How are energy price indexes used in global markets?

How are energy price indexes used in global markets?

Energy price indexes are used in global markets to track energy cost changes across the market. They’re utilised by most participants involved in the energy market, including traders, utilities, and corporates and help to identify fluctuations in pricing as well as movement within the market. Elements that inform energy pricing indexes include the behaviours or the wholesale fossil fuel market, as well as commodity pricing and consumer behaviour. Traders and energy producers tend to apply them for trading, hedging, procurement, reporting and risk management.

What is an energy price index?

Energy price indexes are a standardised price measure that can be applied to several changes in the market. This might include a commodity, such as oil, or it might relate to a specific location, such as a geographical area, to provide more targeted local pricing. Other elements considered are time, which tracks energy pricing over a certain time period. 

Typical data points put into energy price indexes might include trades, which examine genuine transactions that have happened. Bids or offers concern potential transactions reflected in selling or being interested from parties, while assessed prices look at averages of an energy asset over a certain period; a Volume-Weighted Average Price (VWAP) can be calculated by looking at that average over a single day.

Indexes are essential in the context of the energy market because they can become a common reference for financial activity such as deals, hedges, and valuations.

Major index families across commodities

A list of benchmarks across trade and index families gives sectors the ability to track different investment information across various sectors and more. In the power industry, day-ahead allows prices to be set the day before they are purchased, allowing companies to buy or sell half-hour increments of energy based in perceived demand. Real-time market, on the other hand, determines prices at the exact moment they are required, or within a few minutes. This allows it to be more reactive to market changes and pricing. Nodal or area prices set energy prices based on locations throughout the grid, known as nodes. This creates pricing specific for particular regions, offering affordability and efficiency. EPADs are typically used in Australia, which pays generators the true value of the energy they distribute, accounting for contingencies such as network issues. Specific gas index family hubs include TTF, NBP and Henry Hub. In the coal and carbon industries, API coal indexes are one example of index families, with API 2 (Rotterdam), API 4 (Richards Bay), and API 8 (Indonesian) being three of the most prolific.

How indexes are constructed?

Indexes are constructed from several sources before being benchmarked and run against time and governance factors:

• Data sources: data is gathered from several locations, including exchange trades, broker runs, bilateral prints and specific reporting windows.

• Methods: energy assets can then be averaged via VWAP or assessed benchmarks, as well as examining liquidity thresholds and outlier filters applied to data sources to get a more accurate view.

• Time granularity: a time factor can be added to energy data to achieve time granularity, such as hourly, as used in power, as well as daily, weekly, and monthly, which is more common in gas, oil and LNG.

• Governance: methodology updates, audits, and transparency notes.

How do traders and risk teams use indexes?

Traders can use indexes to more closely control how they trade and swap power on the energy market:

• Hedging: traders can use financial tools such as futures, swaps, as option to settle on an index, as well as margining and VaR.

• Spread trades: are more concerned with location (basis), time (calendar vs prompt), and cross-commodity (spark/dark).

• Intraday vs day-ahead signals: these factors allow prices to be shaped from hourly to baseload blocks.

How corporates and utilities use indexes

Corporations and utilities can use indexes to help inform energy contracts as well as ethical goals. 

• Procurement: in procurements, corporates can use indexes to help inform linked supply contracts as well as integrating caps, floors and collars.

• PPAs: Power purchase agreements (PPAs) can be shaped by indexing, building in elements such as as-generated vs baseload structures, which help to both shape and imbalance risk.

• Accounting: accounting can benefit from the mark-to-market valuations of indexing, as well as increasing hedge effectiveness and making audit trails clearer.

• ESG and compliance: environmental, societal and governance goals can use carbon price indexes to help determine internal carbon price tests, as well as to inform compliance transparency. 

Common risks when using indexes

While indexes can impact knowledge to participants within the energy industry, they also come with risk: 

Basis risk

A spot price applied at the plan location may change from the hub price, such as on the wholesale market. This can be affected by grid problems, including interconnector congestion.

Shaping risk

This is where a difference occurs between hourly production vs baseload settlement that may be set in fixed PPA energy contracts, which eventually results in profile penalties.

Liquidity risk

Settlement uncertainty can arise when thin markets - the low amount of both buyers and sellers - inflate slippage and affect index pricing. 

Regime risk

Elements like methodology changes, market reforms or price cap rules can make certain trades more risky. 

Choosing the right index for your strategy

Many businesses use a decision checklist to help determine what kind of index might be suitable for their operations. This may include examining liquidity, correlation with load/asset, as well as the contract tenor and market volatility. Indexes can also help to address data hygiene - it’s important to use unit conversions as well as calendar alignment and holidays. When choosing the right index, back-testing is crucial, giving an overview of hypothetical scenarios to test hedge fit and stress scenarios before committing to a specific index. 

Use energy price indexes wisely: align to load and tenor, back-test hedges, and manage basis, shaping, liquidity and regime risks to improve outcomes over time.