Valuing embedded optionality and other complexities in energy contracts


Financier Worldwide Magazine

October 2017 Issue

FW moderates a discussion on the complexities of energy contracts between Dr James Dimech-DeBono, Patrick Hébréard and Nils von Hinten-Reed at CEG.

FW: When drafting their contracts, how important is it for energy companies to measure and control the risks that might arise in this sector?

von Hinten-Reed: In all aspects of their operations, it is important for energy companies to have a robust framework for risk management, including for sector risk. The strategies to manage risk usually include avoiding, reducing, transferring or even accepting risk. As part of their robust framework, energy companies are typically very well-versed with ensuring that the contracts they enter into take account of known risks. Such risks include market risk, volumetric risk, credit risk, liquidity risk, operational risk and legal risk. Given this, the drafting of a contract is the first element of the overall risk management strategy of energy companies. Each market transaction needs to have a reliable contractual basis, which also determines the future credit risk management possibilities. For single complex products, individual contracts would be a reasonable option, however for the regular trading of standard products, master agreements between the parties are used. Several organisations, such as ISDA, EFET and IETA among others, provide common master agreements. These are a good base but paying attention to contractual provisions not only safeguards profitability, but also reduces litigation risk.

FW: Could you outline the role that embedded optionality and other contractual complexities play in this regard?

Dimech-DeBono: Embedded optionality in energy contracts enables energy companies to make quicker revisions to their portfolios, including the ability to hedge risk. These changes may arise when changes emerge in factors which serve as inputs into their financial models. Examples of optionality are included in gas storage facilities, as this effectively represents a process to develop an optimised trading strategy. The strategy consists of daily trading decisions that depend on the price levels and the current volume in storage. The strategy aims to maximise the total discounted expected revenue across all possible price paths over the period of the contract. The strategy must consider all costs and constraints in operating the storage asset or contract. The total discounted expected net revenue resulting from such a strategy is the value of the storage asset over the period of contract. Storage facilities serve as an arbitrage mechanism to exploit the time spread of gas prices. The gas storage example demonstrates the ability to monetise the value of an asset with real optionality as it largely depends on quantifying the value of that optionality, meaning its extrinsic value – and also the ability to decompose the risks of the asset or deal structure so as to be able to hedge for changing market conditions.

FW: How is the level of risk surrounding energy contracts typically governed? Which department should take overall responsibility for this?

Hebreard: The risk management framework required to deal with the contractual complexities needs to be fully integrated with clearly-defined responsibilities. This would form part of an overall governance structure. Sound corporate governance that defines clear responsibilities and avoids conflicts of interest is an essential prerequisite for effective risk management and ensuring compliance with the relevant regulatory requirements. For energy companies, only some of the legal requirements meant for financial institutions are legally binding, depending on the business model and the extent of trading activities. Typical roles and responsibilities start at the very top with the board; having responsibility for the overall company, it approves and foresees the risk strategy, including defining the risk appetite for the overall business. The next level down is usually risk management or risk control, responsible for assessing, measuring and monitoring exposures. More importantly, they assess decisions regarding risk acceptance or risk mitigation measures and whether decisions are in line with the risk strategy. The contract negotiators and risk management department work hand in hand with the legal department in ensuring that contractual terms are appropriate.

Many of the risks faced are outside either parties’ control, making it difficult to assess with respect to liability.
— Nils von Hinten-Reed

FW: Given the risks faced by energy companies, and the challenges these pose, can you provide insights into how this affects the process of resolving disputes in the sector?

von Hinten-Reed: Energy companies will typically try to limit risks and liabilities through contractual clauses, for example regarding post-delivery problems or construction issues. Many of the risks faced are outside either parties’ control, making it difficult to assess with respect to liability. Indeed, if the fault does not lie in the hand of either party, it will be difficult to assess who should compensate the other. However, it is important to keep in mind that the energy sector is highly complex and these issues will not be sufficient to determine the outcome of a dispute. Disputes in the energy sector are often resolved through arbitration proceedings, particularly given the rising use of arbitration clauses in energy contracts. With ever-growing demand for energy resources has come the need for the construction of energy facilities, and these pose many risks to the parties involved – including time, quality, scope, political factors, and so on – often leading to commercial arbitrations. Disputes which may come after that will likely involve parties from different jurisdictions with different views on the risks faced by the other – such as investor-state disputes – and with no parties intending to submit the claim to the local court of the other party, international arbitration provides an attractive alternative to come to a settlement, particularly in cases where liability is difficult to assess.

