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Price Behavior in Electricity Futures: The Story So Far

Fortnightly Magazine - January 1 1997

futures markets will prove critical (em demanding incorporation into the utility's dispatch models.

As power markets become more competitive, utilities (and others buying and selling power) will find it imperative to refine standard operating policies make them responsive to price pressures. Consider an oil-fired plant scheduled to be closed for maintenance. If current spot prices are high the shutdown will mean foregoing profitable sales. Keeping the plant in operation, however, may extend the duration of a later shutdown and add to its cost. And there is no assurance that power prices won't have climbed even higher by the time of the later closure. Futures prices can be used to calculate the market's estimate of the opportunity cost of the longer shutdown, to be compared against the premium earned on current sales.

Signals from Last Summer

Futures markets also provide signals about the value of purchases and sales under fixed-price contracts.

As this past summer progressed, the cash-futures basis displayed in Figure 1 became increasingly volatile. This characteristic will likely occur every summer because the power supply system will be running at peak capacity; small variations in power usage or availability will create large price fluctuations. Buyers with supply contracts ahead of time avoid this volatility, but they must pay a premium to do so. This premium will typically rise to its highest point during the late summer and the winter months, and reach its lowest levels in the spring and fall. In fact, excess generating capacity in the spring and fall can lead to a basis "reversal," meaning that suppliers are ready to offer a discount to lock in the price received for their power.

To measure the premium paid or discount charged for a fixed-price contract, analysts compare the futures price for delivery in a given month against the average spot or cash price paid during that same month. The futures price equals the expected spot price plus the premium paid for locking in the price ahead of time.

Figure 2 shows this comparison of "price expected" against "price realized" for electricity delivered this past June. The futures price paid throughout the month of May for a June delivery lay below the average spot price realized in June. Buyers of the June futures contract obtained their deliveries more cheaply than did buyers on the spot market.

The story proved quite different, however, for August deliveries. Figure 3 reveals that throughout July buyers of August futures paid a premium above the average price charged on the spot market in August. Even so, these buyers avoided the wide swings in the spot market price, which grew quite large in August.

How/When to Sell:

Spot or Long Term?

The premium paid to avoid price risk remains central to effective marketing. A competitive utility needs to know the going rate and should benchmark the prices it is able to negotiate against this

market data. And, in the case of electricity futures, the evidence of the first six months of trading shows that the risk premium varies significantly with the time of the year in which