Financial instruments

The use of financial instruments to manage risks has been well known in commodity industries for decades. Gas and electric market participants including producers, generators, marketers, utilities, and larger end users utilize financial instruments as a means of managing risk and/or providing services to customers. Financial instruments provide a means to shift risk without actually trading a physical commodity. Instruments used to do this include exchange-based futures and options, over-the-counter (OTC) derivatives, and ISO-based financial transmission rights (FTRs). Exchange-based instruments are specific defined contracts that trade on a central exchange like the CME Group (formerly NYMEX) or Intercontinental Exchange (ICE), while OTC instruments are simply contracts between two private parties.

Trading volume, or liquidity, of risk management tools has been high in the natural gas industry for years. There are a number of trading hubs across the United States where any number of financial instruments are easily accessed through CME and ICE.

Liquidity in electric markets, on the other hand, grew relatively slowly during the initial years of deregulation. Reasons for this lack of liquidity include the lack of price correlation between regional hubs due to lack of transmission interconnections, the limited amount of power traded in some wholesale markets due to continued dominance of vertically integrated utilities, and the wide variation of power demand and prices across the day. However, the availability of risk management products has grown significantly in recent years in the competitive wholesale markets. Both CME and ICE offer services that match buyers and sellers for various products at numerous hubs. Products include futures, swaps, location spreads, and options. Also, each ISO offers financial instruments that allow parties to hedge the risk of transmission congestion costs for specific transmission paths. These are commonly called Financial Transmission Rights or FTRs, although different terms are used by different ISOs. Numerous financial services companies also offer OTC products.

Financial instruments are used by wholesale market participants in both the gas and electric industries to cover the risk of price fluctuations. For instance, a marketer may have a contract to sell a block of natural gas to an end-use customer at a fixed price but may be buying power at a market index. Rather than carry the risk of rising market prices, the marketer can lock in a margin by swapping the floating price (the indexed supply purchase) for a fixed price. Electric generators and gas producers may also use instruments to lock in fixed revenues, and generators are likely to be active in the fuel-hedging markets to reduce their risks associated with coal, petroleum, and/or natural gas price fluctuations. And large end users may use financial instruments to fix their commodity cost or to limit the risk of price increases.