt down
even if there is no coolant. China already
has a 10 MW experimental reactor in op-
eration and is building a 200 MW plant.
However, pebble bed reactors do not scale
up well: above 600 MW they loose their
safety advantage.
Traveling wave reactor. Under develop-
ment by TerraPower, a Microsoft spino.
There is some conict about promoting these
new reactors because utilities and manufactur-
ers do not want to imply that the older designs
now in service are unsafe.
The failure of Tepcos Fukushima reactor
was in part due to bad management deci-
sions. In particular, ocials underestimated
the risk that a huge tsunami would overwhelm
Fukushimas defenses. However, it is human
nature to lower the probability of catastrophic
events when you have no idea about how to
deal with them.
2.3 Fundamentals of Electricity Dis-
tribution and Trading
2.3.1 Trading Arrangements [23, ch7,
+]
Trading arrangements are the legal agree-
ments between traders and the system oper-
ator and/or the transmission owners.
The 4 facts that make electricity dierent
from other commodities (section 2.1.3) lead,
respectively, to the 4 pillars of market design:
1. Imbalances between contracted supply in
forward markets and actual demand must
be corrected by the system operator in real
time.
22
2. Congestion management. The system op-
erator has to distribute generation to en-
sure that total electricity ows will not
overload any line.
3. Ancillary services such as operating re-
serves, reactive power, etc, are necessary
to make the transmission system work,
but these other outputs are dependent on
also producing energy.
4. Scheduling (in advance) and dispatch (in
real time) done by the system operator re-
quires incentive-compatible rules.
Alternative models of trading agreements
dier on the degree to which operation and
commercial arrangements for imbalances, con-
gestion, ancillary services, and scheduling are
integrated with spot markets. From low to
high integration:
1. Wheeling model. Used in many areas of
the US as a rst step toward competi-
tion. Prices are regulated and there is no
spot market. A vertically integrated util-
ity with its own generation runs the trans-
mission and system operation. Provides
access to other traders after it has sched-
uled its own resources, ie, native load gets
priority, and the spare transmission capac-
ity can be used for wheeling. Large loads
such as municipalities arrange for inde-
pendent generators to supply large blocks
of their electricity needs instead of pur-
chasing from the local utility.
2. Decentralized model. Used in California
and Texas. The system operator is inde-
pendent of the generators but its commer-
cial responsibilities are deliberately min-
imized the aim is to let traders run
the market. Generators and consumers
trade in bilateral contracts. The system
operator must take the physical origin and
destination of contracts specically into
account when scheduling. However, this
physical matching is a ction, and leads
to ineciencies and arbitrage opportuni-
ties. Typically preferred by marketers and
traders.
3. Integrated model. Used in 3 regions of the
US (eg, PJM, New York) and most mar-
kets abroad. The system operator sched-
ules forward contracts at the request of
traders, but also takes bids from traders
to modify scheduled contracts and to pro-
vide imbalances, congestion management,
and ancillary services. The system oper-
ator runs the spot market using a large
computer optimization program.
This model is typically preferred by utility
engineers, whose concern is the stability
of the transmission system. [23] strongly
prefers this model: it runs smoothly,
incorporating the necessary complexities
of the transmission system and providing
incentive-compatible rules. A major bene-
t is that independent generators can nd
an outlet for their power without having to
nd specic customers, [... which fosters]
real competition in the production mar-
kets.
The essential feature of the integrated model
is that the system operator administers a spot
market integrated with the pricing of imbal-
ances, congestion management, and the ancil-
lary services. The following mechanisms make
this work:
The system operator runs an optimiza-
tion program (every 10 minutes) that min-
imizes costs, subject to transmission con-
straints. The output is a merit order
list of generators and the market clearing
price. It is a nondiscriminatory auction:
all plants that bid below the spot price
will be generating and they will all be paid
that same spot price.
The incentives are for traders to bid close
to their marginal cost; most of the time
they will be paid more than this, making a
23
contribution to the investment costs, but
because the software sets the spot price
at the highest bid selected, they do not
need to add in the overhead when making
their bids, and if they do they will not be
selected to run as often.
[They will receive a contribution to the
investments costs only if the price is
greater than average variable costs: pq
V C FC FC p V C/q =: AV C.
(This is a short-run analysis because some
factors are xed and must be paid even if
output is zero). Unless the AVC is always
zero (like in wind), there is a set of low
quantities where it is better not to pro-
duce than to receive MC. Graphically, this
means that the clearing price must inter-
sect the MC curve above the AVC curve.
See p. 217 in Varian, Microeconomic anal-
ysis.]
The optimization process outputs a set of
locational prices that dier by the cost of
transport.
All imbalances are traded at the market
spot prices that result from the optimiza-
tion process.
Congestion management: traders who
schedule contracts across valuable trans-
mission lines are charged a transmission
usage charge (a bottleneck fee) being
equal to the energy price dierence be-
tween the two ends of the transaction.
Main ancillary services:
Reactive supply.
Operating reserves: available capacity
that is able to run on short notice. Needs
to be about 7%10% of load.
Frequency response (or regulation re-
serve): capacity that continually adjusts
output to exactly match demand.
The total cost of ancillary services is 1%3%
of total costs.
2.3.2 Details of the Integrated Trading
Model [23, ch8, +]
Given that spot prices are set in a nondiscrimi-
natory auction, generators with lower costs will
make a prot from the market prices set at the
marginal cost of the marginal generator. But
how does the marginal generator recover his
investment? Prices need to rise at peak times.
Methods to ensure that prices peak in time
of high demand (from best to worst):
1. Demand bidding. Used in PJM. Cus-
tomers bid for what they want to take and
the price results from the normal intersec-
tion of supply and demand. Demand bid-
ding does two things:
(a) Raises prices when supplies are tight,
thus inducing new investment.
(b) Stops generators bidding up prices
to excessive levels. Because of the
steepness of the end of the supply
curve, a very small reduction in elec-
tric load from demand response can
reduce the price a lot at peak peri-
ods.
However, demand response is still very
small in most markets and so demand
curves are nearly vertical. The markets
thus rely on generators bidding above
marginal cost, which has the danger of
them bidding far too high in times of high
demand.
2. Capacity payments. Was used in Ar-
gentina and the U.K. Pool. Capacity
adders increase the market price. They
are higher when it is more likely that there
will be a shortage.
This is based on the correct notion that
if generators charge marginal costs at
all hours, they will only break even if
they also charge investment costs at peak
times.
24
3. Capacity obligations. All entities that
serve nal customers are required to ac-
quire capacity tickets to cover the ex-
pected load of their customers plus a re-
serve margin.
In the integrated model, traders can still
make forward contracts in private and bilat-
eral markets, just like they do in the wheeling
and decentralized models. The contract sched-
ule (MW, physical locations, and timing) must
be notied to the system operator only if one
the following holds:
The contract is inexible. When all mar-
ket participants are exible willing to
modify operations from their contracted
levels if protable the system operators
dispatch is fully separate from the forward
contracts. The forward contracts then be-
come only nancial, providing only price
risk management.
The contract requires net settlement: im-
balances are calculated and settled by the
system operator as actual metered deliv-
eries net of contract volumes. Contract
schedules are only used for nancial set-
tlement, not for physical dispatch. Net
settlement is recommend over gross set-
tlement.
PJM has net settlement, allowing both inex-
ible and exible contracts. Forward contracts
are scheduled for delivery but the link be-
tween producer and consumer is in truth only a
nancial one, it could never be a physical one.
There is transmission congestion when the
capacity of one line is lled. To manage con-
gestion, plants on the import side of the con-
straint have to increase production, and plants
on the export side of the constraint have to de-
crease production, relative to the production
schedules they would otherwise prefer. Hence,
spot prices will be higher in the import area.
The value of scarce transmission is equal to the
market price of electricity in the import area
minus the price in the export area.
Pay-as-bid versus (nondiscriminatory)
marginal bid pricing. Almost all integrated
electricity markets have marginal bid pricing.
The argument for pay-as-bid is that consumers
would pay less because more ecient gener-
ators would receive lower prices. However,
evidence shows that generators would quickly
adjust to pay-as-bid auction rules and would
stop bidding at mg cost and would instead
bid at their best guess of the market-clearing
price. If there was perfect information, both
methods would give the same clearing price;
in practice, pay-as-bid creates ineciencies.
In particular, it increases the risk for ecient
base load generators (if they overshoot, they
do not run), making them less protable and
less likely to be built.
The day-ahead market operates a day in ad-
vance of the spot market. For example, at 2pm
on Wed, an auction is held for energy delivery
for each hour of Thu. Transactions in the day-
ahead market then become forward contracts
that are settled against spot prices. Benets:
Benecial for generators with high start-
up costs.
Prevents generators from gaming the mar-
ket by withdrawing capacity at short no-
tice to lift spot prices.
Promotes demand response.
A day-ahead market exists in PJM and NY.
2.3.3 Tolling Agreements [15, ch4.3,
++]
With deregulation, some power plant operators
began to specialize in maintaining the physical
hardware of their plants. Others, called power
marketers, specialize on marketing the power.
A tolling agreement is a contract to rent a
power plant from its owners. The power mar-
keter is responsible for supplying fuel to the
plant and selling the resulting electricity into a
25
competitive market. They take on all of the
economic risks and earn the prots above a
xed maintenance fee.
Tolling agreements give the renter the option
to convert one physical commodity (fuel) into
a dierent commodity (electricity). Ignoring
operating costs, the conversion in a gas plant
gives:
Prot ($) =
Dispatch (MWh) Spark Spread ($/MWh)
where the spark spread is dened in (2).
Tolling agreements can be valued through a
real options approach. Each operating decision
(leg) is modeled as a nancial option. Each
leg requires electricity and fuel prices and the
right time and location. Since tolling agree-
ments can run for up to 20 or 30 years, there
can be several hundred separate commodities
traded over the lifetime of the contract.
Implications for risk management:
It is meaningless to add up the exposures
of dierent legs. For example, it is wrong
to ask, Whats the exposure of this power
plant to the price of electricity? because
there is no single price of electricity (Au-
gust electricity is a fundamentally dier-
ent product than May electricity).
High volatility in the spread between elec-
tricity and fuel prices increases the value
of the option. Hence, low correlation be-
tween these prices increases the value of
the tolling agreement.
2.3.4 Wheeling Power [15, Ch4.4, ++]
Wheeling is the act of physically transport-
ing electricity from one location to another.
Wheeling trades require a physical transfer of
electricity over power lines rented from a third
party.
Examples of wheeling trades:
