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ENERGY TRADING POLICY FOR RETAILERS

TPP 99-5 October 1999

PREFACE

The Energy Trading Policy for Retailers is one of a suite of Treasury policy documents aimed at introducing a best practice financial and risk management and accountability framework for NSW electricity agencies involved in retailing electricity.

The purpose of this policy is to establish a high-level policy framework for energy trading to be adopted by NSW owned electricity retailers to manage the inherent price and volume risks associated with their trading activities.

John Pierce
Secretary
NSW Treasury
October 1999

Treasury Ref: TPP 99-5
ISBN: 0 7313 3004

General inquiries concerning this document should be initially directed to:

Ziggi Lejins (Tel: 9228 5685, or E-mail: lejinsz@mail.treasury.nsw.gov.au ) of NSW Treasury.

This publication can be accessed from the Treasury's Office of Financial Management Internet site [http://www.treasury.nsw.gov.au/].

For printed copies contact the Publications Officer on Tel: 9228 4426.

CONTENTS

Preface

1. Introduction 


1.1 Objectives 


1.2 Principles

2.  Energy Trading Framework


3. Operational Risk


4. Market Risk 


5. Credit Risk


6. Legal Risk 


7. Permitted Instruments

 

8. Pricing

9. Reporting


10. Contact Person


Appendix. Portfolio Valuation and Sensitivity Analysis



1. INTRODUCTION

The purpose of this policy is to ensure each electricity agency has a comprehensive energy trading policy framework to manage the inherent price and volume risks associated with its energy trading operations.

1.1 Objectives

The objective of this policy is to establish a high level policy framework for energy trading to be adopted by NSW electricity agencies so associated risks are appropriately managed, and reported on a consistent basis.

A key reporting objective of agencies should be to provide the Shareholding Minister with a clear understanding of the nature and scope of their energy trading activities, including targeted results and related risk exposure. This should be documented in the Statement of Corporate Intent (SCI) and monitored and reported on a regular basis.

The focus of this policy is on outcomes. It is not appropriate for Treasury as adviser to the Shareholding Minister to prescribe the specific details of an agency's policies or to set operating strategies.

1.2 Principles

The policies of electricity agencies should embrace the following principles:

  • Clear separation of retail activities from energy trading activities, creation of separate business plans and the allocation of capital based on the degree of risk exposure of the two activities;

  • The energy trading process is to follow appropriate internal controls covering segregation of duties between trading, settling, accounting and performance measurement;

  • Energy trading risks must be constrained to an acceptable, Board approved, level by limiting the mismatches between contract energy sales and contract purchases;

  • Performance benchmarks should be established which reflect a fully hedged position for energy trading;

  • Where possible, all trades are to be marked-to-market and benchmarked on a daily basis;

  • All pricing margins must be set on a business case basis so as to achieve appropriate returns for energy trading, based on the amount of capital employed;

  • Adoption of scenario analysis and stress testing as quasi capital at risk measures, until a more accurate capital at risk or value at risk measure is possible.

The policies of electricity agencies should at least address the following specific matters:

2. ENERGY TRADING FRAMEWORK

The Board of each agency will be responsible for approving:

  • Strategies which prudently manage energy trading risk;

  • Appropriate performance measures; and

  • Procedures and policies which meet generally accepted market standards and best practices for trading in the electricity market.

The energy trading policy or policies of retailers should:

  • Be documented and approved by the Board;

  • Be reviewed at least annually;

  • Require clear lines of delegated authority encompassing the full risk management process;

  • Ensure that the key information and processing systems are audited to support the requirements of the policy;

  • Document the formal approval process for new products and trading activities; and

  • Require that operational compliance of the policy be audited on a regular basis.

3. OPERATIONAL RISK

While it is recognised that there is a strong link between retail and energy trading activities, for commercial and performance reporting purposes the two activities should be clearly separated. In addition, there should be a clear and total segregation between the trading, monitoring and settlement functions of energy trading. Where physical or organisational separation is not possible, the retailer's policy should require the establishment of procedures to manage any potential conflicts.

