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Paper Electrons and Power Pools: Complementary Markets for a Deregulated Environment

Fortnightly Magazine - July 1 1995

electricity industry.

The proposed New York Mercantile Exchange (NYMEX) electricity futures contract will help electricity sellers and buyers manage business risk. Under a NYMEX futures contract, a buyer could purchase 1,500 megawatt-hours at a constant 5 megawatts (Mw) (plus or minus 2 percent) an hour for 20 business days, during peak hours (7 a.m. to 10 p.m.). The power would be deliverable at 500 kilovolts at the Palo Verde, AZ, bus or the California/Oregon border under Western Systems Coordinating Council rules.

Futures could change electricity industry structure, products, and language. Generators could use a combination of natural gas futures and electricity futures to lock in a "combustion spread" between fuel prices and electricity prices. Electricity marketers or brokers could use electricity futures to lock in a margin between their energy-purchase and -sales contracts. Marketers or buyers' agents could use futures to offer customers electricity with designer prices (em such as fixed prices, capped prices, and collars (fixed-price ranges). End-use customers with heavy electricity requirements and fixed output prices (such as aluminum smelters) could use electricity futures to fix electricity input prices. Futures would allow market participants with different risk preference profiles to buy just the right amount of low-cost price-risk insurance.

Electricity futures and/or other electricity forward markets could provide increased price transparency, accelerating deregulation. Futures could provide important market information (for example, futures would provide a more efficient price index than the surveys used today). Strong futures or forward prices could provide clear signals to de-bottleneck the transmission system. Futures market information should also reduce the need for regulatory oversight of prices.

Futures price signals could provide a clear, measurable incentive for DSM. The market for avanced telecommunications-based personal demand-management products (such as PowerView from First Pacific Networks) should boom. Futures would also provide better supply-management signals. Futures prices could allow companies to finance short-term technological innovation to improve electricity production efficiency, extend asset lives, and enhance distribution efficiency at lower capital costs. Futures price signals could reshape hydropower storage and production patterns. Futures could become the most visible symbol of the new competitive electricity market.

Unfortunately, developing a successful electricity futures market will not be easy. Electricity faces much higher market structure and technological hurdles than natural gas. Moreover, the market may not need electricity futures.

The Challenge:

Why Futures Fail

At first glance, electricity looks like a perfect match for a futures contract (em electrons are completely homogeneous and price volatility is high. However, electricity fails important market tests. Most notably, electricity lacks a deep, highly liquid spot market.

Even though the U.S. electricity industry is highly fragmented, local control areas remain highly concentrated. Open-access rules have only begun to increase trading. Electricity futures will have a better chance if deregulation reduces local market concentration (perhaps by encouraging generation asset swaps and sales and increasing market size or participation through pools) and encourages transmission congestion pricing.

Asymmetric regulatory compacts have limited the incentive for utilities to trade electricity on a spot basis (em losses typically accrue to the shareholders while gains go to the ratepayers. Performance-based ratemaking represents a