On September 17, 2019, the Tokyo Commodity Exchange (TOCOM) commenced test listing of power futures products, and futures trading of base load and daytime load products in the east and west areas in Japan (September 2019 to November 2020) has been realized.
It is difficult to evaluate power futures at this time, but the immediate challenge will be to increase trading volume and create a highly liquid market. This time I would like to consider the practical effects of the widely claimed power futures trading.
1. Hedge of credit risk
TOCOM states that clearinghouses can settle payments, thereby avoiding credit risk, including bilateral transactions. Specifically, by reporting off-auction transactions to TOCOM, Japan Commodity Clearing Corporation (JCCH) will guarantee the execution and settlement of the transaction.
Recently, the credit risk of new power has become an unstable factor in the power market. When the Nippon Logitec Co-operative went bankrupt in March 2016, many power producers who supplied wholesale power to the cooperative gave up collecting debts. TOCOM’s idea is to use the clearinghouse function to avoid such situations and ensure the stability of wholesale transactions.
Whether this function is effective depends on the risk of fulfilling the obligations of trading participants, JCCH’s surplus, and the margin level of power trading. Since JCCH is also a business, It really wants to limit the burden of credit risk as much as possible. Some market participants have already claimed that margin levels are “high.” You need to watch for future trading trends to see if you are going as expected.
2. Hedge of price fluctuation risk
TOCOM says that hedging with electric power futures will fix the price at which it will purchase and sell the spot from JEPX in advance, thereby avoiding price fluctuation risks. As is well known, the price of JEPX is subject to large fluctuations (volatility) due to intense heat, severe winter, power plant troubles, etc., which is a factor that greatly impairs business stability, especially for new power that relies on exchanges for power procurement.
There are two things to keep in mind: First of all, this type of transaction is a risk hedge for buyers (specifically, new power), but it can be risky for sellers (power producers). Assuming that seasonal electricity prices are fixed in advance, sellers are expected to demand a certain seasonal premium, which may add a corresponding premium to summer and winter futures prices. Next, new power demands hedging the risk of volatility during periods of high volatility, but there are only two futures products: base load (24 hours) and daytime load (12 hours), which should meet the needs, but unlikely. New power will be sure to require a more fragmented time-slot listing eventually.
3. Fixed power generation margin
TOCOM says that it is possible to determine in advance the power generation margin (= difference between wholesale power price and fuel (LNG) price) by combining the “buy” of, for example, Dubai crude oil futures and the “sell” of power futures. It’s a bit complicated, so let me explain. The LNG purchase price in Japan is determined by the primary equation (Y = aX + b: Y is the LNG price, a and b are constants, X is the oil price) using the oil price as a variable (long-term contract excluding spots).
Therefore, buying LNG futures in advance can effectively fix LNG prices. At the same time, by “selling” power futures, the future power generation margin can be determined, allowing power producers to hedge against the risk of unexpected lowering of electricity prices and rising fuel costs.
That’s the theory, but there are problems in practice. First, the spread of solar power generation is progressing, and accordingly, the time zone in which wholesale power price is determined by the coal-fired power is increasing. In addition, the thermal efficiency of LNG thermal power sold on exchanges varies from MACC (More-Advanced-Combined-Cycle) to conventional. Under such circumstances, the power generation margin cannot be simply divided by the difference between the wholesale electricity price and the fuel price.
There are many other points to note about electric power futures, but first of all, the realization of the listing on the test should be highly evaluated. In the future, further issues and points for improvement will become clear as the contracts are accumulated.