Information on the Market #10 - A comparison of electricity futures prices with other hedge prices
The NZ electricity futures market, operated by ASX, offers trading in quarterly contracts at Otahuhu and Benmore for three years ahead with four market-makers posting buy and sell prices. The market-makers have agreements with ASX to post prices with no more than a 5% spread between the buy price and the sell price, for the period 3.30pm - 4pm each trading day. Liquidity in the market has developed rapidly since new market-making agreements were established in November 2011.
Information on the Market report number 7 highlighted the development of the electricity futures market and how pricing reflected short and long term electricity price expectations in response to a host of supply and demand information. It also pointed out that market-makers have substantial value riding on the forward price curve, and that futures prices provide an important signal by capturing a comprehensive assessment of all the information available to participants in the market - both confidential and public information.
Some commentators have suggested that, despite the encouraging developments with the electricity futures market and the significant development in liquidity, there may be an upward bias in ASX electricity futures prices relative to other products for hedging electricity price risk. As a result there may not be sufficient confidence in the futures prices for other parties to rely on them.
In order to explore these issues this Information on the Market reproduces some charts from the most recent Energy Link Energy Trendz report comparing CFD (contract-for-differences) and FPVV (fixed-price-variable-volume) contracts with the ASX futures prices. The following chart compares the Energy Link CFD Index with ASX electricity futures prices.
Caution needs to be exercised when comparing electricity prices in this way because contract durations and timing will differ, there are adjustments made to correct for location and seasonality, and the number of contracts (indicated by the height of the red bars on the right-hand axis) can be small. Further, the ASX futures prices are derived by averaging the settlement prices (on the day the chart is produced) across the 12 quarters making up the 3 years currently ending with the Dec-14 quarter, so are more likely to be influenced by near-term hydrology than the CFD Index.
Although there is a need for caution, the chart provides a useful indicator of the relative price levels and it suggests that there is a reasonably good correlation between CFD prices and ASX futures prices.
It is interesting to note the variation in CFD prices that is evident in the chart (indicated by the “whiskers” extending above and below each point on the CFD Index). This suggests that there are some CFDs struck at prices below the futures price, which may explain the occasional comments about a possible disconnect between ASX futures prices and other markets for hedging electricity. However, there are also CFDs struck at prices above the index and the average is often close to the futures price.
It is likely that the divergence in prices that is evident in February is explained by ASX prices being more influenced by near-term hydrology than the CFD Index. The current quarter and some of the following quarters included in the ASX price calculation will reflect current hydrology to varying degrees. CFDs, on the other hand, are typically struck in advance of the period that they cover, and are therefore less sensitive to prevailing hydrology.
The following chart compares the Energy Link FPVV (Fixed-Price-Variable-Volume) index with ASX electricity futures prices.
Again, caution needs to be exercised when comparing the FPVV index with ASX futures prices, for similar reasons to those listed above for the CFD comparison. However, the chart suggests that there is generally a premium priced into FPVV contracts for the security of having spot price exposure eliminated from all electricity purchases, regardless of volume, and to cover the cost of ancillary services. Again, it is noted that there is significant variation in the FPVV Index and occasionally an FPVV contract appears to be struck at a price below ASX futures.
These Energy Link charts tend to support the contention that ASX electricity futures are providing a reasonable forecast of electricity contract prices and that there is generally good correlation between futures prices and other markets for hedging electricity price risk. This is supported by observations of increasing trading activity and liquidity in ASX electricity futures, and the significant traded volumes that are linked to the ASX futures prices via the Virtual Asset Swap agreements between the SOE generator-retailers.
If the electricity futures market was biased towards higher prices than available elsewhere, it is difficult to see how that could be sustained with the liquidity and depth now available in the market. One would expect that any persistent upward price bias in ASX futures would be traded away by any party holding a view that prices are too high. In particular, if parties really do believe futures prices are too high relative to CFDs they can arbitrage the contract, by buying the lower priced instrument and selling the higher priced one.
ASX has commented that the NZ electricity futures market is the fastest growing market it has seen. The recent level of trading activity suggests more confidence in the futures market and the Electricity Authority looks forward to further development and more participation from a wider group of participants as this confidence grows.