Innovation of the year: OpenGamma

One of the most troubling aspects of the energy crisis of 2022 was the huge and unexpected hike in margin calls caused by the surge in gas and power prices. This liquidity crisis posed an existential threat for a number of energy firms, highlighting the need for a new type of solution that can accurately predict capital requirements in times of price volatility. Due to the complexity of modelling potential future margin calls at the different exchanges, such tools haven’t been available for energy traders.

In the wake of the crisis, derivatives software firm OpenGamma, set out to change this. The firm, winner of Energy Risk’s 2024 Innovation of the year award, has developed a margin-at-risk product to predict future margin calls in stressed market conditions. In March 2023, it launched the initial version of the product which enables firms to forecast and stress test capital requirements for cleared derivatives several years into the future.

Historically, energy firms have leveraged their value-at-risk models to estimate how much cash is required for initial and variation margin, says Sean O’Brien, head of commodities at OpenGamma. “While this approach performs well for variation margin, given price change is the main input into this calculation, as we saw in 2022, this approach does not perform well when modelling the impact on initial margin as it does not capture the relationship between price change and initial margin at each exchange.”

Conversations that OpenGamma had with commodity trading firms revealed that the vast majority of uncertainty in predicting cashflows came from initial margin requirements, O’Brien says. “When speaking to chief financial officers and heads of treasury at the major commodity traders and energy providers, it appeared that 90% of the uncertainty in predicting cash outflows associated with derivatives had come from initial margin requirements,” he says. “This is because initial margin requirements have proven to be volatile, and no existing solution could model the effect of large price moves on capital requirements.” 

This led to some nasty shocks in 2022 when gas and power prices surged following Russia’s February invasion of Ukraine and the ensuing disruption of gas supplies into Europe. The price of the front month Dutch Title Transfer Facility natural gas contract at the Intercontinental Exchange, which had been below €40 ($43) a megawatt hour (/MWh) for most of 2021, spiked to €343/MWh on August 26, around 15 times higher than it had been a year ago. Electricity prices also rose sharply in 2022, with European day-ahead prices increasing sevenfold from 2020 to average around €235/MWh. Electricity price volatility in 2022 was on average six times higher than in 2020 and more than double that of 2021, according to energy research institution FFE.

As a result, clearing houses increased initial and variation margin requirements significantly throughout the year. Treasury functions at energy firms that had been used to posting a few euros per contract in margin had to post more than €100 per contract. Margin calls in the millions and even billions of dollars were not uncommon throughout the year and left many utilities and corporate hedgers struggling to find the cash at short notice. In one example cited by Eurogas, an energy producer that hedges large volumes of gas and power on exchanges was charged initial margin of €1 billion in summer 2021, saw its margin requirement rise to €4bn by October 2021 and ultimately to €6 billion in March 2022 – a sixfold increase without any change in the position being hedged.

While this crisis may now be in the rearview mirror, current fundamentals mean the outlook for commodity markets continues to remain volatile. Persistent geopolitical risk, continuing supply-chain upheaval and climate-related risks are all creating an environment of significant uncertainty. Additionally, ongoing macroeconomic woes, high inflation and interest rates make challenging conditions for new energy infrastructure and storage build.

“Energy firms are focused on preparing themselves for the next wave of volatility, ensuring they have enough liquidity in different market conditions,” says O’Brien.

While it was not difficult for OpenGamma to identify the need for better liquidity planning, combining historical market data, quantitative models and the computational capacity to run such a high volume of calculations, required some creative thinking and pioneering spirit.

“The main challenge was creating a solution that could be used for each exchange, and allowing the user to model any market conditions at any point in the future,” says O’Brien. “We leveraged our 15 years of experience in building risk and margin models, combined with historical data that allowed us to calibrate our models to different market conditions, to produce a set of risk factors that works for any product and exchange.”

The liquidity risk-management tool is gaining traction, with some of the largest energy and commodity trading firms already leveraging the platform, according to OpenGamma. 

In today’s turbulent markets, having a product that enables firms to anticipate and avoid liquidity crunches, is hugely useful. Through its innovation, creativity and determination, OpenGamma has created an important new risk management tool for users of energy and commodity derivatives.