Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Price Behavior in Electricity Futures: The Story So Far

Fortnightly Magazine - January 1 1997

affiliates located in New York to secure lower electricity rates. As the [New York] PSC has observed, aggregation is the way in which consumers (em particularly smaller customers (em can obtain favorable prices and services options."

The retail pilot is being proposed for the service territories of Niagara Mohawk Power Corp., New York State Electric and Gas Corp., Rochester Gas and Electric Corp., Central Hudson Gas and Electric Corp., and Orange and Rockland Utilities (O&R). In contrast to O&R's Power Pick, currently the only pilot running in New York in late 1996, the Dairylea program would be New York's first multi-utility retail competition pilot. t

Lori A. Burkhart is an associate legal editor of PUBLIC UTILITIES FORTNIGHTLY.

Articles found on this page are available to Internet subscribers only. For more information about obtaining a username and password, please call our Customer Service Department at 1-800-368-5001.

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 = 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