## Detailed Glossary

A Detailed Glossary of Energy Trading terms for registered users

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### Nick Henfrey

#### Megawatt hour

A measure of energy - abbreviated to MWh

Equivalent to one Megawatt of power flowing for one hour

Detail

In physics Power = Energy per unit time, e.g. joules per second

this can be thought of as an energy flow rate

it follows that Energy = Power * time

think of energy (MWh) as the equivalent of distance (miles or kilometres), and power (MW) as the equivalent of speed (mph or kph)

Electricity (confusingly also normally called power) and gas trades are often described in terms of a rate of energy, e.g. Megawatts, or therms per hour

However energy trades are priced in terms of energy (e.g. €45.3/MWh) so we need to be able to calculate the number of MWh of the trade or delivery period

This is easy if we use the equation:

1 MWh = 1 MW flowing for one hour

and simply remember this

Megawatt.hours = Megawatts x hours

or

MWh = MW x hours

Just like the speed of a car:

you can't meaningfully add two values in Megawatts at different times  - what does it mean to add two speeds together at different points on the Motorway?

If I drive 60 mph for 10 minutes, then 72 mph for the next 5 minutes, does the number 132 mph mean anything? (No!)

If I flow 10 MW one day and 20 MW the next day, the value 30 MW has no meaning

you can meaningfully add two values in Megawatt hours at different times

If I drive 10 miles in the first ten minutes, then 6 miles in the next five minutes, then I have driven 16 miles in total

If I flow 240 MWh one day and 480 MWh the next day, then I have flowed 720 MWh over the two days

you can't normally price something in Megawatts - a toll road makes you pay per mile, it doesn't matter how fast you went

 Keyword(s): Megawatt.hourMegawatt hoursMWh

#### Netting

Netting is the aggregating and offsetting of multiple cash flows between counterparties to arrive at one, or a limited set of physical payments

Detail

There are two distinct sorts of netting:

Settlement Netting - which might also be described as payment netting

All cash flows between two parties are summed (receipts are positive, debits negative) to arrive at one physical payment due

Settlement Netting granularity aggregates cash flows to a single legal entity over one or  more cash flow attributes including:

• Payment Date
• Currency
• Commodity (some times)

The exact terms of Settlement Netting are described in the bilateral Master Agreement that we have in place with the counterparty

Close-out netting - The set of outstanding cash flows that will be netted if our counterparty goes into receivership or liquidation

If we are expecting a payment of £999,999 from our counterparty, and they are expecting £1,000,000 from us, and they go into liquidation - we want to be owing them £1, not £1,000,000.

The liquidator will do his best for all creditors to try and get us to pay the £1,000,000, and have us wait in line with other creditors for the £999,999. Indeed without a legally sound close out netting agreement in place the liquidator would be favouring us as a creditor were they to let us net the outstanding payments

 Keyword(s): netted

#### Nomination

An electronic message sent to a third party detailing a transaction or requirement as part of a pre-existing agreement

Typically gas and power transactions are nominated to system and market operators

Detail

Examples of nominations:

Nominations are sent typically some time in advance, and then updated as any changes occur (new trades are executed, new forecasts are made etc.)

For power and gas there are deadlines for the last nominations for a delivery period - if nominations are missed then the trading organization may face large imbalance costs so:

Nominations are one of the most time-critical processes or capabilities of any trading organization

In the UK nominations are officially known as Notifications - but the general term, nomination, is more usually used

#### Novation

A generic legal term for transferring existing contracts from one legal entity to another

Detail

A legal entity may agree with another legal entity to transfer all, or a subset of, its contracts to another legal entity

Each company that the original legal entity has contracts is notified, and a novation is agreed:

that is our organization agrees to novate our contracts from the first legal entity to to the other on a particular, mutually agreed, date

amongst the contracts novated will be any long term contracts, master agreements and any trades

Trade novation has to be reflected in our ETRMs, and the following convention is usually followed:

• Trades that finish delivery before the novation date and time are left as is
• Trades that start delivery after the novation date and time are amended so that the counterparty is changed from the old legal entity to the new
• Trades that are scheduled to deliver through the novation date (that is they start before the date and time, and finish after the date and time) are split:
• The original trade is amended so that its end date and time is set to the novation date and time
• A new trade is created that has start date and time set to the novation date and time, end date and time set to the original end date and time of the original trade - all other attributes (price, volume etc) stay the same
 Keyword(s): novatenovating

#### Offer

An Offer is a type of Order; a trader offers to sell a product or commodity at the Offer price

Detail

The trader offers a product for sale at a particular price

Offers are normally submitted to a Broker or an Exchange

If an offer is matched by a subsequent bid by another party, then a trade is executed

If the offer matches an already quoted bid then a match is made and a trade is executed

 Keyword(s): Offers

#### Option

At its simplest an energy option is an instrument that gives the buyer the right, but not the obligation, to buy, or to sell, a commodity at a specified price at some point in the future.

