Billy Fung

Electricity Markets

Billy Fung / 2016-08-20

Market basics

The spot market is where electricity is sold at a specific price, in half hour intervals. So you buy the electricity, and the generator fires up and obtains the energy, and then it gets transmitted to you. This creates a supply and demand scenario, where electricity is constantly being bought and sold, so the power stations are able to predict when to turn on and off, to maximize efficiency. As a retailer, it is in your best interest to buy energy contracts at a fixed cost, where the duration is as short as possible to fulfill your needs.

An example in history where this came up is the energy crisis in California, where manipulation and corruption lead to the government having to pay a fixed cost for a long duration, like paying $50 per MW for a year contract instead of something like a half hour.

Along with the spot market, there is the futures market. The futures market allows for an agreement to buy electricity at a certain price on a future date. This is not a physical trade, but an agreement to buy electricity through the spot market. All the products offered in an electricity market is usually to follow economic theory, creating an economy where products are offered to allow for competition as well as to lower risk. A future allows for speculation on the spot price, so if you think the price will go up or down in the future, you can buy a future and then you will be able to buy the spot price for less.

The electricity market follows ideas that are found in the stock market, except that the underlying reasoning differs. The derivative products such as futures and options, mainly work to allow for smaller companies to be competitive in the same market. The products work as hedges against risk, letting traders participate in the market while preventing larger traders to control the market.

Some factors to consider

Being a commodity, electricity markets vary largely depending on the source of energy. In hydro dominant areas, there arise the interesting problem of needing to forecast the weather. Demand can be forecasted in deregulated markets by looking at the consumption of households, but how do you figure out the supply? Being able to predict the supply of energy means you can make money off the electricity market, selling contracts at certain prices because you know the general trend that the supply will be moving towards. For example, if you could predict a drought, then you could sell contracts that show the price of electricity moving upwards towards a certain price.

Another product I haven’t mentioned is a FTR, which is a financial transmission right. This product in the market is used to hedge (protect) risk against transmission losses as electricity must physically move from 1 area to another. This results in losses in the transmission, which will affect electricity prices. The further you have to move the electricity from the power station, the higher chance that something might fail along the way. This allows for another product to be used, if you are able to predict how much electricity can be generated.

What next?

This is all just very basic stuff, a lot goes on into trying to be an energy retailer. The basics is that you buy electricity from a generator, then with the government and market mechanisms put into place, you can provide a consumer with that electricity. By using smart meters, you are able to see the consumption of a household, and be able to bill them accordingly. A trader then wants to buy electricity for a lower price, in order to make a profit.