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Trading on the Index: Spot Markets and Price Spreads in the Western Interconnection

Fortnightly Magazine - October 1 1996

as part of its strategy. This hypothesis draws reinforcement from the lack of correlation between daily prices at the Alberta Power Pool daily prices and electric prices elsewhere in the WSCC.

Transmission Constraints

and Basis Risk

NYMEX defines "basis risk" as the uncertainty as to whether the differential between the cash and the futures markets will widen or narrow between the time a hedge position is implemented and the time it is liquidated. The predictability and size of the basis depends on three different relationships:

1) The price of the futures contract versus the spot price of the underlying commodity (the "cash/futures basis")

2) The spot price at the futures contract delivery point versus the spot price at a different location (the "locational basis")

3) The spot price at the futures contract delivery point versus the spot price of a similar, but not identical, commodity at the same location (the "product basis").

Recent power negotiations have produced a variety of basis schemes. Some industrial contracts have proposed using natural gas indices at local hubs. A number of these contracts have specified the natural gas price at Sumas, WA. As a general rule, natural gas indices serve as a poor choice for electric contracts. In the WSCC, the correlation between natural gas and electric prices is surprisingly poor. A more natural approach would be to use the market prices at COB, Palo Verde, and Alberta as a benchmark for pricing in bulk-power contracts. But how accurately do these indices predict local prices? What differential should apply when the local power market is distant from the index?

Power transfer capability can illustrate relationships between different market regions. In this case, data from the WSSC (bidirectional, nonsimultaneous, 1995 summer) reveals just how weak the interconnections are between regions (see Chart opposite). This revelation appears at odds with the reputation of the WSCC as one of the world's most tightly integrated power markets. In fact, WSSC's internal interconnections are small when compared with the area's 140,000+ Mw of generation. Transmission capability is routinely saturated on an annual basis (em so much so that constraints often arise for transmission over the Canadian border, access to the Pacific Northwest intertie, and transmission though Utah.

The most significant transmission constraint that affects the use of a price index in bulk-power contracts may be the seasonal hydro "fish flush" in the Pacific Northwest. Recent environmental rulings have moved more and more generation into spring months. On a planning basis, the oversupply in these months is now sufficient to displace all thermal generation in the Pacific Northwest and to fill transmission lines to California. This effect creates a disparity between prices north of the California border and those in the rest of the WSCC. During some hours in recent years, prices in the Pacific Northwest have fallen to 1.5 mills. Since 1.5 mills just covers transmission costs, the seller in effect pays a commodity price of zero. Prices throughout the remainder of the WSCC tend to reflect natural gas generation costs during the same period.

Using the COB index tends to