More complex options may be financially settled, the payout being dependent on some condition(s) being met, and varying with some observable value(s) at the time of exercise

There is usually a single non-refundable payment made by the buyer of the option (the holder) to the seller of the option (the writer) - this is the option premium

Detail

First, let's try and categorize the different types of options we'll come across, and then describe each in detail, starting with the simplest:

1. Vanilla options - so called because they are a standard "flavour", which may themselves be divided into:

a) Simple physical options - already briefly described above, these include European and American options

b) Financially settled options - these pay out if some measurable, usually a published index, meets some specified criteria. The payout varies with this or other measurables. This category includes Asian options

c) Simple combination options - not strictly different types of options, but traders frequently combine simple options to tailor risk and payout to their circumstances

2. Exotic options - in contrast to vanilla options, exotic options are non-standard, usually complex and are designed to offer, or conceal, a combination of characteristics

Let's look at the simpler types in more detail

Simple physical options

Simple physical options may be thought of as an option to execute a Forward Contract. Indeed, if the option is exercised it effectively becomes a Forward Contract

When the option is traded the following terms are agreed:

• Whether the option buyer has the right to sell the commodity or buy it - that is whether the Forward would be a buy or sell:
• An option to buy is a call option
• An option to sell is a put option
• The price that the commodity will be bought or sold at - the strike price of the Forward Contract
• The type of the option - which determines the exercise time or period, that is when the buyer of the option may exercise their right
• A European option may be exercised at a specific date, specified at time of execution
• An American option may be exercised at any time in a date range, specified at time of execution
• It also follows that the Option terms must include all terms of the potential Forward Contract, that is delivery location, volume and timing

Financial options

Financial options pay out a cash amount if they are in the money - the cash payout usually being the difference between a fixed strike price, and some variable observable, usually the published price of a energy commodity or product

Spread options and options on swaps (swaptions) are types of financial options

Asian options are financial options which pay out on the average price of an underlier over the delivery period - assuming they are in the money

 Keyword(s): Optionality

#### Order

An Order is an instruction sent to an Exchange or a Broker to execute a trade unconditionally, or when or if specific criteria are met

Detail

A Market Order is the simplest, unconditional, type of Order. It is a simple instruction to buy or sell a specific volume of a product or commodity to be executed immediately at the best price available

A Limit Order is an instruction to buy or sell a specific volume of a product or commodity if the price of execution is at or better than the Limit Price specified with the Order

An Order may combine, in a single instruction, a number of transactions that are required

A Fill or Kill Order requires all transactions to be carried out, or none. Partial execution is not permitted

Exchanges handle all types of Order internally

Other organizations or parts of organizations may accept combination Orders, and then route different parts of the Order to different Exchanges, Brokers or other parts of the organization

For example a large trading organization may have several desks issuing Orders that overlap. An internal order routing capability matches internal orders as far as possible before routing the unmatched orders to external organizations (brokers or exchanges)

Bids and Offers are types of Order

 Keyword(s): OrdersMarket OrderLimit OrderFill or Kill Order

#### Origination

Origination - the negotiation and conclusion of bespoke contracts, and structuring of non-standard products to offer for sale

Detail

Origination teams and originators in energy trading organizations are about putting together large integrated contracts, outside standard master agreements. These might involve:

Structured long-term procurement deals particularly for oil and gas

Virtual Assets - Virtual storage, virtual power plants, virtual refining

Complex hedging products

 Keyword(s): originatororiginators

#### OTC

OTC - Over-The-Counter

Generally used to refer to any trade not executed with an Exchange

Detail

Over-The-Counter trades may be executed by a broker, or directly bilaterally between two parties. The resultant trade, whether brokered or not has the following characteristics:

The trade details may be anything the parties agree - compared to the standardized contracts offered on an Exchange

The agreed trade price is private to the parties - although either may report it to a market data service to increase price transparency

