05.09.2022 | The most important facts about electricity, gambling, hedging and rescue umbrellas

7 things you need to know about hedging electricity prices

Why do Swiss energy companies hedge electricity on exchanges? What is hedging, anyway? What are ‘initial margins’ and ‘variation margins’? And what does all this have to do with gambling? We answer your most frequently asked questions.

1. What is meant by ‘hedging’ in the energy industry?

To ‘hedge’ is to protect oneself against financial loss by making balancing or compensating transactions. Axpo and other electricity companies sell the electricity from our Swiss power plants several years in advance. We do this because we know precisely how much electricity our plants produce each year. So by fixing the price we can minimise any price risks in the future. This is also good for our customers, such as SMEs or transmission system operators with multiple end customers, as they can secure a guaranteed energy supply at a predictable price. That allows both sides of the transaction to accurately estimate their revenues or costs two to three years ahead, giving them a high degree of certainty. Such transactions are usually made on energy exchanges. To secure buyers and sellers (in the event that one of the two is no longer able to fulfil their obligations), the deposit of cash collaterals (‘initial margin’ or ‘variation margin’) is stipulated by government regulations. These deposits are returned in full as soon as the transaction has been settled as planned. More detailed information on the mechanism can be found here.

2. Why have the necessary cash collaterals increased so much lately?

The amount depends largely on the electricity price level. If prices rise, the liquidity to be deposited also rises. If one party defaults, the other party must find a replacement at the market price or look for new buyers. That is why the approximate difference between the agreed and the market price is deposited. Since the sharp rise in gas and electricity prices – made significantly worse by Russia's war of aggression against Ukraine - the necessary security deposits have risen to historic highs. This unprecedented situation places extraordinary short-term demands on the liquidity of companies. Until recently, the current situation would have been unimaginable. According to media reports, a staggering 70 billion euros in collateral was placed on the EEX power exchange in February.

3. Have electricity companies been gambling abroad?

No. Axpo sells all its Swiss electricity production in advance to protect us from falling prices, but sacrifices potential future profits if prices rise. This is the exact opposite of gambling, which is why it is called ‘hedging’. Instead of betting, we have hedged production from our Swiss plants to minimise the risks for us and our customers.

4. Are the collaterals forever lost to the utilities?

No, because cash collaterals are refunded in full after delivery at the latest, just like a rent deposit which acts as a safeguard against a tenant potentially defaulting on their payment. These funds are therefore only temporarily unavailable to the companies.

5. Is the business model of electricity companies sustainable?

Yes. Increased electricity prices mean the outlook for electricity companies remains positive. The current problem concerns liquidity, not profitability.

6. Can Swiss companies isolate themselves from negative European developments?

If prices suddenly rise massively due to political decisions such as a war or energy embargo, this can rapidly (within 48 hours) lead to very high cash outflows for electricity companies throughout Europe. This in turn can set off a chain reaction if individual companies fail as a result, dragging others with them in a kind of domino effect. As we know from recent experience, prices can rise massively. On 4 April 2022, an hourly price of electricity in France soared temporarily to 3,000 euros/MWh (a normal level would be closer to 50 euros). This extreme price spike for a single hour resulted in the price cap on all European power exchanges being increased to 4,000 euros/MWh. Then on August 17, there was an hour in Lithuania settled at 4,000 euros/MWh, which has now caused a further increase in the European price cap to 5,000 euros/MWh. Even healthy, profitable companies with strong future prospects could find it impossible to cope on their own with such irrational market movements if they had to deposit enormous cash collaterals with an exchange. Don’t forget that Switzerland is involved extensively in international energy trading.

7. How should the Swiss Federal Council's ‘rescue umbrella’ be assessed?

The intention of the Swiss Federal Council to provide a protective mechanism against the current systemic risks is justified. A lean solution is needed that is capable of mitigating the current systemic risks with the least possible intervention and the least possible bureaucratic effort. The bill is currently being discussed in parliament.

More information about power trading can be found here.

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