As a commodity, electricity has many unique aspects, including instantaneous delivery, non-storability, an interactive delivery system, and extreme price volatility.

Electricity lends itself to futures trading. It meets the three broad criteria needed for successful futures markets: prices are volatile; there is a large, diverse universe of buyers and sellers; and the physical product is fungible.

The exchange clearinghouse provides a system of guarantees that mitigates counterparty credit risk.

Indian Scenario

In India, there will be an imminent opening up of the power sector. That would include amendments of archaic electricity laws. The competitive market in India would develop through structural changes in the power industry that have evolved in recent years, resulting in opportunities, price volatility, and market risk.

The physical power supply system in India is still encumbered by the British legacy of vertical integration. Electricity markets are subject to Central and State regulations that are still evolving. As a commodity, electricity has many unique aspects, including instantaneous delivery, non-storability, an interactive delivery system, and extreme price volatility.

The complexity of electricity spot markets is not conducive to common futures transactions. There are also substantial problems with price transparency, modeling of derivative instruments, effective arbitrage, credit risk, and default risk.

How should the contract be?

Greater market participation is a key issue for the emerging rather "under supplied" Indian power market. In an effort to address this, the Indian exchanges in consultation with regulators have to create a contract that reduces the barriers to market entry by removing the requirement for underlying physical OTC contracts and signatory status.

The Unique Nature of Electricity as a Commodity

Storage and Real-Time Balance

The two most significant characteristics of electricity are that it cannot be easily stored and it flows at the speed of light. As a result, electricity must be produced at virtually the same instant that it is consumed, and electricity transactions must be balanced in real time on an instantaneous spot market. Electricity's real-time market contrasts sharply with the markets for other energy commodities, such as natural gas, oil, and coal, in which the underlying commodity can be stocked and dispensed over time to deal with peaks and troughs in supply and demand.

Real-time balancing requirements also complicate the market settlement process. Some electricity market transactions occur before the system constraints are fully known or the price is calculated. In extreme cases, the settlement price may be readjusted up to several months later.

Electricity is typically "stored" in the form of spare generating capacity and fuel inventories at power stations. For existing plants, the "storage costs" are usually less than or equivalent to the costs of storing other energy fuels; however, the addition of new storage capacity ( i.e., power stations) can be very capital intensive. The high cost of new capacity also means that there are disincentives to building spare power capacity. Instead, existing plants must be available to respond to the strong local, weather-related, and seasonal patterns of electricity demand. Over the course of a year or even a day, electricity demand cycles through peaks and valleys corresponding to changes in heating or air conditioning loads. Two distinct diurnal electricity markets also exist, corresponding to the on-peak and off-peak load periods. Each of these markets has its own volatility characteristics and associated price risks.

Regulatory Challenges Ahead for Electricity Derivatives

Financial Risk to Ratepayers

The financial risks resulting from the use of derivatives are illustrated by the number of companies that have suffered significant losses in derivative markets. Large losses can be the result of well-intentioned hedging activities or of wanton speculation. In either case, regulators must be concerned with the impact that such losses could have on ratepayers who, absent protections, might be placed at financial risk for large losses

Market Power

The preceding paragraphs have illustrated the complexity and non-homogeneity of the electricity markets. Amid this dynamic environment, opportunities abound for market power and gaming strategies to develop.

Controlling this potential threat to competitive markets will require substantial regulatory review, as well as physical changes in the marketplace itself. In many areas of the country, only a small number of suppliers are capable of delivering power to consumers on a particular bus bar, and each of the suppliers can easily anticipate the bids of the others. In such "thin" markets, the price of electricity can be driven by market power rather than by the marginal costs of production. The need for overall market transparency will be critical to traders and to the market monitors.

Conservation and Demand

One of the key tools available to regulators for reducing the volatility of electricity prices is demand-side management programs. Electricity prices are likely to be most volatile during the on-peak hours of the day and substantially more stable (and lower) during the off-peak periods.

This fact, coupled with the hockey stick shaped supply cost curve suggests that substantial reductions in volatility could be achieved through the use of market mechanisms and demand-side management programs to shift consumption to off-peak hours. State and Federal authorities have been examining a variety of possible methods for shifting consumer demand for electricity; however, one of the most direct methods�real-time pricing for large electricity consumers�remains largely untapped.

