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Energy Market Participants: The Risks of Being a Jack-of-All-Trades

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.
Fortnightly Magazine - June 1 2003

or short position derived from the company's principal business activity. For example, an owner of generation has a natural long power position, whereas a retail power provider has a natural short power position. Integrated utilities may have combined positions that create a net position that fluctuates between long and short. Furthermore, a company's position may be predictable, in the case of a baseload generator, or unpredictable in the case of a peaking generation owner or retail supplier. Thus both the nature and dynamics of the net position will influence the ideal market role.

Price Impact

For natural buyers and sellers such as retail suppliers or generators, it is critical to understand the price impact of trade size. Price impact refers to the movement in clearing price caused by transaction size. 1 For most markets, price impact is an increasing function of transaction size. That is, larger volumes will have a greater impact on the settled price for that trade. If price impact is large, that will force natural buyers and sellers to assume some amount of active market activity to disguise their position and improve the average price achieved. In other words, if the market is thinly traded, then the optimal strategy for a natural buyer or seller may include active trading and risk taking beyond the natural position, to provide the best risk mitigation at the best all-in cost. The decision to make proxy hedges in related markets also might be justified by the price impact in the proxy market compared with the price impact in the original market. Clearly the execution price improvement from proxy hedging must exceed the risk of proxy hedge failure.

In addition, market microstructure suggests that in general, the more volatile the market, the wider the bid-offer spread will be, all other things being equal. This is because the returns from market-making activities (the spread) must be commensurate with the risk from having an open position (volatility). However, overall liquidity levels also play a major part. Therefore, power markets exhibit larger spreads in less volatile markets such as off peak, since the low liquidity effect dominates. This suggests that market makers in low liquidity products may be able to earn greater than normal returns if willing to take the liquidity risk.

Capital requirements of trading also play a big part in the cost structure of a commodity market maker. The lack of widespread cash margins prevents a market maker from minimizing capital requirements of a market neutral position. This translates into a higher business cost from this activity and again to higher spreads and less liquidity.

Regulatory Intervention: A Heavy Hand on Markets

Regulatory intervention can create market distortions. For example, many utilities that have divested generation and are therefore natural buyers are limited in their ability to participate in forward markets. This may take the form of an outright prohibition, as in the case of California utilities, or an implicit understanding that losses from hedging activities cannot be passed through to ratepayers, while losses from unhedged high market prices can be. In addition, the possibility