What is a swap agreement and how does it work in the energy market?

What is a swap agreement and how does it work in the energy market?

Swap agreements are an essential financial instrument for managing volatility, they allow investors, consumers and energy producers the opportunity to hedge against energy price rises and reduce risk.

A key relationship between a buyer, seller and intermediaries, swap agreements can ensure price stability for market participants as well as support long-term energy investment strategies.

Swap agreements have been around in some shape or form since the 1980s. They are a financial agreement which involves one party, for example, a large energy provider, paying one rate for energy, while the other participant purchases energy at a differing rate or swaps cash flow to make up the difference. 

How do swaps differ from other derivatives like futures and options?

There are four main derivatives in energy trading: options, forwards, futures and swaps. Options allow energy buyers the opportunity to buy energy at a set price throughout the contract. In contrast, futures mandate buyers to buy energy at a specific price on a specific date. But how do energy swap agreements work?

Basic mechanics of fixed-for-floating exchanges

Fixed-for-floating contracts allow for one party to take the risk of fluctuations in energy prices while the other agrees to pay a fluctuating price. For example, a large energy provider pays a set rate for energy, while the other participant, usually a large commercial business, agrees to purchase energy from the energy provider for the current - or spot - price. 

Cash-settled vs physically settled swaps

In the trade of oil, electricity or natural gas, there are several ways that swaps can be settled, with cash-settled and physically settled swaps being two of the most common. 

Cash-settled swaps 

The parties that make up a transaction settle by paying losses or gains at the expiry date, paid in cash. 

Physically-settled swaps 

A transaction is settled by equity shares being delivered over a long position.

Types of energy swap contracts

Different parties will require different types of contracts depending on varying factors such as industry and region. There are several options for swap-based contracts. We take a look at three of the most common in the energy market. 

Physical swaps

Physical swaps can occur between two parties who wish to transfer energy between a buyer and a seller or between two markets. These types of agreements are usually delivery-based.

Commodity swaps

In a commodity swap, an exchange cash flow is linked to a commodity price, locking in prices for energy, agriculture and metals for the future. 

Financial swaps

Sometimes in trading, to mitigate risk, traders will want to hedge the price of energy without physically delivering it to the buyer. This is known as a financial swap. 

Why are swaps important for the energy market?

Swaps are an important tool for the energy market, particularly when it comes to the rollout of the renewable energy sector. For example, swaps can help in the instance of energy price volatility. Energy prices can often be subject to volatility, both in the fossil fuel and renewable sectors. Fossil fuels can experience volatility due to outside influences such as geopolitical factors, For example, the war in Ukraine and Russian power. The weather can often lead to volatility in renewable energy due to the unpredictability of weather patterns, which are required to generate energy. Hedging against volatile energy prices makes renewable energy a more viable option for investors concerned with the unpredictability of the energy market. 

Swaps are important for the green sector because they provide alternative purchasing and funding for renewable energy projects that might not otherwise attract funding through mainstream means. Swaps can help to support investment and financing in energy projects. By removing some of the risk factors through mechanisms like hedging, projects can attract investors who might not otherwise want to invest. This secures funding over the lifecycle of a project for a potential renewable energy plant.

All of these elements combine to help improve stability and predictability in the energy market, making the market as a whole a more attractive proposition for investors, securing funding for energy projects for years to come.

Risks and challenges of swap agreements

While swaps can be an attractive option for some parties, they are accompanied by their own unique risks and challenges. Counterparty risk and default is something for parties entering swaps to bear in mind. Swap types, such as futures, for example, have almost no counterparty risk due to margining. Forwards, however, do bear the risk of default when associated with swaps. 

Market liquidity issues are also a commonplace worry; certain European markets have seen volatility in the last couple of years, which has resulted in large margin cells, accompanied by liquidity risks. 

Regulatory and compliance considerations also come into play, globally, these are fragmented in relation to energy derivatives, though some organisations are attempting to address this fragmentation. In Europe, REMIT (Regulation on Energy Market Integrity and Transparency) prohibits insider trading and market manipulation, mandating detailed reporting about their transactions to the Agency for the Cooperation of Energy Regulators (ACER). REMIT follows three broad mantras: transparency, monitoring and cooperation, which have been the key to the organisation's success.

In summary, swaps can stabilise cashflows, de-risk projects and support renewables; but they succeed only with liquidity, risk controls, credit checks and clear rules now.

References:

Social Science Research Network - Counterparty Risk Valuation for Energy-Commodities Swaps: Impact of Volatilities and Correlation

European Central Bank: Eurosystem - Financial stability risks from energy derivatives markets