Delivery, settlement, and all credit risk is entirely between the two parties

 Keyword(s): Over-The-CounterOver the Counter

#### P&L

Profit and Loss (P&L) is a finance and risk reporting term to describe the profitability of an individual trade, a book, a desk, or a company. Whilst the P&L of a company includes all activity, and costs (offices, staff etc.) the trading P&L is a measure of the profitability of a single, or a set of, trade(s)

Detail

P&L is a change in the value of something, or a set of things between two points in time

You will often hear people refer to the P&L of the trade in terms of its value - the value at any point in time is effectively the difference between the value at that point in time, and the value before the trade was executed. We usually refer to this as the Lifetime to Date P&L or LTD P&L

Often we are interested in the change in value, the P&L, from the start of the year, from the start of the month, or from the last valuation. These are respectively known as:

• Year to Date P&L (YtD)
• Month to Date P&L (MtD)
• Change on day P&L (CoD or DtD)

As an example, let's say we bought some shares in a company for £60, and a year later we sold them for £100, then it seems obvious that we made £40 profit, assuming there were no cost of buying the shares, or selling them, nor indeed any other costs directly associated with the buying or selling

From the trading point of view we have executed two deals, or trades. Let's now think a bit more about these two trades, and ask some further questions:

We know the P&L after both trades have been executed (£40) but:

• What was the P&L after the first trade?
• What was the P&L of each individual trade?
Before continuing we will align our example with a more normal energy trading example.

In general traders don't buy a commodity, and then sell it later because of the difficulty and cost of storing energy commodities - see Storage

In general traders enter into a Forward contract, that is to buy the shares at  fixed time in the future, at a fixed price

The other advantage of Forward contracts is that the trader can enter a Forward contract to sell, as well as buy, at some time in the future. This is known as taking a short - i.e. negative - position

We enter into a Forward contract to buy an amount of shares for £60 in March 2018

In March 2018 we will give £60 to the seller of the shares. This is called the financial side or leg of the trade. It has a known cash value: £60

The seller will give us (he will deliver) the shares. We don't know what they will be worth then, but we can look up the current expected market value of the shares in March 2018, and see what they're worth - see MtM for the details. We call this marking to market, or MtM. Let's say we go online and the market value is £58, then at that time the P&L of the trade is minus £2, we have made a loss. Each day a new price is published we should revalue our trade, and this should continue until the shares are delivered. We have a long position in this share until we sell it. We say the trade has an unrealized P&L of minus £2. We say it is unrealized, because we still have the contract to buy the shares and their value (to us) will continue to vary until we receive them

We call this the physical side or leg (it's physical because it's not cash, even though the share certificates are electronic, we still call this physical)

After ten months we note that the market price has risen to £110, the trade has a P&L of £50, the current physical side value of £110 less the cash or financial side of £60. We say the trade has an unrealized P&L of £50

In March 2018, our seller delivers the trades, and we give the seller £60. We note that the market price has dropped to £100, the trade has a P&L of £40, the current physical side value of £100 less the cash or financial side of £60. We say the trade has an unrealized P&L of £40

We decide to immediately execute the second trade and sell the shares for £100, by then the spot price, and execute a sell transaction

Between the two trades we can say that the P&L is £40 and that it is now realized. We can say the P&L is realized based on three criteria:
In general, with derivatives, these criteria are usually not met simultaneously, and realization may be defined according to one or more of these criteria, and may be dependent on other criteria as well

We have said the P&L of the two trades is £40, but what is the P&L of each individual trade? There are two general ways to define this:

1. Ignore the physical side of each trade, so the first trade has a P&L of minus £60, the second trade has a p&l of £100, between them the P&L is £40. We can use this method when we are sure that the position of both trades has been closed out (which is another way of saying that the two trades' net position is zero). This method is sometimes called realized cash flow because it only considers the value of the cash elements of the trades
2. Retain the physical side of each trade, and continue to mark it to market for each trade. By this method the realized P&L on the day the second trade was executed was £40, and the P&L of the second trade is zero. If we use this method the P&L of each individual trade will continue to fluctuate for as long as we use it. This method is sometimes called Realized MtM
In general the first method is preferred because it is simpler, we may have to use the second method when we are not sure the position is entirely closed out, or we know some is, and some isn't.

if the first method sounds odd, think about buying and selling a house, once you've bought a house you're very interested in how much you paid for it, and how much it's currently worth. Once you sell it however, you're only really interested in the price you paid and the price you sold it. You have little real interest in the current price

P&L that may result in a cash flow in the future is often discounted back to present day value

We may refer to undiscounted, and discounted P&L

 Keyword(s): p&lProfit and LossP&L"P&L"

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