Building a transmission line to connect the
upper Midwest (where coal is the marginal
fuel) to the southern US (where gas is the
marginal fuel). This trade is a bet on nat-
ural gas prices being much more volatile
than coal prices.
Import hydroelectric power from the Nia-
gara Falls region into the New York City
metro area.
Building a nuclear plant a long way from
a population center [and a transmission
line].
Investing in a PV solar installation in New
Mexico and building a long distance high
voltage DC power line to get the power to
the East Coast.
Wheeling trades can be valued as nancial
options. The premium is the up-front cost of
building or renting the line. The underlying
asset is the price dierence between the two
regions. The strike price is the transportation
cost (line losses and variable expenses).
Long-distance transmission alternatives:
High voltage Alternating Current (AC)
lines. Transmission losses are proportional
to the square of the current. To trans-
fer the same amount of power, it is neces-
sary to increase the voltage to reduce the
current. Transformers only work on AC,
which is why AC transmission is the most
used.
High voltage Direct Current (DC) lines.
They are typically lower cost and lose less
power than AC lines. However, DC power
has to be converted to AC before being
distributed to end users, which has 5%
10% losses. These conversion losses have
to be weighed against transmission losses.
Furthermore, voltage drops whenever any
energy is removed from a DC line, making
multiple end points problematic. Hence,
HVDC lines are primarily for extremely
26
long distance, point-to-point connections.
Location spread trades are nancial trades
made in the futures or forward markets. They
can be done nancially with no physical trad-
ing capability (this is the primary dierence
to a wheeling trade). The trader takes a long
position in one region and a short position in
another. The trades are liquidated before the
physical delivery is required.
Example of a spread trade:
1. Opportunity: expect snow melt earlier
than April this year. This would lead to
cheaper power in the Pacic Northwest
(due to larger hydroelectric production)
than the market is anticipating.
2. Trade March futures for peak power: buy
California (NP-15) and sell Pacic NW
(MID-C).
3. Result will be positive if futures prices
have changed by the time the trade is liq-
uidated (must be prior to expiration).
2.4 Load Forecasting
2.4.1 Spatial Load Forecasting [15,
ch4.1, ++]
Spatial load forecasting is a prediction of elec-
trical demand within a specied region for a
specic period of time. In the short term, it
is used to schedule power plants; in the long
run, it is used to construct new power lines
and plants.
Factors that go into producing a load fore-
cast:
Location. Forecasts are made for lim-
ited geographical areas, typically dened
as connecting to the same part of a power
grid.
Type of consumer:
Residential: higher consumption be-
tween 6am9am and 6pm11pm.
Commercial: oces and retail. Have
standard schedule and moderate de-
mands.
Industrial: high variation.
Base load demand. Is the minimum level
of demand that must be met at all times.
To be cost eective, should be met by
highly ecient low [fuel] cost base load
power plants that can take advantage of
the fact that they will be able to work
around the clock.
Weather. A lot of electricity is used for
space heating and cooling (AC). Hence,
temperature accounts for a very large por-
tion of the variation in demand, at two
frequencies:
Day-to-day: demand will typi-
cally increase (decrease) with above-
average temperature in summer
(winter) time.
Month-to-month: demand is typi-
cally higher in summer and winter,
and much lower during spring and
fall.
Calendar eects:
Higher demand on weekdays than on
weekends and holidays.
Typically, in the summer the daily
peak is in the early afternoon (more
AC), while in the winter there is a
peak in the early morning (people
waking up) and another in the end
of the day (people arrive home from
work).
The steps in creating a load forecasting
model should be: get historical load, look at
graphs, develop a preliminary model, expand
the model. It is important to test the model
through error analysis: analyze the dierences
between actual loads and the models pre-
dictions. Do it in-sample and out-of-sample.
27
Check whether the errors correlate with typi-
cal factors like weather, calendar, etc.
3 Renewable Energy Sources
and Carbon Emissions
(10%)
3.1 Economics and Financing of
Global Investment in Renewable
Energy
3.1.1 The Economics of Renewable En-
ergy [21, ++]
Contrary to fossil fuel plants, renewable energy
sources are generally capital intensive and have
low or no variable costs. If we build a renew-
able power station, we are eectively prepaying
for the next 40 years of electricity. This makes
long-term debt nancing seem fair.
The Levelized cost of electricity (LCOE) is
the constant price at which electricity would
have to be sold for the production facility to
break even over its lifetime, assuming a rea-
sonable level of capacity utilization. From a
policy perspective, we should add the social
costs.
Social costs of using a fossil fuel :
CO2 emissions. Cost estimates range from
$8 to $85 per ton of CO2.
A large coal-red power station can use
10 000 tons of coal daily, costing between
50100 $/t, so that fuel costs can reach
$1 million per day. Burning 1 t of coal
will produce 1.53.5 tons of CO2 [eia.gov
says 2 t, wet basis]. Hence, a CO2 price
of $30/t can double the fuel costs of a
coal power station. At the higher price
of $85/t, the LCOE rises from $0.06/kWh
to $0.11/kWh.
Other pollutant emissions, such as SO2,
NOx, PM, are associated with environ-
mental damage, poor health, and early
death. Costs of electricity production
range from almost zero to 0.15 euros per
kWh [Paper has references]. Marginal
costs for new capacity in the US are low
due to high emission standards and a cap
on total SO2 emissions.
The attractiveness of investing in renewables
depends on four factors:
Costs of oil and other fossil fuels.
Cost of carbon emissions.
Cost of capital.
Incentives for production of green electric-
ity. US uses production tax credits, but
this is inecient for start-ups because it
requires federal tax liabilities. Direct sub-
sidies tend to be more ecient.
The capacity factor [or load factor] is the ac-
tual output as a fraction of the maximum out-
put that would have been produced if the plant
had operated at maximum capacity. Wind and
solar are in the 25%35% range (due to in-
termittency), while coal or geothermal reaches
90%.
Intermittent renewables are only able to
bid in the day-ahead electricity market be-
cause they cannot guarantee steady base load
power (usually supplied through long-term
contracts).
In states with renewable portfolio standards
(RPS) there is generally a market in renewable
energy certicates (REC). REC are tradable
certicates proving that 1 kWh of electricity
has been generated from renewables. To com-
ply with the RPS, electricity distributors have
to own sucient REC at the end of the year.
Economic viability of major renewables:
Wind. Capital costs around $4 000/kW
for oshore and $2 000/kW for onshore.
LCOE for onshore in 8-10 cents/kWh.
Solar. PV: capital $7000/kW; LCOE 25
30 cents/kWh. PV is already competitive
in distributed applications where there
28
is no grid connection. CSP: LCOE 11
cents/kWh, 15 cents/kWh with thermal
storage.
Geothermal. LCOE 3.5 cents/kWh.
Water. Hydropower capacity in the US
may actually decrease to protect endan-
gered sh species. Wave and tidal are not
yet at commercial scale, but costs seem
substantially above market rates.
Carbon capture and storage. Costs in $50
100 per t of CO2, too high to be com-
mercially attractive. A variant is to cap-
ture CO2 directly from the atmosphere at
a cost of $200/t.
Biofuels. Sugar-based ethanol is compet-
itive with gasoline at oil prices of $5060
per barrel. For biodiesel to replace diesel
it will be necessary to develop new tech-
nologies.
For comparison, LCOE for coal is less than 7
cents/kWh, gas and diesel are higher, nuclear
is in 810 cents/kWh.
3.1.2 Project Finance Primer [19, +,
inc]
Project Finance is a method of nancing in
which the lenders have limited or no recourse
to the assets of the parent company that spon-
sors the project. The project is owned by a
special purpose entity, the project company.
Lenders will typically demand a secure revenue
stream for the project, which in wind and solar
projects is typically obtained through a power
purchase agreement (PPA) with the local util-
ity. Project nance is a way to nance large in-
frastructure projects that might otherwise be
too expensive or speculative to be carried on a
corporate balance sheet.
Advantages:
Debt is held in the project company, not
in the sponsors books.
Protection of key sponsor assets, such as
intellectual property, key personnel, and
other assets, in case of project default.
The expected IRR for the equity in a fully
leveraged project can be very high.
The sponsor may be able to recover devel-
opment costs at the closing of the project
nancing and put their money into new
projects.
Monetization of tax incentives (see below).
Project nance is a realistic opportunity
when:
The project is large, with debt above $50
million (project nance is time-consuming
and expensive to consummate).
The revenue stream will be large enough
to support a highly leveraged debt nanc-
ing.
The power purchaser is creditworthy.
The physical assets are sucient to repay
lenders in case of foreclosure.
The technology can be new, but not
untested.
Success does not depend only on a few key
individuals who may depart.
The sponsor must be willing to turn over
the project to lenders if it becomes unable
to service its debt.
The sponsor is not looking for a quick exit.
The sponsor is willing to share manage-
ment with lenders.
Project revenues are distributed to investors
through a waterfall with the following order:
1. Construction and operating and mainte-
nance costs, typically paid to sponsors af-
liates.
2. Fees, interest, and principal to lenders.
3. Reserve accounts and cash sweep to
lenders.
29
4. Subordinated debt.
5. Equity holders.
[Project Finance seems just like Collateral-
ized Debt Obligations...]
Federal income tax incentives for renewable
energy projects:
Production tax credits (PTC): around 2.1
cents/kWh in 2009.
Investment tax credit (ITC): based on the
cost of the qualifying property. Taxpayer
can choose either PTC or ITC for facilities
that qualify for PTC.
Treasury grants: cash payment in lieu of
the ITC (and the PTC). The taxpayer
need not have a federal income tax liabil-
ity to benet from a grant.
Accelerated depreciation.
Advanced energy project credit for manu-
facturing facilities.
Tax credit for the production of cellulosic
biofuels: $1.01/gallon.
Tax structures used to monetize available
project subsidies. When a developer is not able
to benet from the various tax benets, the
following strategies allow the developer to re-
ceive value, or monetize, the tax incentives
through the intervention of an institutional in-
vestor that can benet from those tax incen-
tives:
Partnership ip. The developer and an
institutional investor form a partnership.
In the initial stage, the investor receives
a disproportionate allocation of the part-
nership income and tax credits (PTC,
ITC). When the investors target return
is achieved (the ip point), the investors
allocation is reduced to a small portion.
Sale-Leaseback. The developer sells the fa-
cility to an investor. The investor leases
the project back to the developer for a
term equal to the PPA. The investor is
considered the owner of the project and
can thus claim the ITC. The investor
shares its tax savings with the developer
in the form of reduced rents. Can be used
for ITC, but not for PTC.
Pass-through lease. More complex struc-
ture. Has been used to monetize solar en-
ergy credits and Treasury grants. It is
usually preferred by investors who value
the credit/grant but place less importance
on depreciation.
3.1.3 Global Trends in Renewable En-
ergy Investment [5, +]
In 2010, global investment in renewable power
and fuels set a new record at $211 b(billion),
+$51 b than in 2009.
Considering only nancial new investment
(venture capital and private equity, public
markets, and asset nance of utility scale
projects), for the rst time developing coun-
tries at $72 b overtook developed countries at
$70 b. This is mostly due to China at $49
b, and smaller amounts in South and Central
America ($13 b) and Middle East and Africa
