How undervalued cross border capacities really are?
With auctions for yearly cross border capacities less than two weeks away it might help shed some light on the pricing mechanism behind cross border capacities.
Transmission rights are spread options
Talking about pricing only makes sense when one considers cross border capacities as a financial instrument. But what kind of financial instrument are we talking about? Most cross border capacities give the owner the right but not the obligation to transfer electricity between borders for a limited period of time. Since the owner of the capacity will only ‘exercise’ the capacity (transport electricity or collect rent) when the difference between the two cross border markets is positive the financial consequence of owning the capacity can only be positive (disregarding those cases where the right is nominated and not closed before this since this transforms the TR into a forwad). Same holds for financial transmission rights without the need to transport electricity and just getting the payoff between the two markets in case of positive price difference. Having said that, an instrument, which can only bring profit (or zero) at maturity, should have positive value at the time of the sale (auction). Since the payoff in any time depends on the difference between the spread on two cross border markets the capacity acts in effect as a call option on the spread between prices of the two markets.
What is new and why does it make sense to invest in cross border capacities?
If one looks at the aforementioned explanation it is seems clear how to determine prices of cross border capacities.
1. Treat them as spread option.
2. Determine all the necessary parameters required by the formulae for spread options.
3. Make a bid below the theoretical price.
So far so good but there are two problems with this approach:
One, in reality the yearly PTR’s are not a collection of European spread options (as some authors claim) but double American Spread options and some more. Whoa! If it sounds complicated, it really is, therefore the value can only be determined numerically. With the exception of sounding fancy and being a good pick up line for girls at Emart or Eworld (trust me it is not) the coding behind the pricing is fairly straightforward. The important takeaway from this is that even if we use a simple model like a call spread option, the capacity or FTR is going to be worth more in reality.
Secondly, even if one uses a simple proxy model such as a European call spread option to determine the price, when back-testing we can see that the bidders in most cases undervalue the prices of FTR’s and PTR’s. Even more, by segmenting the bids one can check that the contracts with the most optionality were the ones that were the most undervalued.
In layman’s terms this means that most of the bidders on the market disregard the optionality of the instrument and use the capacity to hedge their physical positions in the cross border markets. As an example see what the returns would have been in the past if one invested in transmission capacities (GER – FR) with high option value compared to price, versus a random strategy.
– The price you should bid is equal to the difference between yearly futures and then some.
– In reality the best proxy for the value is sum of positive differences between HPFCs at the time of the bid and a markup.
– The markup should be higher for markets with high volatility of futures/forward prices and high volatility of spot market.
– The price should also be higher with lower reversion to the mean; in other words if the supply curve is relatively flat. The longer the spikes are – expected to persist the more revenue one gets from having the transmission right.
The more the market is liquid the higher the price you should bid.
There is optimal time to exercise the transmission right – lock in the intrinsic value via taking offsetting position on monthly futures (long one part of the border, short other part of the border).