FW: Do contractual structures typically allow for asset flexibility with counterparties? Further, do typical contractual structures affect the risk of disputes arising?

Hebreard: Volume optionality of an energy asset is typically a key component of asset value. In light of current market conditions, investors take this extrinsic value into account. Relative pricing dynamics mean that flexible gas and power assets increasingly have ‘at-the-money’ optionality characteristics, making extrinsic value a key component of asset value. In long-term gas contracts, parties usually use pricing formulas to calculate a price which will often be indexed to indices such as oil prices, or prices based on gas hubs, for example. These contracts indeed are supposed to reflect a ‘fair market’ value and are supposed to be competitive. They will have been computed given specific market characteristics, and will typically therefore include clauses for regular price reviews. These reviews can take months of discussions between the parties to agree on whether, firstly, pricing should be at all reviewed and, secondly, under what terms. These discussions might fail to bring agreement between the parties and can therefore end up in arbitration proceedings. While historically price reviews have been negotiated successfully between parties, we have seen a rise in such arbitration proceedings in the past decade, particularly in Europe due to factors such as a reduced gas demand, the rise in renewable energy use, the rise of gas-to-gas pricing as opposed to oil-indexation, and other structural changes to the European energy markets.

FW: What frameworks, such as real options analysis, can be used to measure the value of contracts?

Dimech-DeBono: The real options (RO) framework provides a means to both identify and value the optionality in contracts or assets with embedded flexibility. In other words, real options analysis (ROA) is useful in situations where management can exert a degree of flexibility when it comes to deciding on the course of action to be taken because of newly-acquired information, such as information relating to pricing, for example. The embedded optionality and trading strategies to optimise storage, ground and marine transportation, assets and long-term contracts in gas, power and oil markets, need to be evaluated appropriately through ROA. For example, RO-based valuation reveals and correctly quantifies the value of efficient power plant operation in the face of volatile electricity market prices. In addition, optionality helps in enabling energy companies to make quicker changes to their portfolios. Extrinsic risk, which can be termed as dynamic, would require the isolation of embedded optionality found in most non-standard contracts, and these can then be quantified and valued as options, which can be exercised as part of an overall effective strategy.

The valuation model has to be built to reflect the characteristics of the energy contract in question.
— Dr James Dimech-DeBono

FW: Could you provide some insight into applying earnings-at-risk (EaR) versus value-at-risk (VaR), and the pros and cons of each approach?

Dimech-DeBono: Value-at-risk (VaR) provides insights into the worst case a company can face in terms of losses, under a given period and under ‘normal’ market conditions, given a certain level of confidence. It is a very common measure and has become a standard method of reporting risk within trading industries, such as energy. The earnings-at-risk (EaR) measure is used in order to monitor earnings for a specific period of time, and is particularly useful to appropriately react to disadvantageous price movements. The considered random variable is the earnings of a company until a certain date. For energy companies, this includes spot price revenues generated by the assets, less all production costs plus all related trading and hedging transactions. Note that VaR only makes a statement about which loss is not exceeded with a given probability, but it does not give any information as to what happens in the remaining cases with a probability of 1 – α. Other measures besides EaR, such as profit-at-risk and cash flow-at-risk, are used by different segments of the industry, and there exists no standard calculation concepts.

FW: What general advice would you offer to companies on valuing complex aspects of their energy contracts?

