12-17-2003
An Efficient Electricity Futures Contract Structure For Risk Transfer: Why Can’t We Get One?
By Tom Lord for EnergyPulse
The existing 5x16 electricity contract will never allow the creation of an open, liquid trading market; it just doesn’t transfer risk reasonably. It is simple, it does wonders for generators but it can’t get us where we want to go. There are three flaws that need to be addressed.
First, the risk profile of the demand and generating sides of the market are very dissimilar. This is a point I have written and spoken about frequently. The following graph points out the issue – it has appeared in this publication before.

 

When the energy provider without generation buys over about 2,500 MW of 5x16 power (in this example) it starts becoming long the hour 8 and hour 23 periods. By the time the hedge position reaches the line shown as hedge volume, the provider has over a 1,000 MW long position in hour 8. If the provider fully hedges its peak load it is almost 4,000 MW long in hour 8. How can this be efficient?

Many industry participants would suggest that structured products would meet the provider’s needs. But that begs the point that the exchange contract only manages 1?4 of the market risk well. This is because the granularity of risk – the minimum time period for risk – is the hour, while the minimum period of the contract is sixteen hours. In natural gas this relationship does not occur because the minimum pricing period for both the buyer and seller is daily pricing. ( Intra-day pricing is such a small portion of the pricing risk that it does not impact the overall market risk transfer).

Second, the electricity contract is not acceptable for the exchange locals to participate in. The locals tend to trade spread trades or to utilize spreads – especially time spreads – to manage risk in an individual contract if it becomes highly volatile. The electricity contract is not amenable to spreads – either time spreads (going long a July contract to hedge a June short) or location spreads (going long a PJM West Hub June to hedge a Cinergy June short). Since the July contract may not be highly correlated to the July contract and the PJM contract may not correlate to the Cinergy contract, these risk management strictures don’t work. In reality, taking a position in an electricity contract is a straight speculative trade. The locals have trouble participating in a market like that. And the inability of the locals to participate has significant implications for potential market liquidity.

Third, the 5x16 contract masks the real pricing structure of the market. The reality is that the market may be long hour 8 power on a day that the market is short hour 16 power. The standard contract masks this reality. Therefore, the electricity contract compounds the standard monthly averaging of prices that an exchange contract implies with a daily averaging of price that no other contract creates. This just reduces the efficiency of the contract.

A suggestion that I have made a number of times over the past 6 years to industry participants, product development staff at the exchanges and in seminars is that some exchange should adopt a more complex but rational standard contract structure. The standard electricity contract structure should include three contracts covering the peak hours of the day: one covering the 5x16 period, one covering a 4 hour super peak period and one covering the twelve hour “doughnut” of hours in the 16 hour contract that are not in the super peak.

The baseload producer can still sell a 16-hour block and now the provider can buy a 4-hour block. If an intermediary – a local, a trading shop – buys the 16 hour and sells out a 12 and a 4 hour contract, they are flat. There is no location risk. The 16-hour versus the total of the 12 and 4-hour contracts should be perfectly (or nearly perfectly) correlated – meaning there is no risk of decoupling the contracts. The locals and other spread traders (I can imagine the crack spread traders could find a niche here) would be busy creating a market value for the risk of holding the 12 hour shoulder “doughnut” if the generators all want to sell 16 hour strips and the providers all want to buy 4 hour strips. If the there is enough selling pressure for 16 hour contracts and enough buying pressure for the super peak, the shoulders will become very attractive in price.

This creates many of the hallmarks of a successful contract structure – the buyers can more efficiently manage their risk, the contract more accurately prices the risk of the product and the locals can participate in a manner that makes rational economic sense. If the market trades options on this contracts, the risks of volatility spikes on the super peak will be more accurately priced than the 5x16 contract covers. The contract structure makes sense. The drawback that always is raised is that the contract is too complex.

The reality is that electricity market structures are complex. The simple 5x16 contract has not managed to ever gain a foothold and liquidity – especially among the locals. The decline of the electric power energy trading industry has further reduced the contract volume. Complexity isn’t a bad thing; it just means that investment in higher quality skill sets will trump the conservative, low cost approach. The reality is that it always has in commodity markets. I feel it is time to take a new look at how much risk is structured in electricity and how the exchanges can provide a mechanism for efficient risk transfer. That will be the first step in creating the seamless new market everyone wants.

One focal point for this change from my point of view is that emerging technologies in the distributed energy market have the ability to allow consumers and utilities to better “shape” their demand profile exposed to the grid pricing. A more efficient contract structure would increase price transparency, allowing better economic valuation of technology solutions. The attendant option contracts that could be deployed in this market structure would correlate well to such technologies a dispatchable demand side management, compressed air energy storage, battery systems, etc. It even has applicability to load shifting and energy efficiency systems. Therefore, the support for these structures may come from “non-traditional” market participants.

If market participants are ready for this structure Volatility Managers is willing to work with them to get these changes made. The industry must work to convince the exchanges this is a structure they are willing to adopt and utilize – the exchanges will not make this change without evidence of adequate support.