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Price Behavior in Electricity Futures: The Story So Far

Fortnightly Magazine - January 1 1997

deliveries are made.

The premium paid should help determine whether to market under longer-term contracts or whether to sell into the spot market. Utilities differ in their costs of providing reliable supply and in providing peak-load capacity. Baseload capacity can be profitably sold under long-term contracts if the price is right. Peaking capacity often earns a higher return by selling into the spot market. The decision on how much capacity to sell under long-term contracts and how much capacity to leave unencumbered for spot-market deals should depend upon the premium paid in the futures market. As the premium increases it becomes profitable to commit larger amounts of the utility's capacity under long-term contracts.

Electricity buyers must make the same calculation. Some buyers can afford to purchase their electricity at highly volatile prices. For others a locked-in price is essential. Deciding whether a fixed price for electricity supply over several months is right for your company requires comparing the premium against the value your company places on price security. Electricity buyers can learn from the futures price how the premium negotiated in a contract compares to the going market premium.

The ongoing transformation of electricity into a commodity market should increase the volatility of electricity prices, especially during high-demand months. As this happens, the premium paid for price security will likely increase, making it that much more critical to valuing the different assets in a utility's portfolio of generating resources. t

Antonio Mello, assistant professor of Finance at the University of Wisconsin (Madison), holds a PH.D. in financial and monetary economics from the London School of Economics. John Parsons (principal) and Anna Godlewska (associate) come from Charles River Associates, Inc., a consulting firm that maintains offices in Boston, Washington, and Palo Alto, CA. Messrs. Mello and Parsons have collaborated in the past on research and consulting in the area of commodity futures markets, and together have published various works in the Journal of Finance, Journal of Applied Corporate Finance, Derivatives Quarterly, Journal of International Economics, and RISK magazine.

Technical Appendix

Futures Pricing Relationships

1. The Cost-of-Carry Formula

Futures market analysts like to compare the cost of locking in supply for a later date: The cost of a futures contract measured against the cost of purchasing the commodity on the spot market and holding it to the later date.

A strategy of buying futures contracts will incur a cost equal to the futures price, Ft. Turning to the cash market will cost the current spot price, P, as well as the storage charges incurred in carrying the commodity until the later date. Moreover, since the futures price is not paid until delivery, while the spot price is paid immediately, the financing costs of buying on the cash market must be incorporated into the comparison. Finally, the holder of the commodity in storage always enjoys the opportunity to profit off of short-run price variations. This so-called "convenience yield" must also be incorporated into the calculation. When the costs of the two alternatives are equal the relationship can be expressed as the cost-of-carry formula:

FT =