($5 b).
Nonetheless, in total investment (which
adds R&D and small distributed projects), de-
veloped economies remain well ahead. This is
mainly due to small-scale distributed capacity
(SDC) investments of $60 b, most of which in
rooftop photovoltaics (PV) in Europe. Total
investment in the US was $25 b, an increase of
58% from 2009.
Total investment in solar came close to wind
for the rst time in 2010. Again, the big chunk
in solar is SDC and the increase is due to falling
PV prices. Considering only nancial new in-
vestment, the decomposition is (in $b):
1. Asset nance: solar 18.9, wind 89.7.
2. Public markets new equity: solar 5.3,
wind 8.2.
30
3. VC/PE: solar 2.2, wind 1.5.
Challenges in renewable energy projects:
Reduction in feed-in taris for new
projects and even threats of retroactive
cuts.
Low natural gas prices.
Outside skepticism: clean energy shares
under-performance and cooler mood in in-
ternational politics.
Renewable power, excluding large hydro-
electric, made up 8% of total world electricity
generation capacity in 2010 and 5% of actual
generation. It accounted for 34% of additional
capacity brought online.
Asset nance is dened as all money in-
vested in each year, either from internal funds,
debt nance, or equity nance. [If it is re-
ally all arent they double counting equity
in nancial new investment?] Asset nance
of new utility-scale projects increased in 2010
to $128 b, distributed through Asia & Ocea-
nia ($56 b, mostly in China), Europe ($29 b),
North America ($25 b), and South America
($13 b). Balance sheet nance continued to
be dominant (70%), but non-recourse project
nance increased to 30%. The wind sector ac-
counted for 70% of overall nancing.
3.2 Sustainable Energy and Biofuels
3.2.1 Sustainable Energy [33, ch9, inc]
[The paper is interesting but does not add
much to other readings and it is a bit old.]
3.2.2 Biofuels: Markets, Targets and
Impacts [40, ++]
Biofuels are classied into:
1. First-generation. Ethanol produced from
the sugar or starch portion of plants (e.g.,
sugarcane, sugar beet cereals, and cas-
sava) and biodiesel produced from oilseed
crops (e.g., rape seed, sunower, soybean,
and palm oil).
2. Second-generation. Biofuels produced
from lignocellulosic biomass (e.g., agri-
cultural and forest residues) or from
advanced feedstock (e.g., jatropha and
micro-algae).
While 1st generation biofuels directly compete
with food supply, 2nd generation can produce
both food and fuel together. Unfortunately,
cellulosic biomass is more dicult to break
down than starch, sugar, and oils, and the tech-
nology to convert it into liquid fuels is more
expensive.
Leading producers:
Ethanol. US and Brazil accounted for 90%
of the total world production in 2008.
Biodiesel. World production is less than
25% of ethanol production. In addition to
US and Brazil, main producers are in the
EU (Germany, France, Italy).
Despite growth in production, biofuels only ac-
counted for 1% of world road transport fuel
consumption in 2005.
International trade in biofuels is only 10%
of total production. The major importers are
the US and EU (due to blending mandates)
and the major exporter is Brazil. Import tar-
is, domestic subsidies, and sustainability reg-
ulations have restricted trade. Still, trade is
expected to increase due to the comparative
advantage of some developing countries.
Production costs:
Ethanol: $0.2/liter ($0.3/liter of gasoline
equivalent) for new plants in Brazil, 50%
more in US, 100% more in EU. Trans-
portation, blending, and distribution adds
$0.2/liter. Cellulosic ethanol, still in
demonstration stage, is about $1/liter.
Biodiesel: $0.7$1.0/liter.
Aside from sugar cane based ethanol in Brazil,
biofuels are not presently competitive without
31
substantial government support if oil prices are
below $70 per barrel.
Investments in biofuel production plants in
2008 amounted to $3 billion in Brazil, $2.5 bil-
lion in the US, and $1.5 billion in France. The
worldwide total was around $15 billion.
3.3 Current Trends in the Carbon
Market
3.3.1 State and Trends of the Carbon
Market [42, +, inc]
The EU Emissions Trading Scheme (EU ETS)
accounted for 97% of the global carbon mar-
ket value in 2010 (considering both European
Union Allowances (EUA) and Clean Develop-
ment Mechanism (CDM)). The growth of the
global market stalled in 2010.
To reduce emissions, countries are adopting
one or several of the following policies: cap-
and-trade schemes, baseline and credit mech-
anism, renewable energy and energy eciency
certicates, carbon taxes, subsidies, and emis-
sion standards.
Policies are fragmented across countries:
EU. The current goal is to achieve a 20%
emissions reduction by 2020 on 1990 lev-
els. But the Roadmap for 2050 aims to
reduce emissions by 8095% by 2050 [rel-
ative to what year?].
During Phase III of the EU ETS that
starts in 2013, half of the allowances are
expected to be auctioned. During the pre-
vious Phase II (200812) they were all al-
located for free.
The EU ETS will include emissions from
aviation, but airlines from China and the
US are opposing the inclusion of their
emissions.
US. Climate policy is uncertain: there are
several regional initiatives to reduce CO2
and increase renewables, but their fate is
not clear. The only state more determined
is California. It aims to reduce GHG emis-
sions to 1990 levels by 2020 by: launch-
ing cap-and-trade in 2012; requiring 33%
renewable electricity by 2020; cut carbon
content of fuels by 10% by 2020.
Australia. Goverment announced plans
for a carbon xed-price mechanism that
will transition into an emissions trading
scheme.
China. Aims to reduce carbon intensity
(CO2 emissions per unit of GDP) by 17%
by 2015. May introduce emissions trading
in 2013.
The EU ETS has suered several frauds and
is undergoing regulatory reform. This has in-
creased interest in OTC spot markets.
Kyoto Protocols: the uncertainties sur-
rounding a post-2012 international agreement
have left Europe alone to absorb the supply
of project-based certied emission reductions
(CER) after 2012.
Voluntary carbon markets remain tiny (only
0.3% of global volume), but are growing. The
fastest growing product is Reducing Emis-
sions from Deforestation and Forest Degrada-
tion (REDD), in part due to probably becom-
ing eligible for oset in Californias cap-and-
trade scheme.
3.4 Emissions Trading Models in the
European Union
3.4.1 Emissions Trading in the Euro-
pean Union [17, ch37, ++]
[Paper is good, but a bit outdated. This mar-
ket is changing a lot.]
The purpose of the European Union Emis-
sions Trading Scheme (EU-ETS) is to allow
companies to nd the cheapest possible CO2-
abatement options. It covers activities such
as electricity generation, steel production, and
paper industry.
32
The EU ETS works as follows:
1. Governments allocate allowances for a
trading period (phase I, 200507; phase
II, 200812; phase III, 2013?) to covered
companies. About 57% of allowances were
allocated to the power and heat sector and
43% to industrial installations (which typ-
ically do not trade much).
The total allocation is below the expected
emissions in a business as usual scenario.
This scarcity guarantees demand and that
the environmental goals are fullled.
2. Once a year, each installation must re-
deem allowances corresponding to its
emissions.
3. Each company will have to decide whether
to buy allowances in the market, abate
emissions by technical measures, or re-
duce production. (But it is unlikely that
a plant will be short in the rst years of
each phase).
4. A company that cannot meet its obliga-
tions has to pay a ne and buy the missing
allowances on the market.
Currently [2008?], most trade is OTC. How-
ever, exchanges are expected to become more
important, as they eliminate counterparty risk
and are reliable sources for market prices. The
typical size of a deal in both markets is 10 000
allowances, corresponding to 10 000 t of CO2.
Price drivers:
Weather is major driver of electricity de-
mand. Higher demand is typically met by
sources that emit more CO2.
More precipitation means more CO2-free
hydroelectric power.
The relative prices of coal, gas, and crude
oil determine the electricity generation
mix (gas emits less CO2).
Economic growth.
Political and regulatory issues.
In the spot market, delivery and payment are
done within a few business days. In the forward
market, December 1st was established as the
delivery date. There is a banking arbitrage-
free relationship between the prices:
F
T
= S
t
e
i(Tt)
where i is the interest rate. Note that this rela-
tion only applies to allowances within the same
trading period because allowances from phase
I cannot be traded in phase II (it is assumed
that there will be no restrictions after 2012).
4 Financial Products and Val-
uation (20%)
4.1 Forward Contracts and Ex-
change Traded Futures
Terminology. At maturity (T), the long po-
sition party either: (1) buys the underlying as-
set for a specied price F
t,T
(physical settle-
ment); or, (2) receives a payo S
T
F
t,T
(cash
settlement).
4.1.1 Behavior of Commodity Futures
Prices [16, ch3, ++]
Relationships between cash (S) and futures (F)
prices through time:
1. Parallelism: high correlation between S
and F. This is because the same factors
must aect S and F when there is the
possibility of storing commodities for de-
livery against the contract in the future.
However, the correlation (and therefore
hedges) are seldom perfect.
2. Convergence of S and F at expiration of
the futures. This is due to the possibility
of physical delivery.
Relationships between cash (S) and futures
(F) prices for several maturities at a given mo-
ment:
33
Contango or carrying charge market:
S < F
1
< F
2
< . . .
Futures prices are usually at a premium
to cash when there are adequate supplies
in the cash market. This is due to carry-
ing charges: storage, insurance, and inter-
est costs. The market is at full carry
when F S = carrying charge, but usu-
ally F S < carrying charge due to a con-
venience yield of holding some inventory.
The interest rate is the most volatile of the
carrying costs.
Backwardation or inverted market:
S > F
1
> F
2
> . . .
This is caused by a shortage of supply rel-
ative to demand in cash markets. This
encourages sales now rather than in the
future and thus discourages storage of
goods.
Examples:
In the US, the gasoline or driving sea-
son lasts from Apr to Aug. Hence,
gasoline futures prices are typically
in contango during the early months
of the season (MarMay), but are
inverted in the later months (May
Aug) when it is expected that gaso-
line will be in short supply. [Decreas-
ing F are caused by higher conve-
nience yields in the later months due
to the chance of shortages.]
The NYMEX crude oil futures has
usually been inverted since 1983.
A cash market arbitrage opportunity occurs
when prices in two dierent markets for the
same commodity dier by more than trans-
portation costs between the markets. Exam-
ple: move heating oil between NY and London.
A cash/futures arbitrage opportunity occurs
when F > S by more than carrying charges.
[aka cash-and-carry arbitrage.] Example:
1. Heating oil: S
0
= $0.60, F
1
= $0.63, and
it costs $0.015 to nance and store 1 gallon
per month.
2. Strategy: buy cash, sell futures.
3. One month from now: sell at $0.63, for
a prot of +$0.015 per gallon. This can
be done by either: delivering on the fu-
tures at F
1
; or settling the futures nan-
cially and selling the oil in the cash mar-
ket, (F
1
S
1
) +S
1
= F
1
.
The basis for a given futures contract (usu-
ally the nearby) is:
Basis = F
t,T
S
t
where S
t
is the cash price for a given location
where the commodity is traded. Since there
are typically various such locations, there is a
unique basis for each location. Therefore, it is
helpful to decompose the basis into:
Basis = (F
t,T
SD
t
)
. .
StorageBasis
+ (SD
t
S
t
)
. .
LocationBasis
where SD
t
is the cash price at the delivery
point of the futures contract. While the Stor-
age basis 0 as t T, the Location basis typ-
ically remains constant. There is also a product
basis when the cash and futures are not exactly
the same commodity (eg, hedging jet fuel with
gasoline futures).
Basis changes. In a full carrying charge mar-
ket, the basis will decrease systematically at a
rate approximately equal to carrying costs per
unit of time. In an inverted market, S and F
still have to converge at expiration, but basis
changes are unsystematic and unpredictable.
4.1.2 Commodity Forwards and Fu-
tures [29, ch6, -]
A synthetic commodity position is created by:
34
1. Going long in a forward contract. The
cash ows are: CF
0
= 0, CF
T
= S
T

