[BETA] Fortnightly

Paper trading is here, introducing an element of speculation in wholesale electric markets.The electric power industry joined the commodity markets on March 29, 1996, when power futures began to trade on the New York Mercantile Exchange (NYMEX). This first tentative step in the commoditization of electricity promises the emergence of a paper market for power, which, as in the case of other commodities, will likely prove substantially broader and more complex than electricity's physical market. From the interaction of the physical and paper markets will surface the long-term price structure for electric power, and the discovery of the full potential for interregional trade.

As was the case with other energy commodities, the paper and financial markets will tend to exert downward pressure on power prices because, among other reasons, free trade in electrons will make evident the classic market condition of commodities: that capability to supply chronically exceeds typical demand. Current electricity rates will come to be seen as a reflection of local regulatory inertia, while the market price of electrons will internalize the economics of state and regional excess capacity, a decade of deflation in the cost of the critical generation fuels, and the effects of the historic opening of the national transmission system by the Federal Energy Regulatory Commission.

Compare electricity with fossil fuels. Figure 1 illustrates how real fossil-fuel prices fell over the last two decades from 216.3 cents per million British thermal units (Btu) to 132.9 cents, while electricity rates rose inexorably over the same period.1 In combination, fuel price deflation, uneconomic rate structures, and excess capacity represent sources of "rents" that fall prey to attack by commodity markets.

On the first day of trading, electricity futures volume on the NYMEX reached a respectable but not significant 1,200 contracts, representing 900,000 megawatt-hours (Mwh) of electricity. The power futures market began in classical contango: For California/Oregon border (COB) delivery (see sidebar for contract definitions), a price of $8.33/Mwh emerged for the prompt month, with a higher $13.95/Mwh price for December 1996 contracts. For Palo Verde (PV) delivery, the price range showed $11.45 for June and $16.50 for September.2

The COB and PV contracts may not prove viable, but the paper market for electrons is now virtually inevitable. Paper deals (swaps) for power - based on spot market prices - are already common. Moreover, a number of utilities have entered into long-term deals that, in practice, are creating a variety of future price curves. Nevertheless, NYMEX trading will surely provide a futures price curve that will gradually become the standard by which all other futures deals are judged.

A successful NYMEX futures market for electrons would give additional impetus to the development of a comprehensive commodity market for power - one that would eventually consist of futures, options, swaps, and derivatives. NYMEX should prove crucial to all these trading instruments because it will provide a transparent series of prompt and future prices on which to build other paper instruments.

Paper Markets:

The Future Structure

If the evolution of open interest and trading volume in natural gas and oil can be