I have found an interesting article in today’s Financial Times, “Europe power producers run short of cash” Financial Times September 6, 2022.  The situation is that most European power producers are running short of cash because of their need to integrate collaterals in their short positions in the futures markets.

A power producer is supposed to have a natural long position in power, meaning that when electricity prices rise they make a profit, but when prices decrease they face a loss.  Standard hedging practices for this situation can include using short positions, both linear (going short in power futures), or nonlinear, (buying power put options). In both cases, when electricity prices decrease, thay will have a profit in their short position that will offset their losses from selling the electricity at a cheaper price.  Analogously, when prices rise, they should have an extra profit on their operations that will be offset by their losses in the derivatives markets.

This is not working at the moment, even if the companies are selling their electricity at record-high prices, they are struggling to meet the cash required by the collateral required by the derivative markets clearing houses.  The problem is that the reason for the high electricity prices are exceptionally high gas prices, (gas is the main supply for electricity production).  This means that even if electricity prices are very high, the producers are not making additional profits since their margin is squeezed by high gas costs.  On top of this, thay are required to send liquidity to integrate the collaterals for their short positions in the market. Not a very appealing situation.

So, what went wrong? Does this mean that we do need to hedge open exposures? 

What we can learn from this case, is that we need to put more effort in understanding the exposure.  We assumed producers were long electricity, but for that to be true, at least for our purposes, they should be making extra profits with high prices and lower profits with lower prices.  And this is not the case these days.  High gas prices push electricity prices up, but margins and profits stay at the same levels.  In this situation high electricity prices, derived from increasing gas prices, do not mean extra profit for power producers.  The exposure has been poorly defined.  In some sense, higher or lower electricity prices, driven by variations in gas prices, should not significantly affect the profit of energy companies. In reality, electricity producers face a short exposure to gas prices, but they are translating this exposure to their final clients by increasing prices, this means that they are already operationally hedging that position.  In the end, the exposure was poorly defined, and this is why the hedge is not working.