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Power Prices Today: Growing More Unpredictable

Even the volatility is volatile. And that can play havoc with hedging.
Fortnightly Magazine - October 1 2002

and wholesale power companies were working very hard to set prices.

Yet regulators are now for the first time fully accepting the fact that markets for natural gas and power have unique and extreme features at times, and that some regular surveillance of these markets is necessary. Some even understand that price risk insurance is a good thing, that price risk management is necessary and not just a deadweight cost, and that a variety of large additional costs may follow from price risk that is left totally uncontrolled.

Perhaps the easiest way for anyone to get a view of price risk is to examine a graph of percentage changes in price, such as daily stock returns or a related figure-the natural logarithm of price today to price yesterday. Such a plot for power prices for Into Cinergy is presented in Figure 3. The relative frequency and size of large price changes are revealed in such figures. A change in price of 100 percent in either direction in a day is not unheard of. Moreover, the average size of the change varies greatly over time. Since volatility is an estimate of the average variability of these price changes, the computation of price risk for power is always difficult, especially for a future time period. 3

That appears even clearer in Figure 4, which is based on a GARCH (generalized autoregressive conditional heteroscedasticity) estimation. Figure 4 shows that price risk often varies and comes in clusters. 4 Periods of high price risk follow periods of much lower risk. Thus, companies that are not hedged could be hit by a price tsunami. Moreover, companies may either pay a high premium or receive a huge discount for price risk insurance if it is based on dated estimates of volatility.

There is also seasonality in price risk. Not surprisingly, price risk increases in the summer. However, the degree and timing of the increase in price risk also varies much across summers.

Power price risk can also increase in the winter, as in heating season 2000/2001. Yet, this increase may be attributable only to the exceptionally high and sustained natural gas prices in that heating season. It may also be a first sign that price volatility will increasingly propagate across natural gas markets to power markets, as these markets become increasingly interconnected and as natural gas power generation continues to grow.

Interestingly enough, power price risk was relatively moderate for power markets between September 2001 and early May 2002. ( 4) But, power price volatility did pick up in summer of 2002.

Naturally, an increasing number of utility companies are paying explicit attention to price risk. Keeping tab of the behavior of price variability over time is an activity that will most likely grow in importance for utility companies, whose revenues or costs, or whose customers' bills, are exposed to such large and varying amounts of price risk.

Some Things Stay the Same, Others Change

Although power price risk is still very high and spark spreads are still significant, they are just not the huge fires they were