*Submitted on May 16, 2021*

*“**How does a Contract-for-differences work?**” *

In New Zealand the contract-for-differences (aka CFD) is the most common off-exchange method for hedging the price of electricity traded on the wholesale market for a specified quantity and time period. In other words, the CFD is a fundamental tool in the hedging toolbox.

The CFD is a type of derivative contract known as a ‘swap’ with wholesale electricity as the underlying commodity. Under a CFD two parties agree to exchange (swap) the difference between a fixed and a variable price over a specified time period.

The best way to get your head around a CFD is to use an example. Let’s imagine *EarthPower** *owns a small geothermal power station in the Central North Island. Over the past three years revenue from generation sold into the wholesale market has been unpredictable, with some good months and some not so good months. Looking for more stability in cash flow, *EarthPower** **has** *issued a request for offers to purchase a CFD to cover its expected output of 10 MW for the 2022 calendar year.

*PeoplePower*, an electricity retailer with a growing customer base, also in the Central North Island, wants to lock in a predictable wholesale electricity price to underpin its retail offering. *PeoplePower** *offers *EarthPower** *a CFD price of $100/MWh, which is accepted, and a CFD is signed by both parties making them ‘counterparties’ to the contract.

Using this example, we can look more closely at the terminology traders use when working with CFDs. Our example CFD will be effective for exactly 12 months: from midnight on the 31^{st} of December 2021 until midnight on the 31^{st} of December 2022. This effective period is known as the term.

A payment required under the CFD is known as a settlement. While short term CFDs are not uncommon, many have terms much longer than the 12 months in our example. A year or more is a long time to wait for a payment, so standard CFDs are settled monthly. Which brings us to the question: how does the CFD determine who pays who and how much?

In our example, *EarthPower** *is the seller (aka ‘floating price payer’) selling 10 MW of electricity at $100/MWh to *PeoplePower*: the buyer (aka ‘fixed price payer’). The quantity of 10 MW is known as the volume and the fixed $100/MWh is the ‘strike’ price. The all-important ‘difference’ determining the payment amount is between the strike price and the wholesale market price at an agreed location on the grid (aka reference node). Now, the wholesale spot price at a node changes every half hour, and therefore so does the ‘difference’. It follows then that the calculation of payment is the net sum of all half hourly differences across the monthly settlement period.

Let’s look at the settlement for a single half hour which is really the basic building block for the total settlement calculation.

Suppose for the half hour 4:30 to 5:00 am the spot price at the reference node is a low $50/MWh. Over the half hour a volume of 10 MW equates to 5 MWh (10 MW x 0.5 hours = 5 MWh). The difference between the strike and the spot price is $50 ($100 - $50) so a sum of $250 is required to settle for the half hour (5 MWh x $50/MWh = $250). Under the CFD, *PeoplePower** *has agreed to pay $100/MWh so has to pay the $250 to *EarthPower*.

All straight forward so far, but in the next half hour from 5:00 am to 5:30 am demand at the reference node increases, driving the spot price up to $75/MWh. Now the ‘difference’ is only $25, and the half hourly settlement is $125, again paid to *EarthPower*.

With the settlement amount changing every half hour, how can the CFD actually provide the desired fixed price at all? The answer is simple, by itself the CFD doesn’t fix anything, the cash flow stream is as volatile as the underlying wholesale market. But, alongside the CFD, *EarthPower** *is also selling into the wholesale market and is receiving a parallel cash flow from those sales, which is based on its generation and spot prices. So, for the half hour when the wholesale price is only $50/MWh *EarthPower** *receives $250 from the CFD plus $250 from the wholesale market. A total of $500, which gives us the “magic number” of $100/MWh for all 5 MWh actually generated. In the next half hour, when wholesale price rises to $75/MWh, *EarthPower** *receives only $125 from the CFD but $375 from the wholesale market: again, a total of $500.

How does* **PeoplePower* benefit from all of this? Consider the case that by 8:00 am demand at the Reference Node is close to peak and the price has risen to $135/MWh. How does the CFD settle now?

Here the difference between strike and spot price is $35 so a sum of $175 is required to settle for the half hour. Under the CFD, *EarthPower** *has agreed to sell at $100/MWh so has to pay the $175 to *PeoplePower* who now sees a positive cash flow from the contract.

Let’s see if the CFD fixes the price for both parties now. Starting with *EarthPower,** *who has to pay out $175 from the $675 received from selling generation which, again, gives total revenue of $500! On the other hand, *PeoplePower** *receives $175 which reduces the cost of wholesale purchases of $675 to, yes you guessed it, $500: equivalent to the strike price of $100/MWh!

With a CFD, and as long as *EarthPower** *generates at 10 MW into the physical wholesale market and *PeoplePower** *takes the same volume to supply its customers, both parties will see a fixed price for their wholesale sales and purchases averaging out at over each settlement period and the entire term at $100/MWh.

So now that you understand the basics of hedging with a CFD, here are three questions that you might like to think about:

· What happens to the price obtained through the CFD for *EarthPower** *if there is a significant generation outage, or for *PeoplePower** *if, due to unseasonably cold weather, average customer demand at the reference node rises to 15 MW or more?

· How do *EarthPower** *and *PeoplePower* agree on the CFD strike price in the first place?

· How would the CFD work if *EarthPower** *was located in Auckland and *PeoplePower* was located in Wellington (given that spot prices vary by location across the country)?

Key takeaways:

1. For a given quantity of electricity over a specified period of time, a CFD will counterbalance price volatility in the wholesale market and can provide increased price certainty for both buyers and sellers of electricity.

2. A CFD is a purely financial instrument. While settlement is based on a fixed notional volume of electricity and the underlying wholesale market spot prices, there is no actual exchange of the physical commodity. This means the obligation to settle on the contract remains independently of the quantity of physical electricity either counterparty buys or sells on the wholesale market.

In the next blog we take a closer look at: “Risks to be aware of when using CFDs to hedge wholesale prices.”