F
0,T
.
2. Buying a ZCB with cash ows: CF
0
=
e
rT
F
0,T
, CF
T
= F
0,T
.
The total CF
T
= S
T
. To avoid arbitrage,
CF
0
= S
0
or
S
0
= e
rT
F
0,T
[Note: this only applies to investment assets,
like stocks, bonds, gold, silver, etc. It does
not apply to consumption commodities, like
copper, oil, etc. The full equation for a con-
sumption commodity would need to add stor-
age costs (u) and the convenience yield (c):
S
0
= e
(r+uc)T
F
0,T
. See Hull [22].]
Using a simple PV relationship for the price
of a commodity, we also have
S
0
= e
T
E
0
[S
T
]
where is the appropriate discount rate. [Does
it make sense to estimate in the usual way
(eg, CAPM) for a consumption commodity?]
Comparing these two equations, we get
F
0,T
= e
(r)T
E
0
[S
T
]
Hence, the forward price is a biased estimate
of the expected spot price. [Downward biased
when the return on the underlying has positive
covariance with the market, as r < F
0,T
<
E
0
[S
T
]. Example: stock index. See Hull [22].]
Electricity forward prices can show large
price swings (eg, in day-ahead prices) because
electricity is not storable. Variations in elec-
tricity forward prices likely reect variations
in expected spot prices.
Lease rate (l): l = g, where g is the ex-
pected growth rate of the commodity price. l
is the commodity analog to the dividend yield
of a nancial asset. If we borrow the asset (in
order to short sell it), we have to pay the lease
rate to the lender. Hence, F
0,T
= S
0
e
(rl)T
.
[I dont see the point: l is not observable and
it has exactly the same interpretation as the
convenience yield see eqn (6.11) and ftn 5
in the paper. Further, the paper does not give
any real life example of l, though Hull [22] says
that gold and silver have lease rates (note that
he considers them investment assets, not in-
vestment commodities). This formula still ig-
nores storage costs.]
Storage costs (u). Let U denote the present
value of storage costs per unit. Then, F
0,T
=
(S
0
+ U)e
rT
. Alternatively, if u denotes stor-
age costs that are paid continuously and are
proportional to the value of the commodity,
F
0,T
= S
0
e
(r+u)T
Note that u = l. [Equality is only guaranteed
by no arbitrage for investment assets, as shown
next.]
Cash-and-carry arbitrage for both invest-
ment assets and consumption commodities:
C&C 0 T
Borrow $ S
0
+U (S
0
+U)e
rT
Buy asset S
0
+S
T
Pay storage U 0
Short Fwd 0 F
0,T
S
T
Payo 0 F
0,T
(S
0
+U)e
rT
Hence, dening u appropriately, no arbitrage
requires
F
0,T
S
0
e
(r+u)T
Reverse Cash-and-carry arbitrage for an in-
vestment asset. The strategy for the holders of
the asset is
R C&C 0 T
Sell asset +S
0
S
T
Save storage +U 0
Lend $ (S
0
+U) +(S
0
+U)e
rT
Long Fwd 0 S
T
F
0,T
Payo 0 (S
0
+U)e
rT
F
0,T
Note that these are incremental payos to
the holders relative to doing nothing (keep the
commodity stored). Alternatively, these are
35
the payos to an arbitrageur that short sells
the asset. He needs to rst borrow it from the
holders, which means that the holders pay the
storage costs to the arbitrageur. Hence, den-
ing u appropriately, no arbitrage requires
S
0
e
(r+u)T
F
0,T
Convenience yield (c). For a manufacturer,
holding physical inventory of a consumption
commodity provides insurance that he can
keep producing. [The convenience yield is the
benet from holding the physical asset. It re-
ects the markets expectations concerning the
future availability of the commodity.]
Reverse Cash-and-carry arbitrage for a con-
sumption commodity. If the holders of the
commodity sell it, they stop receiving the con-
venience yield, hence they only save U C (if
they lend it to a short seller, they will only
pay him U C). Replacing U by U C in the
strategy, and the dening c appropriately, no
arbitrage requires
S
0
e
(r+uc)T
F
0,T
In summary, for a consumption commodity,
the no arbitrage region is:
S
0
e
(r+uc)T
F
0,T
S
0
e
(r+u)T
Thus, the convenience yield only explains
anomalously low forward prices.
[Hull [22] and Clewlow and Strickland
[11] dene the unobservable c such that
S
0
e
(r+uc)T
= F
0,T
.]
Basis risk: the price of the commodity un-
derlying the futures contract may move dier-
ently than the price of the commodity you are
hedging.
4.2 Energy Swaps
Terminology. The swap buyer pays xed
and receives oating. The long/short termi-
nology is not clear for swaps, but being a swap
buyer is equivalent to being long in a series of
forward contracts.
4.2.1 Energy swaps [27, ch1, ++, inc]
A plain vanilla swap is an agreement whereby a
oating price is exchanged for a xed price over
a specied period. There is no transfer of the
physical commodity: dierences are settled in
cash for specic periods usually monthly, but
sometimes up to annually. Counterparts:
Swap Seller: pays the oating leg and re-
ceives the xed leg. Typically, a commod-
ity producer that wants to lock in the sales
price.
Swap Buyer: (opposite). Typically, a
commodity consumer that wants to sta-
bilise the buying price.
A dierential swap exchanges the actual dif-
ferential between two products for a xed ref-
erence value. Counterparts:
Swap Seller: pays the actual oating dif-
ferential and receives the xed dierential.
Swap Buyer: (opposite).
Typical users are reners that want to hedge
changing margins of rened products and com-
panies that need to manage basis risk. Exam-
ple: an airline hedges with gasoil futures. To
x the basis risk, they buy a dierential swap
on jet minus gasoil at $36/t. If the average
(jet - gasoil) is above $36 for a given month,
they receive the dierence multiplied by the
monthly volume specied in the contract.
A rening margin swap or crack swap allows
the protability of a renery to be guaranteed
for a few years forward. In the crude oil leg,
the rener is the xed-price buyer thus guaran-
teeing the input price; in the rened-products
leg, the rener is the xed-price seller thus
guaranteing the output price.
A participation swap is similar to a regular
swap in that the xed price payer is fully pro-
tected when prices rise above the agreed price,
but he participates in the downside. Exam-
ple: a fuel oil buyer sees the current dip in
market prices as a good opportunity to hedge
36
its budget for the next year. However, it has
a strong view that prices may go lower and so
it wants an instrument that allows it to bene-
t from any downside move without having to
pay any upfront premium. The company buys
a 50% participation swap at $80 per ton. If
prices rise to $95 it receives the full $15 dier-
ence. If prices fall to $70, it would only pay $5
rather than the $10 under a regular swap.
Most companies only hedge 4060% of their
1 or 2 years exposure. Some limiting factors on
the use of swaps are illiquidity and accounting
issues.
Swaps are useful in the following nancing
structures:
Project nance: e.g., to x the selling
price of an oil eld project.
Pre-export nancing: oil-exporting coun-
tries pledge future oil production as col-
lateral against immediate cash. [This is
cash now in exchange for physical oil in
the future why is it related to swaps?]
Asset, bond, or equity nancing: link cash
ows to fuel prices.
(See pricing in Panel 8, p. 35, of the paper).
4.3 Energy Options
4.3.1 Energy options [27, ch2, +, inc]
NYMEX began trading crude oil WTI options
in Nov 1986. IPE followed with gasoil options
in Jul 1987. The growth of the options market
was spurred by the launch of an OTC market
in swaps from 1986.
In the oil market, while exchange options are
exercised into futures contracts (which result
in physical delivery if held to maturity), OTC
options are generally cash settled.
Any individual settlement period for a swap
buyer (pays xed, receives oating) is equiva-
lent to either:
Long forward.
Long call and short put options.
(Note that this implies that a call and a put
must have equal value when they are both
struck at the forward price.)
Components of an options value:
Intrinsic value: [maximum of zero and
the] amount the option would pay if ex-
ercised immediately.
Time value: amount due to the possibil-
ity that the intrinsic value may increase.
Time value is highest when the underlying
is trading at the strike.
Types of option exercise:
American. Can be exercised at any time
up to maturity. Most exchange-traded op-
tions are American, like the energy op-
tions on the NYMEX and IPE.
European.
Asian. Settle in cash based upon an aver-
age price. Most OTC energy options.
Greeks:
Delta: := c/S
Gamma: := /S =
2
c/S
