Managers of portfolios with commodity exposures may see the day when they are investing in exchange-traded products covering more commodities than they currently imagine. If so, thank suitable indexes such as those described here that make commoditized markets and financial instruments for them possible where they were not possible before.
Since the publication of the Dow Jones California Oregon Border Electricity Price Index (COB Index) in 1995 there has been a proliferation of power market indexes in the US and in Europe. Not only have these indexes played a central role in the creation of the power markets on both continents, they have fueled the emergence of an over-the-counter financial market that could some day surpass the physical power market in size. Given the global trend toward liberalization in recent years can this trend toward indexing expand into newly emerging markets such as bandwidth, emissions trading, etc? Undoubtedly some of these markets will experience major price volatility and, as a result, will see substantial demand for derivative products. Can these indexes be made robust enough to serve as benchmarks for settling exchange-traded futures, even in exceptional cases where physical delivery may present major problems? The methodological approach to creating power market indexes described below may prove relevant in various emerging commodities markets.
ELECTRICITY NEEDED PRICE INDEXES
The major impetus behind the commoditization of electric energy began in the late 1970s and has been spreading worldwide.
Although, in most cases, the electricity industry has made a successful transition to the new market environment, there is much about electricity that makes a commodity trading market difficult to establish. Except in markets dominated by ample hydro supply, for instance, electric energy is practically non-storable. This means electricity must be consumed as it is produced. This lack of storability makes electricity a highly volatile product. Even prior to deregulation, the marginal cost of electric power routinely reflected unpredictable spikes during the summer and winter months. This tendency to become volatile is illustrated in Figure 1.
çThis inherent volatility became apparent as the new market place began to value power in terms of prices. It became more pronounced as trading practices shifted from long-term contracts spanning over many years to transactions that could be consummated on the spot.
Transportation is another problem area. For instance, given two transmission lines running next to each other, power will tend to flow through the line that offers the least resistance and any imbalance at any point of the transmission network can cause the entire system to fail. This and various other transmission issues tend to exacerbate the fear, especially in markets still adapting to the new competitive environment, that the com-moditization of electric energy could cause a threat to the security of supply. For this reason many of these markets tended to promote the formation of various pooling organizations that not only controlled the central dispatch of power plants, but also maintained a very controlled pricing environment. Such pooling arrangements all suffer from the perception that prices are determined through rigid mathematical formulae instead of by a competitive market.
Nevertheless, the over-the-counter markets have done well in most countries where the legislature does not prohibit bilateral trading. In the United States, the number of marketers buying and selling electric energy in the bilateral market has increased from less than 10 in 1993 to over 500 by the end of 1999. As of September 1999, these power marketers moved over half of all market-based wholesale electricity traded. In Scandinavia where liberalization has been highly successful, hundreds of brokers and power marketers coexist side by side with NORD Pool, the Nordic power exchange. In Germany, where power marketers and brokers began trading in March 1999 in the newly liberalized power market of Europe, the trend indicates a highly successful spot market is underway.
To a large extent this success is due to a high level of price transparency embedded in the creation of various price indexes. During the early phase of market development the various efforts made using the traditional price gathering method proved inadequate for power traders. Even the most innovative approaches that introduced some form of electronic bulletin boards which enable traders to post bids and offers did not win market confidence.
This occurred for two main reasons. First, because of the complexities of the power business, it was not clear to the new entrants what electricity products to trade. For instance, while the electrons in a megawatt-hour of power may be the same as others throughout the day, the premium associated with a megawatt-hour at midnight is less than that paid for the same unit at noon. Second, the perception that some power producers could not be trusted to be forthcoming with reliable information forced the market to seek a more robust form of price gathering.
Mindful of the importance reliable pricing signals play in market development, investor-owned utilities, municipal utilities, power marketers, and various financial institutions agreed to collaborate in the creation of electricity price indexes, first in the United States, and more recently in Europe. The creation of these indexes called for the definition of a set of products, the choice of market hubs, and an acceptable data gathering methodology. The markets also saw the need for a neutral arbiter who could not only assist in developing these indexes but also guarantee their widespread development and educate the public of their implications for the emerging market.
