[BETA] Fortnightly

Those that attempt to participate in more than one area of forward energy markets will be internally conflicted in terms of performance measurement and risk profile.

In the past year, much consideration has been given to the design of the wholesale power market. This effort has been directed primarily at the market structure of the physical system and the definition of the markets necessary to create incentives for delivery of reliable power. Yet, scant attention has been paid to identifying the conditions necessary for maintaining a successful and liquid forward market and the various roles that a participant may play. Identifying this aspect of market development is especially important, as there exists a critical relationship between the market structure in which a company operates, the assets it controls within that market, and the role of the company as a market participant.

Forward markets are particularly important in power because they provide the pricing signals necessary to make decisions on major capital investments that are necessary to ensure reliable power delivery. While it is important to have well-functioning spot markets for power, these provide insufficient information to decide on capital investment in this sector. Forward markets provide the insurance mechanism for buyers and sellers wanting to lock in price certainty. Price certainty contributes to cash flow certainty, which is critical to definition of the funding structure of any business.

In the current environment, the funding structure of energy market participants is under renewed scrutiny as business models are put to the test. Forward price discovery allows for informed capital investment decisions, based on market demand. The decision to hedge or not can be made separately, but in an informed way.

Defining Market Roles: What's Your Bread and Butter?

One of the many problems that contributed to the over-investment in energy trading was an unclear definition of market role by participants. In general, the lesson from other markets is that each market participant can only inhabit one market role. Those that attempt to participate in more than one area of the market will be internally conflicted in terms of performance measurement and risk profile.

Speculators provide a critical and often misunderstood role in markets. They are needed to fill the gap between natural buyers and sellers in a market. Natural buyers and sellers are those that have a short or long position in the markets by nature of their business or other activity. There is a continuous spectrum from natural buyers through speculators/market makers to natural sellers (see Figure 1).

If there is inadequate speculation in a market, then the forward market will trade at a premium or discount to the expected future spot price. This has broad implications for energy markets. For example, a forward market will trade at a premium to the expected future spot price if there are more hedgers on the buy side. In equilibrium, this premium will also reflect the risk-adjusted return to speculators of taking that net risk, including the frequency and severity of losses.

Moreover, the natural position of a market participant refers to the net long