2
Theta: := c/t
Vega: v := c/
Delta hedging. Consider an $18 call on
1 000 000 barrels (1 000 futures contracts) of
crude oil. Assume S
t
= $18 (at-the-money)
and = 0.517. To delta hedge a long call,
a trader would need to sell short 517 futures
contracts at a price of $18 per barrel. If S
t
changes, the prot/loss in the long call is com-
pensated by the loss/prot in the short futures.
Energy options strategies. Everyone wants
to buy options until they see what they cost.
The following strategies reduce the cost of
hedging by simultaneously buying and selling
options.
Caps, oors, and collars. Caps(oors) are
consecutive series of call(put) options with
the same strike. A collar is the simulta-
neous purchase of a call and the sale of
37
a put, often constructed to have zero up-
front cost. If an airline or a gas burning
electric utility buys a collar (= long call
and short put), the call strike is the max-
imum price it will pay for fuel, while the
put strike is the minimum price it will pay
for fuel. The advantage is that the pre-
mium from selling the oor subsidises the
cost of buying the cap. A collar can be
thought of as a forward (or a swap) with
a band in the middle (the range between
the put and the call strikes) where noth-
ing happens. A oil producer would want
to short a collar (= sell cap and buy oor).
Participating collars. The company par-
ticipates in any favourable price move in
the underlying commodity, while still be-
ing fully protected against unfavourable
price movements. The (out-of-the-money)
option bought is for a larger quantity
[the amount that needs to be hedged?]
than the (at-the-money) option sold. The
strikes are such that the total premiums
paid and received are equal. The cost of
the participation is the less favourable
placement of the option strike prices.
Participating swaps. Are like participat-
ing collars except that the gap between
the call and put strikes is eliminated by
moving the strikes to the same point.
Bull and bear spreads. A bull(bear) spread
is a call(put) that is partly nanced by si-
multaneously selling back a higher(lower)
strike call(put).
Swaption. A swaption is an option to buy
(or sell) a swap. Compared to a cap cov-
ering the same period as the swap, the
call swaption is cheaper because after the
swaption is exercised, there is two-way risk
on the swap, while the cap contains no
downside risk for the buyer. Swaptions are
typically purchased by clients who need
the assurance of a maximum xed price,
but feel that there is a reasonable prospect
of a price fall before the expiry of the
swaption.
4.4 Exotic Options
..
4.5 Option Valuation and Risk Man-
agement
Put-call parity.
European stock options:
p +S
0
= c +Xe
rT
European futures options:
p +F
0
e
rT
= c +Xe
rT
4.5.1 Overview of option pricing for en-
ergies [34, ch9, - -, inc]
[Equation 9-3 is about payos; it is not the put-
call parity, which is a relation between prices.
Formula 9-4 is wrong. The terms are not stan-
dard and are just more confusing.]
Parity value [is the same as intrinsic value].
Call parity value = max(0, S X).
4.5.2 Option valuation [34, ch10, inc]
The Black model is used to value options that
settle not on the spot price at the time of the
options expiration, but rather on a forward
price. The spot price is still assumed to fol-
low GBM and the valuation formulas are very
similar to Black-Scholes (see formulas in the
paper).
4.5.3 Risk management of energy
derivatives [11, ch9, +]
[Greeks are dened in section 4.3.]
38
Delta Hedging an option involves dynami-
cally trading a position in the underlying equal
to the negative of the option delta, such that
the changes in value oset each other.
Example: suppose we have a short call op-
tion on a forward contract ( = c/F).
To delta hedge, we must buy a quantity
of the underlying forward. The value of the
hedged portfolio is P = c + F, which does
not change for small F.
Since delta changes continuously, we should
rebalance continuously; in reality there are
transaction costs, so rebalance only when the
underlying has moved by a signicant amount.
Delta for European call options starts at zero
for out-of-the-money, increases to about 0.5 for
ATM, and reaches almost one for in-the-money
options.
Gamma Hedging neutralizes the sensitivity
of our delta hedge to changes in the underlying.
This is important for ATM options where
changes faster. Steps:
1. Trade a second option such that the
gamma ( =
2
c/F
2
) of the combined
position is zero:
1
+a
2
= 0.
2. Since this will have residual delta, neutral-
ize it by taking a position in the underly-
ing equal to the negative of the residual
delta. Note that since forward contracts
are linear, they only have delta and no
gamma. Consequently, this trade does not
mess up the gamma of the overall com-
bined portfolio; it only changes delta.
This portfolio needs to be rebalanced much less
frequently.
Volatility Hedging is similar to gamma hedg-
ing, replacing gamma with vega (V = c/).
For delta-gamma-vega hedging, we need even
another hedge option:
1. Simultaneously nd quantities a and b
such that
1
+ a
2
+ b
3
= 0 and V
1
+
aV
2
+bV
3
= 0.
2. Neutralize the residual delta with a posi-
tion in the underlying.
Note that vegas for puts and calls with the
same strike price are the same (this results
from put/call parity).
4.6 Real Option Valuation
..
4.7 Speculation and Spread Trading
4.7.1 Speculation and Spread Trading
[16, ch4, ++]
Speculation increases liquidity and price e-
ciency, which facilitates hedging.
Position trading speculation consists of out-
right positions in futures. If expect price to
increase, take long position (buy) in futures,
for a payo of F
t+t,T
F
t,T
. It is dicult to
make money with this strategy because futures
markets are very ecient.
Spread trading speculation consists of both
a long and a short position in dierent futures
contracts. Absolute price changes are unim-
portant. If the spread X Y is expected to
widen, buy X and sell Y .
Intermarket spreads trading involve the si-
multaneous purchase and sale of dierent but
related commodities that have a reasonable
stable relationship to each other. Examples:
A crack spread creates a paper renery
by buying crude oil and selling gasoline
and heating oil futures. A crack spread
position would be assumed when rened
product prices are high relative to crude
oil prices and are expected to fall.
To replicate the average renery, the ratio
is:
Buy 3 crude contracts.
Sell 2 gasoline contracts.
Sell 1 heating oil contract.
The resulting premium ($/barrel) is (H +
2G 3C)/3. A crack spread should be
39
implemented when this value is above
$4/barrel (reverse crack if below $3/bar-
rel) [the book is from 2002...].
A spark spread allows generators to lock
in a margin by purchasing natural gas fu-
tures and selling electricity futures.
Henry Hub natural gas vs. Per-
mian/WAHA Hub natural gas.
Heating oil vs. gasoline.
NYMEX heating oil vs. IPE gas oil.
NYMEX light, sweet crude oil vs. IPEs
Brent crude oil.
Natural gas vs. propane futures (frac
spread).
4.8 Hedging Energy Commodity
Risks
4.8.1 Dierent kinds of risk [4, ch3, -]
Price or directional risk is movement on the
NYMEX.
Basis or dierential risk is the risk due to
time or location dierences. NYMEX futures
contracts can be delivered any time during a
full month at the sellers discretion, which cre-
ates time basis risk for a buyer that needs
prompt barrels today.
Availability or supply risk.
Volume risk is most generally associated
with extreme temperature deviations. One
way to protect against the possibility of need-
ing greater supply is through buying call op-
tions. When the risk is on the downside and
lower prices, use put options.
4.9 Weather Derivatives
4.9.1 Introduction to weather deriva-
tives [12, -]
Weather derivatives are trading OTC since
1997 for most US cities. CME is introducing
futures and options on futures on HDD and
CDD for 810 cities.
Weather options are written on the cumula-
tive HDD or CDD over a specied period (typ-
ically 1 month). One could buy a CDD option
for the summer, or a HDD option for the win-
ter.
One can also buy or sell a futures contract,
such that one counter party gets paid if the
degree days over a specied period are greater
than the predened level.
4.9.2 Heating and Cooling Degree
Days [3, +]
A degree day is a measure of the average
temperatures departure from a human com-
fort level of 18