The policy should specify the markets the retailer is permitted to trade in and all other markets should be explicitly prohibited.

Energy trading is only to be carried out by qualified personnel. Specific Board or Chief Executive delegations of authority are to be implemented which give delegated authority to specific individuals for trading, transaction confirmation, authorisation and authority to sign legal agreements.

The agency's policy should require the maintenance of a list of approved personnel who may enter transactions and a list of approved counterparty personnel.

Each approved person should have a specific delegated limit regarding the tenor for each type of contract or instrument that may be traded.

Each approved person should have a specific delegated limit regarding the value for each type of contract or instrument that may be traded.

The policy should clearly state the process required for the management of policy breaches.

No new product is to be introduced unless the agency has a complete understanding of the risks associated with the product and procedures are in place to record, settle and account for the transaction. The Board should approve a process for the introduction of new products.

4. MARKET RISK

Although it is not possible for an agency to have a totally risk free energy trading position (due mainly to short load variation), this risk must be constrained to an acceptable level by limiting the mismatch between energy sales and purchases.

A market risk benchmark should be established and used. The performance benchmark is to represent a fully hedged position of all spot and forward transactions for the duration of these transactions.

Controlled deviations from the fully hedged benchmark are permitted within a range about the benchmark. Different percentage deviations may exist for peak/off peak periods, consistent with the price risks (and load variability) applying in each period. The controlled deviations from the fully hedged benchmark have to be approved by the Board. Trading and portfolio constraints could also impact the magnitude of the approved deviation.

A measurement methodology should be developed and used for setting and reporting deviations from the benchmark.

A capital at risk limit should be developed and assigned to the energy trading function. The method of determining this limit is to be advised to the shareholder, taking into account credit risk and deviations permitted from benchmark.

5. CREDIT RISK

The credit risk policy should be based on a recognised ratings system or an objective internal credit assessment process.

For each level of credit rating there should be a limit on the total value of contracts that may be transacted with a counterparty possessing the given rating level. Complementing this should be limits on maximum maturity of contracts undertaken with these counterparties.

In addition to the individual limits, each ratings group should have an aggregate limit on the value of contracts transacted.

The credit policy should recognise the value of credit enhancement instruments such as bank guarantees and should allow for internal credit assessments to be made where it is deemed appropriate or necessary.

In determining the value of credit exposure current market value and potential movement in market values should be recognised.

The credit requirements of the Treasury Management Policy (TPP 97-1), which relates to dealing in financial instruments, must be considered.

Transactions executed for the sole purpose of earning a premium in exchange for exposing the retailer to a credit risk (i.e. credit intermediation) are prohibited.

6. LEGAL RISK

With the exception of properly documented Power Purchase Agreements and similar types of contracts, International Swaps and Derivative Association (ISDA) documentation should be mandatory for all transactions and master agreements should be signed with all counterparties.

Any variations to standard ISDA documentation, including the adoption of new products, should be explicitly approved by appropriate personnel.

Internal and external parties (ie, employees or agents of counterparties) authorised to confirm ISDA transactions should be specifically identified.

7. PERMITTED INSTRUMENTS

The policy should specify the instruments the organisation is permitted to trade in and all other instruments should be explicitly prohibited.

Retailers are only allowed to sell an option when it is used to close out a bought position or the contract forms part of a specific commodity hedge (eg a collar position). Retailers are required to demonstrate to their Boards prior to trading in options that:

  • Appropriate recording and valuation systems are in place;

  • Option risks can be incorporated within the energy trading portfolio; and

  • Energy dealers have specific product knowledge.

8. PRICING

The margins (incorporating an appropriate profit margin) allocated to both energy trading and retail are to be transparent and separately reported.

Pricing margins are to provide an adequate return on capital employed for energy trading taking account of risks (e.g. credit risk).

