Technology Is Critical for Hedging and Trading in Energy Markets
Credit to Author: Paul Conlon| Date: Thu, 04 May 2023 14:43:08 +0000
The world is currently going through a major shift toward clean energy, triggered by concerns over climate change, depleting resources, and energy security. The energy transition is a massive undertaking, requiring significant investment and a long-term vision. However, as with any transition, there are challenges and uncertainties, and this is where hedging and trading come into play.
Hedging is a risk management strategy that involves taking positions in the market that offset the risks of an existing position. Hedging can be done using a variety of instruments, including futures, options, and swaps. Trading, on the other hand, is the buying and selling of financial instruments in the market with the aim of making a profit or cost saving. The recent energy crisis has been characterized by volatile prices, supply disruptions, and geopolitical tensions, which have been exacerbated by Russia’s invasion of Ukraine. The energy transition, on the other hand, is marked by technological disruptions, regulatory changes, and shifting consumer preferences. Both of these events create a lot of uncertainty in the market, which makes hedging and trading more critical.
One way to hedge against the risks of the energy crisis and transition is by diversifying energy sources. This creates an opportunity to invest in solar, wind, and battery storage, either on-site or purchased from a third party through a corporate power purchase agreement (CPPA). By signing a CPPA, companies can lock in a fixed price for electricity, which can help them manage their energy costs and reduce their carbon footprint. CPPAs can also offer long-term price stability, which can provide a hedge against the volatility of traditional energy markets. Overall, CPPAs can be an effective hedging strategy for companies looking to manage their energy costs and reduce their environmental impact.
For example, let’s assume that a manufacturing facility in Texas that has annual energy consumption of 8.76 GWh has installed a 2-MW solar system and a 1-MWh battery storage facility connected in a microgrid. The average electricity price for this facility is 14¢/kWh. If the solar system generates electricity for six hours per day and the battery is charged and discharged once per day, the potential cost savings and revenues could be estimated as follows:
- The solar system generates 12 MWh daily from the six hours its 2-MW generation capacity operates.
- The factory’s industrial load demand is 24 MWh per day but it only consumes 6 MWh of the power generated by the panels, due to the mismatch between solar generation hours and unit production activity.
- With the battery discharging 1 MWh per day for industrial use, the factory uses only 17 MWh per day of grid power, rather than 24 MWh, resulting in a daily cost saving of $980 and monthly savings of about $29,000.
- With production accounting for only 6 MWh of the 12 MWh generated by the solar array daily, and assigning a further 1 MWh to charge the battery, the remaining 5 MWh could generate daily revenue of $500 if sold to the grid for 10¢/kWh, for a monthly revenue stream of $15,000.
- That all adds up to monthly energy saving and energy payments of $44,000 for this notional factory in Texas.
This is, of course, a very stylized example and ignores factors such as actual load and solar-generation profiles, which will not be flat as assumed in the simple example discussed above, as well as arbitrage revenue opportunities that exist for the battery to further increase savings by avoiding peak grid electricity prices and selling back excess energy to the network at optimal times. A more realistic representation of the interaction between load, solar, and battery storage is depicted in the diagram below. The site could also earn revenue by participating in demand response or ancillary service markets, which balance supply and demand in the event of unexpected generator failures to maintain frequency levels. The potential savings from such programs are highlighted below.
Actual savings and revenues will depend on various factors such as the location, size, and type of installation; energy prices; and demand profiles in a specific region. The interaction of all these variables on any given day ensures the decision-making process can become quite complex. Under such circumstances, it is useful to employ mathematical optimization programming to achieve the best outcome and derive the greatest return on investment. The critical point to note is that a battery co-located with a solar generation plant changes the risk profile of the investment, ensuring that some of the uncertainties associated with weather power generation are, at least in part, mitigated.
Trading is another essential tool used to manage price risk, optimize energy assets, and take advantage of market opportunities. Energy traders can use futures and options contracts to hedge against price fluctuations and lock in prices for their energy assets. Trading can also help optimize energy assets for participation in grid programs and demand response services. For example, energy traders can use algorithms and advanced analytics to identify market trends and optimize energy production and consumption in line with grid conditions, which can help businesses avoid price peaks or shift load to gain revenue from demand response. This can help reduce costs and improve efficiency, which is essential in the context of the energy transition.
Key to either hedging or trading is having the forecasting and automation technologies in place to be able to identify actions needed and respond at the right time and in the right market. For instance, looking at the Electric Reliability Council of Texas (ERCOT) market (based on 2022 prices), a business with 1-MW load, depending on utility company, could earn an additional revenue by participating in demand response or reserve markets with automated co-optimization while taking advantage of reduced dispatches under peak avoidance.
In conclusion, the energy crisis and transition present significant challenges and uncertainties for the energy sector. Hedging and trading are essential tools that can help manage risk, optimize assets, and capture value. Diversifying energy sources, investing in energy efficiency, and leveraging trading strategies can all help energy companies navigate the transition and emerge stronger in the long term.
—Paul Conlon is head of Modeling and Forecasting at GridBeyond.
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