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Power Price Volatility and Risk Management: An Introduction
by Anne Ku (Sept 2000)
This is the original, unedited article, later submitted to Global Energy Business magazine (Sept/Oct 2000)
The idea of being able to choose your energy supplier and pay the true cost of energy is one of the main reasons for deregulating the power industry. Deregulation should lead to competition, and competition should lower the price to buyers. Almost everyone believed that prices would drop after liberalisation. In fact, certain power marketers even expected to capture the "economic rent" by offering fixed price contracts prior to full retail access in California.
What went wrong?
When San Diego residents' electricity bills doubled this summer, the state became alarmed that deregulation wasn't working. Emergency measures of setting price caps of $250/MWh and speeding the approval process for new power plants were introduced. But many criticized that these temporary fixes will would not solve the underlying problem.
This is the first time, since deregulation and retail access, that residential customers have felt the full impact of wild swings in power prices. Previously under the Cost of Service regulation, utilities passed through its costs (fuel, operations, stranded costs) to its customer over a period of time, but the prices they charged were set against approved rate of return. In the new regime of free markets, utilities may also pass the cost of power they purchase to their customers. Without proper risk management, utilities are effectively passing the full impact of unpredictable power prices to the end user.
This is not the first time, however, that power prices in the free market have disrupted normal business activity. Montana Resources (Butte, Montana), a copper mine, had to lay off over 300 workers this summer because it could not afford to pay its number one operating expense: electricity. After its fixed price contract expired at the end of June, the mine faced a 20-fold increase in power prices in the spot market! Another heavy energy user, Ormet Primary Aluminium Corporation (Hannibal, Ohio) decided it would make more money by idling its production and selling the electricity it would normally have used instead.
Once hailed as a major innovation and technical success, the UK Pool, after more than ten years in operation, is being scrapped completely this year due to its economic failure. High market concentration, flaws in the pool bidding and scheduling mechanisms, ability to game as a result of market power due to type and location of plant ownership have all contributed to the uncompetitive price levels at various times.
Even the Nord Pool in Scandinavia is far from perfect as the generation imbalance and capacity bottlenecks between Sweden and Norway are causing severe differences in system and area prices this year.
Is price stability possible in power markets?
Ideally, a competitive market should give the correct short term and long term signals to buyers and sellers. In the short term, prices should reflect the short run marginal cost of production. In other words, energy buyers should not have to pay more than what it costs to produce and deliver. It should also give incentives for investment in generation and transmission capacity in the long term. The ideal result is price stability.
Take the oil market, for instance - probably the longest established and most efficient energy markets around. Crude oil prices do not move as wildly or spike as enormously and frequently as power prices. The fluctuations are mainly due to perceived and actual supply and demand imbalances - and spikes driven by specific events such as the Gulf War or OPEC supply decisions.
One measure of price fluctuation is volatility. It is not simply rising or falling prices, but how prices move in magnitude relative to time. Defined as the standard deviation of log returns, volatility measures the magnitudes of percentage changes in prices over time. As a unit-less measure, it allows you to compare relative and absolute price movements in different markets. The greater the volatility, the greater is the uncertainty surrounding prices. It is an indication of level of risk, that the future will not turn out the way you expect.
In the stacking order of volatilities, coal spot prices have been at the 20% region in the past year in Europe. The most volatile metal traded - the 3-month nickel on the London Metals Exchange - has seen volatility of 60%. The last five years, natural gas futures prices have swung wildly above 100%.
But none of this can compare to power prices whose volatilities in Europe have exceeded 2,000%! On the Amsterdam Power Exchange in early January this year, the sudden jump from average levels of 44 Euro/MWh to 474 Euro/MWh translates to volatilities in the order of 1,500%. Volatilities of hourly prices in some markets have reached as high as 3,000%.
Returning to the recent events in California, it is not surprising that power prices are the most volatile of all traded commodities.
Hourly price movement is even more dramatic as seen in NEPOOL (northeast US) below. Rich Patrick, Partner, Global Resources Practice, Andersen Consulting, explains "Wholesale power markets, during periodic supply-demand crunches, have exhibited volatility 20 to 30 times that seen in financial and oil markets. This is driven in part by the fact that power cannot truly be stored, and in part by market rules which in effect limit supply and demand adjustments to these price signals. We anticipate that these market rules will be fine-tuned over time to allow these adjustments, which should dampen the volatility."
