The UK’s Electricity Market Reform (EMR) White Paper suggests that providing low-C generation projects with a hedge of the wholesale electricity price can lower the cost of providing low-C electricity. Can this be?
No.
A fairly priced hedge changes both the project’s risk and it’s return. The first order effect of the two is to leave the risk-adjusted cost of the project unchanged. This is commonly known as the M-M Proposition of Hedging.
In an earlier post I showed a stylized graph of a low-C generator’s revenue, costs and profit margin, all unhedged, and associated with them a present value for each of the three cash flow streams using a simple risk-pricing model. Now, using the exact same risk-pricing model I can construct a fair value hedge. A fair value hedge is one with NPV=0. The hedge is a swap in which the low-C generator sells the floating cash flow, tied to the wholesale electricity price, and receives the fixed cash flow:
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This post takes up the core theoretical issue behind the EMR’s advocacy for having public authorities assume risk from low carbon generators. The White Paper claims that the profit margin of a gas-fired generating station is naturally hedged because the price of electricity moves in line with the price of gas. In contrast, the profit margin of a low-carbon technology generators is exposed to electricity price risk, since the operating costs of a low-carbon generator does not fluctuate with the electricity price. Consequently, the White Paper claims,
(i) even if the levelized cost of electricity were approximately the same for gas-fired and low carbon technologies,
(ii) nevertheless, investors would prefer the former over the latter.
Can (i) and (ii) be true at the same time?
No. Not if we are operating in an orthodox model of risk pricing. Not if there are robust capital markets where each risk has a unique price. Not if the principle of value additivity applies — “If we have two streams of cash flow, A and B, then the present value of A+B is equal to the present value of A plus the present value of B.” (Brealey, Myers and Allen, Ch. 17).
To examine claims (i) and (ii) more carefully, I constructed the two figures below based on Newbery (2008) which is one of the background papers underpinning the EMR’s White Paper. Similar figures have been used in other academic papers underpinning the EMR’s White Paper.
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Last week, the Coalition for Derivative End Users filed a new comment letter with bank regulators on the rulemaking for the Dodd-Frank reform of the OTC derivatives markets. The Coalition has taken a lead role in lobbying to expand the end-user exemptions on clearing and margins. One interesting thing about the letter is how it betrays progress in the intellectual debate on the cost of margins.
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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.
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The UK government released its Electricity Market Reform (EMR) White Paper today. One of the central goals is increasing the share of low carbon electricity generation in the UK mix. The central premise is that the current price of carbon is too low, but also that a number of key institutional features of the electricity market create additional obstacles to investment in low carbon generation. Risk plays a big role in these additional obstacles. The institutional reforms proposed in the EMR transfer risk from corporate investors to the UK public, either as consumers or as taxpayers. The EMR claims that this risk transfer is beneficial to society.
I plan to use a series of posts to scrutinize in detail the EMR’s analysis of risk, investment in generation capacity and the costs and benefits to society. My central complaint is that the EMR’s analysis of the cost of risk is an unorthodox one, completely at odds with modern financial markets theory. It is only by baldly abandoning traditional financial calculus that the EMR is able to produce numbers that show a benefit to society. In fact, the proposed reforms threaten to load society with very costly risk that consumers and taxpayers may later regret.
The arguments made in the EMR have been kicking around among UK policy circles for a while, and I discussed the issue at a general level in a 2009 presentation at the London Energy Forum hosted by the London Business School available here. But the publication of the EMR White Paper and supporting documents offer the opportunity to examine the issues in more careful detail. The pressure to produce substantive numbers forces the advocates for these reforms to be more concrete in their analytic tools, and so it is easier to call attention to how the argument is so at odds with modern finance theory. Stay tuned.
