A division of Westpac Banking Corporation ABN 33 007 457 141
Importance and Evolution of Forward Markets in Electricity
ISCR Conference Wellington
Paul Quilkey
4 September 2003
“…forward prices also comprise the most vital decision
parameters when planning energy linked projects.”
‘Managing Energy Price Risk’
Perspective
Electricity market deregulation commenced in the 1990’s
Geographies evolved at different rates as a function of market design and market attributes
Credibility of electricity markets damaged by Enronitis
Electricity markets evolved and regressed in a short period of time – part of a natural cycle
Electricity price risk management is as new as the market itself
Fundamental to price risk management is the concept of of a forward market
When is a Market a Market ?
Term is often misunderstood and misapplied in electricity
Characteristics of a market
Multiple buyers
Multiple sellers
Hedgers and speculators
Relatively low barriers to entry
Set of consistent rules and contracts
What is a Forward Market ?
A forward contract is a bilateral agreement between a buyer and seller to execute a trade at some date in the future
Buyer and seller agree on the quantity and price of the commodity or instrument to be traded
Difference between a forward and spot transaction concerns the timing of the trade
Forward markets have been around for centuries and many basic sales agreements can be viewed as types of forward agreements
Forward contracts are fundamental to financial markets
Why is a Forward (and Futures) Market Important?
Price and volume risk management
Credit risk management
Transparent price signals
Appropriate long-term investment
Challenges with Electricity
Issue In Financial Markets In Energy Markets
Maturity of market Several decades Relatively new
Fundamental price drivers Few, simple Many, complex
Impact of economic cycles High Low
Frequency of events Low High
Impact of storage and deliver; the convenience yield None Significant
Correlation between short and long term pricing High Low, 'split personality'
Seasonality None Key to natural gas and electricity
Regulation Little Varies from little to very high
Market activity ('liquidity') High Low
Market centralization Centralized Decentralized
Complexity of derivative contracts Majority of contracts are relatively simple Majority of contracts are relatively complex
Price Forecasts v Forward Markets
Under regulated regimes, all price forecasting was cost forecasting
In electricity markets it is less clear what is meant by a forward curve
Forecasting prices involves understanding the uncertainties surrounding the drivers of price e.g. fuel
Forward curves are made up of forward prices which reflect what people are will to pay today for delivery in the future.
The two concepts have and continue to be confused
Price forecasts v forward markets
Forward curve
A snapshot of where market participants are currently willing to transact
Either market-observed or derived based on arbitrage relationships between prices and rationality bounds.
The market is always right. The whole exercise of the forward curve is to portray where the market is.
Used for marking positions to market and determining liquidation value.
Forward prices can be locked in today.
Can be used for deal pricing, to the extent that one expects to offset exposure in the open market.
Uniform for all market participants.
Price forecast
A prediction of what might happen in the future Based on economic/engineering analyses of future supply and demand, regulatory and technological trends, etc.
The market can be wrong.
Should not be used for mark-to-market purposes.
Price forecasts may not be locked in today.
Can be used for deal pricing, to the extent that one does not look for an offset but uses the transaction as a bet on future prices.
Each market participant may have a different forecast.
Source: Leong, ‘The Forward Curve in the Electricty Market’
Forward Markets v Price Forecasts
Source: Leong, ‘The Forward Curve in the Electricity Market’
Forward curve
A snapshot of where market participants are currently willing to transact
Either market-observed or derived based on arbitrage relationships between prices and rationality bounds.
The market is always right. The whole exercise of the forward curve is to portray where the market is.
Used for marking positions to market and determining liquidation value.
Forward prices can be locked in today.
Can be used for deal pricing, to the extent that one expects to offset exposure in the open market.
Uniform for all market participants.
Price forecast
A prediction of what might happen in the future
Based on economic/engineering analyses of future supply and demand, regulatory and technological trends, etc.
The market can be wrong.
Should not be used for mark-to-market purposes.
Price forecasts may not be locked in today.
Can be used for deal pricing, to the extent that one does not look for an offset but uses the transaction as a bet on future prices.
Each market participant may have a different forecast.