Ideal features of the contract

Baseload and Peakload contracts should be listed based on the power supply calendar and settlement cycle favoured by the industry with 12 months, 6 quarters and 4 seasons; No requirement to be a power supplier party; Margin offset between Electricity Futures and Natural Gas Futures/Coal Futures/Crude Oil Futures; Each contract will be physically deliverable and will be cleared by one central counterparty, Minimum trading size will be 10 lots; Months, Quarters and Seasons will be listed in parallel -- no cascading; All positions will be held as months for maximum flexibility for participants.

There should ideally be 50 per cent margin offsets between Peak and Base Load contracts; Inter-month spreads should be made available and there will be price implication down the curve.

Outright margin rates are envisaged to be about Rs. 136 per MWh for baseload contracts and Rs. 248 per MWh for peakload contracts. Inter-month spread rates are envisaged to be Rs. 180/- per MWh for baseload contracts and Rs. 300 per MWh for peakload contracts; the Contracts will initially be available for trading through existing commodity exchanges and will then be rolled out to ISV solutions.

The exchanges should provide financially settled monthly futures contracts for on-peak and off-peak electricity transactions based on the daily floating price for each peak day of the month at the respective regional hub. For eg The western hub could consist of delivery points, primarily on the BSES /TATA Power [Get Quote] transmission systems. Additional risk management and trading opportunities should be offered through options on the monthly futures contract.

The peak daily floating prices should be the weighted exponential average of say the western hub real-time locational marginal pricing for the 16 peak hours of each peak day, provided by the Utility service providers in the western hub. Peak hours should be designated from 7 am to 11 pm (the hour ending 0800 to the hour ending 2300) prevailing local time. Peak days are Mondays through Fridays, excluding the Railways consumption.

Off-peak hours are from midnight to 7 am (the hour ending 0100 to the hour ending 0700) and 11:00 PM to midnight (the hour ending 2400) Mondays through Fridays; also, all day Saturdays and Sundays (the hour ending 0100 to the hour ending 2400). All times are prevailing local time Locational marginal pricing is the marginal cost of supplying the next increment of power demand at a specific location on the network, taking into account the marginal cost of generation and the physical aspects of the transmission system

Quality Specification

Electric energy delivered under this contract shall be in the form of three phase current alternating at a nominal frequency as prescribed by the Central Electricity regulatory authority, and be in conformance with the specifications of the CERC.

Transmission

Except as set forth in, seller shall be required to make all transmission arrangements to deliver electric energy to central buyers, and buyer shall be required to make all transmission arrangements to receive electric energy at Central sellers

Alternative Delivery Procedure

Seller or buyer may agree with the buyer or seller with which it has been matched by the Exchange Rules to make and take delivery under terms or conditions which differ from the terms and conditions prescribed by the exchange. In such a case, Clearing Members shall execute an Alternative Delivery Notice on the form prescribed by the Exchange and shall deliver a completed executed copy of such Notice to the Exchange. The delivery of an executed Alternative Delivery Notice to the Exchange shall release the Clearing Members and the Exchange from their respective obligations under the Exchange contracts.

In executing such Notice, Clearing Members shall indemnify the Exchange against any liability, cost or expense it may incur for any reason as a result of the execution, delivery or performance of such contracts or such agreement, or any breach thereof or default thereunder. Upon receipt of an executed Alternative Delivery Notice, the Exchange will return to the Clearing Members all margin monies held for the account of each with respect to the contracts involved.

Conclusion

There is an urgent impending need for a market driven vibrant instrument for electricity futures, which would attract huge market participation automatically.

The electricity futures/options markets may provide useful information about forward prices. Futures prices represent the market participants' forecasts of what future spot prices will be. An essential feature of electricity futures contracts (for delivery at a specific location) is that as the delivery date of the futures contract approaches, the futures contract price and the spot price will converge. While the futures contract prices provide forecasts of forward spot prices, there is no assurance that the forecast will be correct, although the forecast error can be expected to diminish, the shorter the time remaining to futures contract maturity.

Srinivasan Venkataraghavan is Chief Executive Officer, Altos Advisory Services