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The Progressive Policy Institute (PPI) just released a Policy Brief by Jason Gold and Anne Kim on “The Risks of Over-Regulating End-User Derivatives”. The piece recycles bad arguments made previously by others, and offers absolutely nothing new. For example, to quantify the potential job losses attributable to requiring margin from end-users, the authors repeat the discredited numbers produced earlier this year in a “study” commissioned by the Business Roundtable–see analysis here, here and here. Maybe that’s the point. Although the earlier work has been discredited, if the numbers are recycled through enough other outlets, then they can be naively quoted in future lobbying work. We’ve already addressed the Brief’s main arguments in previous posts (start here or here), and won’t rehash those points again now.
However, one of the central premises of the Brief is a delusion shared by many other commentators on end-users and margins, and it would be useful to take this occasion to puncture that delusion and return the discussion to the real historical facts and sound economic theory underpinning margins and end-users.
What is the delusion? It has two parts.
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The World Bank this past week announced the creation of The Agriculture Price Risk Management (APRM) tool, jointly offered by the IFC, the World Bank Group’s private sector arm, and J.P. Morgan. The IFC and J.P. Morgan will each commit approximately $200 million in guarantees and letters of credit to enhance the collateral required from farmers, food processors and consumers in developing countries, to enable these groups to trade derivatives that hedge the price of commodities such as corn, wheat, soybean, rice, sugar, cocoa, milk and live cattle.
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There has been renewed discussion and debate again about the impact of speculators in the oil market. Some of it has been occasioned by recent enforcement actions against illegal activity.
- In May, the US Commodity Futures Trading Commission (CFTC) filed civil charges against Parnon Energy, Arcadia Petroleum and Arcadia Energy SA as well as two individuals for manipulating the price of crude oil in 2008.
- The US Federal Trade Commission this week confirmed it had opened an investigation examining whether oil companies, refiners or traders had manipulated crude oil prices.
- The InterContinental Exchange this week fined Goldman Sachs for “disorderly trading” in crude oil futures which distorted prices.
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The US Energy Information Administration (EIA) has gone live with a new set of pages on “What Drives Crude Oil Prices.” Of course, supply and demand factors are front and center. But what’s new is the inclusion of pages on the role of Financial Markets. True to its role as an information provider, the EIA is only reporting the facts, not hawking a line. There’s no startlingly new information on these pages. It is mostly a compilation of data otherwise available from the CME group on futures trades, from the CFTC’s Commitment of Traders report and other sources. But, the effort to put these together and within the larger picture of supply and demand forces is a worthy one, and an important step for the EIA.
These pages are one output of the EIA’s Energy and Financial Markets Initiative that Richard Newell instituted when he became Administrator.
My favorite product of the Initiative is one of the first ones. The EIA now publishes confidence bounds on price forecasts. These are produced using implied volatilities from exchange traded options. The full analysis of volatility, including confidence bounds is here. This is an important step forward in raising the level of public discussion.
The EIA is a very valuable source of data on US and international energy markets. There is nothing comparable anywhere else in the world, which is a shame. Unfortunately, it’s a fact of life that information costs money, and budget cutbacks are affecting the EIA, too. So it is unclear how much of the EIA’s new Initiative will last. I have my fingers crossed.
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Carolyn Cui and Liam Pleven at the Wall Street Journal have a nice piece today on the competition between gold ETFs and gold mining companies for the investment dollars of gold bugs.
Share prices of gold-producing companies have lagged the huge run-up in the price of gold, as well as the broad stock market, for years. Investors, instead, have poured billions of dollars into exchange-traded funds backed by actual bullion, believing that would provide purer exposure to gold prices and avoid unrelated stock-market risk.
But the companies are fighting back:
In April, the Denver company introduced a “gold-price-linked dividend,” promising an increase of 20 cents a share in its annual payout for every $100-an-ounce rise in gold prices. Newmont receives about $300 million in additional cash after taxes for every $100 increase in gold prices, Mr. O’Brien said. Based on current gold prices, the company is expected to declare a 25 cent quarterly dividend in July, a 25% rise from April’s.
The promised payouts, although still small compared with traditional big dividend payers such as utilities or health-care providers, are aimed at setting gold stocks apart from bullion or gold ETFs.
I say the mining companies should stop trying to battle the tide and instead declare good riddance.
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