Dimech-DeBono: As with any valuation, the valuation model used has to be ‘fit-for-purpose’. In other words, the valuation model has to be built to reflect the characteristics of the energy contract in question, including any optionality and constraints attributable to the physical delivery of the underlying commodity. A common mistake is to fit a contract into a model, as this not only ignores some of the aspects of the contract but fails to correctly address the characteristics of the contract and can have a major impact on value. Testing and validating the model is also a key aspect of this process. The model validation process is usually performed by a person who is independent of the model builder in order to ensure that both the interpretation of the contract and the coding is of a reasonable level. Stress testing is particularly important, as some valuation models tend to be based on simplifying assumptions which can lead to a lack of identification of unexpected movements in key variables.

FW: Have any recent disputes in the sector caught your attention? What do their outcomes tell us about how they may impact future cases?

von Hinten-Reed: A particularly uncertain economic environment has led to worsened counterparty relationships among buyers and sellers, contractors and producers, and so on. With the substantial investments needed to explore for, produce and transport energy both globally and regionally, many disputes arise in this sector and they are particularly interesting due to the specific nature of every case. This is also true for the renewable energy sector, and we have seen a rise in arbitrations in this sector, particularly due to the scaling back of investment incentives by European governments. For example, in Charanne and Construction Investments v. Spain, the UNCITRAL tribunal dismissed the claims from investors, and ruled that Spain’s conduct did not constitute direct expropriation or the deprivation of fair and equitable treatment to investors. The state’s partial victory has raised precedents, particularly regarding the scope of the fair and equitable treatment (FET) obligations, as well as legislations regarding solar investments. It is important to note that Spain made even more significant changes to its renewable energy investment regime in 2013, which may lead to different outcomes in arbitrations being brought on those grounds, and whether FET can mean that governments are blocked from making any regulatory changes.

No matter how well drafted a contract is, with long term contracts many factors can contribute to disputes arising.
— Patrick Hébréard

FW: How do you see the use of energy contracts with embedded optionality, alongside other contractual complexities, developing in the years to come? Further, do you think this will increase or decrease the likelihood of disputes arising in the sector?

Hebreard: Embedded optionality has become an intrinsic part of energy contracts, and with increased uncertainty and volatility in the energy sector, other contractual complexities are likely to be increasingly used in the years to come. With the rise of the importance of LNG and the increased competition between suppliers, I expect to see further optionality within the industry. This has already led to the development of different business models and structures. Only time can tell whether such structures are sustainable enough to avoid disputes. Indeed, no matter how well drafted a contract is, with long term contracts many factors can contribute to disputes arising. It is becoming increasingly important for companies to protect themselves from unexpected movements in important variables, such as prices. Contractual complexities play a role for each party to try to protect itself, but many other factors outside the control of the parties at the time of drafting are likely to have an effect on disputes arising. Therefore, it is difficult to assess whether there is a direct link between contractual complexities and the likelihood of disputes arising, as many disputes arise from changes in factors which had not been accounted for in the initial contract drafting.


Dr James Dimech-DeBono is a director at CEG Europe and the Quantitative Finance Practice leader at CEG. His expertise is in the valuation of complex and illiquid assets in energy and financial services as well as shareholder disputes. He has more than 26 years of advisory experience in energy and commodities as well as in financial services. He has provided expert advice to clients as well as acted as testifying expert witness in a variety of instances. He can be contacted on +44 (0)20 3908 7017 or by email:

Patrick Hébréard is a director with CEG Europe, a valuation expert and an experienced adviser and negotiator with a long career spent in the energy and utilities industry. Mr Hébréard has a significant experience of the energy markets, especially of the long-term gas and LNG sales and purchases agreements, on which he worked both as buyer and seller, giving him a unique perspective on the corresponding commercial, contractual and financial issues. He can be contacted on +33 (1) 5660 5074 or by email:

Nils von Hinten-Reed is the managing director of CEG, an economics and finance consultancy specialised in providing expertise in complex disputes, including in the energy sector. Mr von Hinten-Reed has over 25 years of experience applying economics and finance to competition and market issues and has been involved in advice and disputes in the electricity, gas and nuclear industry in Europe. He can be contacted on +32 (2) 642 0017 or by email:

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Dr James Dimech-DeBono

CEG Europe


Patrick Hébréard

CEG Europe


Nils von Hinten-Reed


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