Electricity is a tradable but not tangible commodity. It has many unique aspects as compared to other commodities, which include instantaneous delivery, non-storability, no substitutes and an interactive transmission system. In fact, electricity travels as fast as the speed of light.
Since electricity cannot be stored so supply must be produced exactly when needed to meet demand. This is one reason why electricity prices tend to be extremely volatile at times. Its volatility even reach as high as 1,000% in an interval. Other commodities will surely pale in comparison with such a movement. In foreign exchange, an overnight volatility of 500 pips is considered extreme, while a 2% daily price volatility in the stock market is already significant. In other commodities, volatilities are ranging from 10% to as high as 90%.
Nonetheless, the electricity market still exhibits seasonal cycles as far as demand is concerned, making price trends fairly predictable on an annual basis. High prices typically occur during summer and show some declines on rainy days. But volatility on an intra-day scale is no longer easy to anticipate, especially if transmission constraints and congestions come into play.
Comparison with other commodities
Non-storability aspect. Electricity’s real-time market contrasts sharply with the markets for other commodities in which the underlying commodity can be stocked and dispensed over time to deal with peaks and troughs in supply and demand. As such, 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 to be able to tame price spikes or risk system failure.
Regionalized market. Electricity markets are likely to be more regionalized than other commodity markets, making fundamental analysis in economics and engineering more important for trading electricity. In addition, there is substantial uncertainty about the price of transmission capacity between regional markets.
Price volatility. Short-run electricity volatility (intra-day, day-ahead and week-ahead) will be higher than in other commodity markets, but long-run volatility will be lower. In the short run, the key factors include weather, fuel prices and power plant operations (i.e., outages). In the longer term, electricity prices can be affected by demand, regulations and new technology. Likewise, electricity price variations in the short run reflect economic and engineering factors to a much larger degree than for other markets where short-run prices are less subject to fundamental analysis but more on technical trading.
Demand elasticity. Elasticity differs for each commodity and reflects the particular characteristics of the commodity's usage and markets. Elasticity refers to the effect of price changes on supply and demand. Broadly stated, elasticity of demand is the measure of how steeply demand goes down when prices go up. In the short run, system-wide elasticity for electricity is near zero in which there is almost no reduction in demand as prices rise on an hourly basis. This is because electricity cannot be stored nor be substituted by its users; and if users elect to cease power usage while the price is high, they themselves would suffer unacceptable disruptions in their activities or business operations. However in the long run, users can be more elastic by shifting to more energy-efficient technologies, acquiring energy-saving devices or implementing demand-side management techniques.
Variable costs. In the electricity sector, the competitive price is set in every period by the variable cost of the marginal power generator; whereas in other commodities, storage cost plays a major factor as withdrawals from storage can exert a large impact on commodity prices.
Trading of Electricity
Similar to any commodities, the trading of electricity consists of buying and selling of energy. But contrary to common perception, a buyer of electricity is not purchasing megawatt-hours (MWh) of energy produced by a specific generation unit. A buyer is only purchasing the right to withdraw that quantity of energy from a specific location in the network and a seller is paid for injecting a certain quantity of energy into the grid at a specified location in the network.
On the other hand, electricity being a commodity is quite homogeneous as all electrons are effectively identical, not unlike oil and other energy commodities which are very much differentiated as to types, products and by-products.
However, electricity can be differentiated by time and location and so does oil, gas, coal and other energy commodities. It just so happens that time and location tend to be less important to the latter, as they can be stored and shipping costs are low. In each case, the differentiating factors are the ones being traded actively in the market. For instance, spreads between different types of oil and gas are traded and so with electricity location spreads.
This “commodization” of electricity applied mainly at the wholesale level. Wholesale trading of electricity involves the development of new types of electricity contracts. These contracts can either be sold on the bilateral market or on an organized exchange. They can also be physical contracts (for delivery) or financial contracts (for hedging). Nonetheless, like in all types of commodity markets, these contracts share three characteristics: a defined period, a certain quantity, and a price. And these are the essential elements of commodity trading.
*Energie De Corp, vol. 1, no. 1 (2006).
© 2006 by Ludwig Ritchel A. Kalambacal
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