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|EI Principal John R. Morris leads the energy practice at Economists Incorporated. Su Sun is a Senior Economist at EI. They have examined spot/forward price relationships for electric energy in several matters and presented a paper on these relationships at the 87th Western Economic Association Annual Meeting in June 2012.|
The relationship between spot and forward electric power prices can shape appropriate public policy for restructured electricity markets. For example, states with competitive electric retail markets in the United States often require regulated utilities to provide Standing Offer Service (SOS) or act as Providers of Last Resort (POLR), and the utilities often must procure the capacity and energy for these products through auctions administered by the regulators. State regulators must decide the duration of the procurement contracts because longer contracts provide more price stability at the cost of higher prices. The relationship between spot and forward prices will determine how the cost of electricity rises with the length of the contract.
The relationship between spot prices and forward prices also comes up in the context of mergers and acquisitions. Reviewing agencies may be concerned that a merged entity would reduce its forward sales thereby increasing its spot sales and thus its incentive to exercise market power in the spot market. But when the forward premium is large relative to the ability to exercise market power, and spot prices do not affect forward prices, the merger is unlikely to affect the merging parties’ forward sales.
Electric generation companies have significant incentives to sell forward and not rely on spot sales for a majority of their income. Forward prices for monthly futures contracts traded daily on the New York Mercantile Exchange reveal significant price premiums relative to the actual future realized spot prices, especially for contracts longer than one year into the future. Thus, generation companies often sell forward to increase their profits by capturing these premiums. These firms will also want to sell forward to reduce the variability of earnings. Our studies of the daily real-time peak spot prices at the PJM Western Hub, which are from trades on the Intercontinental Exchange, show substantial price volatility. Other studies of electric energy prices also consistently show that selling most output forward well in advance of delivery minimizes the price and earnings variability of generation companies. Because both the volatility of spot prices and the significant forward sales price premium provide strong incentives to sell forward, electricity generators are very unlikely to reduce forward sales to increase the incentive to exercise market power in the spot market.
Another question when assessing mergers is whether electric generation companies would have an incentive to raise prices for spot transactions as a way of increasing prices in their forward transactions. Standard arbitrage theory indicates that the seller has the choice to sell a commodity today and receive the spot price, or sell it forward to be delivered on a future date and receive the forward price determined today. From the buyer’s perspective, the latter is a buy-and-hold strategy. The arbitrage equation implies that there will be a relationship between spot and forward prices that will ensure that both strategies are equally profitable after taking into account of the risks, because otherwise sellers would switch between spot and forward sales. Thus, an attempt to raise spot prices, if successful, may affect forward prices as well.
Because electricity is largely non-storable, however, this arbitrage equation may not hold well for electricity. A first look at spot and forward electricity prices may reveal a relationship between the spot price and the forward price in electricity. This relationship is small, and much weaker than the relationship observed between the spot price and the forward price for natural gas, but it is statistically significant. Such a relationship may be observed for electricity because although electricity cannot be stored, the fuels used in generating electricity are stored. During peak hours in the eastern United States, the most common fuel used in marginal generation is natural gas, and natural gas is stored.
Thus, the apparent arbitrage relationship between spot and forward prices for electricity might be spurious, an appearance created by a strong spot/forward price relationship in the natural gas market. To control for the impact from the arbitrage in the natural gas market, we estimated the relationship between the spot electric price and the spot natural gas price and between the forward electric price and the forward natural gas price. When these estimated effects between the natural gas prices and the electricity prices are excluded, the spot-forward relationship in the electricity market is no longer statistically significant. This result indicates that an electric generator’s raising spot electricity prices would be unlikely to raise forward prices.
In summary, the empirical literature reveals significant price premiums for electricity forward sales, electric generators have a strong incentive to sell most of their expected output as forward sales, and the daily spot prices of electricity do not affect forward prices of electricity. These results have implications for both electricity generators and policy makers. For generators, the results suggest a strategy of selling forward, especially more than one year in advance, to take advantage of the available forward premiums. For state regulators, the results suggest that having one-year terms for electric power procurement may be preferable to longer terms. One-year terms provide price certainty for a year out while avoiding paying the large price premiums on contracts beyond one year. The results also indicate that agencies reviewing mergers should have little concern that raising electricity daily spot prices for a short period would have any material effect on forward prices.