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Vibhuti Garg, IEEFA Energy Economist, Lead India

June 2021

Deepening India’s Short-Term

Power Market With Derivatives
New Financial Products Will Boost National
Trading of Renewable Energy
Introduction
Long-term power contracts dominate the Indian electricity sector. Power purchase
agreements (PPAs), with tenures of 25 years, comprise 88% of the overall traded
volumes. While providing investors with certainty over a long duration and de-
risking from price volatility, the growing implications of these PPAs need to be
addressed to aid the financial viability of state distribution companies (discoms).

In the wholesale market, liquidity in the short-term market has increased over the
years, although the overall volume is still low. Short-term bilateral contracts traded
up to 3 months in advance of delivery comprise 3-4% of the volume; the day-ahead
market comprises another 5-6%; and the balance of 1-2% is Unscheduled
Interchange (UI).

June 2020 saw the introduction of the

real-time market with price discovery
through double-sided closed auctions
which happen every half hour for two 15-
minute time blocks, one-hour ahead on
the power exchange. Further, in August
2020 the Green Term Ahead Market The introduction of green
(GTAM) for trading renewable energy was markets on the national
launched. The introduction of green exchange platform is
markets on the national exchange
platform is a significant milestone that a significant milestone.
will enable consumers to make a
sustainable choice, help the government
to achieve its renewable energy goals and
enable integration of renewable energy in
the most flexible and efficient way.

In April 2021, the Indian Energy Exchange (IEX) commenced the Cross Border
Electricity Trade (CBET) on its platform, with the aim of building an integrated
South Asian regional power market in support of the One World One Sun One Grid
ambition of the Government of India, developing a green electricity export market.

With the massive deflationary effect of renewable energy, discoms are becoming
increasingly wary of signing long-term PPAs, thereby impacting development of
new renewable projects in the absence of off-taker certainty. Long dated two-part
PPAs for many coal power plants also undermine India’s ability to retire expensive,
Deepening India's Short-Term Power Market
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polluting end-of-life coal-fired power plants. Discoms are struggling with huge
financial losses, with total debt projected to hit an all-time high of Rs4.5 lakh crore
(US$61bn) in FY2020/21.1

In order to ease their financial burden, the discoms need to be unshackled from
expensive long-term PPAs with old, inefficient plants. The long-term PPAs are rigid
contracts that underwrite the capital cost (financing and depreciation) of the old
plants without providing value for customers. India now needs to transition
towards development of financial products in the derivative (or financial) electricity
market that developers could utilise to hedge risk without requiring the signing of
long-term PPAs for the financial closure of projects.

An Overview of the Indian Physical and Financial Electricity Markets

Source: IEEFA.

1ET Energy World. Discom debt to hit all-time high of Rs 4.5 lakh crore in 2020-21: CRISIL. June
2020.
Deepening India's Short-Term Power Market
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Stagnating Short-Term Market Needs Innovative

Products
The short-term market has evolved over the years with the introduction of a variety
of products which have led to an increase in liquidity and can provide efficient
discovery of prices. The figure below shows the volume of electricity transacted in
the short-term market, which has stagnated at 10-12% of total electricity
generation. Growth is consistent with the underlying market volume of electricity
transacted which has increased at a Compound Annual Growth Rate (CAGR) of 6%
from fiscal year (FY) 2010/11 to FY2020/21.

Figure 1: Volume of Short-Term Transactions of Electricity Relative to

Total Electricity Generation, 2010-11 to 2020-21

Source: CERC Annual Report on Short-term Power Market 2019-20, CERC Monthly Market
Monitoring Reports 2020-21.

The volume of electricity transacted through traders and power exchanges as a

percentage of the total volume of short-term transactions is ~60%. At the Indian
Energy Exchange (IEX), the electricity market achieved an all-time high volume of
74BU during 2020/21 leading to 37.2% YoY growth, a significant market share
gain.2

The weighted average price of electricity transacted through traders and power
exchanges declined from Rs4.79/kWh and Rs3.47/kWh respectively in 2010/11 to
Rs3.50/kWh and Rs2.86/kWh respectively in 2020/21. The prices were high in
2008/09 and 2009/10 when the power exchange was established and volumes
were low. With huge generation capacity added, and with supply exceeding demand
during most hours of the day, prices in the short-term market have gone down and
stabilised over the years.

