Journal of Energy Markets

Effective risk management in energy markets often requires extensive analysis of forward price dynamics and how they relate to spot prices. Electricity is particularly challenging in this respect, with high spot volatility, lack of storage options and complex fundamental drivers. This issue of The Journal of Energy Markets includes four papers, each of which makes distinct and substantial contributions to this important area of research and practice.

The issue's first paper, "Electricity futures prices: time-varying sensitivity to fundamentals" by Stein-Erik Fleten, Ronald Huisman, Mehtap Kiliç, Enrico Pennings and Sjur Westgaard, provides useful insights into the time-varying relationship between electricity futures prices and fundamentals. The authors recognize that the supply functions that generators offer to the market are not constant over time, and to research this they apply a model that relates electricity futures prices to the marginal costs of production and calculates time-varying coefficients. The model is specified in statespace form and estimated via a Kalman filter to observe the dynamics. It is applied to historical prices of futures contracts with different delivery periods (calendar year and seasons, peak and off peak) from Germany and the United Kingdom. The results confirm that analysts should choose a time-varying specification to relate the prices of power futures to the prices of underlying fundamentals.

In our second paper, "Calculation of a term structure power price equilibrium with ramping constraints", Miha Troha and Raphael Hauser propose a quadratic programming formulation for calculating the equilibrium term structure of electricity prices. This is a competitive game-theoretic model with players divided into producers and consumers, all of whom seek to maximize their own mean-variance utility functions subject to production (eg, capacity, ramp-up/ramp-down times, etc) and consumption constraints. The model incorporates information about over-the-counter and exchange-traded block electricity contracts, transaction costs and liquidity considerations. The authors' numerical simulations examine the properties of the term structure and its dependence on various parameters of the model. They apply their model to the equilibrium term structure of electricity prices in the United Kingdom, with the model representing the entire power grid, consisting of several hundred power units, within which the impacts of ramp-up and ramp-down constraints are evaluated. It is unusual, but increasingly relevant, to include so much operational detail in power price formation modeling and this paper therefore makes an important contribution.

The third paper in the issue, "Approximation of the price dynamics of heating degree day and cooling degree day temperature futures" by Fred Espen Benth and Sara Ana Solanilla Blanco, focuses on temperature. To the extent that underlying temperature is an important driver of energy consumption, fundamental analysis of futures prices may involve explicit models for heating degree days (HDDs) and cooling degree days (CDDs). In this paper the authors propose an approximation that makes the price dynamics ofHDDand CDD temperature futures linearly dependent on the underlying temperature. Specifically, their analysis is based on continuous-time, autoregressive, stochastic dynamics for the time evolution of temperature in a given location, and it is fitted to temperature data collected in NewYork over a long time period. The authors then derive a simple version of the Black-76 formula for pricing a call option on CDD and HDD futures, and in so doing they provide a link to energy risk management through temperature hedging.

Finally, in the issue's fourth paper, "Facilitating appropriate compensation of electric energy and reserve through standardized contracts with swing", Deung-Yong Heo and Leigh S. Tesfatsion emphasize three key issues that have arisen for centrally managed wholesale electricity power markets in Europe and the United States as a consequence of the increased penetration of variable energy resources. First, rigid definitions for energy and reserve products make it difficult to ensure appropriate compensation for flexibility in start-up times, ramp rates, power dispatch levels and duration. Second, participation restrictions hinder the achievement of an even playing field for potential providers of flexible services.And third, reliance on out-of market compensation for the provision of some valued services encourages strategic manipulation. This paper examines the possibility of addressing these three issues through the introduction of standardized energy and reserve contracts with swing (flexibility) in their contractual terms. Concrete examples are used to demonstrate how the trading of these standardized contracts can be supported by linked forward markets in a manner that permits efficient real-time balancing of net load subject to system and reserve-requirement constraints. Comparisons with existing wholesale electricity power markets are given and key policy implications are highlighted. Evidently, market design and policy need to coevolve to further facilitate the efficient risk management of electricity price risk.

Derek W. Bunn
London Business School

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