A $300 Cap Contract is one of the main financial instruments that market participants, such as retailers or generators use to manage their risk exposures to the electricity spot price.
Caps are essentially insurance against high price volatility. Each contract ensures that the buyer pays no more than $300 for one megawatt of electricity over a specified period.
This could be over a calendar year, a financial year, a quarter or even a month, but monthly contracts are rarely traded in the market.
For providing this insurance, the seller receives a premium from the buyer. Simply put if the spot price stays under $300 per megawatt hour, the seller wins. They get to keep the premium without having to compensate the buyer.
But if the spot price goes above $300 per megawatt hour, the cap seller loses. This is because they must pay the buyer the difference between the spot price and the $300 strike, which may end up being more than the premium that they received.
Retailers tend to be natural buyer of these contract. This allows them to put a ceiling on what they pay for their customer load, while allowing them to remain exposed to potentially more favourable spot price outcomes. That is, if retailers locked in the price, they pay for a megawatt of electricity using, for example, a swap, they wouldn’t be able to enjoy the benefit of lower spot prices. On the other hand, generators tend to be natural sellers of these contracts. This is because generators have the ability to defend the premiums, they receive from selling these contracts.
They do this by bidding in the number of megawatts they have sold in caps at prices below $300. This means that so long as the generator is not experiencing an unplanned outage and they can increase their generation quickly enough within a five-minute settlement period, or 30-minute settlement period, prior to the 1st of October, 2021, they can ensure that they are dispatched when prices spike above $300.
In summary, $300 Caps can be thought of as insurance against volatility. Each contract covers one megawatt of electricity over a period of a month, quarter, calendar or financial year. They ensure that the buyer pays no more than $300 per megawatt hour over the given period. In exchange for providing this cover, the seller receives an upfront premium. And finally, natural buyers tend to be retailers, while natural sellers tend to be generators.
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