Why are power prices so volatile
Power, unlike other commodities, cannot be stored. As such, it must be there when you need it. While some power plant can ramp up and down quickly to follow the load, it is more efficient for others to stay on-line than to be switched on and off. Thus the supply of power is relatively inelastic.
On the flip side, demand is largely inelastic. The lack of real time metering means that we don't know how much we use or indeed how much it costs until after the fact. For the consumer, electricity is not something we think about, much less deliberate over. We do not usually decide when to use electricity. Thus we cannot react to high prices easily by cutting consumption. Demand is also highly variable within the day, causing great fluctuations in hourly prices. The short term inelasticity of both supply and demand is the main reason for price spikes.
The delivery of power is also subject to transmission capacity constraints and the requirement for grid stability, further limiting the availability and flow of power. Transmission constraints can cause the formation of load pockets. Plants located in such areas have price-setting ability.
In power markets, prices tend to move in the same direction as demand (positive price-volume correlation). This "double whammy effect" exacerbates the tendency of prices to spike in times of shortage. When you need power the most, that's when everyone else also needs it. In extreme conditions when demand is hard to meet, the few providers of power can act like monopolists, asking any price they want. On the other hand, owners of inflexible plant will find it very difficult to get rid power in times of low demand, leading to negative or zero prices just to keep the plant running.
Price behavior is also influenced by the cost and availability of generation, the type of generation technology, and market structure. For example, the dominance of hydropower in the Colombian (Bolsa) and Nordic power markets (Nordpool) contributes to great price swings.
This combination of the inflexibility of generation plant, transmission congestion, and unresponsiveness of demand leads to price volatility.
Price volatility isn't everything
More critical than price risk - and perhaps the most unique feature of power - is volumetric risk. This is the risk that a buyer uses more or less than the original quantity bought, and the seller must supply more or less than the original amount sold. As power consumption is difficult to predict accurately, supply contracts typically embed "swing" and "interruptible" elements. A swing option allows the buyer to consume different quantities of power. An interruptible contract allows the seller to cut off supply.
Weather conditions such as temperature and wind greatly affect non-industrial electricity consumption. Sudden heat waves or cold spells may cause a surge in power requirements. The sudden heat wave in May coincided with the scheduled maintenance of several power plant in the NEPOOL region. This resulted in prices hitting $6,000 per MWh. Temperatures are not the only weather risks. The amount of cloud cover indicates the need for illumination, which affects not only lighting but also other indoor activity.
Besides the usual market and operational risks that affect all businesses, power energy retailers face many other risks as illustrated below. (Energy retailers face may risks, source: PHB Hagler Bailly).
A more thorough discussion of power markets and associated risks can be found in "Managing Energy Risk, 2nd edition" of Risk Books publications.
Need for risk management
Imagine if interest rates were as volatile as power prices. Your floating rate mortgage could go through the roof, and you might lose your house.
Energy buyers who observe only the price levels rather than the volatility and lured into purchasing from the spot market are in for a big surprise. San Diego residents were effectively purchasing power at floating, spot prices passed through by their utility SDG&E. Energy buying is no longer a straightforward procurement activity but one requiring sophisticated risk management. While many of us apply the concepts of risk to our financial management, few of us are aware of the same need for our energy management.
What can energy buyers do to protect themselves against big price swings? They can enter into fixed price agreements. They can take out interruptible contracts - lower prices but with possibility of getting supplies cut. They can enter into contracts that give them greater flexibility in price and volume. They can outsource the entire energy procurement function.
The purpose of risk management is to eliminate surprises. It refers to the use of financial instruments to manage one's exposure to risk. This involves identifying the types of risks, measuring the exposure, and managing through hedging. The different strategies can be summarised below:
"More than any other deregulated market, energy needs risk management because all energy companies' risks are complex," says Shezad Abedi, CEO of Bright Spark, a new intermediary focussing on reducing risk for energy clients in Europe.
"Risk management cannot remain in elite business units. Everybody within a utility must understand the kinds of things included in risk management. I envision a grassroots revolution where people understand options, delta, and what makes markets efficient. The biggest threat to markets becoming efficient is fear of risk issues and return to regulation as a result," says John Wengler, president of SAVA, author of a forthcoming book called Keeping Management in Energy Risk Management (Spring 2001).
Power price volatility cannot be avoided even in perfect markets. Risk management is necessary to stabilise prices for the end-user. It's time that we start thinking about risk for energy management in the same way that we do for financial management. Energy IT and Global Energy Business will be covering risk management, online trading, electricity brokers and other players, analytical technologies (sophisticated modelling and forecasting techniques) through case studies and interviews.
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