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Price Behavior in Electricity Futures: The Story So Far

Fortnightly Magazine - January 1 1997

P + ST + IT - CT

where S, I, and C represent, respectively, the costs of storage, financing, and the convenience yield.

If the futures price lies above the cost-of-carry, then a strategy of buying through a futures contract appears profitable relative to a spot market purchase combined with storage. If the futures price lies below the cost-of-carry, then arbitrage profit can be had by spot purchases stored until the time of delivery under the futures contract.

A good number of commentators have complained that the cost-of-carry formula may not be applicable to electricity, a commodity that cannot be stored economically. However, this assumption marks a naive dismissal of the cost-of-carry formula. The formula was derived when futures markets were organized primarily in "hard" commodities, such as gold and silver. For these goods, storage in a warehouse offered a convenient method of transforming the commodity available today into delivery tomorrow. In sophisticated industries such as electricity, capacity is shifted from today to tomorrow in a less direct and obvious manner. Nevertheless, there is still a cost associated with shifting capacity. This cost belongs in the appropriate cost-of-carry formula for electricity. The company that knows its own costs and that can compare them with the market price revealed in futures prices stands to make a significant profit. The cost of carry relationship is more complicated to specify in the electricity industry, but more valuable to whose who get it right.

2. The Expected Spot Price Formula

Economists have long wondered whether the futures price serves as a good predictor of the eventual spot price for the commodity, E(PT). Because the futures price paid is fixed and without risk, while the spot price paid remains risky, buyers and sellers may require a risk premium to do business in the spot price:

FT = E(~PT) - x

where x is the risk premium built into the spot price. In the cost-of-carry formula the spot price shown is for immediate delivery, at t = 0. In the expected spot price formula, the spot price shown is the eventual price quoted at the time delivery is due on the futures contract, T. The subscript on P denotes that it is the spot price on date T, while the tilde denotes that from the perspective of today it is a random variable.

One of the most important pieces of data one can learn from watching futures prices is the value of x, the risk premium paid in the market for a fixed price. This risk premium is the key to valuing fixed-price contracts as well as baseload versus peak-load capacity.

N.Y. Dairy Farmers Ask for Choice

By Lori A. Burkhart

Independent power marketer Wheeled Electric Power Co. (WEP) has joined with Dairylea Cooperative Inc., an organization of 3,500 New York dairy farmers, to petition the New York Public Service Commission (PSC) for a pilot program allowing farmers and food processors to choose their electricity suppliers. Rick Smith, Dairylea's chief executive officer, says "Dairylea plans to aggregate the electricity buying of its over 3,500 dairy farmer members and