Congestion Futures And Derivative Instruments In Electricity Markets

1. Introduction

Congestion futures and derivative instruments are financial contracts that can be used to manage the economic risks created by congestion in electricity networks. Electricity congestion occurs when transmission infrastructure cannot safely carry all the electricity that market participants want to transmit between different locations.

When congestion occurs, the price of electricity at one location may differ significantly from the price at another location. This creates basis or location risk for generators, traders and large electricity consumers. Financial derivatives can be designed to transfer or hedge this risk.

South African electricity law does not currently have a fully developed electricity-congestion-futures market comparable to some international electricity markets. Therefore, the legal framework must be understood through the interaction of electricity regulation and South Africa's general financial-markets and derivatives legislation.

2. Meaning Of Congestion Futures

A congestion future is a derivative whose value is linked to an expected difference in electricity prices caused by transmission constraints.

For example, assume electricity at Location A normally costs R1,000/MWh while electricity at Location B costs R1,300/MWh when transmission congestion occurs. A financial contract could be structured around the difference between these prices.

The parties could use such an instrument to:

hedge congestion-related price risk;

manage transmission-related financial exposure;

improve price-risk management;

provide information about expected future congestion; and

support investment decisions concerning generation and transmission.

The derivative itself does not necessarily reserve physical transmission capacity. It primarily manages financial risk associated with congestion.

3. Futures And Other Derivatives

A derivative derives its value from an underlying asset, price, index or other reference.

In Absa Bank Ltd v Ukwanda Leisure Holdings (Pty) Ltd (2013), the High Court explained the general nature of derivatives and futures. The judgment recognised that derivatives may be based on physical commodities, financial assets, indices, interest rates, currencies or other derivatives. It also discussed futures as contracts concerning transactions at a future date.

This general legal understanding can be applied to electricity-related derivatives, where the underlying reference could be an electricity price, congestion differential or other market index.

4. Financial Markets Act

The Financial Markets Act 19 of 2012 (FMA) is important where an electricity-related derivative qualifies as a financial derivative.

In JP Markets v Financial Sector Conduct Authority (2021), the Supreme Court of Appeal considered the regulation of over-the-counter derivatives. The Court explained that the FMA framework regulates OTC derivatives and that persons acting as OTC derivative providers require appropriate regulatory authorisation.

Therefore, an electricity congestion derivative cannot simply be treated as an ordinary commercial contract where it falls within the regulated derivatives framework. Licensing, conduct, reporting and other financial-market requirements may apply.

5. Commodity Derivatives And Electricity

Electricity has unusual characteristics compared with ordinary commodities because it is difficult to store economically at large scale and must generally be balanced continuously.

This makes electricity derivatives particularly important for managing price and delivery risks.

South Africa already has an established regulatory framework for commodity derivatives through the financial-markets system. The JSE's commodity-derivatives rules provide mechanisms for trading, pricing and handling errors in commodity derivative transactions.

However, an electricity derivative would also need to be assessed against the specific characteristics of the electricity regulatory system.

6. Relationship With Electricity Regulation

Congestion derivatives should not be confused with physical grid-management tools.

The electricity system operator remains responsible for maintaining grid stability and operating the transmission system according to applicable Grid Code requirements. A financial derivative cannot give its holder an automatic right to physical transmission capacity.

This distinction is important because financial rights and physical electricity rights are legally different.

The principle can be expressed as:

Financial hedge ≠ physical transmission right.

Thus, buying a congestion-related derivative should not allow a trader to bypass grid-access rules, network constraints, licensing requirements or system-operator instructions.

7. Eskom And Electricity Price Exposure

South African case law demonstrates that electricity contracts can already contain complex pricing arrangements and embedded financial exposures.

In BHP Billiton PLC Inc v De Lange and Others (2013), the Supreme Court of Appeal considered Eskom's electricity supply contracts with major industrial consumers. The case records Eskom's financial statements concerning embedded derivatives and electricity pricing arrangements linked to commodity prices and other variables.

This is significant because it demonstrates that electricity supply contracts can create financial exposures resembling derivative risks even when they arise from long-term physical electricity agreements.

8. Hedging And Risk Management

Congestion derivatives can be used for hedging.

For example:

a generator may hedge the risk that congestion reduces the price it receives;

a large consumer may hedge the risk that congestion increases its electricity cost;

a trader may hedge differences between two electricity-price locations;

an investor may use derivatives to manage exposure to future congestion conditions.

South African courts have recognised the economic purpose of hedging instruments in other commodity markets. In Central Energy Fund SOC Ltd v Venus Rays Trade (Pty) Ltd (2020), the High Court discussed forward-price risk and the use of futures contracts as hedging instruments.

Although that case concerned oil rather than electricity, its explanation of hedging is relevant by analogy.

9. Market Abuse And Manipulation

Congestion derivatives also create risks of market manipulation.

A trader might theoretically attempt to influence physical electricity flows or prices in order to profit from a derivative position. For example, deliberately withholding generation could potentially affect congestion and price differences.

Financial-markets law therefore needs safeguards against:

market manipulation;

insider trading;

false or misleading information;

abusive trading;

excessive concentration;

conflicts of interest; and

manipulation of benchmark prices.

In Fourie v Directorate of Market Abuse (2018), the High Court considered deliberate trading in sunflower-seed futures on the JSE Commodity Derivatives Market in the context of market-abuse provisions. The case illustrates that derivative markets are subject to legal controls designed to protect market integrity.

10. Proposed Legal Framework For Electricity Congestion Derivatives

A suitable framework could include:

1. Clear definition

Legislation or market rules should define congestion-related derivatives and their underlying reference prices.

2. Regulatory classification

The instrument should be classified under the appropriate financial-markets framework.

3. Transparent pricing

Reference prices and congestion calculations should be independently verifiable.

4. Market-abuse controls

Manipulation and insider dealing should be prohibited and monitored.

5. Separation of financial and physical rights

A derivative should not automatically create physical transmission rights.

6. Clearing and margin requirements

Appropriate risk-management arrangements should protect market participants from counterparty default.

7. Regulatory coordination

NERSA and financial-market regulators should coordinate where a product affects both electricity markets and financial markets.

11. Conclusion

Congestion futures and derivative instruments could provide useful mechanisms for managing the financial risks created by electricity transmission constraints. They may allow generators, consumers and traders to hedge location-based price differences and improve financial planning.

South African law does not yet provide a dedicated and comprehensive congestion-futures regime for electricity. The legal framework would therefore need to combine electricity regulation under the ERA and Grid Codes with financial-market regulation under the FMA and applicable derivatives rules.

The cases of Absa Bank v Ukwanda, JP Markets v FSCA, BHP Billiton v De Lange, Central Energy Fund v Venus Rays, and Fourie v Directorate of Market Abuse provide useful legal principles concerning derivatives, hedging, electricity-related financial exposure and market integrity. These cases do not themselves establish a specific South African electricity-congestion futures market; their relevance is through the general legal principles governing derivatives and electricity-related financial arrangements.

A future framework should therefore ensure that congestion derivatives support risk management and efficient markets without allowing financial instruments to undermine physical grid security, transmission rules or electricity-market integrity.