2 IEX. Power Market Update. April 2021.

Deepening India's Short-Term Power Market
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Figure 2: Price of Electricity Transacted Through Traders and Power

Exchanges

4.5

4
RS/KWH

3.5

2.5

2
2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21

Price of Electricity transacted through Traders Price of Electricity transacted through Power Exchanges

Min 3.50 2.50

Max 4.79 4.26
Average 4.13 3.29

Source: CERC Annual Report on Short-term Power Market 2019-20, CERC Monthly Market
Monitoring Reports 2020-21.

Analysis of electricity prices transacted by traders during round-the-clock (RTC),

peak and off-peak periods shows that the price during peak periods is higher than
the price during RTC and off-peak periods.

The launch in June 2020 of the real-time electricity market (RTM) on the IEX has
benefited renewable energy generators. The RTM allows them to sell their
unanticipated surpluses and earn additional revenues. Data reveals that volume in
the RTM picked up from 515MU3 in June 2020 to as high as 1473MU in April 2021.
The weighted average price is ~Rs2.9/kWh, while the maximum price during the
period June 2020 to April 2021 is Rs10/kWh.

In August 2020, a new product, the Green Term-Ahead Market (GTAM), further
facilitated sale of renewable energy on the power exchange. About 786MU volume
was traded in this market during August 2020 to March 2021.4 The market has
enabled distribution utilities, industrial consumers and green generators to buy and
sell green power while also fulfilling their Renewable Purchase Obligation (RPO) in

3 1MU (Million Units) = 1GWh and 1BU (Billion Units) = 1 TWh.

4 IEX. Power Market Update. April 2021.
Deepening India's Short-Term Power Market
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the most competitive way.

Another milestone was achieved when the government allowed electricity to be

traded like other commodities with forward contracts and derivatives on
exchanges.5 Delivery-based long-term contracts are likely to be traded on power
exchanges under Central Electricity Regulatory Commission (CERC) jurisdiction,
and the derivative contracts are likely to be traded on commodity exchanges under
Securities and Exchange Board of India (SEBI). This will pave the way for the
introduction of long duration, delivery-based contracts on the power exchanges and
allow discoms to lower their power purchase costs and hedge their risk.

Next Step in Power Market Development

Need for Derivatives Market
Discoms are reeling under huge losses and in recent years have not been signing
long-term PPAs with power developers. As a result, there is a large number of
unsigned PPAs, which puts at risk future development of additional renewable
energy capacity.

Delays in signing PPAs are a bottleneck in

the growth of renewable energy capacity
in India, jeopardising the government’s
renewable energy targets of 175
gigawatts (GW) by 2022 and 450GW by
2030, dampening investor confidence and
threatening the viability of new projects.
The introduction of financial instruments
Delays in signing PPAs
in the derivative market will help in are a bottleneck in
hedging the offtaker risk and provide the growth of renewable
flexibility and certainty of supply to both
discoms and developers for sale of power
energy capacity.
in the futures market, and should help
develop the price signal needed to
incentivise supply into peak demand
periods – the key to enabling battery
deployments and demand response
management.

Discoms with their power optimisation tools, can also participate in derivative
markets and hedge their risk. This will help discoms to lower their power
purchasing costs and also prevent them from being saddled with the inflexibility of
long-term PPAs as electricity demand profiles change. Discoms will have the
flexibility to buy power based on demand. This is important because demand is
evolving as rising incomes lead to greater penetration of both energy-intensive and
energy-efficient products, and electricity storage.

5 ET Energyworld. Govt Allows Electricity Derivatives, Forward Contracts. 15 July, 2020.

Deepening India's Short-Term Power Market
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The derivatives market will provide the vibrancy by increasing trade volumes and
encourage more participants by separating the physical delivery of electricity from
the financial settlement. This will allow hedgers, speculators and a host of other
participants to trade in the electricity market.

The derivatives market will also provide

diversified avenues for supply, higher
visibility of a more reliable forward price
curve and transparency in power pricing. The derivatives market
It will enable the transfer of risk from
entities that have it but may not want it to
will provide a forward
those with an appetite for it, which further price curve that will
enables market participants to expand help in making
their volume of activity. Moreover, prices
in the derivatives market will reflect the
investment decisions.
collective perception of market
participants about the future.

Currently, the practice is to extrapolate the price trends in the day-ahead or term-
ahead market. The derivatives market will provide a forward price curve that will
help in making investment decisions. With an increasing share of renewable energy,
the derivatives market will provide avenues for sale with price certainty, thereby
attracting more investment into the sector.

