Is India Ready for Introduction of Financial Markets in Power Sector?

India's power system is undergoing a transition to cleaner electricity, powered by a 175 GW national renewable energy target by 2022 and a 450 GW national renewable energy goal by 2030. As of 2020, however, traditional generation still dominates the power mix of India, with 205 GW (55 percent) of coal and lignite and 25 GW (7 percent) of gas of 374 GW. On the basis of the 2020 annual peak demand of 177 GW and considering non-firm power, losses and outages, there is an embedded capacity surplus of around 10 percent (60-90 GW). At over 90 GW (24 percent), renewables (including small hydro, biomass, waste, solar PV and wind) constitute the second largest source, followed by large hydro power at over 46 GW (12 percent). There are numerous new coal-fired power plants planned in the short term, while a few states, such as Gujarat, have committed to no new coal power plants beyond 2021.

India has set a 9 percent target growth rate that would put it on a track to become a USD 5 trillion economy by 2024-25, making it the world's fastest-growing large economy. Sustained economic growth in India puts a huge pressure on its energy resources, energy systems and infrastructure.

Solar PV and wind production grew from 4 percent to 12 percent of annual electricity generation between 2016 and 2019. The scenario at the state level is very diverse. Andhra Pradesh, Gujarat, Karnataka, Rajasthan, Tamil Nadu and Telangana have a higher solar and wind share of 25% and are already facing major challenges in system integration. India's end-user industrial electricity prices at USD 99/MWh are substantially higher on a nominal basis than residential prices at USD 69/MWh. This is due to substantial government funding by cross-subsidization from industry to vulnerable households and agricultural consumers. Significant numbers of industrial users in India are motivated by high industrial prices to pursue the advantage of open-access contracts, with prices on average 20% to 30% lower than utility prices. Electricity affordability, again illustrated by Covid-19, is still a big problem in India in 2020. In international contrast, residential prices based on purchasing power parity are very high despite being subsidized and slightly lower than industrial prices.

In South Asia and the ASEAN region, the Indian wholesale energy market is the most important one. Since 2008, India has had competitive power markets, although only a reasonably small proportion of all electricity is exchanged through power exchanges. On the India Energy Exchange (IEX), over 95% of the electricity traded in 2019 was sold and the remainder on Power Exchange India Limited (PXIL).

Covid-19 and the resulting decline in demand had a huge effect on the wholesale trade in electricity. First in 2020, wholesale prices were approximately 29 percent lower on average at INR 2.5/kWh (in the range of INR 2-4/kWh) in the day-ahead market between March and September than in the previous year. Secondly, the volume of trading increased compared to the previous year; for all business segments, this growth stood at about 44 percent in September 2020. Multiple factors have guided the rise in volume: utilities prefer short-term trade as compared to business-as-usual three-to-nine-month contracts in the light of unforeseeable demand patterns; in addition, utilities sell their surplus volumes due to lower demand for electricity for market sales; and finally, driven by lower prices, some utilities have replaced their contracted generation. Several reforms are being made in order to improve competitiveness and transparency in the sector. Today in India, the power market is a surplus market, and spot prices are dropping day by day. The introduction of derivatives to the power market comes at the right time, with all these indicators indicating a journey towards India's mature power market.

