1Conference_presentation_15_09_2009.pptx "A4rb_standard" – 20090407 – do not delete this text object! Moscow, 15.09.2009 Workshop presentation Anastassia.

1Conference_presentation_15_09_2009.pptx

Moscow, 15.09.2009

Workshop presentation

Anastassia Ksenofontova, post-graduate student of the Academy of Finance

Evaluation and management of price risk in the new Russian power market framework


1 Analyze the current stand of the Russian power market

2 Review best in class approach to risk-management

3 Analyze the challenges for the Russian power market participants in applying risk-management system

4 Propose solutions to these challenges


Natural MonopolyNo competitionin infrastructure→ Regulation

= Open for competition

= Monopoly

No choice

Gene-ration

Monopoly Choice

Before liberalization ...

Trans-mission

Distri-bution

Clients Clients

Gene-ration

WholesaleTrading

Marketing/Sales

Trans-mission

Distri-bution

After liberalization ...

Through liberalization the new Russian power market is created within the value chain paving the way for competition

Open market

Electricity value chain before liberalization and target value chain after liberalization


The wholesale power market is liberalized more than by half, although the recent damage in the power system may slow down the process

20%

100%

25%

31.12.200931.12.2008

90%

Liberalized market

Regulated market

Power balance, 2007 (excl. domestic consumption)

31.12.2010

50%

31.12.2007

80%

50%

01.01.2011

10%

75%

Market framework

• Growth of free prices until 2009• Free long-term contracts are not

in demand yet

• New challenges for the market participants:• High price volatility• Forecast the load• Define target sales structure

between the spot and forward market

• Find balance between the profit and the volume

• Legal uncertainty in view of the recent damage at the S-Sh. HPP

= Liberalized market = Regulated market

Demand growth/ new capacities

Russian wholesale market liberalization plan [%]


The Russian wholesale power market is now divided into 5 segments, another 3 segment are being developed

Overview of segments on the Russian wholesale market

Calculation of the power capacities balance in order to forecast and plan the volumes of power production and consumption

Regulated segment Liberalized segments

Regulated long-term bilateral

contracts

Free long-term bilateral

contracts1)

Spot market (day-ahead)

Financial transmission

rights

Balancing marketAncillary service

marketPower derivatives

market

1 2

3

4

Planned segments

Power capacity market

5

6 8

7

1) Settled at the current spot price


While the absence of free forward prices, power generation and consumption on the Russian power market is balanced by the SO

Russia

• Regulated by the government System operator (SO) forecasts the future consumption and defines the future power capacity structure. Then during the competitive choice SO defines the load of the power units

• Equilibrium between the production and wholesale consumption is settled for each hour on the spot market basing on the cost competition

• Hourly spot price is the same for all market participants in one region

• No price signals for power capacities are provided, because capacities are paid though the capacity market

(thus, the upper spot price limit exists)

Europe

• Production and consumption are balanced by the price signals (forward prices)

• Equilibrium between the production and wholesale consumption is settled by the power generation cost and capacity cost within the multilateral trading system (forward trading) and the final balancing on the spot (day ahead) market

• Hourly spot price is different for the market participants and depends on the purchasing portfolio (along the time periods)

• Electricity prices give the signals about the need on new capacities


Best-in-class risk management process consists of four steps in a closed circle – for each step the required tools are defined

Best-in-class Risk Management Process

Ongoing risk management ... ... and the content of each step to be set-up

Process/ policies

CommunicationReporting

Identification

Asses

smen

t

Controlli

ng

Navigation

Identification Assessment Navigation Controlling1 2 3 4

Risk pyramid Risk map MeasuresReporting and feedback

• Quantitative• Qualitative

Pro

bab

ility

Impact

• Accept

• Prevent/ outsource

• Reduce

• Finance/t ransfer

• Bottom-up reporting procedures

• Top-down definition of thresholds and MBOs

• Early warning system (parameter based)


Market risks and namely the price risk is the one to be emphasized by every power market participant

Political / legal

Market

Technological

Social/ cultural

Competitors

Product

Operational

HR

Investment

Financial/liquidity

Other

Inte

rnal

Ext

ern

al

Ver-bund EVN EON RWE BKW AlpicRisk category Company

Focus on power market risks, namely the price risk on the Russian power market

Identification – best practice1

Risks categories used by the European power energy companies


Price risk was not considered by the Russian companies in the tariff economy – now have to they learn to evaluate and manage it

Market liberalization challenges

• Increased competition in generation and retailing: Dramatic margin reduction with direct impact on P&L-result

• Increased wholesale price volatility: Temporary price movements may lead to enormous cashflows (in and out) and hence bankruptcy

Need for risk and capital management

• Better understand/manage and price risk exposure

• Manage capital base to meet shareholder's ROE expectations and avoid bankruptcy

Shareholder expectation

• P&L-squeeze leads to stock market underperformance

• Increased risk and hence downgrading increases return expectations further

• Underperformers will become takeover candidates

The new market paradigm for the Russian power energy

Identification - Russia1


Price risks shell be evaluated basing on the system of interconnected quantitative indicators

