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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
  • such as two-part real-time pricing tariffs as responses to significance price risk. Increasingly, an understanding of price risk is being used to understand the value of such technologies and instruments. Distributed generation allows for better timing to bring generation online. Two-part, real-time pricing tariffs can provide price insurance and price instability which, nonetheless, will stabilize bills over time. 6
  • And credit is king. The future structure, organization, and regulation of the power and gas business will be different from what it was in the past. And a new roster of major players will also appear. Yet significant price risk is most likely to continue in the wholesale power business, if only because of the enormous additional capital expenditure that would be required in transmission and other equipment to reduce it.

These expenditures would entail a phenomenal increase in debt, and despite low interest rates, few companies would be interested in doing this. The emphasis in the industry now is on acquiring a better credit rating and on reducing debt, not increasing it.

  1. Economists at major institutions in California have now come full circle from believing in an ability to create a power market design that would be immune to the special circumstances and conditions in the power business. Now it is understood that such factors as highly inelastic demand and supply in the short run, frequent and significant capacity constraints, extremely expensive storage, and opportunity costs that can exceed production costs because of trading opportunities across markets can set the stage for a regular assertion of market power. One interesting study found that not only do these factors matter but that 59 percent of the $6.94 billion increase in electricity expenditures in California restructured wholesale market between summer 1999 and summer 2000 is attributable to increased market power. Severin Borenstein, James Bushnell and Frank Wolak, "Measuring Market Inefficiencies in California's Restructured Wholesale Electricity Market," University of California Energy Institute, Berkeley, California,, June 2002.
  2. Enron's chief trader in 2001 booked an enormous $750 million in profits by trading natural gas and by correctly predicting price movements and taking positions accordingly. This trader was probably the most successful trader in 2001 in any commodity market. Yet, this same trader lost 27 million in 2000. See , Tuesday, July 9, 2002, pages C1 and C6.
  3. Models are used widely to determine the value of physical and financial assets such as options to put a cap on prices. Yet, ordinary use of these models requires that average daily percentage changes in price be relatively constant over time, or if not relatively constant, able to be reliably estimated. The goal is to obtain measures of price volatility that represent price risk around any level. Thus movements in price levels should not influence price volatility. Ordinary applications of these models also may require that changes in price are normally distributed and independent from one day to the next, just like flips of a coin would be independent from one flip to the next. These assumptions are often not satisfied with power prices. This makes pricing options