Equilibrium Pricing and Optimal Hedging

In Electricity Forward Markets*

Hendrik Bessembinder
Goizueta Business School, Emory University
1300 Clifton Avenue
Atlanta, GA 30322-2710

and

Michael L. Lemmon
Department of Finance, University of Utah
Salt Lake City, UT 84112-9303

Initial Draft: September 1998

Current Draft: May 2000

* This paper is derived from an earlier manuscript titled “Pricing, Risk Sharing, and Profitability in the
Deregulated Electric Power Industry” that was developed while both authors were on the faculty of the
Arizona State University College of Business. The authors thank Douglas Cochran, Alex Eydeland, Jean Gray,
Paul Joskow, Vince Kaminski, John Dalle Molle, Steve Norris, Duane Seppi, Rene Stulz, Catherine Wolfram,
and an anonymous referee for many helpful comments. The authors also benefited from the participation of
seminar participants at the University of Arizona, Arizona State University, the University of Colorado, Emory
University, Rice University, the University of Texas at Austin, the University of Utah, Washington University,
Instituto Technologico Autonomo De Mexico, the 1999 University of California Energy Institute POWER
conference, and the 2000 American Finance Association Meetings.
 Equilibrium Pricing and Optimal Hedging
In Electricity Forward Markets

ABSTRACT

Spot power prices are volatile and, since electricity cannot be economically stored, familiar arbitrage-
based methods are not applicable for pricing power derivative contracts. This paper presents an
equilibrium model implying that the forward power price is a downward biased predictor of the future
spot price if expected power demand is low and demand risk is moderate. However, the equilibrium
forward premium increases when either expected demand or demand variance is high, due to positive
skewness induced in the spot power price distribution. Optimal forward positions for power producing
and retailing firms depend on forecast power demand and on the skewness of power prices.
Preliminary empirical evidence indicates that the premium in forward power prices is positively related
to expected demand, and is large during the summer months.
I. Introduction.

Wholesale power markets, where producers trade electricity among themselves and with power-

marketing and power-distribution companies, have grown rapidly in recent years.1 The United States

Department of Energy (1999) reports that U.S. wholesale power transactions during 1998 amounted to over

2.5 billion megawatt hours (MWh), or about $75 billion dollars. The U.S. wholesale power market is likely to

soon comprise the world’s single largest commodity market.

Electricity as a commodity has many interesting characteristics, most of which stem from the fact

that it cannot be economically stored.2 Market-clearing prices are volatile because inventories cannot be used

to smooth supply or demand shocks. For example, the standard deviation of percentage changes in average

daily power prices at Palo Verde, Arizona, from August 1996 to December 1999 was 15.3%. By comparison,

the standard deviation of daily returns on the S&P 500 Index during the most volatile single month in recent

decades, October 1987, was 5.7%. Power prices are also subject to sudden, but temporary, upward spikes.

In a dramatic and well-publicized example, power prices in the U.S. Midwest rose from near $30 per MWh to

over $7000 per MWh during June 1998.3 The absence of storage also allows for predictable intertemporal

variation in equilibrium prices. Power prices for daytime delivery are typically more than twice as high as for

nighttime delivery, and power prices during the summer are predictably higher than during the temperate

months of spring and fall.

Finally, and most important for purposes of this paper, the inability to store power means that the no-

arbitrage approach to pricing derivative securities cannot be applied in the usual manner. The well-known

cost-of-carry relation links spot and forward prices as a no-arbitrage condition. However, the arbitrage

strategies required to enforce the cost-of-carry relation include purchasing the asset at the spot price and

1 The growth in power trading is partially attributable to ongoing deregulation of the industry. Most deregulation
scenarios call for the separation of power production from transmission and retailing, with production and retailing
opened to competition.
2 Though power cannot be stored, potential energy can be stored in the form of fuel stockpiles or water behind dams.
The capacity to quickly convert potential energy to power remains limited, however, as evidenced by the differential
between daytime and nighttime power prices.
3 For example, see “Staff Report to the Federal Energy Regulatory Commission on the Causes of Wholesale Electric
Pricing in the Midwest During June 1998,” available at http://www.ferc.fed.us.
storing it for subsequent sale at the forward price. 4 Since this strategy cannot be executed in power markets,

forward prices for electricity need not conform to the cost-of-carry relation.