Current Scenario

In India, there is a long debate about the treatment of electricity as a service or a commodity and the general view appears to change to electricity as a commodity and thus to a similar treatment. Electricity, however, differs greatly from other goods with certain properties that are only peculiar to it. Except for extremely expensive storage systems, energy cannot be stored. As a system default, there will always be a mismatch between power supply and consumption as opposed to contracted power, thereby requiring a settlement balancing mechanism. It cannot be transported unidirectionally because its flow is contingent on the availability of grids and the control of congestion. Unlike every other commodity, its interdependency with other ancillary services is well known. Accordingly, the treatment of electricity as a commodity cannot be contrasted with other commodities available on the market and thus needs special treatment. Electricity trading as a commodity is well established in India. In the electricity exchanges, electricity is currently being exchanged as DAM (Day Ahead Market) and TAM (Term Ahead Market). Trading of electricity in the real time market has recently begun and any constraints on the organizational and technological side are closely monitored. In this case, the launch of the futures market would not only be a shot in the arm for traders, but for all other stakeholders as well. Currently, power purchases by distribution companies are primarily connected to power generators for a period of 20 to 25 years via long-term PPAs. These long-term PPAs make up about 80 percent to 90 percent of their portfolio of power procurement. Bilateral trade, OTC or spot market transactions provide the rest of the power. The long-term PPA agreement offers less flexibility for the portfolio to be strategically built to suit their need to reduce their total procurement costs. Even if they decide not to schedule the PPA electricity, they must provide the generators with capacity charges as fixed cost compensation. With the stabilization of base load for distribution companies with less variation due to incremental demand, they need more power to plan their procurement strategy effectively. Apparently, the only way to do this is to reduce the total cost efficiently in the spot market, where the volume of transactions is not that enormous. With the advent of the futures market, with negotiation and precise market price forecasting, there would be potential for them to reduce the cost of power procurement. With the right details, the transaction costs can be significantly reduced at the right time for the buyers.

Market Regulator – CERC or SEBI?

If CERC is given the power to regulate electricity derivatives, the Sectoral Electricity Regulators will also be assigned responsibility for regulating electricity derivatives. As Parliament intended to control the Centre and not state regulators for this reason, this would be a significant invasion of the Seventh Schedule. In order to prevent the incidence of systemic risk, all traders dealing in the derivatives market must maintain a margin account with the particular exchange in which they are trading for that specific commodity. Therefore, if there is a default, it is unsustainable to say that SEBI would regulate all other derivative transactions of commodities in that particular exchange, but CERC will regulate electricity alone. This will cause grave inconvenience in the functioning of these exchanges as they will have to abide by rules set by both the Financial Market Regulator as well as the Electricity Regulator.

The purpose of SEBI is to protect the interests of all investors trading in the financial market and not just electricity traders. The interest of the electricity regulator, however would be primarily to protect its respective customers and to ensure the welfare of electricity on the market as a commodity.

Therefore, if there is a big fraud in the financial market that also involves transactions in electricity and other commodities, it will be an embarrassment for CERC to interfere when SEBI is carrying out its functions to stabilize the market. In order to avoid uncertainty and unpredictability in commodity prices, SEBI controls the Derivative Market. It would breach its objective as a regulator of the Derivative Market to prohibit it from doing so with electricity. There are rumours in the media that soon after they come to a common understanding of the settlement, the jurisdiction dispute between CERC and SEBI will be sorted out. SEBI is expected to look at the financial transactions and settlements in futures contract trading and CERC is expected to look at the physical execution of contracts with the price and amount concerned. While the initial hurdles regarding the settlement of contracts will be resolved through mutual understanding by the two regulators, the operational, design and technical part will take some time to establish.

Role of Various Market Participants

It will open up a multitude of start-ups offering predictive pricing tools from the business opportunity perspective. Present research and consultancy firms can also have new methods and techniques for forecasting the volume and price of futures. Several instruments and techniques may be developed to accurately forecast the market based on different macro and micro parameters, such as economic scenarios, industrial development, socio-political scenarios, etc. As far as speculation is concerned, at this point in time it seems difficult as the market is dominated by a large number of players from both the manufacturers and the buyers. In addition, there is intense competition from power traders, and new participants will enter the market. The surplus demand situation and fewer margins often provide less bandwidth for the market game.

Historical Milestones

In 2020, the Indian Power Market has reached two historical milestones:

? The Real-Time Power Market in India was introduced in June 2020, filling a major gap by offering real-time corrections (an hour ahead) for intermittent and variable generation, such as solar and wind. Just a few months after the launch of the market, the market has already seen substantial trading rates and a large number of investors. The price volatility of the real-time market has been higher than that of the day-to-day market, but prices are usually lower on average, at INR 2.36/kWh on average, and prices appear to converge on the day-to-day market.