SETTING UP THE MARKET
In the Western United States, where the Western System Power Pool (WSPP) had set the framework for the creation of a spot market, it was easy to define a set of products that could be traded easily: day-ahead on-peak firm energy, day-ahead off-peak firm energy, and so forth. In Continental Europe, where there was no central organization like the WSPPpromoting the trading of electric energy, defining a set of products was more challenging. The issues became much simpler when two leading utilities in Switzerland agreed to cooperate on the development of the Swiss Electricity Price Index (SWEP) in 1998. A year later, the decision by PreussenElektra, Germany's second largest utility, to support an index on its power grid, the Central European Power Index (CEPI), removed the final obstacles to defining standard products most traders could agree on.
In all cases firm power was defined as energy that must be delivered once sold except in case of force majeure. To be considered as firm these contracts had to be backed by generating capacity. Non-firm energy was a type of contract that gave buyers and sellers some flexibility in how they chose to deliver the energy. These contracts could be cancelled at any time for any reason once adequate notice had been given.
Due to structural similarities between natural gas and electricity, power executives were quick to learn from the experiences of the natural gas industry. Having successfully been deregulated nearly a decade earlier, the US gas market was a perfect example of a newly competitive market. Market centers emerged around the numerous interconnections of the gas pipelines. These centers, especially those with many interconnections, were called hubs, of which the most famous is the Henry Hub in Southern Louisiana. Two of the major characteristics that made these gas hubs successful was their capability to bring large number of buyers and sellers together and the ease with which these agents transferred gas title from one owner to another. The large number of power marketers that entered the electricity business were quick to promote this concept as an ideal solution to the complex issue of defining delivery points in the emerging power markets. To facilitate the creation of the first power marketplace in the United States, the market selected the California/Oregon Border (COB) as a hub. In reality the COB was a point of interconnection on three high voltage transmission lines linking the Pacific Northwest with the Pacific Southwest. The continued demand for power at that point and the ease with which buyers and sellers could transfer ownership of power made the COB one of the few points on the west coast with the characteristics of a major market hub. Similar hubs have been designated in Europe.
The methodological approach to gathering data played a crucial role in the development of power indexes. Two of the central issues were the perception that the sheer size of some power suppliers could not only lead to data manipulation but also to off-centered indexes. On the latter issue it soon became clear that no matter how well designed, an index could never remove the structural imbalances of a market. This was understood to be not only true for the commodities markets including power, but also for the equities markets as well. However, it was possible to introduce safeguard mechanisms that would at least facilitate the tracking of manipulation to the source and, if necessary, take measures to remedy the wrongdoing. Two such mechanisms were a) the recognition of Dow Jones & Company as a neutral arbiter to help design and calculate the indexes, and b) the execution of a legal agreement between each data provider and Dow Jones. One of the key provisions of this document was the agreement by each data provider to submit to occasional audits by a professional auditor at Dow Jones' sole cost. Although none of the providers would agree on a financial penalty in case there was evidence of a pattern of deception the knowledge that a provider could be publicly dropped from the index was deemed a strong enough deterrent. The market also agreed that a volume-weighted-average formula would accurately depict the realities of the power industry.
Having agreed on a methodology and a calculation method, the data-collection process was straightforward. Each day, by a time agreeable to all parties, Dow Jones collects prices and volume of daily energy transactions. This includes prices and amounts of energy sold. The information is transferred electronically and is stored in a permanent file for auditing purposes. Because of the confidential nature of the data, it is processed in a highly secured environment by staff members whose main task consists of guaranteeing that the index is accurate and reliable. Data that deviate substantially from the mean are investigated and, in the absence of a reasonable explanation for the deviation, are removed from the pool.
How well do electricity indexes track the power market? Although the electricity market is still evolving and may not have yet reached the level of maturity of the equities markets, the evidence suggests that electricity indexes provide a reliable picture of a market well on its way to becoming informational-ly efficient. This is apparent when the Dow Jones power indexes are compared to other time-tested benchmarks. In assessing the reliability of the power indexes, the distribution of their daily returns is compared to that of the S&P 500 and a set of randomly generated and uniformly distributed numbers. As would be expected the random-data control-group series sample showed an almost linear pattern with a Pearson's correlation coeficient of 0.9954.