Pirrong and Jermakyan (1999) and Eydeland and Geman (1999) also observe that the no-arbitrage

approach does not apply to power derivatives. Pirrong and Jermakyan note that electricity forward prices will

differ from expected delivery date spot prices due to an endogenous market price of power demand risk.

However, they do not attempt to model the determinants of the market price of power risk. Eydeland and

Geman focus on electricity options, noting (page 72) that:

“there is another important consequence of non-storability: using the spot price evolution models for
pricing power options is not helpful, since hedges involving the underlying asset, i.e. the famous delta
hedging, cannot be implemented, as they require buying and holding power for a period of time”.

Eydeland and Geman present a pricing model for power options that relies on assumptions regarding the

evolution of forward power prices. In contrast, we adopt an equilibrium approach and explicitly model the

economic determinants of market clearing forward power prices.

We present an equilibrium model of spot and forward power markets that applies when prices are

determined by industry participants rather than outside speculators, and power companies are concerned with

both the mean and the risk of their profits. We evaluate power producers’ and retailers’ net demands for

forward contracts, and obtain closed form solutions for the equilibrium forward power price and for optimal

forward positions. The implications of the model are illustrated with a set of simulations. These show that

the equilibrium forward power price can be greater or less than expected delivery date spot prices, depending

on expected market demand and on demand volatility.

More specifically, the model generates the testable implication that the forward risk premium is a

function of the difference between two covariance terms that can be approximated as the variance and

skewness of power prices, respectively. Positive skewness in wholesale power prices is attributable to

convexity in the industry supply curve. When expected power demand is low and demand variability is

modest (as might be expected during the temperate months of spring and fall) there is little skewness in spot

4 For a description of the standard cost-of-carry forward pricing model see, for example, MacKinlay and Ramaswamy
2
prices, and power retailers’ desire to hedge their revenues leads to a downward bias in equilibrium forward

prices. In contrast, when expected demand is high relative to capacity or demand is more variable, the

distribution of spot power prices becomes positively skewed. Short forward positions incur large losses if

upward spikes in spot prices occur, and the equilibrium forward price is bid up to compensate for skewness

in the spot price distribution. The U.S. demand for power is largest and most variable in the summer.5 The

model therefore predicts an upward bias in U.S. forward power prices for summer delivery.

We also evaluate optimal forward positions. Power-producing firms’ optimal forward market

positions depend on forecast output and on the skewness of power demand. Power retailing firms’ optimal

forward positions depend on forecast usage, and on the interaction between local and system demand as

measured by power demand betas.

Finally, we conduct some preliminary empirical analysis using the available short time series of

electricity forward and spot delivery prices. The evidence is generally supportive of the model’s predictions.

Forward prices for summer delivery exceed forecast spot prices, while forward prices for spring and fall

delivery are similar to, or slightly less than, forecast spot prices. Regression analysis confirms that the

premium in forward power prices is significantly related to forecast power demand.

Routledge, Seppi, and Spatt (1999b) also consider the equilibrium pricing of electricity contracts.6

They focus on linkages between the natural gas and electricity markets (i.e., the spark spread) that arise from

the fact that natural gas can be stored or converted into electricity. They obtain several implications,

including predictions of mean reverting spot prices and unstable electricity/fuel price correlations. They also

obtain the implication that electricity prices will be positively skewed, while we obtain the implication that

skewness will affect the equilibrium forward premium and optimal forward positions.

This paper is organized as follows. Section II outlines the general setup of the model and discusses

(1988), or Kawaller, Koch, and Koch (1987).

5 See “New Rules, Demands Put Dangerous Strain on Electricity Supply” Wall Street Journal, May 11, 2000, page
A1.
6 There are also several papers that consider pricing of derivatives on storable energy commodities such as oil and
natural gas. These include Routledge, Seppi, and Spatt (1999a), Amin, Ng, and Pirrong (1995), and Gabillion (1995).
3
the demand for risk reduction on the part of power industry participants. Section III derives the equilibrium

forward price and the optimal forward positions of power producers and retailers. Section IV presents some

preliminary empirical evidence, and Section V concludes.

II. Power Production, Wholesale Markets, and the Demand for Risk Reduction.

A. The General Setup.

Our primary goal is to assess equilibrium forward power prices and optimal hedge positions for

power firms. To do so requires a model of the underlying spot market and of the transactions that

participants will optimally make there. We analyze power production during a single future time period, and

assume that there is no uncertainty in spot markets; i.e. that power companies are able to forecast demand in

the immediate future with precision, and are able to enter contracts in the wholesale market at known prices.

