At a time when many states and municipalities are facing budget deficits of historic proportions, many power generators are struggling against declining demand, the lowest electricity prices in...
Pricing Power in Whosesale Markets: A Risky Business
additional costs of risk-taking are for an enterprise.
Moreover, the emergence of traded gas and power markets with sophisticated practitioners using advanced financial and statistical techniques for valuing, parcelling, and transferring risk appears to have ignored the basic requirements for profit maximization in competitive markets-pricing at marginal cost. Advanced techniques to recognize and quantify optionality in the modern and flexible operation of power generation are critical to success in deregulated and competitively traded markets, but their use unadjusted for what is the actual marginal cost of exposure is incorrect.
A Fine Line Between Pricing and Risk
Reviewing the literature, one searches in vain to find out how pricing in a purely theoretical framework, both internally and to third parties, should be related to the cost structure and comparative advantages of an individual firm. 3 Yet how one implements a transfer-pricing scheme might have a big impact upon the success of a particular business model. 4 It may be as important as how derivatives are valued and the statistical methods utilized.
Perhaps the absence of attention to how one implements a transfer-pricing scheme involving derivatives, and how it should relate to company-specific factors (e.g., cost structures) arose because advances in financial-risk management have narrowed into a specialized field, emphasizing advanced mathematics and statistics. The relevance of company-specific factors has been ignored in favor of the weighty challenge of spanning state-spaces (that is, pricing non-traded or illiquid contingent assets or liabilities). 5 In creating such state-spanning prices (e.g., half-hourly options on power, or daily options on gas), differences over results, typically are attributed to market inefficiency or doctrinal views on methods. 6 Company-specific differences, such as customer-base diversification, technology, and cost structures usually are not considered as sources of risk-pricing differences. How surprising, since company-specific differences do not imply inefficient financial-commodity markets. 7 Moreover, informational efficiency does not imply long-run perfectly competitive markets for goods and services, which by implication would mean that all participants produce at the same marginal cost, albeit with different levels of risk-taking services.
Markets may be efficient and prices may convey all relevant information regarding such risk-taking services, but participants may be very different, reflecting company-specific abilities to carry such risks. Turning this point on its head, the absence of perfect competition in product/service markets implies that significant differences in the costs of risk-bearing may exist. 8 Often, it seems, such differences in cost structure are perceived erroneously as a form of market inefficiency. It may simply imply that markets for non-traded energy risk are not in long-run equilibrium, not perfectly competitive, or that firms in such markets produce at different cost structures. Thus, in the presumption that the price for accepting risk should be the same for all market participants, allowing for conceptual differences has no merit. 9 Introducing non-risk neutrality into pricing does not address underlying assets, technology, or cost structure, and their effect on pricing risk in gas or power markets. 10
Evaluating the costs of risk on a purely theoretic stand-alone basis, and ignoring potential savings that may arise from one's assets and other activities,