[BETA] Fortnightly

The deregulated power market will feature large numbers of buyers and sellers. Buyers will worry that prices will rise unexpectedly above current levels; sellers will worry that prices will fall unexpectedly. Some will be interested in fixed-price forward deals that protect them from these risks. Retail marketers will want to offer fixed prices to customers for one or several years.

Power marketers will be especially interested in risk management, because offering forward price deals will make up an important part of their business. In particular, they will be interested in understanding the sources of power-price volatility and available mechanisms for managing this risk.

Nevertheless, despite predictions that electricity and natural gas will converge into a single, unified

energy market, many significant differences will likely remain between these two commodities, especially in terms of price risk and uncertainty.

The gas market is conducive to a futures market. Many parties are concerned with either unexpectedly low or high prices, and hence, very interested in nominal fixed prices. Production is also concentrated regionally to a high degree. The great majority of production lies in the Texas, Louisiana, and Oklahoma area, such that a central regional hub, the Henry Hub, has emerged as the dominant and reasonable basis for a stylized futures contracts. Such contracts are of interest and make sense for enough players to support trading on a public exchange.

But even as power marketers are waiting and hoping that the power business will change and allow for a gas-styled, commodity market, limitations are becoming more evident. In the gas business, problems can be seen increasing over differences in "basis" (em problems that could loom for power as well (see Tables 1 and 2, for a hypothetical example of "basis" problems for the power sector). The essence is that the change in the futures market price fails to track the cash market.

These limitations do not mean that the gas market model cannot serve as a valuable starting point for the power business. Nor do they diminish the extraordinary success in bringing fixed forward prices to the gas business. Rather, they indicate that other risks may become increasingly important in the gas business and play a larger role in the power business.

Because of these limitations, and differences between gas and electric power, we predict that engineering and economic analysis will prove more important in the future in assessing risk in the electric power commodity market than in the gas industry. This conclusion rests on four principal observations:

s Regional Variations. Regional differences in power markets are much more pronounced for electricity than for gas, making fundamental analysis in economics and engineering more important for electricity.

s Short-run Volatility. Power price variations in the short run reflect economic and engineering factors to a much larger degree than for gas, where short-run prices are less subject to analysis.

s Different Histories. The relative lack of statistical data on power prices (compared with gas) will place increased emphasis on the fundamentals, at least during the transition period.

s One-way Cross-Hedging. Gas as an input fuel directly affects