Actual spot power markets operate with short delivery horizons: the most active markets are for next-hour

and next-day delivery. In practice, power demand over a short horizon such as the next hour can be forecast

with substantial, though not complete, precision.

There are NP power producers, each of which produce power using identical technology and sell it to

power retailers in a competitive wholesale market.7 We assume that power can be transmitted without cost.8

There are NR power retailing (or power marketing) firms that purchase power in the wholesale market and

sell it to final consumers at a fixed unit price, denoted PR. Retail customers consume as much power as they

7 Whether wholesale power markets are in fact competitive has been the subject of considerable analysis. Green and
Newbery (1992), Newbery (1995) and Wolfram (1999) conclude that there are an insufficient number of suppliers in
the British power markets. Borenstein and Bushnell (1999) conclude that the California electricity markets have some
potential for market power, but view the resulting costs to be small relative to the potential gains from deregulation.
See also the survey by Joskow (1997). In relying on the assumption that wholesale power markets are competitive,
our analysis can be viewed as the limiting case obtained when market mechanisms are developed to mitigate possible
producer market power.
8 We abstract from analyzing transmission costs in order to focus on an alternate set of issues. The pricing of
transmission rights is itself an interesting and challenging issue, made complicated by the presence of externalities
within the distribution system. For a discussion of possible market-oriented solutions to the allocation of
transmission capacity, see Joskow and Tirole (1999) and Harvey, Hogan, and Pope (1996).
4
desire at that price. 9 The realized demand for retailer i is denoted by the exogenous random variable QRi .

Each producer i is assumed to have a cost function of the form:

a
TC i = F + (Q Pi ) c (1)
c

where F represents fixed costs, QPi is the output of producer i, and c is a constant greater than or equal to

two. This simple cost function captures many features relevant to the production of electricity. It implies that

marginal production costs increase with output, which reflects the fact that the industry employs an array of

production technologies and fuel sources with differing out-of-pocket costs, including hydro, nuclear, coal,

oil, and natural gas. Increasing marginal costs are also consistent with empirical regularities such as higher

daytime than nighttime power prices.

If the cost parameter c is greater than two, marginal costs increase at an increasing rate with (are

convex in) output. This allows some flexibility to account for complexities that are not formally modeled,

including the use of relatively inefficient peaking plants to meet high levels of demand, as well as the

possibility that constraints on production and transmission capacity will become binding when demand is

high. The rapid increases in marginal costs implied by production levels that approach capacity can be

approximated by considering the effect of increasing the cost convexity parameter, c. Note also that if c is

greater than two the distribution of power prices will be positively skewed even when the distribution of

power demand is symmetric.

9 Note that this approach does not rule out pre-determined seasonal variation in retail prices --- the assumption is
that the retail price does not respond to real-time shocks. Despite the familiarity of the fixed-price retail contract, it is
actually a complex derivative: a variable quantity forward contract. The main argument in favor of the fixed price
contract is that retail customers do not have a comparative advantage in bearing price risk. However, a fixed retail
price fails to provide incentives to curtail demand at times when wholesale prices are high. Hybrid contracts that
allow for some variation in retail prices in response to wholesale prices have begun to evolve, being offered mainly to
larger and more sophisticated final customers.
5
B. The Demand for Risk Reduction.

The literature on corporate risk management argues that firms can benefit from hedging market risks,

because excessive volatility increases the expected costs of financial distress and can lead to suboptimal

investment. For example, Smith and Stulz (1985) show that risk hedging can reduce expected tax liabilities,

expected bankruptcy costs, and equilibrium wages paid to risk-averse managers. Stulz (1990), Bessembinder

(1991) and Froot, Scharfstein, and Stein (1993) present models incorporating contracting costs and costly

external financing, and show that a policy of hedging market risks can lead to more efficient capital

investment decisions.10

Relying on the corporate hedging literature, we argue that companies in the power industry are likely

to benefit from reducing the risk of their cash flows. The extreme volatility of wholesale power prices

implies that even well-capitalized power firms may be subject to power price exposures sufficiently large that

an adverse price change could lead to corporate default or bankruptcy.11 Also, the large capital investments

involved in power production and distribution increase the relevance of risk-related changes in investment

incentives. In practice, power producers have used bilateral forward contracts for decades, and there is an

active brokered market in power forward and option contracts. The New York Mercantile Exchange and the

Chicago Board of Trade have each introduced power futures contracts, and there is an emerging market in

weather-related derivatives targeted to power producers.

