The price is right?

For banks entering the physical power markets the opportunities are many, but pricing contracts in these volatile markets is fraught with difficulties. Aarzoo Shah, Riccardo Anacar and Antony Kakoudakis look at how to tackle these challenges

For new entrants, building up experience in the electricity markets is no easy task. Developing a presence in the underlying physical markets is both time-consuming and costly. Three years are generally necessary to build up a worthwhile book. Pricing of forward contracts is proving a particularly knotty issue, with firms hampered by the non-standard nature of contracts, lack of standard pricing methods and unavailability of reliable pricing tools. In addition, the scarcity of highly experienced staff is also proving problematic. This last factor, as well as insufficient experience of the market, is leaving some firms struggling to develop strategies.

However, despite the complexity and volatility of electricity markets, banks are keen to participate in them. Their primary reason is to develop the experience necessary to provide risk management services to utilities. This type of service can be highly profitable, with utility companies looking to take advantage both of banks' traditional risk management expertise, and to enlist banks' help in areas such as the valuation of long-term contracts.

The unique structure of power markets throws up many difficulties. Electricity markets are highly complex, differing in structure from country to country. Consumer demand is variable, influenced by the time of year, as well as specific events. The inability to store electricity makes balancing of supply and consumer demand tricky, while delivery risks have a profound effect on prices, causing considerable volatility. Sharp price spikes can occur as a result of unpredictable delivery risks such as congestion influences.

Pricing challenges

All this means pricing poses a number of challenges. Firstly, as prices are settled on an hourly basis in US and Europe, and half-hourly in the UK, firms must deal with contracts which change in detail on an incredibly frequent basis. This entails processing a huge volume of data, while the non-standard nature of the product creates uncertainty. Not only is the contract itself subject to possible change every 30 minutes, but a host of nuances, for example, optionality, must constantly be reconsidered.

In considering pricing of electricity contracts, firms must take into account the physical nature and non-storability of the product. As electricity cannot be stored, carrying it forward for use at another point in time is not an option, which in turn creates a disconnection between current spot and forward prices.

Unlike the financial markets, where current and future prices are linked, it is not possible to determine forward electricity prices from present ones. It is also not safe to assume a relationship between forward prices at two adjacent dates, or to rely on price changes between those dates occurring in a predictable manner.

To make matters more complex, pricing methods used in the financial markets often break down when applied to the electricity markets. Take the creation of a forward curve, for example. Widely used within the financial markets, forward curves consist of forward prices which reflect what market participants are willing to pay today, for delivery, in the future. While this works well for financial markets, when applied to the volatile electricity markets, the method becomes unreliable. Furthermore, with a lack of market standard forward curves - and therefore an accurate snapshot of future prices - considerable difficulty is created when building hedges.

Nevertheless, firms must still find a reliable method of pricing electricity contracts. At present, in the absence of a tried and tested methodology, each market participant finds itself obliged to develop its own 'view' or strategy. So, what steps should be taken to achieve accurate pricing?

Clearly, pricing methods must take into account factors such as the mean reversion behaviour of electricity prices, price spikes, and non-constant volatility. Modelling future prices via stochastic processes represents one way of including these factors in calculation.

Looking more specifically at the definition of a forward curve for an electricity contract, firms must incorporate a wide range of physical aspects into each calculation; for example, factors such as weather events. At the same time, variable consumer demand and seasonality must both be taken into account. Other factors, such as grid losses or the quality of a particular power plant (which can influence the cost of running the power plant, or affect its ability to deliver power) must also be factored into pricing calculations.

To improve the efficiency of forward curve calculation, firms should also consider investing in forward curve building tools based on cubic spline interpolation. Such tools allow a smooth curve - one with a continuous differential - to be obtained, and, in turn, smoothness enables more accurate valuation. In addition, companies should also be looking more closely at upfront price discovery: information from third-party data providers can provide a better feel for the market and enable different parts of the forward curve to be identified more precisely.

Market illiquidity

Illiquidity creates a further pricing challenge for firms: in liquid markets, a forward curve can be derived by finding quotes for specific forward contracts. However, with little market liquidity, and few quoted forward prices from brokers, this is not possible. At present, illiquidity represents a very significant obstacle for firms. However, as more participants enter the electricity markets and exchanges grow in number, liquidity issues will gradually resolve themselves. Interestingly, exchanges are starting to provide some visibility on prices by having end-of-day settlement prices for their futures contracts. French exchange Powernext, for example, provides prices for French futures, while Germany's EEX provides prices for the German futures market. In addition, brokers are now producing end-of-day prices for futures contracts.

Lack of price transparency

Lack of price transparency also represents an obstacle for firms. Most markets are dominated by a handful of companies, and contract prices are commercially sensitive, so existing players have a vested interest in keeping pricing opaque, and releasing as little data as possible to other market participants. At the same time, the lack of transparency also acts as a barrier to liquidity. In order to improve transparency, brokers must begin to provide daily or monthly indicative quotes to the clients or to provide them with standard documentation on the appropriate methodology for making valuation adjustments.

Absence of standard pricing tools

Obstacles are also caused by a lack of standard pricing tools. The unavailability of pricing tools makes it particularly difficult for firms to assess delivery risks into pricing models. Unfortunately, this is one of the greatest risks when trading physical electricity. Due to the physical nature of delivery, it is not possible to know when a grid failure or congestion on the interconnector will occur, which, in turn, can cause the price of electricity to spike enormously. Even when there are known outages such as maintenance days, traditional pricing tools cannot take this variable into account.

While a handful of vendors (for example, GED, FEA and SunGard) have produced pricing tools to assist in risk management of electricity contracts, it is, in practice, difficult to produce pricing tools that meet the requirements of each contract.

For the most part, market participants have relied on developing their own, custom-made tools. Unfortunately, the absence of standard pricing tools also obliges firms to become highly dependent on certain skilled individuals, and being forced to cut back on services of pricing experts can create a huge human risk.

Harnessing technology

While the market currently suffers from a lack of standard pricing tools, firms can, nevertheless, make use of technology to improve the efficiency and accuracy of pricing. For example, organisations can make use of intensive computational technology such as grid computing to facilitate the running of a large number of simulations. At the same time, firms should also be looking at investing in demand forecasting and calibration tools, and ensure that servers capable of coping with the volume of data required for mark-to-market calculations are in place.

In summary

While the volatile and complex nature of electricity markets makes it exceedingly difficult for banks to price contracts accurately, it also makes it all the more important that they strive to do so. While there are many barriers to entry for non-physical players, financial players should investigate the latest technologies available to them.

Aarzoo Shah, Antony Kakoudakis and Riccardo Anacar are practitioners at City Practitioners Ltd. Email: [e-mail], [e-mail], [e-mail].