Electricity Trading with Derivative Instruments: Speculation, Hedging, or Speculative Hedging?

Abstract

The physical nature of electricity makes it difficult to store, which means that current demand must always match current production. This requires both flexible and internationally interconnected generation capacity and appropriate hedging strategies. Electricity is typically traded ‘forward’, i.e., future energy volumes and prices are hedged in advance with derivative instruments to minimize price risks. In times of crisis, when energy prices can be highly volatile, such instruments can also be used for speculative purposes. However, hedging and speculative positions can trigger margin calls on derivatives exchanges or increased collateral requirements in the over-the-counter (OTC) market. The causes, interrelationships and possible consequences of such margin calls on the financial situation of buyers and sellers of electricity (e.g., on balance sheet liquidity) are discussed.

Paradoxically, the use of hedging instruments to protect against price volatility, together with prudential accounting standards, has led to financial problems for many electricity producers during the market turmoil of 2022, and to governmental bail outs. Whether the problems of large energy companies in Switzerland are due solely to hedging motives or to speculative proprietary trading is difficult for outsiders to judge.