Electricity Derivatives: Catalyst for Next Level Reforms in Indian Electricity Markets

With long standing dispute between Central Electricity Regulatory Commissions (CERC) and Securities Exchange Board of India (SEBI) over regulatory jurisdiction on Electricity Derivatives is almost over, next few years are going to be very exciting for power markets participants.

Vide notification dated 10th July 2020, Ministry of Power approved Electricity Forward and Derivative Contracts and specified that:

1. All ready Delivery Contracts and Non-Transferable Specific Delivery Contracts as defined in Securities Contracts (Regulations) Act 1956 in electricity, entered into by the members of the power exchanges, registered under CERC Power Market Regulations 2010 shall be regulated by CERC subject to following conditions

• The contracts are settled only by physical delivery without netting;

• The rights and liabilities of parties to the contract are not transferable;

• No such contract is performed either wholly or in part by any means whatsoever, as a result of which the actual delivery of electricity covered by the contract or payment of the full price therefore is dispensed with;

• No circular trading shall be allowed and the rights and liabilities of parties to the specific delivery contracts shall not be transferred or rolled over by any other means whatsoever;

• The trading shall be done only by authorized grid connected entities or trading licensees on behalf of grid connected entities as participants;

• The contract can be annulled or curtailed, without any transfer of position due to constraints in the transmission system or any other technical reason as per principles laid down by CERC in this regard. However, once annulled, same contract cannot be reopened or renewed in any manner to carry forward the same transaction;

• All information or returns relating to the trade, as and when asked for shall be provided to CERC who shall monitor the performance of the contracts entered into the power exchanges
​​​​​

2. Commodity Derivatives in the electricity other than Non Transferable Specific Delivery Contracts as defined in SCRA shall fall under the purview of SEBI.

Summarily, above notifications says that Contracts pertaining to delivery of electricity (forward contracts) will be governed by CERC whereas contracts without physical delivery of electricity (future and option contracts) will be regulated by SEBI.

While the dispute between CERC and SEBI is still sub-judice in Hon’ble Supreme Court and since amicable out of court solution has been reached between the parties, the matter is mere judicial formality to quash the ongoing proceedings.

While this reform has long term impact, we have put forth our views on immediate business opportunities that may arise because of above reforms esp for C&I consumers.

Virtual Power Purchase Agreements (VPPAs)

Being purely bilateral in characteristics, Virtual Power Purchase Agreements neither involve physical delivery of power nor these contracts are transferable/listed in any exchanges. Therefore, strictly speaking VPPAs do not fall under jurisdiction of either CERC or SEBI. However, since Virtual PPAs derives its value for underlying asset selling electricity in open market, they are classified as Electricity Derivatives. So far, Electricity Derivatives were prohibited under CERC Power Market Regulations 2010, and hence VPPAs are yet to see day of light in the country but with opening of derivative markets, these are lowest hanging fruit available to market participants esp Renewable IPPs.

For the benefit of readers who are not aware of Virtual PPAs, these are contracts executed between Independent Power Producers (IPPs) and Sustainability Offtakers who intend to promote renewable electricity but have limitations on physical procurement of electricity. The IPP executes a long term Contract for Difference (CfD) agreement or Virtual PPA with Sustainability Offtaker for fixed price and build the renewable energy project to sell electricity in open markets. In case price discovered in open market is higher than price fixed under VPPA, Sustainability Offtaker keeps the difference whereas in case VPPA price is higher than market price, Sustainability offtaker pays to IPP for such difference.

Say for an example, a leading technology company A Ltd has total requirement of 50MW or 438MUs for its Data Centre. However, due to various limitations of contract demand and/or restricted banking, the company can maximum procure 50MW solar power which effectively offset less than 20% of its total requirement (~87.6MUs). For the remaining 80% requirement (~350MUs), A Ltd may execute VPPA for ~200MW for fixed price of Rs 3.00/kWh with a leading IPP which then sell electricity in open market.

Now if open market price is Rs 4.00/kWh, A Ltd gets to keep the difference of Rs 1.00/kWh. Further, if market price is Rs 2.50/kWh, the A Ltd pays Rs 0.50/kWh to the IPP.

To understand the risk-return reward under this VPPA for A Ltd, let’s analyse the notional gain or loss if this contract would have been executed in 2011;



Effectively, if the contract was executed in 2011 for a fixed price of Rs 3.00/kWh, the A Ltd would have netted a notional gain ~Rs 90 crore in past 10 years while meeting its sustainability goals.

While this can be argued that history is unlikey to repeat itself, odds are in favour of VPPA being in the money on account of the fact that cost of renewable power generation has significantly reduced relative to the marginal cost of thermal power. Based on past 10 year day time prices, break even price (for cumulative net gain or loss to be zero) for a VPPA is Rs 3.17/ kWh against average discovered tariffs of Rs 2-2.5/kWh under utility bids for solar/hybrid projects (whereas thermal power’s marginal cost shall be ~Rs 3.00/kWh based coal prices & SHR of the plant).

Since Open market or power exchange operates on firm power basis and hence will be driven by thermal power, open market prices are likely to be higher than renewable projects in over course of period. Further, open market prices also get impacted by various macro economic factors i.e. sudden increase in demand during elections, seasonal variations and incentive driven economic growth, its reasonable to assume that VPPAs in India should be cash positive in long term.

Hedging Instruments for Optimizing the Power Purchase Cost for Bulk Consumers

Taking the example forward of A Ltd, which has executed a 50MW Long term solar power contract and Virtual PPA for 200MW is still left with almost 40MW or 350MUs of physical power requirement which they intend to procure from exchange.

As provided in the chart above, A Ltd is severely exposed to market vageries and hence its difficult to reasonably project cost of power procurement in medium term say 6 months to year now.

To minimize the market exposure, say the company enters into 1 year PPA for 40MW with a thermal generator at say price of Rs 4/kwh. Since market prices widely fluctuating, it may so happen that market prices are less than Rs 4/kWh in certain months leading to notional loss and more than Rs 4/kWh garnering notional gains.

Say, if Electricity Futures are available in the market, Consumer may simply take a Sell position (short) for each month (may decide to simultaneously take positions for all months depending upon the preimum or may roll over the carry forward contract for each month). Say now, in a particular month, market price is Rs 3/kWh which has been shorted by Consumer against a buy position under the PPA of Rs 4/kWh, leading to Mark to Market gains of Rs 1/kWh and this goes vice versa when market price is higher than PPA price.

The risks for the bulk consumer may be further mitigated using Put Option or even involve complex stratgies around use of both Put and Call options.

To summarize, as and when electricity derivates are fully functional in Indian power markets, this technology company has following scheme for the procurement of power:



The above is merely an illustration and actual power procurement mix shall be subject to state specific regulations and various restrictions. Nevertheless, times ahead are exciting for bulk consumers, IPPs and electricity trading companies.

- Aditya Malpani,
 Director- Open Access, 
Amp Energy India