We assume that power firms consider both expected profits and the risk of profits. Higher expected

profits from power transactions improve firm value, while higher risk imposes costs due to increases in the

likelihood of financial distress and/or effects on future investment incentives. For simplicity, power firms’

objectives are assumed to be linear in expected profit and variance of profit.

C. Forward Market Participation.

10 Consistent with the reasoning that risk management can enhance corporate value, Shin and Stulz (2000) present
empirical evidence that an increase in nonsystematic risk is associated with reductions in the excess of firms’ market
values over book values.

6
 We model the forward market as a closed system, where only producers and retailers (power

marketing firms) can take positions. While this oversimplifies the actual situation, it seems a reasonable

starting point. Since power cannot be stored, each power marketer must deliver the power it purchases to an

ultimate retail customer who will consume it.12 Allowing for a series of trades among power marketers

before the power is consumed would not fundamentally alter the model.

Outside speculators, i.e. those who neither produce power nor have delivery contracts with final

customers who will consume the power, cannot take positions in contracts that require physical power

delivery. Outside speculators can take positions in cash-settled contracts, but prices of cash-settled

contracts remain linked to prices of physical-delivery contracts only by the trades of those participants who

can accomplish physical delivery.13 In practice, trading in cash-settled electricity contracts has not developed

rapidly. Krapels (2000) observes (pages 13 and 72) that:

“regional over-the-counter markets are the centres of price dynamics, with very limited potential for
participation in trading by organized or individual speculators” and “electricity markets have not yet
developed effective mechanisms for speculator participation”.

Ong (1996) reports the market for cash-settled trades in electricity (mainly options and swaps) to be only

about five percent as large as the physical delivery market. He attributes the slow growth in cash-settled

trading to the lack of definitive spot power price indices.14

Though we do not formally present an alternative model with costless participation by outside

speculators, it is easy to envision the possible equilibria that would result. With risk-neutral outside

speculators, the forward price would converge to the expected delivery date spot price. If the outside

11 See, for example, Anderson (2000) for a description of how events in June 1998 caused power prices in the U.S.
Midwest to increase from $30 per megawatt hour to over $7000, leading to contract defaults and the near bankruptcy
of some power firms.
12 A power-marketing firm that contracts to purchase power must also arrange a “sink” for the power. Conversations
with industry participants indicate that some power marketing firms have defaulted on agreements to purchase
power, not for financial reasons, but because they were unable to arrange for a sink.
13 Eydeland and Geman (1999) also consider the role of physical production capacity, noting that the safest way to
hedge the risks involved in trading power options is to operate a power plant.
14 The best-publicized spot power indices are those disseminated by Dow Jones, & Company, Inc. However, the
Dow Jones data reflect the average price paid for power delivered at a location on a given day. Since many deliveries
result from previously-arranged forward or option contracts, the data does not accurately represent actual spot
prices.
7
speculators are risk-averse but hold diversified portfolios, then a CAPM-style result will be obtained, with the

bias in the forward price as a predictor of the spot price dependent on the covariance between power prices

and overall market returns. If (as might be expected) power prices are not significantly correlated with

aggregate market returns, then frictionless models with unlimited numbers of either risk-averse or risk-neutral

speculators will imply a zero risk premium for power contracts. Section IV below presents tests of the

implications of the model developed here against the zero-risk-premium alternative.

III. Wholesale Power Trading, Equilibrium Hedging, and the Forward Risk Premium.

The inability to store power implies that traditional cost-of-carry models for pricing forward

contracts do not readily apply to power markets. We therefore use an equilibrium approach. We begin by

assessing real-time trading in the wholesale spot market while taking into account the previously selected

forward positions. We then work back to assess optimal strategies and market-clearing conditions in the

forward market, given that each producer and retailer will behave optimally in the spot market.