However, even without accounting for these factors, it is worth noting the high correlation coefficients, 0.97 for the Palo Verde Index, and 0.95 for the COB Index, compared to a 0.98 correlation coefficient for the S&P 500. This suggests that power indexes in their current states are highly reliable. They also indicate that despite the fact that the US electricity market is still going through an evolutionary phase, it is relatively efficient when compared to the more mature equities markets.
GETTING TO CASH EXCHANGES
Financial instruments such as swaps and options are not new to the electricity industry. Swaps are private agreements between two parties to exchange cash flows in the future based on a pre-arranged formula. Options are financial instruments that give the buyer the right to purchase or sell a security at a predetermined price - the strike price. The growth of swaps and options was long stifled by the lack of transparent and reliable prices. Electricity price indexes have removed that impediment by providing electricity traders with barometers that enable them to gauge the dynamism of the cash market. This makes it much easier to use swaps and options - and eventually futures contracts - to manage risk in the increasingly sophisticated electricity market.
At that point, the buyer or seller of electricity is dealing in exchanges of cash, and may, through a broker, choose to negotiate a swaps deal with any credit-worthy institution willing to guarantee him a revenue stream over the period he feels exposed. It could be a commercial bank, an investment bank, a trading house - or any other large or sophisticated small investment-management firm.
There have been various arguments about the need for and the suitability of price indexes for settling electricity contracts. These arguments are in part fueled by the lack of interest in the existing futures contracts traded on the NYMEX and the CBOT. From the early days of deregulation, many financial and power experts believed that financially settled electricity futures contracts would be more viable than physically delivered contracts. This view was ignored by the various exchanges competing to be first in launching successful contracts in the power industry. Now that there seems to be a clearer consensus on the direction of the cash market, many experts are wondering whether it would make sense to develop indexes that could serve as benchmarks for settling electricity futures.
It is indeed possible to envision a scenario where electricity price indexes serve as the underlying benchmarks for settling electricity futures. The issue of firm power delivery is at the core of the debate on the viability of delivered futures contracts in the power industry. New York Mercantile Exchange futures contracts are traded on a firm delivery basis. However, if in the old days of the industry firm delivery implied that physical assets such as plant capacity, transmission access, etc. backed firm power transactions, the modern definition of firmness is couched more in financial terms. For instance, in today's power nomenclature, "liquidating damages" is the term most often referred to when power traders seek to guarantee the terms of the deal. This means that buyers can be financially compensated when a party fails to act on a firm promise to deliver on a power transaction whether as a result of an act of God or simple negligence from the seller's side. By providing a financial definition for firm delivery, traders seem to tacitly agree that a liquid power market cannot be adequately served if agreements are strictly tied to physical assets. It is therefore fitting to assume that futures contracts based on the modern definition of firmness will gain in popularity in the wholesale market. Since financially settled futures contracts call for strong benchmark prices, it seems likely that reliable electricity price indexes would be a part of a solution involving such settlement.
As for the current offering of power indexes in the market, despite their widespread application in settling over-the-counter swaps and options and their statistical validity, they may need to be more broadly accepted by the marketplace before they can be used for settling futures contracts. For instance, the Dow Jones power indexes are considered the preferred benchmarks for settling over-the counter swaps and options in the United States and in Europe. Many US states and recently one Canadian province have recommended that utilities use these indexes as benchmarks for pricing certain industrial contracts. However, as the power market evolves, Internet trading platforms are capturing a great portion of the deals, and the trend is increasing. The brokerage community is also playing an active role in matching buyers and sellers of electric energy. Given this wide representation these indexes may need to capture some of these activities as well in order to give a more complete snapshot of the trading activity.
RELEVANCE TO OTHER MARKETS
Despite its seemingly unique complexities, electricity shares a number of similarities with some of the markets emerging the world over. This is especially true for natural gas, coal, and telecom bandwidth.
