By: By André Jerusalem

Derivatives are financial contracts involving two parties who agree to buy or sell an underlying asset at a future date. These two parties define in a contract the price, quantity and a date for settlement with or without delivery of the asset. This contract is traded in almost all world markets and involves the most varied assets: stocks, interest rates, currencies, commodities (gold, corn, coffee, soybeans) and others.

As stated above, derivatives are financial instruments whose value derives from other assets. In the case of energy, the asset currently used is the Settlement Price for Differences (PLD), determined by the Electric Energy Trading Chamber (CCEE). The registration system allows the maturity date to be chosen in accordance with the availability of the PLD.

When trading derivatives, buyers and sellers will be in one of two positions: the first aims to mitigate the financial risks of the market and the second aims to speculate. This is important in the energy sector, since prices are highly volatile, and therefore interesting for investors and, mainly, for market stability, as an instrument for mitigating financial risks, such as abrupt climate changes or, as recently occurred, the drop in electricity consumption.

As a result, derivatives can stimulate investments in the energy sector, since the risk will be reduced and the investor in energy generation will be able to guarantee a stable return on the capital invested in the construction of a power generation plant. It is expected to increase the security of operations and liquidity in the free energy market, carried out through financial contracts.

According to Law No. 6,358/76, also known as the “Capital Market Law”, derivatives are considered securities. Thus, the National Monetary Council (CMN) and the Securities and Exchange Commission (CVM) are the regulators of the derivatives market, which may only be traded and registered in companies previously authorized to operate by the CVM, the so-called “financial market infrastructures”. Currently, only two companies are registered with the CVM: B3 (Brasil, Bolsa, Balcão SA) and BBCE (Balcão Brasileiro de Comercialização de Energia SA).

It is important to highlight that, unlike what happens in the energy purchase and sale market, under Law 6,385/76, there are several regulatory requirements regarding risk, Prevention of Money Laundering and Financing of Terrorism and others, which also oblige the Participant in the derivatives market to register their contracts on the day of execution.

It is clear that the migration of part of the free agents of the energy market may occur through the simplification of operations, in which settlement is exclusively based on differences, without the regulatory weight of Aneel and CCEE, but new obligations arise, those provided for by CMN and CVM.

Whereas for the free market agent who trades the energy asset, the financial market will contribute to ensuring that their operations have an adequate transfer of financial risk (after all, the main function of the derivative is to transfer risk), in return they will not be subject to the regulatory rules of Aneel and CCEE, allowing for a more assertive financial and economic reading.

With this view, the derivatives market will be able to eliminate investors from the energy purchase and sale market, enabling the use of a more suitable instrument for speculation against price variations, as well as making the price of the commodity more transparent, facilitating and contributing to the possibility of transferring financial risks to the derivatives market for energy generators and consumers. Thus, the forecast is for the accelerated evolution of the energy market in the country.

For an objective understanding of energy derivatives, the following purposes are envisaged:

• Hedge (protection): Protecting the participant in the physical market of a good or asset against adverse variations in rates, currencies or prices, to minimize the risk of financial loss resulting from adverse price changes.

• Leverage: Increase the total profitability of these at a cheaper cost, since trading with these instruments requires less capital than purchasing the asset outright.

• Speculation: Aim to operate the market price trend.

In this sense, derivatives are instruments used, in essence, to manage risks, since their value depends on other assets to which they refer, allowing companies and individuals to have a more predictable cash flow and, therefore, with more planning.

The advantages observed with derivative operations can be particularly mentioned: Possibility of

i. increased liquidity in the physical market;

ii. improving the level of market transparency;

iii. the volume of energy traded in the futures market would exceed the volume traded in the physical market, resulting in less volatile prices and conditions in the physical market;

iv. increasing agents’ confidence and improving their willingness to invest in the expansion of the electrical system;

v. increase in long-term operations (purchase and sale);

vi. substantial improvement in price formation in the physical market; and,

vii. abrupt decrease in the level of default by agents, since the use of derivatives would reduce their losses and uncertainties.

As stated above, derivatives are also investments, being variable income assets, that is, they do not offer investors guaranteed profitability. Since they do not offer a guaranteed return, they should be considered risky investments. Additionally, as occurs in other more traditional types of derivatives (such as currencies, for example), it is common for counterparties to transactions to request the deposit of collateral (or margin account) to avoid non-compliance with the obligations assumed, as well as to protect the transaction in the event of leverage.

Furthermore, the following can benefit from using derivatives:

• Traders transferring the risks of negotiations carried out in the purchase and sale of energy.

• Companies and investors who wish to obtain financial returns from price fluctuations.

• Consumers who can transfer and mitigate market risks.

• Power generators that can set sales prices, ensuring predictability, without being tied to energy delivery.

Therefore, by using the financial instrument correctly and with the help of a consultancy firm that is prepared and linked to the sector, the company that chooses to use derivatives will be able to take advantage of the benefit of reducing price unpredictability.

Thus, with the derivative – Hedge -, which seeks to protect the participant in the physical market against adverse variations, and aims to minimize the risk of financial loss resulting from adverse price changes, no matter how much prices vary, the company will be assured in the financial market.

Therefore, with more predictable cash flow and improved budget and tax planning, the free energy market agent will have an efficient tool to mitigate financial risks and may potentially obtain tax advantages. While the free market agent who exclusively seeks price speculation will be able to transfer operations to the financial market, escaping the regulatory framework of CCEE and Aneel.

Derivatives are also investments, being variable income assets, that is, they do not offer the investor a guaranteed return. Since they do not offer a guaranteed return, they should be considered as risky investments.

Furthermore, the following can benefit from the use of derivatives: traders transferring the risks of negotiations carried out in the purchase and sale of energy; companies and investors who wish to obtain financial returns from price fluctuations; consumers who can transfer and mitigate market risks; energy generators who can set sales prices, ensuring predictability, without being tied to the delivery of energy.

Therefore, by using the financial instrument correctly and with the help of a consultancy that is prepared and linked to the sector, the company that chooses to use derivatives will be able to take advantage of the benefit of reducing the unpredictability of the future price.

Thus, with the derivative – Hedge -, which seeks to protect the participant in the physical market against adverse variations, and aims to minimize the risk of financial loss resulting from adverse price changes, no matter how much prices vary, the company will be assured in the financial market.