Designing the Derivatives Market

Financial Products
All financial contracts will be derivative contracts, with value derived from the price
of the underlying commodity. These products will perform economic functions such
as transferring risks, discovery of future prices, and increasing saving and
investments in long run.

The products may involve physical delivery of electricity in the future at a specific
time of day or they may be merely a financial instrument for hedgers, speculators
and arbitrageurs. The physical delivery of products will happen on the power
exchanges – Indian Energy Exchange (IEX), Power Exchange India Limited (PXIL)
and the new third exchange Pranurja Solutions Limited (PSL). The financial
contracts will be settled on commodity futures exchanges like Multi Commodity
Exchange of India Limited (MCX) and National Stock Exchange of India Ltd. (NSE).
Deepening India's Short-Term Power Market
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Figure 3: Products in the Derivatives Market

Source: IEEFA analysis.

Upon reaching the due date, the contract is settled at the price, which covers the
difference between the final closing price of the futures contract and the Market
Clearing Price (MCP) on power exchange in the delivery period. The settlement of
futures contracts involves both a daily mark-to-market settlement and a final spot
reference cash settlement. A mark-to-market settlement covers gains or losses from
day-to-day changes in the market price of each contract.

The futures market will allow saleability of hybrid products more easily than the
plain vanilla wind and solar projects. With an increasing share of renewable energy
in the total generation mix, multiple products including wind, solar and biogas,
along with battery storage, are likely to see more demand, and financial markets
could enable the sale of hybrid products. Unlike with an inflexible 25-year long-term
contract, availability of different hybrid products in the financial market could help
to better manage seasonal and peak/time-of-day demand periods.

Reference Price
Electricity is a flow commodity rather than
a stock. Given electricity is not a storable
commodity, the general pricing model of
cost of carry does not work for electricity For buyers and sellers
unless there is a price signal to incentivise
storage by time arbitrage of electricity
to participate in the
delivery. However, India can learn from the derivatives market,
U.S. and European electricity derivatives the right price signal
markets, where reference pricing models
exist for products in the futures market.
needs to be established.
Australia is also illustrative, given the
market in 2021 has moved to a five-minute
Deepening India's Short-Term Power Market
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interval of supply and demand pricing to enhance grid reliability by a stronger short
time interval price signal.

For buyers and sellers to participate in the derivatives market, the right price signal
needs to be established. This price should give signals to investors for new capacity,
particularly of increasingly important storage infrastructure.

How to determine the right reference price? The price at power exchange is a good
start to prevent market manipulation or collusion, or gaming by players. The price
discovery will also take into account other factors such as demand, supply, weather,
temperature, humidity, water storage levels, and events like festivals. Given the
price discovery will be a collective decision by various buyers and sellers, there is
little scope to influence prices.

The average of the unconstrained market clearing price (UMCP) could be used as
the basis for setting up the reference price. If there is no congestion in the
transmission network, there will be one price at the power exchange rather than
different prices for different areas. When there are different area prices due to
network congestion then UMCP will not fully hedge all participants. However, in
order to create liquidity, generally UMCP for base and peak are used for settlement
of futures contracts.

Whether the reference price will be derived from the short-term market or long-
term contracts is a tricky question, given the power exchange volume constitutes
~5% of the total generation share. The optimal duration for determining the
reference price for long-term contracts also needs to be established. How much
difference should there be between the instrument, age and the price signal? These
are questions that need to be answered when designing regulations for determining
the reference price.

For example, a Commercial and Industrial (C&I) consumer would like to hedge its
landed cost which includes open access charges. Such charges are fixed for a year
and revised by the regulatory commission at least every six months. However, the
open access charges cannot be accounted in the financial market. Open access
charges are regulated and not market based, so designing an instrument that takes
care of such charges is difficult.

Timelines for Launch of Products

When designing products in the financial
market, the mantra should be to keep
them simple, stable and standardised,
increase the liquidity in those products A variety of financial
and then gradually bring more products instruments could
into the market. To begin with, futures
be created once
and options should be considered for
trading in the financial market. The the market matures.
products could be launched for weekly,
fortnightly, monthly and then also
Deepening India's Short-Term Power Market
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quarterly contracts to reflect seasonal changes. The type of products in these

markets could be RTC or peak products based on the unconstrained market clearing
price. As the markets evolve and liquidity in these products goes up, more products
can be added.

More innovative products like weather derivatives linked with electricity

derivatives could be launched. To address the issue of congestion in the
transmission network, another product for congestion management could be
introduced. A variety of financial instruments could be created once the market
matures, providing lot of scope for innovative products to be launched in the
derivatives market going forward.