Natural Gas - Over the next several years the European continent will witness the emergence of a very active natural gas market. In the United States where the wholesale gas market has been successfully deregulated, retail competition will soon become a way of life. Undoubtedly, most of the new entrants in this new market will be institutions with vast experience in the electricity business. Because of the strong interdependence between natural gas and electricity both industries will share a common set of values and business practices.
As more and more consumers look for new ways to save on energy expenditures, price will become extremely important not only in the wholesale markets, but at the retail level as well. In addition, energy intensive businesses will be actively involved in the daily spot market for gas and power. For many of these consumers price risk management will play a central part in daily operation. As a result, these businesses are expected to become active users of benchmark indexes that enable them to tie the price of gas or electric power to financial derivatives. Because natural gas is also used as an input fuel in electricity generation, electric utilities will also pay close attention to retail as well as wholesale gas prices. In some cases electric utilities will maintain a balanced portfolio of financial risk management products that include gas as well as electricity derivatives. Given the realities of these two sectors, it is reasonable to assume that demand for natural gas and power price indexes will rise over the next few years.
Coal - Coal accounts for over 50% of the basic input used in electricity production both in the United States and in Europe. Until recently most utilities purchased coal based on long-term contracts spanning many years into the future. However, since the late 1990s, there has been a growing movement toward commoditizing coal on both continents. In the United States, the New York Mercantile Exchange has been a leading proponent of several coal futures contracts. Various utilities are buying coal on a short-term basis. Others have gone as far as using a method called tolling to hedge coal and electricity price risks. For instance, in a tolling arrangement, a coal supplier or a power marketer may pay a power plant operator a fee to convert coal into electricity when the market value of power is greater than that of coal.
At the center of these sorts of transactions price remains the major determining factor on whether or not the deals will take place. As the coal market become more competitive and tolling practices gain in popularity, price indexes that allow buyers and sellers to make a one-to-one comparison between a unit of coal and a unit of power will become extremely valuable, as will the basis provided for swaps, options and futures.
Telecom Bandwidth - The emerging bandwidth market is another area where the experiences of the electricity market could prove relevant. Over the past three years, the global economy has experienced a phenomenal growth in electronic commerce. In the US alone business-to-business e-commerce was estimated at nearly $140 billion in 1999 and analysts predict this market will grow at a rate of 41% a year to over $500 billion by 2003. Residential usage of the Internet has seen a phenomenal growth, from a few million users in 1994 to over 100 million in 1998, and experts believe one billion people around the world may be connected to the Internet by 2005. This convergence onto the Internet of electronic commerce and residential demand for information technology has led to increased demand for broadband telecom. The demand for broadband telecom is engendering a commodity market, which analysts predict may be worth over $400 billion by 2005 and $1.5 trillion by 2010. The importance of bandwidth as a commodity takes on a special meaning for power executives. First, almost every major electric utility has a large infrastructure of fiber optic network. As demand for telecom products increases and market pressure unveils the volatility of bandwidth prices, electric utilities will be highly pressed to protect their bottom lines. As a result, demand for risk management products will surge. However, since financial risks cannot be managed without reliable benchmark prices demand for bandwidth indexes will also increase. Because of the influence of power marketers such as Enron in this newly emerging market and the tendency to introduce the same basic trading concepts that have worked for electricity and natural gas, the future telecom indexes will not be unlike electricity indexes in design. There, too, the opportunity for developing new swaps, options and futures markets will in time emerge.
TOMORROW, THE WORLD?
As the experience in Europe and North America suggests, electricity price indexes are powerful instruments that have not only facilitated the creation of the power market in both continents. They also serve as powerful benchmarks that help simplify the risk-management practices in the power industry. This simplicity is at the core of the recent explosion in the growth of electricity derivatives in both the US and Continental Europe. As the market evolves, these indexes will not only become the benchmarks of choice in the over-the-counter market, they may also play a central role in promoting the growth of exchange-traded electricity futures. We have barely even mentioned emissions trading, another promising derivatives venue. This experience can be applied to other goods, perhaps including goods that do not exist today, as they become commoditized and widely traded.