Structuring Contract-for-Difference Instruments for Hedging Electricity
Price Risks on a Blockchain-based Marketplace
Abstract
The volatile nature of day-ahead electricity markets means that
participants often resort to some form of derivative hedging instrument.
One such derivative instrument is a Contract-for-Difference (CfD),
specifically available to renewable generators in some jurisdictions to
enable them to hedge against their price risk. CfD is a bilateral
arrangement between a generator selling into, and an offtaker buying out
of, a centrally cleared pool market for electricity. In this
arrangement, the generator subsidizes the offtaker when the spot price
is high; whereas, the offtaker subsidizes the generator when the spot
price is low. This establishes a synthetic bilateral electricity
transaction, operating in parallel to the pool market. Embracing CfD to
hedge against price risk presents new risks such as counterparty credit,
margining, third-party, and legal risks. They also incur high costs and
possess underlying process risks. Decentralized Finance - an overarching
term representing financial services built on top of a public blockchain
- seems to present particularly compelling opportunities in electricity
derivatives for these reasons. Therefore, we propose a novel
Decentralized Finance instrument: a blockchain-based marketplace
governed by a smart contract to act as a mediator between stakeholders
mutually enrolled in bilateral CfD arrangements. The employed smart
contract structure autonomously and irrefutably enforces the terms of
the CfD, underpinned by a novel collateralization and settlement
mechanism. This novel approach mitigates the hedging-related and
underlying process risks of traditional CfD instruments.