In the derivatives market, the contract should be standardised. Parameters such as

type of settlement, delivery point, timelines for clearing and settlement, margins and
delivery process need to be defined properly. The trading system should provide an
interface for accepting bids and offers that includes price/quantity/tenure, and the
ability to trade on a continuous trade basis.

Risk Management
In order to mitigate the risk of market
manipulation or gaming by players, a
surveillance mechanism needs to be put in
place. A real-time surveillance mechanism Events in Australia
which prevents collusion by players and
influencing of price needs to be
show an independent
established. surveillance and
assessment capacity
Events in Australia show an independent
surveillance and assessment capacity is is needed to
needed to prevent gaming e.g. prevent gaming.
withholding supply at times major plants
or grid links are scheduled to be offline, as
happened twice in May 2021.

Further, contract sanctity and payment of charges needs to be ensured. The Clearing
Corporation provides the counter-party risk and that requires counter-party risks to
be borne by the exchange and/or clearing corporation. Such counter-party risk is
managed through margins and collaterals specified under contract specifications.

Way Forward
The national electricity market already has a robust basic structure in place, and
now the regulator and the market participants are gearing up for the successful
launch and implementation of the derivatives market. This should help provide
price discovery and transparency to assist in two-way power flow markets and
incentivise the rollout of new storage investments.

IEEFA notes that liquidity will increase in the short-term market with the
Deepening India's Short-Term Power Market
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introduction of the financial market. The financial and physical electricity market
will complement each other. Further, the physical delivery market is also likely to
witness increased liquidity as risk will be minimised by reducing volatility on
account of extreme events.

A spot market at power exchanges and the derivatives market will feed into each
other. It will be a virtuous cycle wherein the derivatives market will establish
forward prices, more participants will shift from PPAs to exchanges, thereby
increasing liquidity in derivatives and subsequent increasing of liquidity in spot
market at power exchanges and vice versa.

The derivatives market will be lucrative for players including developers, discoms,
open access buyers, traders, investors in the power sector and others who also have
the ability to take on risk. It opens up the market for many more participants who
don’t want to own an asset, thereby increasing liquidity in the market.

While the prices in the short-term market have stabilised over the years, there is
still variation on account of seasonality, weather, festivals etc. Less volatility in
short-term prices does not negate the need for the financial markets. In fact, it is
beneficial as the margins to reference price will not be very high.

Furthermore, electricity as a commodity

cannot be stored absent large-scale
battery and pumped hydro storage. Thus,
the price volatility will always be there as
the price is determined by demand and Electricity as a commodity
supply during each block of the day. The cannot be stored absent
financial market enables avoidance of the large-scale battery and
vagaries of demand and supply and
thereby price variation on a day-to-day pumped hydro storage.
basis. The contract is settled at the price
prevailing at the date of the end of the
contract period.

IEEFA notes that the derivatives market will be a boon for renewable energy
developers, both for existing projects with untied PPAs as well as for projects under
the development phase for sale in the financial market. Also, stranded gas peaking
power plants may find buyers in the financial market, if a separate derivative
product for gas-powered plants were to be created linking the time of delivery price,
possibly with the input price of gas to help solve the financial stranding of much of
India’s gas-based electricity capacity.

The electricity derivatives market in India is likely to take shape in 2021. With the
resolution on the jurisdiction of power between CERC and SEBI, a joint working
group by the Ministry of Power will be established. The role of the working group
will be to vet the contracts for the derivatives market and determine the types of
contracts that need to be introduced etc., which will be approved by SEBI for the
launch of products on NSE or MCX. CERC will be required to notify the Power
Market Regulation detailing the roles and responsibilities, market clearing
mechanism etc. in greater detail.
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About IEEFA
The Institute for Energy Economics and Financial Analysis (IEEFA) examines
issues related to energy markets, trends and policies. The Institute’s mission
is to accelerate the transition to a diverse, sustainable and profitable energy
economy. www.ieefa.org

About the Author

Vibhuti Garg
IEEFA Energy Economist, Lead India Vibhuti Garg has advised private and
public sector clients on commercial and market entry strategies, investment
diligence on power projects and the impact of power sector performance on
state finances. She also works on international energy governance, energy
transition, energy access, reallocation of fossil fuel subsidy expenditure to
clean energy, energy pricing and tariff reforms. vgarg@ieefa.org