Pricing margins are to be reported to the Board on a regular basis.

9. REPORTING

The policy should specify the agency's energy trading reporting framework and the reports required by senior management and the Board. The reports should as a minimum:

  • Identify the actual portfolio position and the sensitivity of the portfolio to external factors;

  • Identify the level of risk utilised in trading operations and associated return; and

  • Report on any breaches of the energy trading policy.

The policy should also specify the information required by the Shareholder Minister to be disclosed in the SCI and reported as part of the quarterly reporting regime. Each agency should disclose the following information in the SCI and/or the accompanying Business Plan:

  • An exposure report in chart form showing the retail and wholesale commitments for the duration of these commitments as at 1st July;

  • Details of the agency's forward price curve;

  • A valuation of the contract portfolios and the value sensitivity of the portfolios to both a $1/MWh and a $10/MWh parallel increase and decrease in the forward price curve as at 1st July; and

  • The maximum value exposure to a $1/MWh parallel shift in the forward price curve the agency's Board has approved.

The following information should be reported in an agency's quarterly report:

  • An exposure report in chart form showing the agency's retail and wholesale commitments at the end of the quarter for the duration of these commitments;

  • Details of the agency's current forward price curve;

  • A valuation of their contract portfolios and the value sensitivity of their portfolios to both a $1/MWh and a $10/MWh parallel increase and decrease in the forward price curve as at the end of the quarter; and

  • A high level summary of any energy trading policy breaches which occurred in the previous quarter.

10. CONTACT PERSON

For further information contact:

Mr Ziggi Lejins
Director Energy Ownership Branch
NSW Treasury
1 Farrer Place
Sydney NSW 2000
Tel: 9228 5685

APPENDIX. PORTFOLIO VALUATION AND SENSITIVITY ANALYSIS

The portfolios of agencies contain a number of contract types. These include Swaps, Type 1 Vesting contracts, Type 2 Vesting contracts, Futures, Caps, Floors, Collars, Contestable Retail and Franchise Retail contracts.

The value of an agency's portfolio is equal to the sum of the values of all contracts from each contract type (i.e. both retail and wholesale obligations). Individual Swap, Type 1 Vesting,

Futures, Contestable Retail and Franchise Retail contracts should be valued using a mark-to-market methodology.

For each contract this consists of determining the difference between the forward price and the contract price in each half-hour and discounting it using an appropriate discount factor. The value of a contract is equal to the sum of these present value components. Algebraically this can be expressed as:

Value = S (Forward Price - Contract Price) * Volume / Discount Factor

The forward price for each half-hour should correspond to the price in an agency's forward price curve. Agencies which have obligations in other regions in the NEM, should use the forward price curve appropriate to that region to value these contracts.

The discount factor should be based on a zero coupon forward curve which is compounded to the relevant time to maturity (i.e. represents the time value of money).

Options, including embedded options in retail contracts, should be valued using standard option valuation techniques.

To determine the sensitivity of the portfolio to a movement in forward spot prices, the respective forward price curves should be changed by the sensitivity amount and the value of the portfolio recalculated. The difference between this value and the value calculated using the agency's forward price curve represents the value sensitivity to a uniform change in the forward price of electricity. This sensitivity analysis should be undertaken for a uniform $1/MWh increase and decrease and a $10/MWh increase and decrease in the forward price curve.

For reporting purposes it is proposed that agencies disclose the value and sensitivity of their discretionary and non-discretionary portfolios. The non-discretionary portfolio consists of agencies franchise retail obligations and their vesting contracts. All other obligations fall within the discretionary portfolio.

The table below illustrates the format of the proposed report.

 


Portfolio Valuation


1/MWh Sensitivity


-$1/MWh Sensitivity


$10/MWh Sensitivity


-$10/MWh Sensitivity



Contestable Retail Contracts

Bilateral Wholesale Contracts

Discretionary Value

Franchise Retail Obligations

Vesting Contracts

Non Discretionary Value

Total Value