? August 2020 marked the introduction of the "Green Market" on the IEX, where green electricity is traded at an INR 3.4/kWh (within the range of INR 3-3.8/kWh) premium (compared to the standard day ahead market) for consumers trying to meet their Renewables Procurement Obligations through market purchases. International Power Markets – Creation of Exchange Marketplaces

International Power Markets

France

? Generation concentrated with top player (>90% share); 60%+ nuclear generation with stable supply

? Power retail completely liberalized

? Launch of spot & derivatives exchange in 2001-04, however penetration has been low (20-25%)

Germany

? Market liberalized in 1998 -> territorial monopolies removed; generation/retail opened for competition

? ~50% coal/gas/nuclear based generation -> relatively stable supply

? Spot & derivatives launched simultaneously in 2001 Nordic

? Liberalization of power sector (1990-95)

- Unbundling of generation and transmission

? Launch of spot exchange in 1993 (Norway), common market established by 1993-2000

? 50%+ hydro based generation

- Supply fluctuation leads to high seasonal price variance

- Led to early launch of derivatives in 1996

Singapore

? Launch of spot exchange (2003) -> move from cost plus to market-based pricing; mandatory participation on exchange

? Imported natural gas-based generation share increased from 20% (1999) to 95% (2015); market-linked gas price led to price volatility

? Launch of electricity derivatives in 2015 to hedge against volatility

Key Takeaways from Liberalization of Energy Market in Europe

Energy markets liberalization introduced competition among market players by reshaping a traditionally conservative and vertically integrated sector of wholesale energy production and trading. One of the features of this structural evolution was the development of new market players, including modern energy exchanges. In a liberalized energy market, exchanges play a fundamental role: as well as bringing together supply and demand from different types of market participants, they allow market participants to anonymously display their true willingness to pay for their production costs in the process. Matching these bids and offers helps to create a fair and efficient price which is available to all participants, as well as communicated externally, so there is a level playing field within the market, which can also be used outside it. During the liberalization of the energy sector in the EU, and worldwide, electricity and gas trading dramatically increased in many countries and Europe saw a wave of new energy exchanges and over-the-counter (OTC) markets emerging.

Conclusion

With the addition of newer and innovative products, exchanges will see its portfolio basket offering various new products to its customers. No doubt, the customers base will see a surge with both suppliers, buyers joining the race. Operational and structural issues would require some time to stabilize. Also, the right technology with integrated ICT tools will be a prerequisite for ensuring transparency in the exchanges. The regulator may take a first step to operationalize this as a pilot to test the operational features. It has to come up with stringent policy and regulations to check any speculation in the market and see that few players do not hijack the platform. Also, there should be a proper mechanism in place to check any type of cartelization in the market to check any gaming. Never the less, these innovative products would push the market for innovation and transparency in the market.

It is important that both physical (spot) markets and forward (derivative) markets work well to respond to the evolving energy mix and to promote cost-effective risk management to help decarbonization efforts effectively.

Electricity derivatives play an important role in the restructuring of the electricity market in setting price signals, providing price discovery, promoting successful risk management, inducing generation and transmission capacity investment, and enabling capital formation. Customized design of financial instruments and structured transactions for electricity can provide protection of energy prices, hedge volumetric risk, synthesize generation and transmission capacity, and introduce interruptible service contracts. The introduction of electricity derivatives offers an important avenue for risk management and lets participants in the value chain hedge price risks and safeguard their revenue margins. India is also joined by a small community of developing countries offering electricity futures on an exchange platform. Multi-Commodity Exchange and the Indian Energy Exchange have entered into a licensing agreement to launch electricity derivatives on the MCX trading platform linked to IEX spot electricity rates, subject to the required approvals by the Government of India and the regulators concerned. This lays the foundation for the vibrant market for electricity derivatives in the region.