The unorthodox model of risk pricing behind the UK EMR #2: the government as derivatives dealer!

The central aspect of the UK government’s proposed Electricity Market Reform (EMR ) with which this series of posts is concerned is the desire to shift all risk from private investors in generation onto public authorities. One example of this is the recommendation that the public authorities get into the risk management business by selling electricity derivatives to low carbon generators. In the EMR these are called Contracts for Differences (CfD). In the finance world they’re called electricity price swaps.  The EMR bundles these swaps together with a price premium paid to low carbon generators–the Feed-in Tariff–and so calls the full package a FiT CfD.

The figure above is taken from the EMR White Paper and shows how this swap works. The swap has a strike price of £70/MWh shown at the top red line. The black line shows the realized wholesale electricity price. When the wholesale price is below the strike price, the public authority pays the generator the difference, shown in dark green. When the wholesale price is above the strike price — which in the diagram happens briefly late in the period shown — the generator pays the public authority the difference.

This is a plain vanilla derivative. Nothing new here. The private marketplace provides such things for all sorts of commodities and financial indexes. What is radical about the UK’s EMR isn’t the design. It is the recommendation that the government start dealing these derivatives.

No one suggests that government should sell oil price swaps or natural gas price swaps or coal price swaps or aluminum price swaps or rice price swaps, etc. Just electricity. What’s so special about electricity?

The EMR has an answer. It isn’t the electricity generation business in general that is special. Fossil fuel generation of all types seems to have no problem making rational investment decisions. It’s just those funky low-carbon technologies that are special. The White Paper provides a helpful breakout box (Box 2 on p. 28) explaining

Why investment in low-carbon technologies differs from standard investment choices

Gas-fired power stations are a mature technology with low and predictable capital expenditure. They are quick to build and their fuel costs, which are a large proportion of operating costs, are naturally hedged because the price of electricity moves in line with the price of gas, since gas (or sometimes coal) is typically the price-setting (or marginal) plant. Their generation costs will tend to fall in line with any fall in revenues as electricity prices fall, preserving profitability.

Gas-fired power stations are able to run flexibly and can therefore relatively easily respond to shifting demand. The costs of flexing a gas plant to respond to daily peaks in demand are relatively modest although more frequent stop/start and fast ramp-up operations do have a significant impact on maintenance costs.

Each of the low-carbon technologies the Government is considering differs materially from this standard investment choice. In particular, low-carbon generation typically has high construction (capital) costs and low operating costs, and as a result low-carbon plants are wholesale price takers. It is therefore difficult to make an investment case for them in a market where wholesale electricity prices are predominantly set by the short-run marginal costs of unabated gas and coal plant, even if the carbon price was high enough for their levelised costs to be similar.

That explanation is a hodge podge of diverse issues. Several are red herrings.

It mentions that gas-fired power stations are a mature technology, as if all low carbon technologies are not yet mature. But the EMR White Paper includes nuclear among the low carbon technologies that need a government manufactured price hedge. Surely nuclear is as mature as gas for the purposes at hand, so is the maturity of the technology really the argument behind having the government sell electricity derivatives?

When mentioning that gas-fired stations are mature, the White Paper acknowledges that they have low and predictable capital expenditures. Is that supposed to be a fault? Should we be subsidizing low carbon technologies to make up for the fact that they have high and unpredictable capital expenditures? Surely what would be better is to simply differentiate them by their carbon emissions and leave it to the market to reward or penalize them for their cost structure.

Sifting out these red herrings, we come to the core economic argument within that box, which is the claim that the profit margin of gas-fired generating stations are naturally hedged because the price of electricity moves in line with the price of gas. Less clearly stated in the box is the contrasting situation of low-carbon technology generators. Their profit margin is not naturally hedged because the price of electricity fluctuates independently of their costs. That is how the box leads into the final assertion that even if the levelized cost of electricity were approximately the same for gas-fired and low carbon technologies, investors would prefer the former over the latter.

Does this economic argument make sense?

No. At least not within the logic of any orthodox version of modern finance theory.

In another post I will get all wonkish and go into how orthodox finance theory contradicts this claim and make clear the unorthodox assumptions inherent in this claim. But one shouldn’t have to get too theoretical to see how radical and unlikely an argument the White Paper is making here. Here are two ways to see this.

First, the claim about the differential volatility of profit margins will apply in lots of other industries. The claim has little, if anything, to do with carbon emissions or electricity. Therefore, the White Paper’s logic could just as well be extended to all sorts of other industries.

Second, why is the government the right institution for selling the needed electricity price insurance? If low carbon technologies need an electricity price swap, why won’t the global financial market provide it? Will public authorities do this business better and at low cost to taxpayers, including all of the potential risks involved?


  1. Posted July 17, 2011 at 2:53 pm | Permalink

    There are many simpler approaches. The one consistent with the current system is to simply tighten the EU-ETS. Alternatively, the UK could impose it’s own tighter UK allowance system overlayed on the EU system. Finally, one could simply set a UK specific carbon price floor adequate to do the job itself, without all these extra bells and whistles.

  2. Posted July 17, 2011 at 11:28 am | Permalink

    Same old problem with capitalism: brilliant at short-termism, hopeless at long-termism.

    How else will liberalized markets decarbonize power capacity – when low-risk gas & coal are so much cheaper, quicker and simpler – without governments essentially bribing utilities to build it?

    The CfD looks like a way to achieve PFI-style public procurement in a liberalized power market without upsetting the EU. A more saner power policy might co-ordinate capacity volume and CO2/kWh levels and put it out to tender. But where’s the fun in that?!

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