Drought hedge for power trading company
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Background: Brazil, the world's third largest producer of hydropower, is slowly recovering from the worst drought it has suffered in 40 years. Since 2013, hydropower generation, which makes up almost 70% of the country's energy supply, has decreased drastically due to the lack of water in major reservoirs. To compensate for the production shortfall, thermoelectric plants, which are more expensive to operate, have had to be brought on line. As a result, energy prices have soared and many players in the energy markets have suffered severe losses.
Risk-transfer solution: An energy trading company wanted a hedge against drought risk. A customized derivative solution based on an index which measures the energy obtained from a river's natural flow was developed. The index is calculated daily by an independent body responsible for coordinating and controlling electricity generation and transmission facilities in Brazil. If the index falls below a defined threshold, the derivative pays financial compensation.
Benefits: The index-based deal hedged the trading company's position against drought risk – its most important weather-related risk – hence stabilising its expected future earnings.
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