Quantifying Energy Retailers’ Exposure to Wholesale Price Risk

# Answer by David Addison (score 3, accepted)


# How do energy companies measure the magnitude of the risks of buying energy at a variable price and selling it at a fixed price?












Power and gas retailers are exposed to a variety of risks when selling to domestic customers. Many of these risks arise from the fact that customers are offered a fixed price, while the retailer must purchase the gas and power to supply their customers from the wholesale markets. The risk associated with offering fixed price contracts is exacerbated by correlations between demand and market prices. For example, during a cold spell gas demand increases and wholesale prices tend to rise, whilst during milder weather demand falls and wholesale prices reduce.

How can a power and gas retailer estimate the magnitude of these risks?

## Answer by David Addison (score 3, accepted)

https://quant.stackexchange.com/a/37949

@Noob2’s comment above is “spot” on. Across the natural resource and energy value chains there are significant price risks that:

A. Market prices will fall below price takers’ unit costs; and, B. Market prices will exceed price setters’ unit prices.

In either case, if you assume that log price changes are a martingale, and that expected profit is the unconditional expectation that $P_t > K$ (I.e. units will be produced/sold at any price), then expected profit is simply $P_t - K$. I.e., market risk is priced into the spot and forward markets.

If, however, you add market forces to the mix in which quantities produced, bought and sold are dependent on price, then you can introduce more complex conditional expectations. In the simplest example, where producers halt production at no cost when prices fall below the cost of production, then the problem is tractable using some variation of the Black-Scholes options pricing framework. I.e., solve for $V_{t,P}$ given the condition that $V_{T,P} = Max[0,P_T-K]$.

If the market dynamics are not so simply expressed (they never are!), practitioners use approaches which fall under real options analysis (ROA).

ROA is inherently a broad term since it encompasses various discrete and continuous estimates for price processes, cost structures, decisions types, definite and indefinite time frames, optimal strike boundaries and other boundary conditions, and other determinants. Estimating value under simulated real market conditions is the unifying characteristic for all ROAs.

For more reading, I recommend:





## Answer by ZRH (score 1)

https://quant.stackexchange.com/a/76434

While this question has been posed well before the European energy crisis, it is interesting to comment with the benefit of hindsight. Breaking down the answer into two parts:

1) Retailers with no generation assets: They are subject to the price basis between floating and fixed prices. In the past, many players in this space have not explicitly managed, or even quantified, the financial risk arising from this mismatch. In view of the fact that spot market volatilities in power markets are very high, and that prices can span orders of magnitude (as seen in '21 and '22), these risks are often deadly. Often by the time that these smaller less professional companies realise that they are in trouble, it is already too late to term-hedge. Usually such companies are thinly capitalised and can absorb spot-price shocks only for very limited periods. If a serious crisis drives up spot market prices, as happened in the runup to the Russia/Ukraine conflict, and in the early stages thereof, waves of bankruptcies are the norm. In UK, the energy market regulator Ofgem had to intervene in '22 as well over a dozen of retailers went bankrupt.

2) Retailers with generation assets: Managing generation assets is a different game, whereby the economic exposure mainly lies in the net margin between power sales prices and the cost of procuring fuels (coal, gas, emission ertificates). Such firms will procure fuels on a fixed price basis for longer periods, whenever they sell to their end user portfolio (households, corporates). In doing so, they eliminate spot market price exposure and lock in sales margin, ie they fully hedge their position.

In summary, while many retailers gladly assumed open spot price risk in the past (often arguing that the market systematically overprices the security of long-term fixed prices), the risk-taking attitude has become considerably more conservative. Furthermore, energy market regulators also exercise more rigorous scrutiny of the books of retailers to preempt that the state has to step in to bail them out