A. The Wholesale Spot Market.

In the wholesale spot market producers sell to retailers who in turn distribute power to their

customers. Let PW denote the wholesale spot power price, Q W

Pi denote the quantity sold by producer i in the

wholesale spot market, and QFPi denote the quantity that producer i has previously agreed to deliver (purchase

if negative) in the forward market at the fixed forward price PF,. The ex post profit of producer i is given as:

a
π Pi = PW QPi + PF QPi - F - (Q Pi ) ,
W F c
(2)
c

Pi + QPi .
where each producer’s physical production, Q Pi , is the sum of its spot and forward sales, Q W F

Retailers simply buy in the real-time wholesale markets the difference between realized retail demand

F
and their previous forward purchases. Letting QRj denote the quantity sold (purchased if negative) forward

8
by retailer j, and PR denote the fixed retail price per unit, the ex post profits of each retailer j are given by:

π Rj = PR Q Rj + PF QRj − PW (QRj + Q Rj ) .
F F
(3)

The profit-maximizing quantity sold in the spot market by producer i is:

x
P 
Q W
Pi =  W  − Q FPi , (4)
 a 

where x = 1/(c-1). Equating the total physical production of producers to total retail demand, and using the

fact that forward contracts are in zero net supply, the market-clearing wholesale price can be expressed as:

c−1
 QD 
P W = a  , (5)
 NP 

where Q D = ∑ j=R1 Q Rj denotes total system retail demand. Note that if c > 2, as would be expected if
N

marginal productive efficiency decreases with output or if capacity constraints are potentially binding, then

this expression can readily account for some of the important characteristics of observed power prices.

These include disproportionately large increases in spot prices when demand rises, and positive skewness in

the probability distribution of spot prices.

Using expressions (4) and (5), each producer’s sales in the wholesale spot market can be written as:

QD
Pi =
QW − Q FPi . (6)
NP

B. The Demand for Forward Positions.

We next step back in time to determine the optimal forward positions taken by retailers and producers

and the equilibrium forward price. It is useful to consider the interaction between profits in the absence of

any hedge positions and wholesale prices. Restating (2) and (3) with forward positions set equal to zero,

define the “but-for-hedging” profits of producers and retailers as

a W c
ρ Pi ≡ PW Q W
Pi − F − (QPi ) , (7)
c

9
and

ρ Ri ≡ PR Q Ri − PW Q Ri , (8)

respectively.

Optimal hedging strategies when the objective is linear in expected profit and variance of profit have

been studied by Rolfo (1980) and Hirshleifer and Subramanyam (1993), among others. Let A/2 denote the

coefficient on the variance of profit in the objective function. If A is zero then risk is not relevant to

corporate objectives, while A>0 implies that risk is viewed negatively. The optimal forward position when

the objective is linear in expected profit and variance of profit is known to be:

PF − E(PW ) Cov( ρ {P,R}i , PW )

R}i =
F
Q{P, + , (9)
AVar(PW ) Var(PW )

The optimal forward position contains two components. The first term on the right side of (9)

reflects the position taken in response to the bias in the forward price as compared to the expected spot price.

The second term is the quantity sold forward to minimize the variance of profits. In evaluating (9) it is

useful to further consider the covariance between “but for hedging” profits and the wholesale price. Forward

hedging can reduce risk precisely because this covariance is non zero. Using expressions (7) and (8) along

with expressions (5) and (6) for PW and Q W

Pi derived above (to reflect that firms will optimize in the spot

markets), these covariance terms can be written as:

1 1
Cov( ρ Pi , PW ) = x
Cov(PWx +1 , PW ) − x Cov(P Wx +1 , PW ) , (10)
a ca

and

Cov( ρ Rj , PW ) = PR Cov(Q Rj , P W ) − Cov(PW Q Rj , PW ) . (11)

Expressions (10) and (11) reveal the four types of risk that power forward positions can potentially

hedge. The first term on the right side of (11) reflects that, despite fixed retail prices, retail revenues covary

positively with wholesale prices when the quantity demanded locally is positively correlated with wholesale

10
price. Because the wholesale price is an increasing function of system demand, this correlation is necessarily

positive on average, implying that the industry’s retail revenue is risky. Second, retailers bear risk in their

costs of acquiring power on the wholesale markets, reflected by the second term on the right side of

expression (11). Third, producers bear risk in their sales revenue, reflected by the first term on the right side

of expression (10). Finally, producers bear risk in production costs, reflected by the second term on the right

side of expression (10). Each of these risks will affect the forward positions that individual firms take. Note

though, that producer’s revenues and retailer’s costs are zero-sum, implying that these risks are diversifiable

within the system. The equilibrium forward price will depend only on the risks borne by the industry as a

whole: variability in retail revenues and in production costs.

