Credit Risk Mitigation with Margining and Impacts on Power Plant Valuation
As part of the doctoral research of Joachim Lang of E.ON, we investigate the impacts of a stronger collateralization policy on all European derivatives markets on European utilities and their underlying power plant portfolios. So far, the following studies have been completed.
1. Relevance of risk capital and margining for the valuation of power plants: cash requirements for credit risk mitigation (Lang and Madlener, 2010a)
In a first assessment of the topic, we analyze the collateralization requirements for power plants by applying the margining rules of the European Commodity Clearing AG (ECC, 2008, 2009) on coal- and gas-fired power plants, and the sale of outright power in the German market in a simplified way. As a starting point, we determine expected load factors per plant for two subsequent years based on given EEX data for commodity prices. We apply different hedging strategies to calculate the open positions that would have had to be covered with collaterals. Moreover, we consider netting possibilities between short and long positions in accordance with the ECC rules. The foci of our studies are particularly geared towards questions of power plant valuation, portfolio optimization, and portfolio selection problems for power plants under recognition of liquidity constraints. In this study, we strive for a deeper understanding of the effects of credit risks mitigation via margining on the cashflow of power plants, and the resulting risk capital needs. Moreover, we determine the major impact factors on the total margin requirements with respect to different hedging strategies. Also, we illustrate the differences between the fuel types and the correlation of margining requirements vs. the underlying commodity price developments. Finally, we analyze in which way the mitigation of credit risk with margining has to be recognized for investment decisions or, more generally, for the management of financial resources of utility companies.
2. Cost evaluation of credit risk securitization in the electricity industry: Credit default acceptance vs. margining costs (Bellmann, 2010; Bellmann et al., 2010)
A further sub-study explores the impact of margining on the financial costs in comparison to the direct management and the intentional acceptance of credit risk. For this purpose we evaluate the losses due to defaulting business partners with the interest requirements of the cash reserve cushion for an assumed margining account. We compare a scenario that assumes 100 % margining with a scenario in which none of the credit risk is collateralized. We test the robustness of our model through the use of sensitivities on commodity prices, partner structure of the sales/purchase portfolios, and the underlying fuel mix. The results suggest that the use of margining in the electricity industry is significantly more expensive than the potential costs of defaulting counterparties. According to the employed model, the introduction of centralized clearing, and with this, the necessity to collateralize all trades, will significantly burden the utilities sector. It was found that both in the short and the long run it is cheaper for companies to accept and bear the credit risk, rather than to bear the arising costs of margining.
3. Portfolio optimization of power plants: the impact of credit risk mitigation with margining (Lang and Madlener, 2010b)
The introduction of a centralized clearing mechanism enforced by regulative powers like the EU Commission has a significant impact on the risk capital needs of the European utilities as a consequence of further margining requirements for trading activities. In this context, we analyze the impact of credit risk mitigation via margining on the optimal portfolio selection for power plants from a viewpoint of a practitioner. For this task we simulate margining cashflows for an exemplary power plant portfolio based on the clearing framework of the European Commodity Clearing AG (ECC) and conduct an evaluation of an underlying asset portfolio. The resulting differences for the values, with and without margining, are analyzed with the mean-variance portfolio approach of Markowitz (Markowitz, 1952), to specify the consequences of margining on the efficient frontier of possible power plant portfolios. We find that the introduction of a centralized clearing and the consideration of margining for power plant portfolio selection can markedly change the composition of efficient portfolios on the efficient frontier.
Bellmann E., Lang J., Madlener R. (2010). Cost Evaluation of Credit Risk Securitization in the Electricity Industry: Credit Default Acceptance vs. Margining Costs, FCN Working Paper No. 13/2010, Institute for Future Energy Consumer Needs and Behavior, RWTH Aachen University, September.
European Commodity Clearing AG (ECC, 2008). ECC Margining, Release 001, Leipzig, Germany, 22 October 2008: Description of Clearing procedures and regulations for trading electricity for the partner electricity exchanges of the ECC.
ECC (2009). Clearing conditions of the European Commodity Clearing AG, Release 0007, Leipzig, Germany, 1 April 2009.
Lang J., Madlener R. (2010a). Relevance of Risk Capital and Margining for the Valuation of Power Plants: Cash Requirements for Credit Risk Mitigation, FCN Working Paper No. 1/2010, Institute for Future Energy Consumer Needs and Behavior, RWTH Aachen University, February.
Lang J., Madlener R. (2010b). Portfolio Optimization for Power Plants: The Impact of Credit Risk Mitigation and Margining, FCN Working Paper No. 11/2010, Institute for Future Energy Consumer Needs and Behavior, RWTH Aachen University, September.
Markowitz H. M. (1952). Portfolio selection, Journal of Finance, 7(1): 77-91.
Supervised student research (selection)
Bellmann E. (2010). Vergleich und Bewertung unterschiedlicher Verfahren zur Absicherung von Kreditrisiken der Elektrizitätswirtschaft auf Rohstoffmärkten (Comparison and Valuation of Different Strategies for Hedging Credit Risks of the Electricity Industry on Commodity Markets, in German). Diploma thesis, Chair of Energy Economics and Management, Faculty of Business and Economics, RWTH Aachen University, September.
Prof. Dr. Reinhard Madlener
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Dipl.-Kfm. Joachim Lang
- +49 (0)211 45 79322
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