Derivative market for electricity in India: Will it lead to innovation or speculation?

It can create a win-win situation for all stakeholders with transparency and efficiency

Radha Krishna Tripathy | September 30, 2020


#CERC   #SEBI   #derivatives   #energy   #power   #electricity   #markets   #Economy  
GN Photo
GN Photo

The Indian electricity sector is going through an interesting phase right now. Many reforms are being introduced to increase competitiveness and transparency in the sector. The power market in India is a surplus market now and the spot prices are going down day by day. With all these indicators signaling a journey towards a mature power market for India, the introduction of derivatives to the power market comes at an opportune time.

There are reports in the media that the jurisdiction fight between CERC and SEBI is going to be sorted out soon after they come to a mutual understanding of settlement. It is expected that SEBI would look at the financial transactions and settlements in the trading of futures contracts and CERC would look at the physical delivery of the contracts with concerned price and volume.

The treatment of electricity as a service or a commodity is long debated in our country and the majority opinion is continuously shifting towards electricity as a commodity and hence a similar treatment. However, electricity varies considerably from others commodities with some features that are unique only to it. Electricity cannot be stored except the highly costly storage devices. There would always be a mismatch between power supply and consumption as compared to contracted power as a system default, thus requiring a balancing mechanism for settlement. It cannot be transported unidirectional as its flow is dependent on grid availability and congestion management. Its interdependencies with other ancillary services are well established unlike any other commodities. So, treatment of electricity as a commodity cannot be compared with other available commodities in the market, thus it requires a special treatment.

However, trading of electricity as a commodity is well established in the Indian market. Currently, electricity is being traded as DAM (Day Ahead Market) and TAM (Term Ahead Market) in the electricity exchanges. Real time market trading of electricity has recently been started and any limitations on the operational and technical sides are closely monitored. In this scenario, introduction of futures market will be a shot in the arm not only for the traders but also for all other stakeholders.

Currently, power procurements by distribution companies are largely through the long term PPAs where they are tied with power generators for a period of 20 to 25 years. These long term PPAs constitute around 80% to 90% of their power procurement portfolio. The rest of power comes through bilateral trading, OTC or spot market transactions. The long-term PPA agreement provides less scope to strategically design the portfolio to suit their need to bring their overall procurement cost down. Even if they decide not to schedule the PPA power, they have to provide for capacity charges as fixed cost compensation to the generators. With base load stabilizing for distribution companies with less variation due to incremental demand, they require more power at their hands to effectively design their procurement strategy. Currently, the only way to do it is through the spot market where volume of transactions is not that huge so as to effectively reduce the overall cost. With the introduction of futures market, there will be scope for them to reduce the power procurement cost with bargaining and accurate prediction of the market price. The transaction cost will be reduced drastically with right information at the right time for the buyers.

What's in store for stakeholders?
For the generation companies, they would better manage their risk and will be able to sell any surplus power at a price certainty. This will help them plan better for their future investment. The futures market will indicate a direction of the electricity market. Economic indicators and investments related decisions by government and private sector will indicate the requirement of incremental power generation, which can be supplemented through newer generation capacity from captive and merchant power plants apart from green field and brown field investments in the sector.

It would give open access a head-start through custom specific contracts such as one generator providing electricity to a specific customer as per their need, time and volume requirement. This will be a boon, specifically to stand-alone renewable energy systems, which can get a dedicated buyer. With prices of renewable energy reducing rapidly, there may be a spike of such futures contracts between the seller and the buyer.

Traders will see their volumes going up as they play the role of market makers in the market. This will also provide them a hedge against any risks and uncertainty of the future. Being a volume player in the market, no doubt, their margins will come down due to intensive competition in the market and free market due to open access challenges; they will make profit by taking clear positions in the market. The futures contract’s price and volume indicators will act as a tool to stabilize price fluctuations on the power exchanges.

Ultimately, the consumers will be benefited more with certainty of quality power supply due to competition, less tariffs due to reduction of risk premium by the market participants. The new features of EA 2003 (amendment) that proposed creation of sub licensees at distribution level with separation of carriage and content would see service level delivery improvement at the consumer level due to direct or indirect impact of these new products in the market.

From the market opportunity perspective, it will open up a plethora of startups providing predictive pricing tools. Also, the existing research and consulting agencies may provide new tools and techniques to predict futures volume and price. There may be several tools and techniques developed for accurately predicting the market based on various macro and micro parameters such as economic scenario, industrial growth, socio political scenarios etc.

As far as speculation is concerned, it seems difficult at this point of time as the market is dominated by a large number of players both from the suppliers and buyers side. Also, there is intense competition from the power traders and it may see newer participants entering into the market. Also, the surplus market scenario and less margins provides less bandwidth to game the market.

The way forward
While the initial hurdles regarding the settlement of contracts will be resolved through mutual understanding by the two regulators, the operational, design and technical part will take some time to establish.

With the addition of newer and innovative products, exchanges will see its portfolio basket offering various new products to its customers. No doubt, the customers base will see a surge with both suppliers, buyers joining the race. Operational and structural issues would require some time to stabilize. Also, the right technology with integrated ICT tools will be a prerequisite for ensuring transparency in the exchanges.

The regulator may take a first step to operationalize this as a pilot to test the operational features. It has to come up with stringent policy and regulations to check any speculation in the market and see that few players do not hijack the platform. Also, there should be a proper mechanism in place to check any type of cartelization in the market to check any gaming. Never the less, these innovative products would push the market for innovation and transparency in the market.

Tripathy is Senior Fellow, CUTS Institute for Regulation and Competition, and PhD scholar from RGIPT, Jais, UP.

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