C (65

F).
Heating degree days (HDDs) are dened as
18 T, where T is the average temperature
of a given day. Thus, a day with an average
temperature of 10

C will have 8 HDD.
Cooling degree days (CDDs) are dened as
T 18. Accordingly, a day with an average
temperature of 25

C will have 7 CDD.
[In Fahrenheit, the reference temperature is
65

F - see Considine [12].]
For both heating and cooling degree days,
average temperature of a particular day is cal-
culated by adding the daily high and low tem-
peratures and dividing by two.
5 Modeling Energy Price Be-
havior (10%)
5.1 Introduction to Energy Model-
ing
5.1.1 What makes energies so dierent
[34, ch2, -, inc]
What makes energies so dierent is the ex-
cessive number of fundamental price drivers,
40
which cause extremely complex price behav-
ior. For example, price depends on location,
which does not happen with traditional nan-
cial products.
Energy prices display spikes and strong
mean reversion. The mean reversion appears
to be a function of either how quickly the sup-
ply side of the market can react to events or
how quickly the events go away.
Main supply drivers are production capacity
(determines long-term prices) and storage limi-
tation (causes high short-term price volatility).
Main demand drivers are the convenience
yield and seasonality.
5.2 Data Analysis and Essential
Statistics
5.2.1 Essential statistical tools [34, ch4,
- -, inc]
[The lognormal distribution has positive skew-
ness or is skewed to the right, i.e., the tail is on
the right side. Skewness := E[(X

X)
3
]/
3
.]
The quantile-to-quantile (Q-Q) plot looks
like a diagonal line when the random variable is
normally distributed. [What does 4-13 mean?
It should = 0 (msr 0 set)!!]
If a rv is normally distributed, then the val-
ues are uncorrelated. [Absurd! Ex: AR(1).]
5.3 Spot Price Behavior
5.3.1 Understanding and Analyzing
Spot Prices [11, ch2, ++]
Schwartz (1997) model for a mean reverting
spot price:
dS/S = ( ln S)dt +dz (3)
The long-term mean is e

. The half-life is the

time taken for the price to revert half way back
to its long-term level: t
1/2
= ln(2)/. For =
10, t
1/2
= 25 days. Mean reversion rates are
relatively low for most energy prices (except
electricity).
Hull and White (1988), Heston (1993), and
others, model for stochastic volatility:
dS
t
/S
t
= dt +
t
dz
d
2
t
= a
_
m
2
t
_
dt +
t
dw
Model for jumps with mean reversion (good
for electricity):
dS/S = ( ln S)dt +dz +dq
where is the random jump size and dq is a
discrete {0, 1} process.
The following variables may display season-
ality: price, volatility, mean reversion rate,
jump frequency and jump volatility.
5.3.2 Spot price behavior [34, ch5, -,
inc]
Shortlist of possible models:
Lognormal price model:
dS
t
/S
t
= dt +dz
t
Famous in nonenergy markets. Guaran-
tees that prices will never be negative.
Width of distribution increases with time
to maturity (T).
Mean reversion in log of price: developed
by Schwartz and Vasicek - see equation
(3). Spot prices are always positive.
Performs not too badly in capturing the
distribution width [for short horizons], but
does a poor job of capturing the distribu-
tions tails. This can be improved with
jumps.
The drawback of this single-factor mean-
reverting model is that it forces the im-
plied Black-equivalent average volatility of
the price distribution to go to zero over
a long period of time (as the spot price
approaches the immobile long-term mean
level).
41
Mean reversion in price. (Pilipovic
model). The spot price is assumed to
mean-revert toward an equilibrium price
level, which is itself lognormally dis-
tributed. The volatility of the spot price
never goes to zero. [See paper for eqns.]
Energy markets require mean-reverting
models. Both models give negative autocor-
relation for the changes in spot prices, which
is important for energy markets, particularly
electricity.
[Box at the end explains reasonably well Lo-
cational Marginal Pricing in electricity mar-
kets.]
5.4 Forward Curve Modeling
5.4.1 Energy forward curves [11, ch4,
++]
The full cost of carry relationship for an energy
is:
F
t,T
= S
t
e
(r+uc)(Tt)
Depending on the relative size of storage costs
(u) and convenience yield (c) the resulting for-
ward curve can be in contango or backwarda-
tion. [See section 4.1 for more details.]
Oil can be in contango sometimes and in
backwardation at other times. The natural gas
forward curve typically displays a seasonal pat-
tern (higher prices in winter).
Electricity forward prices exhibit the most
complicated forward curves, with seasonal,
daily, and hourly patterns. These complicated
patterns arise because electricity is not storable
and because electricity markets are segmented.
Since most electricity contracts are illiquid,
other methods are used to construct the for-
ward curve:
Arbitrage approach. Although electricity
cannot be easily stored, the fuel used to
generate electricity can be stored. Hence,
a basic electricity forward curve can be ob-
tained via:
Power price = Fuel price Heat Rate
where the heat rate is dened in (1).
Econometric approach. Prices are esti-
mated with econometric models based on
key variables such as fuel cost, weather
patterns, etc. But note that the output
is a forecast of spot prices; it is not a for-
ward price.
Spot price modelling approach. Forward
prices are derived from assumptions about
the stochastic processes for the spot en-
ergy price and other key variables (eg, the
long-term price, the convenience yield, or
interest rates). This approach is similar to
interest rate models.
5.4.2 Forward curve models [11, ch8,
++, inc]
Forward curve models represent all the forward
prices simultaneously rather than just the spot
price. A simple model is:
dF(t, T)/F(t, T) = (t, T)dz(t) (4)
There is no drift because futures and forwards
have zero initial investment.
A simple specication that ensures that
short-dated forward returns are more volatile
than long-dated forwards is (t, T) =
e
(Tt)
.
However, the real behaviour of the curve is
more complex and we need more factors:
dF(t, T)/F(t, T) =
n

i=1

i
(t, T)dz
i
(t)
These risk factors can determined by principal
components analysis (PCA). Typically, there
are n = 3 risk factors, which act to shift, tilt,
and bend the curve.
42
Since S(t) = F(t, t), we can derive a process
for the spot price from the process for the for-
ward price. [See the paper for equations.] One
important result is that the simple model in
(4) with (t, T) = e
(Tt)
implies the mean-
reverting spot price in (3), albeit with a time
dependent drift term. If = 0, we obtain the
Black (1976) model.
Seasonality for gas and electricity can be in-
corporated by
dF(t, T)/F(t, T) =
S
(t)
n

i=1

i
(T t)dz
i
(t)
where
S
(t) is the time dependent spot volatil-
ity.
[See the paper for option pricing formulas.]
5.5 Estimating Price Volatility
5.5.1 Volatility Estimation in Energy
Markets [11, ch3, ++]
GBM is not a good model for energy prices
because:
Energy commodities are inputs to produc-
tion processes and/or consumption goods;
they are not investments assets. For ex-
ample, electricity prices may be negative,
which is not allowed in GBM.
Seasonality.
Jumps.
Mean reversion. Prices may depart from
the cost of production in the short term
due to abnormal market conditions, but in
the long term, the supply will be adjusted
and the prices will revert to the cost of
production.
However, a simple mean-reversion process
like Vasiceks (1977) may not perform well
because:
The speed of mean reversion may be
dierent below and above the mean.
In many markets, especially electric-
ity, departures to the upside are more
likely than to the downside.
A price spike is frequently neutral-
ized by a following spike of opposite
sign.
Prices of energy commodities behave dif-
ferently during dierent periods of their
lives. Eg, the volatility of forward con-
tracts increases as they get closer to their
maturity.
If the underlying price follows a GBM (re-
turns are iid), volatility can be estimated from
historical data as follows:
1. Calculate [daily] logarithmic price returns
[continuously compounded returns]: S
t
=
S
t1
e
r
r = ln(S
t
/S
t1
). Note that
r
0,T
:= ln(S
T
/S
0
) = r
1
+r
2
+. . . +r
T
.
2. Calculate standard deviation of daily se-
ries,
d
.
3. Annualize:
2
y
= 250
2
d

y
=

250
d
If the underlying price follows a mean-
reverting Ornstein-Uhlenbeck process, dS =
(