EBIT

Absoluterisk indicators

EBIT@risk

- +

Relativerisk indicators

e.g. RORAC

e.g. EBIT@risk

Absolute financial indicators

e.g. EBIT

- +

negative deviation

positivedeviation

Budget value

• Actually observed value (e.g. EBIT 2002)• Estimated value (e.g. EBIT 2004)

• Variates and their propabilities• Different indicators, e.g.:

– Mean– Threshold– Maximum value

• Financial result of the company's is liked to the risk to be taken in order to achieve this result

• VaR is used as this risk indicator

Assessment – best practice2


Because of the high price volatility and shortage of the historical data, _@R indicators on the Russian power market shell be calculated using parametric approaches which best suit the price dynamic

Russian spot price dynamic: equilibrium price index, Europe zone [RUB] Possible instruments for the VaR calculation

• Historical simulation approach

• Monte Carlo simulation

• Parametric approaches, e.g.• Autoregressive model of returns with constant

variance (AR-ConVar)• Autoregressive model of returns with errors

following EGARCH process with Normal or t-distribution of quantiles (

• AR-EGARCH approach using Extreme value theory by dividing residuals on "extreme" and "normal" and modeling them separately

1 200

1 000

800

600

400

200

• high price volatility • occasional price spikes • mean reversion• empirical distribution of returns with a non-standard shape

To be used on the Russian power market

Assessment - Russia2

01.09.2006 17.11.2008

10% 25%share of liberalized market


On the free power market risk strategy requires to clarify trading role and risk appetite

Speculator

• Exploit arbitrage opportunities

Degree of hedging

Trading role

Low High

Generate additional profit

Support current assets

Market maker

• Develop and sell complex risk management products

Operational hedger

• Support basic operational needs (supply management, process balancing)

Risk mitigator

• Reduce risks of underlying business

Navigation – best practice3


In fact, now market players choose between a free spot price and a regulated tariff, which is fixed for one year

Russian wholesale market: electricity

ForwardSpot

Exchange

Contracts with physical

delivery

OTC bilateral contracts

Exchange


delivery

Financial contracts


delivery

Financial contracts

Balancing


delivery

Exchange

Existing segments Planned segments

Navigation – Russia3

TariffSpot price

VS

Segment to be eliminated after 2011


After 2011 Russian power market players will have to make their choice between the possible trading roles

14

Characte-ristics

• Procure supply and dispose of product at market prices to meet asset requirements

• Extend beyond asset requirements to capture favorable market opportunities

• Use assets to conduct physical trades for profit

• Close arbitrages

• Execute back-to-back deals

• No net trade positions held

• Capture bid-ask spread

• Develop and sell complex risk management products

• Take long- or short-term positions with no offsets

System trading

Arbitrage

Market making

SpeculationProfit potential

Sophistication

Asset optimization

Navigation – Russia: solutions3


ASSET OPTIMIZATION

• Asset optimization involves trading to fulfill basic operational needs and contractual obligations of an organization. Asset optimizers purchase and sell commodities at levels supportive of their assets and do not look to profit from purchases or sales in excess of system needs

• Reduce supply costs such as transportation, inventory carry costs, and back-office transaction costs

• Protect asset-operation margins by capturing/ diverting distress cargoes

• Maximizes day-to-day margins by optimizing asset economics• Manages niche market supply and demand to protect asset margins



SYSTEM TRADING

• Trade commodity beyond system needs to “shield his position” and protect his margins

• Leverages asset position, unique knowledge, and risk management expertise to create additional value

• Anticipates price changes and purchase/sell quantities to capitalize on them

• Hedges against positions taken to optimize assets

• System trading uses operational needs of a system as the basis for trading decisions, but extends beyond asset optimization to purchase and sell in excess of system needs to capitalize on favorable market prices. A system trader might purchase excess quantity with intent to store and resell at a later date for profit or to conceal his asset positions



ARBITRAGE

• Profit from superior knowledge of market dynamics and information without taking on significant additional risk

• Arbitrageurs attempt to profit from price differentials in different markets for same or related commodities. They manage risk by simultaneously buying in one market and selling in another



MARKET MAKING

• Provide liquidity by offering to provide a price and buy and/or sell at all times

• Construct and sell risk management products of physical and paper positions

• Creating a market outside of major commodity exchanges

• Managing a book and the inherent risks

• Market makers quote “buy’’ (ask) and “sell’’ (bid) prices for a given commodity. Their purpose is to keep a balanced position by holding a book with matching long and short positions. They make money by capturing the buy/sell differential (i.e., the bid/ask spread)



SPECULATION

• Profit from anticipated but uncertain changes in prices by leveraging proprietary information

• Provide liquidity to the marketplace• Speed up arbitrage and price discovery

• Take on outright long or short positions in commodities in which he/she has superior information

• Speculators take outright (i.e., fully exposed) long or short positions in physical/financial markets with the objective of achieving profits through the successful anticipation of future price movements. Speculators leverage proprietary information and take on risks with the objective of capturing profits


1Conference_presentation_15_09_2009.pptx "A4rb_standard" – 20090407 – do not delete this text object! Moscow, 15.09.2009 Workshop presentation Anastassia.

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