The transition from fossil fuels to renewable energy, makes supply and demand more challenging to balance because electricity production is increasingly going to be dependent on the weather. Along with renewable energy, particularly solar and wind, expanding at an unprecedented rate, the global push for electrification is set to dramatically increase electricity demand across various sectors. With power grids lacking capacity and when the sun does not shine and the wind does not blow, this may cause power shortages. Conversely, if there is an abundancy of sun and wind, there may be a surplus resulting in negative prices. This necessitates more trading to balance supply and demand. Electricity trading helps manage the variability in renewable generation by enabling the transfer of power from regions with excess generation to those with deficits. At the same time, variability leads to price volatility as markets continuously adjust to balance these dynamics, and this presents both opportunities and risks for market participants, including trading firms and hedge funds with investments in asset ownership: Weathering Electrification: Value and Risk in Volatility.
Increased Electrification and Renewable Integration
The global push for electrification is set to dramatically increase electricity demand across various sectors. According to the International Energy Agency (IEA) the share of electricity’s in final energy consumption will increase from 18% in 2018 to close to 30% in 2030. The electrification of transportation, buildings, and industry, as well as adoption of electric vehicles (EVs) and the rising computing demands from data centers using digital technologies such as AI and blockchain are major contributors to this surge in demand.
Renewable energy, particularly solar and wind, is expanding at an unprecedented rate, and grid-scale battery storage capacity is set to double, enhancing the grid’s ability to manage the variability of these sources. Global industrial initiatives are on the rise, with corporate commitments to 100% renewable energy to meet carbon-matching targets and promote the use of clean electricity.
However, as electrification boosts demand and distributed energy resources add variability, the retirement of coal- and gas-fired plants, along with delays in renewable generation and storage projects, could increase reliability risks if not addressed.
As the European regulator ACER stated in their Market monitoring report “Despite falling wholesale prices, energy remains costly due to supplier risk and market volatility. Energy suppliers continuously buy to meet future demand, facing potential losses in volatile markets. Efficient risk-hedging solutions are now crucial.”
Market Volatility
Power is one of the most volatile commodities. As an example, just as recent as last May, Texas power prices briefly soared 1,600% as a spring heat wave was expected to drive record demand for energy. Around the same time in Queensland, Australia, wholesale prices increased year-on-year, reaching the highest Q1 average of $118/MWh due to record demand and wild weather. In Europe, during the first week of April, almost all of European electricity markets registered negative electricity prices.
This volatility presents both opportunities and risks for market participants:
Opportunities
- Traders can exploit price differences across different markets or times to generate profits. This involves buying electricity when prices are low and selling when prices are high.
- The variability of renewable energy sources like wind and solar can create lucrative trading opportunities. Traders who can accurately forecast renewable output can capitalize on price fluctuations.
- The volatility drives the creation of new financial products and services, such as weather derivatives, which allow companies to hedge against weather-related risks affecting energy production and consumption.
Risks
- Sudden increases in demand or supply shortages can lead to significant price spikes, impacting profitability and operational stability.
- Shifts in regulatory frameworks can create uncertainty and affect market conditions, potentially leading to increased compliance costs and operational risks.
- The complexity and volatility of energy markets can make them susceptible to manipulation, leading to distorted prices and unfair trading practices.
Risk and Portfolio management.
Fortunately, risk can be managed well. The art is to identify and mitigate them. A risk is something that can happen but has not happened yet. And if it does happen, it is a problem and no longer a risk. Moreover, as long it is a risk, you can manage this. Provided of course you are properly equipped to do so.
As Aquila Capital, a developer and operator of renewable energy projects, recognized: “To deliver optimal returns and support our substantial PPA and GOO growth, we need specialized energy trading and risk management functionality to have clear visibility of our asset exposures and revenues.”
Managing a diverse portfolio of assets requires holistic, portfolio-level risk management, specifically for renewable power and green gas portfolios, which are highly complex for measuring and managing risk. The ability of an integrated ETRM system can provide the required single overview to keep taps on Market risk, Credit risk, Value at risk (potential loss in value), and Operational risk.
- Market Risk results from changes in market parameters which affects all open positions, driven by market prices, volatilities, foreign exchange rates, spreads, interest rates etc. A modern, “live” ETRM system can capture and configure your risk policy, and subsequently report critical impacts to the position in near-real time, for immediate action, while notifying decisionmakers when volumetric, value-at-risk and other limits are reached.
- Credit Risk is the risk the company is willing to take regarding over-the-counter transactions. It stems from counterparties not able or not willing to pay. Drivers include credit worthiness of the counterparty, the mark-to-market of the deal, and contractual terms like payment conditions, netting clauses, and more. An integrated ETRM system allows to capture credit scores, define credit limits per counterparty, manage collaterals, and monitor credit exposure. Crucially, the ETRM system allows for seamless integration with the accounting system to receive payment information that update credit limits.
- Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. Thus, if the VaR on an asset is $100 million at a one-week, 95% confidence level, there is only a 5% chance that the value of the asset will drop more than $100 million over any given week. As an input it requires the volatilities and correlations of all monthly prices. Historical market prices from the basis but VaR can also be estimated by running hypothetical portfolios from Monte Carlo simulations.
- Lacking that single view is part of the Operational Risk. This risk results from financial damage due to inadequate processes, systems, human activities, as well as external events like natural disasters. A highly configurable ETRM helps to navigate the changes a business will go through and to capture customer-specific business processes, while implementing the necessary controls.
Advances in technology, such as better forecasting tools, real-time data analytics, and improved grid management systems, enhance the ability to trade electricity efficiently. These technologies enable more accurate predictions of supply and demand, optimizing trading strategies.
The lower-risk way to plug in.
The combination of variable renewable energy generation, fluctuating demand from electrification, evolving market structures, and technological changes creates an environment where electricity supply and demand can vary significantly. This will increase electricity trading in an environment where this variability leads to price volatility as markets continuously adjust to balance these dynamics. To navigate the complexities of the evolving electricity trading market, several tools and strategies are essential for hedging market risk and maximizing asset valuation. Energy Trading and Risk Management software provides comprehensive solutions for managing the complexities of trading, risk management, and regulatory compliance. By using AI and machine learning, predictive analytics tools can forecast market trends, demand fluctuations, and price movements. These insights enable traders to anticipate market changes and adjust their strategies thereby reducing exposure to adverse price movements and enhancing asset valuation. Weathering the compelling electrification journey, means participants must revisit their risk management processes and systems.