S S)dt + dz, volatility can still be esti-

mated from historical data by considering an
AR(1) discretization. [See formulas in the pa-
per].
A leptokurtic distribution has fat tails, ie, its
kurtosis is higher than in the normal distribu-
tion. Eg, electricity prices have fat tails due
to jumps. Time varying parameters can also
cause the unconditional distribution to look
leptokurtic.
An heteroskedastic process has time depen-
dent volatility, be it deterministic or random.
Models for stochastic volatility. Assume re-
turns are r
t
= k+u
t
, where k is a constant and
u
t
=
t

t
, with
t
N(0, 1). Alternatives for
the variance:
1. ARCH(q):
2
t
= a
0
+a
1
u
2
t1
+. . . +a
q
u
2
tq
2. GARCH(p,q):
2
t
= a
0
+

p
i=1
b
i

2
ti
+

q
i=1
a
i
u
2
ti
43
5.5.2 Volatilities [34, ch8, - -, inc]
The volatility of a price process is always as-
sumed to represent the annualized standard
deviation of returns.
We can back out a rudimentary term struc-
ture of implied volatilities from several options
on the same underlying. Suppose we have two
options on the same 3-month futures:
1. Option 1 expires in 1 month, has implied
volatility
0,1
.
2. Option 2 expires in 2 months, has implied
volatility
0,2
.
We can then estimate
1,2
from

2
0,2
= (
2
0,1
+
2
1,2
)/2
Referring to the same 3 models of section
5.3.2:
Single-factor lognormal price model
(GBM). Volatility is the same for spot
and all forward prices. Spot and all
forward prices are perfectly correlated
with each other. None of this is consistent
with real energy prices.
Single-factor log-of-price mean-reverting
model. The volatility of the forward price
goes to zero as the maturity date goes to
innity. Correlations remain perfect be-
cause it is still a single-factor model.
Two-factor mean-reverting model.
(Pilipovic model). Correlations be-
tween spot and forward prices are less
than one.
6 Risk Evaluation and Man-
agement (15%)
6.1 Value-at-Risk and Stress Testing
6.1.1 Value-at-risk [11, ch10, +, inc]
The basic VaR model assumes that market
variable returns are normally distributed (or
follow a random walk):
r
t
=
t
+
t

t
,
t
iidN(0, 1)
where r
t
is a log return.
Volatility estimation:
Simple Moving Average:
=

_
1
N
N

i=1
(r
i
)
2
Exponentially Weighted Moving Average:
=

_
1

N
i=1

i1
N

i=1

i1
(r
i
)
2
The decay factor is typically 0.9 < <
1.0. Older returns get exponentially less
weight. Note that

N
i=1

i1
=
1
1
, as in
the RiskMetrics formula (but not good for
close to 1!!!).
The corresponding formulas can be used to es-
timate covariances.
VaR methodologies:
1. Variance-Covariance or Delta VaR. As-
sumes that returns are normally dis-
tributed. Derivatives are represented in
terms of a Delta equivalent position in the
underlying asset, ie, the weights in the
portfolio are modied to w
i
=
V
i
S
i
w
i
(for a
basic instrument that is not a derivative,
V
i
S
i
= 1). The variance of the portfolio is
the usual
2
p
= w

