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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