(originally appeared in Applied Derivatives Trading magazine, November '98 issue)
Still in its infancy, the emerging wholesale electricity forward market is displaying characteristics dramatically different from traditional commodity and financial markets environments. Relishing the sport of this new market, opportunists are lured to trading electricity and developing exchange traded risk management products (i.e. futures contracts) to tame the spirited fundamentals of the new electricity marketplace.
Electricity is the largest non-financial commodity market in the world with a market size of USD 250 billion-plus, consuming 35% of the total energy flow in the US. Officials have estimated an additional USD 2 trillion in trading on and off-exchange electricity derivative markets is possible, using the ten-fold multiples that gas and oil on and off-exchange derivatives trade in relationship to their underlying cash markets:
Electricity's price volatility frequently exceeds even natural gas, with seasonal events of double digit volatility percentages in the monthly forward markets and triple-digit volatility in the next hour markets. The utility industry is undergoing dramatic deregulation on a state by state basis at the retail level, though the wholesale power market has already been deregulated - with the end result of lower prices and greater services for customers. However, the utility industry has been suddenly exposed to the free markets and all the challenges that go along with it: price and credit risk. Deregulation, in effect, is ending the economic fantasy land of traditional cost-plus pricing by the utility industry. Larger market participants and producers see the potential for becoming dominant players in an industry bound to consolidate and rationalize its structure. Waves of innovation in the electricity industry are about to be unleashed, much as deregulation in the telecommunication industry spawned the growth of wireless services and the Internet.
Producers and industrial consumers alike are seeking to hedge forward price risk in a variety of ways, but the fundamental factors affecting the price of electricity make the need for exchange traded risk management products all the more apparent. The proper place to start is to compare electricity with the established capital markets.
The electricity cash market, based on the fact that it is a newer market, is more risky than traditional capital markets. Since a large segment of the physical and financial electricity trading market is comprised of the fledgling power marketing industry and newly minted unregulated trading subsidiaries of large producers, there is a shortage of trading experience - which itself makes the market behave less predictably. Second, the fundamental factors that influence forward electricity prices are relatively more complex than those driving the capital markets. Electricity trading is contingent on a series of interdependent physical factors: production facilities, line capacity, inputs (coal, natural gas, oil, nuclear and hydro), and weather. Since electricity is not storable in the classical sense, it is not possible to take advantage of arbitrage opportunities without taking these physical factors into account. Furthermore, the non-correlated regional distribution channels create large basis risks and delivery concerns when trying to move power across the underlying grid system economically. The fact that transmission plays a large part in the overall trading equation makes electricity transactions even more complex than transactions in the financial capital markets.
Because electricity is a 'flow' commodity and not a traditional 'cash and carry' commodity, its pricing characteristics are complex. Electricity prices have the following properties: 1) demand induced 'time of use' basis risk; 2) geographic location basis risk; 3) unpredictable order of magnitude price jumps; 4) mean reversion to marginal generation cost; 5) seasonality of demand, 6) dependence on transmission availability, and 7) unpredictable weather patterns.
All of this makes electricity potentially the most technical commodity traded in the world and difficult to model, relative to the comparatively straightforward capital markets. Electricity prices are not log-normal, tend to be mean reverting, and exhibit leptokurtosis. The end result of these characteristics is that traditional option pricing (Black-Scholes) and forward curve modeling techniques cannot accurately predict the forward electricity price curve. Yet the electricity forward price curve plays a crucial role in the development of the electricity futures markets, for the industry needs such a value benchmark for deal pricing, portfolio valuation, arbitrage identification, and risk management positioning. To date, many costly attempts to find a theoretical model that accurately replicates the electricity forward curve have proved unsuccessful. The lack of historical price data for electricity increases the difficulty in modeling electricity volatility, risk, and the implied forward price curve.
Despite electricity's complexity, the need for derivatives is clearly apparent from participant demand for energy products to hedge efficiently. The proliferation of electricity risk management products exhibits a curious dual nature. On one hand, most of the over-the-counter (OTC) electricity products are disproportionately complex compared to capital markets, where plain vanilla products dominate. These OTC products are tailored to individual user requirements and the terms and conditions of the counterparties. On the other hand, there are currently standardized exchange-traded electricity products offered on three U.S. futures exchanges (CBOT, NYMEX and MGE) whose trading volumes are slowly growing. The movement to standardized exchange-traded products will continue as key players in the market recognize the power of standardizing terms and conditions. Recent defaults in the off-exchange electricity markets, due to the June price spikes, helped to expose the problematic nature of conducting business in the unregulated off-exchange markets and highlight the real benefits of exchanged traded electricity futures.
The futures contracts closely parallel commercial activity in the wholesale power cash market for electricity and will provide solid benefits to cash market participants. The contracts will provide participants with hedging capabilities against the risk of adverse price movements in the cash market. Moreover, the futures contracts will increase liquidity in the market generally by enabling parties that do not have an interest in making or taking delivery to hedge against, or assume, the risk of changes in the price of electricity. In addition, like other futures contracts, the electricity futures contracts will provide competitively determined, publicly available reference prices for cash market transactions. Furthermore, the exchanges' clearing houses, by acting as a principal to each electricity futures and option contract, will provide credit protection for participants that is not currently available for cash market transactions.
The Chicago Board of Trade has recently launched and is trading two electricity contracts deliverable into the Commonwealth Edison and Tennessee Valley Authority hubs. The contracts are priced in dollars and cents per megawatt hour (MWh), with the contract trading unit size of 1,680 MWh, using a 5 MW delivery rate per every on-peak hour of every on-peak day of the delivery month. This contract size relates well to the average size of monthly wholesale power cash market transactions. The delivery points were chosen based on the development of liquid cash market trading hubs on each utility's system.
The wild west nature of the electricity off-exchange cash markets will inevitably evolve into a more predictable market that incorporates qualities found in the maturer capital markets. As the trading moves to more standardized derivatives, more players will enter the market. The slowly increasing market liquidity, greater understanding of arbitrage relationship between physical and financial markets, and increased understanding of the beneficial qualities of futures will help to attract the more risk averse utility industry participants and eventually create the critical mass of participants which is so important to the success of exchange-traded electricity futures contracts.
Chicago Board of Trade
The information is this article in not guaranteed by the CBOT for accuracy, completeness or any trading result and is intended only for the purpose of information and education. The views expressed in this article are those of the author only and do not necessarily reflect those of the CBOT or any of its members. The author wishes to thank Eugene Kunda and Keith Schap of the CBOT for helpful comments.