The Australian Forward Market
Ele c t r ic it y P r ic e C u r v e ( $ /M W h )
$ 0
$ 1 0
$ 2 0
$ 3 0
$ 4 0
$ 5 0
$ 6 0
1999 2000 2001 2002 2003 2004 2005 2006 2007
V ICNS W Q L D S A Da te : 2 9 /8 /0 3
F o rwa rd S wa p R a t e s
H is t o ric a l S p o t P ric e s
Source: Westpac Analysis
Australian Electricity Trading Activity
168TWh traded; 30 players including two intermediaries
Trading activity obscured by large volume of un-reported direct deals
Major concerns cited for illiquidity include:
Credit
Legal (mainly ISDA)
Regulatory Risk
However, volumes are increasing in the forward markets
Trading Activity – SFE Electricity Futures
Source: d-cypha Trade
Trends and Developments
W eekly Volum e
0 100 200 300 400 500 600 700 800
9-Sep 23-Sep 7-Oct 21-Oct 4-Nov 18-Nov 2-Dec 16-Dec 30-Dec 13-Jan 27-Jan 10-Feb 24-Feb 10-Mar 24-Mar 7-Apr 21-Apr 5-May 19-May 2-Jun 16-Jun 30-Jun 14-Jul 28-Jul 11-Aug
Trading Activity – Reuters
Num be r of We e k ly Ele ctr icity OTC Tr ade s
0 20 40 60 80 100 120 140 160
Dec 98 Jul 99 Jan 00 Jul 00 Jan 01 Jul 01 Jan 02 Jul 02 Jan 03 Jul 03
Source: Energy Bank Link, Reuters
The NSW Forward Market
Calendar 03 NSW Flat Daily Price
29.00 30.00 31.00 32.00 33.00 34.00 35.00 36.00 37.00
02/01/02 02/02/02 02/03/02 02/04/02 02/05/02 02/06/02 02/07/02 02/08/02 02/09/02 02/10/02 02/11/02 02/12/02
Trading Date
$/MWh
NSW Forward Market Price Change
Daily step changes:
Frequency Cal 03 NSW Flat Daily Shift
0 20 40 60 80 100 120
-1 -0.8 -0.6 -0.4 -0.2 0
0.2
0.4
0.6
0.8
More
$/MWh Shift
Frequency
Frequency
Market Volatility
Not such a volatile forward market
12 month swaptions trading at 5%-7% volatility
Lower volatility than interest rates and selected equity markets
Volatility only seems extreme if you only see a price every 3 years
Price changes normally distributed
Most price spreads between 1-5%
YTD Daily Return on 1 yr Forward
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
01/01/03 15/01/03 29/01/03 12/02/03 26/02/03 12/03/03 26/03/03 09/04/03 23/04/03 07/05/03 21/05/03 04/06/03 18/06/03 02/07/03 16/07/03 30/07/03 13/08/03 27/08/03
AUD Int Rate USD Int Rate AUD/USD Gold/USD NSW Elec
2003 YTD 1 yr Forward- Volatility Comparison
AUD Int USD Int AUD/USD Gold/USD NSW Elec Flat
Volatility:
2003 YTD
17.39% 41.82% 10.15% 14.49% 29.59%
Products Used in the Market
How is wholesale risk managed in the market?
Swaps (70%) – fixed price/volume contracts
Swaptions (8%) – options on swaps
Caps/Floors (10 %) – half-hourly options
Asian Options (2 %) – option over a period
Exotics – (1%) – weather/demand/AS
Compliance products – (1%) – REC’s, NGAC’s
Exchange Traded Products (8%) - futures
But Isn’t New Zealand’s Different?
Hydro based, low storage capacity, long skinny transmission system, fuel supply issues
Is relatively small (37TWh pa)
Significant vertical integration and concentrated (no independent retailers)
Majority owned by the state
A “gross” pool-based spot market
No real OTC activity
No futures market
No price transparency
No medium or long term price signals
No new entrants
Vertical integration
So why Bother with Financial Energy Markets
Inability to manage and price risk for all participants
Excessive transaction costs and margins
Inappropriate / incorrect investment decisions
Non-competitive behaviour
Vertical integration
Government intervention and re-regulation
Challenges for New Zealand
Stabilise the regulatory environment
Create changes to market rules which encourage trading activity and transparency
Create incentives for participation
Explore disincentives for anti-market behaviour
Participate and embrace the financial
market…liquidity is self reinforcing
“…significant attention has been given to the role of regulators in mitigating excessive
price levels in electricity markets…a
quantitative analysis of the long-term effects of regulatory intervention through the use of price caps….[shows] how such short term fixes can lead to long term deficits in the
available generation capacity, and ultimately to market failures...”
Skanntze and Ilic, ‘Valuation, Hedging and Speculation in Competitive Electricity Markets: A Fundamental Approach’
Market Model
Physical Market
Exchange Traded
OTC Market
Immediate Price Discovery Volume = 1
Short, Medium &
Long Term Price Discovery
Volume = 2-5 times physical Short to Medium
Term Price Discovery
Volume = 5-20 times physical
