MW times hours, times the move, every morning: why a hedged generator runs out of cash before it runs out of profit.
Variation margin on a power future is the contract volume in MWh multiplied by the change in the daily settlement price, paid in cash every day. A generator short 500 MW of calendar baseload holds 4,380,000 MWh, so every 1.00 move costs 4.38 million: on an illustrative rise from 70.00 to 81.20 over five days that is 49.06 million of variation margin, on top of 28.47 million of initial margin, while the plant it hedges has not yet earned a cent of the offsetting gain.
Worked in full in Energy Trading by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A generator that sells next year's output on an exchange locks in the price but not the timing of the cash. The exchange marks the short future to the settlement price every evening and collects the loss the next morning. The plant's matching gain, the higher price it will be paid for the same megawatt hours, only turns into cash when the power is delivered and invoiced, months later. Economically the position is flat. In the treasury it is not, and the gap between the two is the subject of the margin call that arrives first.
| Input | Value |
|---|---|
| Position: calendar baseload future, sold | 500 MW |
| Hours in the delivery year | 8,760 |
| Trade price | 70.00 |
| Initial margin set by the clearing house, per MWh | 6.50 |
| Cash and undrawn facility available | 120.0 million |
Contract volume: MW × hours in the delivery period = 500 × 8,760 = 4,380,000 MWh.
Initial margin: 4,380,000 × 6.50 = 28,470,000, posted on the trade date and held until delivery.
Daily variation margin: −volume × (today's settlement − yesterday's settlement) for a short position. A rise is a payment out; a fall is a receipt.
Cumulative: −volume × (latest settlement − trade price).
In Excel, with the trade price in B1 and the five settlements in B2:B6: =-Volume*(B2-B1) for day 1, copied down, and =-Volume*(B6-$B$1) for the running total at day 5.
| Day | Settlement | Change | Variation margin | Cumulative | Cash posted incl. initial margin |
|---|---|---|---|---|---|
| 1 | 72.40 | 2.40 | -10.51 | -10.51 | 38.98 |
| 2 | 75.10 | 2.70 | -11.83 | -22.34 | 50.81 |
| 3 | 73.80 | -1.30 | 5.69 | -16.64 | 45.11 |
| 4 | 78.50 | 4.70 | -20.59 | -37.23 | 65.70 |
| 5 | 81.20 | 2.70 | -11.83 | -49.06 | 77.53 |
A move of 11.20, or 16.0 per cent of the trade price, has taken 49.06 million of variation margin out of the company in five business days, and 77.53 million in total once the initial margin is counted. That is almost two thirds of the 120.0 million of liquidity the company had, used by a hedge that is doing exactly what it was bought to do. The largest single day, day 4, called 20.59 million, 17.2 per cent of the liquidity in one morning.
Nothing has been lost. The plant's 4,380,000 MWh of output, if it runs, will now be sold forward at a market 11.20 higher, worth the same 49.06 million. But that gain arrives as invoices during the delivery year, and the futures loss arrived as cash this week. The hedge converted price risk into liquidity risk, which is the trade a board needs to know it has made.
The useful number for the board is the move that exhausts the cash. After the initial margin, 91.53 million is left. Divided by the volume, that is a rise of 20.90 per MWh, 29.9 per cent of the trade price. A move of that size within a few weeks is not exotic in power, which is why the position limit should be set from the liquidity rather than from the hedge ratio. The book's own case, a 4,960,000 MWh short against a declared 40.00 move, puts 198,400,000 out of the door the next morning.
| Position | MWh | Move 5.00 | 10.00 | 20.00 | 40.00 |
|---|---|---|---|---|---|
| 100 MW | 876,000 | 4.4 | 8.8 | 17.5 | 35.0 |
| 250 MW | 2,190,000 | 10.9 | 21.9 | 43.8 | 87.6 |
| 500 MW | 4,380,000 | 21.9 | 43.8 | 87.6 | 175.2 |
The call is linear in both the volume and the move, so halving either halves the cash. Volume also falls as delivery proceeds. On 1 July of the delivery year only the second half remains, 4,416 hours, so the open position is 2,208,000 MWh and each 1.00 move costs 2.21 million, 50.4 per cent of the original sensitivity. During delivery the futures settle against the spot price and the variation margin starts to run alongside the physical sales it hedges, which is when the cash finally lines up.
Most power exchanges cascade a calendar contract into quarters and then months before delivery. Cascading changes the product you hold, not the volume, so the variation margin per 1.00 move is unchanged until the delivery hours actually start to pass.
Computing the exposure in megawatts instead of megawatt hours. A desk that reports "500 MW short, price up 11.20" and multiplies the two gets 5,600, which is off by a factor of 8,760, the hours in the year. The second mistake is subtler: reporting the variation margin as a loss on the hedging programme. It is not a loss; it is the cash leg of a hedge whose other leg sits in the plant. Treated as a loss, it gets the hedge closed at exactly the wrong moment, and the generator ends up unhedged after paying for the rise. Treated as a liquidity need, it gets a facility sized for it in advance.
The third mistake is to hedge more volume than the plant will produce. If the hedge is sized on available hours and the plant runs far fewer, the excess is a naked short, and its variation margin has no physical gain behind it at all. A gas plant runs only in the hours that clear its marginal cost, often well under half the year, as the dispatch in how to calculate a clean spark spread shows, so a hedge sized on availability is usually larger than the output. The case above sidesteps this by assuming the plant delivers every hedged MWh; a real position report has to test that assumption first.
Variation margin = −volume in MWh × change in settlement, every day, and the volume is MW × hours of the delivery period. On 500 MW of calendar baseload, 4.38 million per 1.00, 49.06 million on an 11.20 rise, and 120.0 million of liquidity exhausted by a move of 20.90 once 28.47 million of initial margin is posted. The position report, the margin call and the move that exhausts the cash, with the book's figures as live formulas, are in the free workbook for this case. For how the tenor of a hedge changes the size of the call, see how much more margin a five-year hedge calls than a rolling one.
Multiply the MW by the hours in the delivery period. A calendar baseload contract covers 8,760 hours in a normal year, so 500 MW is 4,380,000 MWh; a peak or monthly contract uses its own hour count. Every margin and P&L figure is then volume in MWh times a price per MWh, so a 1.00 move on 500 MW of calendar baseload is 4.38 million.
No. On a hedge it is the cash leg of a position whose offsetting gain sits in the physical asset. A short future that pays 49.06 million when prices rise 11.20 is matched by 4,380,000 MWh of output now worth 49.06 million more, but that gain is collected only when the power is delivered. The risk is liquidity, not value.
Initial margin plus the variation margin on the move the board chooses to survive. On 4,380,000 MWh with 6.50 per MWh of initial margin, 28.47 million is posted on day one; with 120.0 million available, the remaining 91.53 million is exhausted by a rise of 20.90 per MWh, 29.9 per cent of a 70.00 trade price.
This article is one calculation from Energy Trading. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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