w. Hence,
V aR = z
$
p
z is the critical level for a given con-
dence level. For example, z(95%) =
1.65, z(99%) = 2.326.
Examples:
100 M$ spot crude oil position. Stan-
dard deviation of daily returns of
crude oil price is 2.5%. The 1-day
44
VaR with a condence level of 95%
is
V aR = 1.65 0.025 100 M$
For a portfolio with 2 underlying
market variables,
V aR
2
p
= V aR
2
1
+V aR
2
2
+2V aR
1
V aR
2
2. Delta-Gamma VaR. The change in value
of derivatives are approximated with more
terms: , =
2
V/S
2
, and also =
V/t. The portfolio distribution is no
longer normal [see paper for formula], so
the VaR calculation becomes more com-
plicated. The main point of this approach
is to compute the change in value of an op-
tion without having to use the full option
pricing model. This can be integrated in
the Monte Carlo method to speed up the
simulations.
These methods up to here do not provide
the accuracy required for energy markets.
3. Monte Carlo simulation. Jumps, stochas-
tic volatility, or knowledge of future events
(eg, changes in the operation of a market)
can be easily incorporated.
4. Historical simulation. Good alternative if
returns are not well described by the nor-
mal distribution or other tractable alter-
natives, as is likely for energy markets.
VaR estimates should be backtested: check
how often the actual returns exceed the VaR
forecast.
6.1.2 Incorporating stress tests into
market risk modeling [1, +]
Stress tests are exercises to determine the
losses that might occur under unlikely but
plausible circumstances, i.e., under rare or ex-
treme events. Stress tests respond to VaR ex-
cessive dependency on history or unrealistic
statistical assumptions.
Types of stress tests:
1. Uses scenarios from recent history.
2. Uses predened scenarios that have
proven to be useful in practice. Eg, fall
in stock index of x standard deviations.
3. Mechanical-search stress tests.[?]
Problems with stress tests:
Choice of scenarios is subjective.
Results are dicult to interpret and to act
on because there is no probability for the
event concerned.
VaR and Stress Tests are often presented
as two separate measures of risk. How-
ever, the two methods can be integrated
by assigning (subjective) probabilities to
the stress scenarios.
Stress tests often ignore the correlation
between the stressed prices and other
prices.
6.2 Credit and Counterparty Risk
6.2.1 Credit risk management [7, ch6.3,
-, inc]
Credit risk is the risk that a counterparty can-
not full his contractual obligations. Credit
risk exposure results from:
Settlement risk: the possibility that a
counterparty cannot pay the obtained
benets, e.g. the delivered energy
amount.
Example: at some point before the matu-
rity of a forward contract, the risk is the
present value of the terminal payo, as-
suming that S
T
is the current spot price.
Replacement risk: the possibility that a
new replacement contract will have to be
entered into, under potentially worse mar-
ket conditions.
Credit risk can be quantied through:
Risk-at-Default. [= EAD x LGD ?]
45
Expected loss.
Potential exposure: maximum credit loss
to a given counterparty with a given con-
dence level. Obtained by generating mar-
ket prices scenarios. Useful for setting
credit limits.
Credit VaR.
Credit risk can be reduced through:
Margining agreements. Most powerful
method. [Works like in exchange-traded
products.]
Transfer an OTC transaction into an regu-
lar exchange-traded futures contract. The
European Energy Exchange allows this.
Additional collateralization.
Countertrade.
Price adjustment [?].
6.2.2 Dening counterparty credit risk
[18, ch2, ++, inc]
Counterparty risk is the risk that a counter-
party in an OTC derivatives transaction will
default prior to expiration of a trade and will
not therefore make the current and future pay-
ments required by the contract. Since the fu-
ture value of the derivative contract is uncer-
tain, each counterparty has risk to the other.
Traditionally, credit risk has been associated
only with lending risk. This is the risk that
we dont get our money back. It applies to
loans, bonds, mortgages, credit cards, and so
on. Only one party takes lending risk and even
the amount is fairly predictable.
Metrics for credit exposure:
Exposure is the maximum between zero
and the current Mark-to-Market(MtM) of
the position.
Expected MtM is the expected value of a
transaction for some future time.
Expected Exposure is the average of pos-
itive MtM values at some future time.
Note that E[MtM] < E[E].
Potential Future Exposure is the worse ex-
posure distribution for a given condence
level (similar to a VaR).
Eective Expected Exposure is a nonde-
creasing time series of E[E].
6.2.3 Mitigating counterparty credit
risk [18, ch3, ++, inc]
Termination gives the possibility that an in-
stitution can terminate a trade prior to their
counterparty going bankrupt. It may exist as
an option or be conditional on certain condi-
tions being met (e.g., ratings downgrade).
Close-out allows the unilateral termination
of all contracts with the insolvent counterparty
without waiting for the bankruptcy process to
be nalized. It is often combined with netting
into a single contract.
Netting is the ability to oset amounts due
at termination of individual contracts between
the same counterparties when determining the
nal obligation. Netting comes into force in
the event of a bankruptcy. Can be contracted
bilaterally or multilaterally. Long options with
upfront premiums do not give any benet from
netting because their MtM will never be nega-
tive. However, they may still be worth putting
under a netting agreement to oset negative
MtM of other instrument within the same net-
ting set in the future.
Collateral is an asset supporting a risk in a
legally enforceable way. Typical assets: cash
(most common), bonds, equity.
6.3 Enterprise Risk Management
..
46
6.4 Case Studies in Risk Manage-
ment
6.4.1 The collapse of Amaranth Advi-
sors [10, ++, inc]
Amaranth Advisors was a large-sized hedge
fund that failed in September 2006 due to
losses in natural gas futures and options.
They made a general bet that winter natural
gas prices would rise, while nonwinter natural
gas prices would increase to a lesser degree,
referred to as the long winter, short non-winter
spread trade.
Their trades had high levels of market and
liquidity risk, and also funding risk. Their
VaR numbers underestimated the risk. Some
of their traders were in a dierent city than
risk managers.
6.4.2 The Case for Enron [37, +, inc]
Enrons Board of Directors failed to monitor
... ensure ... or halt abuse. Sometimes the
Board chose to ignore problems, other times
it knowingly allowed Enron to engage in high
... risk practices.
At Enron, risk management neither provided
accurate information nor ensured accountabil-
ity.
7 Current Issues in Energy
(10%)
7.0.3 The Worlds Greatest Coal Arbi-
trage: Chinas Coal Import Be-
havior and Implications for the
Global Coal Market [32, -]
[They do not use arbitrage in the usual sense.
The paper simply says that Chinese consumers
buy coal from the cheapest source: domestic or
international.]
Coal is produced in the North of China and
moved to the consumption centers in the South
by rail and sea. Transport is expensive, repre-
senting 5060% of the nal price. During 2009,
it was cheaper to import coal from Indonesia,
Australia, and Russia. Hence, Chinese imports
accounted for 15% of all globally traded coal
in 2009, despite China still being the largest
coal producer. International coal prices have
since recovered and the import window began
to close by summer 2010.
This highlights the fact that, since China has
a massive domestic coal market, Chinas will-
ingness to import when international prices are
lower than domestic prices will move these two
prices closer to parity.
7.0.4 Oil Scarcity, Growth and Global
Imbalances [26, +, inc]
Oil is considered scarce when its supply falls
short of a specied level of demand, over a long
period. Oil scarcity is reected in the market
price, relative to the price of other goods.
Scarcity arises from continued tension be-
tween rapid growth in oil demand in emerg-
ing economies and the downshift in oil supply
trend growth.
Real oil prices have not trended persistently
up or down in 18752010. Instead, prices have
experienced slow-moving uctuations around
long-term averages. This suggests that periods
of oil scarcity have been long lasting but have
come to an end, and that investment, technol-
ogy, and discovery are eventually responsive to
price signals.
Energy consumption will depend largely on
GDP growth. However, the relation diers
across countries: linear for emerging markets,
but atter for high-income countries.
The paper concludes that gradual and mod-
erate increases in oil scarcity may not present
a major constraint on global growth in the
medium to long term.
47
References
[1] J. R. Aragones, C. Blanco, and K. Dowd.
Incorporating stress tests into market risk
modeling. Institutional Investor, 2001.
[cited in p. 45]
[2] J. T. Bartis, F. A. Camm, and D. S. Or-
tiz. Producing Liquid Fuels from Coal:
Prospects and Policy Issues. RAND, 2008.
[cited in p. 7, 8]
[3] K. Baumert and M. Selman. Data Note:
Heating and Cooling Degree Days. World
Resources Institute, 2003. [cited in p. 40]
[4] P. C. Beutel. Surviving Energy Prices.
PennWell Books, 2005. [cited in p. 40]
[5] Bloomberg New Energy Finance. Global
Trends in Renewable Energy Investment,
2011. [cited in p. 30]
[6] Bunkerworld. D2 and No.2 Diesel Fuel:
An Introduction, 2009. [cited in p. 6]
[7] M. Burger, B. Graeber, and G. Schindl-
mayr. Managing Energy Risk: An Inte-
grated View on Power and Other Energy
Markets. Wiley, 2007. [cited in p. 45]
[8] A. Chambers. Renewable Energy in Non-
technical Language. PennWell, 2004. [cited
in p. 19]
[9] V. Chandra. Fundamentals of Natural
Gas: An International Perspective. Pen-
nWell Books, 2006. [cited in p. 9, 10, 11, 12]
[10] L. Chincarini. A Case Study on Risk Man-
agement: Lessons from the Collapse of
Amaranth Advisors L.L.C. Journal of Ap-
plied Finance, 2008. [cited in p. 47]
[11] L. Clewlow and C. Strickland. Energy
Derivatives: Pricing and Risk Manage-
ment. Lacima, 2000. [cited in p. 36, 38, 41,
42, 43, 44]
[12] G. Considine. Introduction to Weather
Derivatives. Aquila Energy, 2001? [cited in
p. 40]
[13] P. Coy. The Prospect for Safe Nuclear.
Bloomberg Businessweek, March 24, 2011.
[cited in p. 22]
[14] Department of Energy. Liqueed Natu-
ral Gas: Understanding the Basic Facts,
2005. [cited in p. 13]
[15] D. W. Edwards. Energy Trading and In-
vesting. McGraw-Hill, 2010. [cited in p. 8, 16,
25, 26, 27]
[16] S. Errera and S. L. Brown. Fundamen-
tals of Trading Energy Futures & Options,
2002. [cited in p. 33, 39]
[17] F. Fabozzi. The Handbook of Commodity
Investing. John Wiley & Sons, 2008. [cited
in p. 13, 32]
[18] J. Gregory. Counterparty credit risk. Wi-
ley, 2010. [cited in p. 46]
[19] C. Groobey, J. Pierce, M. Faber, and
G. Broome. Project Finance Primer
for Renewable Energy and Clean Tech
Projects. Wilson Sonsini Goodrich &
Rosati, 2010. [cited in p. 29]
[20] C. Harris. Electricity Markets: Pricing,
Structures and Economics. Wiley, 2006.
[cited in p. 17]
[21] G. Heal. The Economics of Renewable En-
ergy. Review of Environmental Economics
and Policy, 2009. [cited in p. 28]
[22] J. C. Hull. Options, Futures, and other
derivatives. Pearson, 2009. [cited in p. 35, 36]
[23] S. Hunt. Making Competition Work in
Electricity. Wiley, 2002. [cited in p. 18, 22,
23, 24]
48
[24] N. J. Hyne. Nontechnical Guide to
Petroleum Geology, Exploration, Drilling,
and Production. PennWell, 2001. [cited in
p. 3]
[25] Institut Francais du Petrole. Oil, Gas
Exploration, and Production: Reserves,
Costs, Contracts. (Ch 3), 2007. [cited in
p. 2]
[26] International Monetary Fund. Oil
Scarcity, Growth and Global Imbalances,
2011. [cited in p. 47]
[27] V. Kaminski. Managing Energy Price
Risk. Risk Books, 2004. [cited in p. 36, 37]
[28] W. L. Leer. Petroleum Rening in Non-
technical Language, 3rd Edition. Pen-
nWell, 2000. [cited in p. 6]
[29] R. McDonald. Derivatives Markets. Pear-
son Education, 2006. [cited in p. 34]
[30] K. Medlock. Impact of Shale Gas Devel-
opment on Global Gas Markets. Wiley Pe-
riodicals, 2011. [cited in p. 14]
[31] T. O. Miesner and W. L. Leer. Oil and
Gas Pipelines in Nontechnical Language.
PennWell, 2006. [cited in p. 4, 5]
[32] R. Morse and G. He. The Worlds Great-
est Coal Arbitrage: Chinas Coal Import
Behavior and Implications for the Global
Coal Market. SSRN, 2010. [cited in p. 47]
[33] R. L. Nersesian. Energy for the 21st Cen-
tury: A Comprehensive Guide to Con-
ventional and Alternative Sources. M.E.
Sharpe, 2007. [cited in p. 20, 31]
[34] D. Pilipovic. Energy Risk: Valuing and
Managing Energy Derivatives. McGraw
Hill, 2007. [cited in p. 38, 40, 41, 44]
[35] PriceWaterhouseCoopers. Todays LNG
Market Dynamics, 2010. [cited in p. 14]
[36] Purvin and Gertz. The Role of WTI as a
Crude Oil Benchmark, 2010. [cited in p. 5]
[37] R. E. Rosen. Risk Management and Cor-
porate Governance: The Case of Enron.
Connecticut Law Review, 2003? [cited in p.
47]
[38] D. Schlissel and B. Biewald. Nuclear
Power Plant Construction Costs. Synapse
Energy Economics, 2008. [cited in p. 21]
[39] J. Speight. Handbook of Coal Analysis.
Wiley-Interscience, 2005. [cited in p. 15, 16]
[40] G. Timilsina and A. Shrestha. Biofuels:
Markets, Targets and Impacts. The World
Bank, 2010. [cited in p. 31]
[41] M. Toman, A. E. Curtright, D. S. Ortiz,
J. Darmstadter, and B. Shannon. Uncon-
ventional Fossil-Based Fuels: Economic
and Environmental Trade-Os. Rand,
2008. [cited in p. 6]
[42] World Bank. State and Trends of the Car-
bon Market, 2011. [cited in p. 32]
[43] C. Wright and R. Gallun. Fundamentals
of Oil and Gas Accounting. PennWell,
2008. [cited in p. 2, 3]
49