C. The Equilibrium Forward Price.

In the appendix, we show that the forward price that yields a zero net supply of forward contracts is

given by:

PF = E(PW ) −
NP
Ncax
[ ]
cPR Cov(PWx , PW ) − Cov(PWx +1 , PW ) , (12)

where N = (N R + N P )/A is a measure that reflects the number of firms in the industry and the degree to

which they are concerned with risk. The forward price converges to the expected spot price if the number

of firms in the industry approaches infinity, or if risk is irrelevant to firms’ objectives (A=0). With finite N

the equilibrium forward price differs from the expected wholesale price by the difference between two risk-

related terms that reflect the net hedging pressure of producers and retailers. The forward price will be less

than the expected spot price if the first term in brackets, which reflects retail revenue risk, is greater than the

second term, which reflects production cost risk.

To gain additional intuition about the characteristics of the forward risk premium, it is useful to

restate equation (12) in terms of the central moments of the distribution of wholesale spot prices. The

appendix shows that when the functions Px and Px+1 are approximated using second-order Taylor series

11
expansions, the equilibrium forward price can be restated as:

PF = E(PW ) + α Var(P W ) + γ Skew(PW ) , (13)

N p (x + 1)
where α ≡
N P ( x + 1)
Nca x
[ E( P W ) x − PR E ( PW ) x −1 ] , and γ ≡
2Nca x
[xE(P W ]
) x −1 − (x − 1)P R E(P W ) x − 2 , and Var(PW )

and Skew(PW ) denote the variance and skewness of the wholesale spot price, respectively.

To induce risk-averse retailers to enter the industry, the fixed retail price must exceed the expected

wholesale spot price, implying that α is strictly negative. If the distribution of spot prices is not skewed, the

forward price is downward biased relative to the expected spot price. The downward bias in the forward

price in this case reflects retailer’s net hedging demand. The revenues of power retailers are positively

exposed, on average, because more retail power is sold when the wholesale price is high. This positive

revenue exposure leads to a net demand to sell (to create an offsetting exposure) in the forward market to

reduce risk. The downward bias in the forward price stimulates an offsetting demand for forward purchases,

so that the market can clear. The magnitude of the bias increases with the expected variance of prices.

Recall that c ≥ 2 and x = 1/(c − 1) , implying that 0 ≤ x ≤ 1. As a consequence γ is strictly positive,

implying that, ceteris paribus, the forward price increases with the skewness of spot prices. The distribution

of wholesale power prices will be positively skewed if production costs are convex (c > 2) or if the demand

distribution itself is positively skewed. Skewness enters due to the production cost exposures of power

producers and the revenue exposures of retailers. Positive skewness in prices implies the possibility of large

upward price spikes. A spike in wholesale prices imposes large opportunity costs on producers who sold

forward or large out-of-pocket costs on retailers who failed to purchase in the forward market, reducing

producers’ willingness to sell forward and increasing retailers’ interest in buying forward. As a consequence,

positive skewness in the distribution of wholesale spot prices implies that the equilibrium forward price must

be increased for the market to clear.

C.1 Simulation of the Electricity Forward Premium.

12
 To illustrate the properties of the forward risk premium as expressed in equation (12), we conduct a

series of simulations. These simulations illustrate the sign and economic determinants of equilibrium forward

predicted by the model, but are of limited use in assessing the magnitude of the premium, which can be made

arbitrarily large or small in the simulations by varying the number of firms or the risk relevance parameter, A.

Initially, we assume that power demand is distributed normally with mean E(QD ) = 100. We consider

demand standard deviations (SD) ranging from SD = 1 to SD = 40. The numbers of firms are set at NR = NP

= 20, and cost functions ranging from quadratic (c=2) to quintic (c=5) are considered. To maintain

comparability across cost structures, the variable cost parameter is set as a = 30(NP /100)(c-1), which ensures

that the wholesale price conditional on demand of 100 is $30, regardless of c. The retail price is set at 1.2

times the expected wholesale price conditional on c. Finally, to keep risk premia comparable across c, the

risk relevance parameter is set as A = 0.8/c 2 . For each value of c and SD, we randomly generate 1000

demand realizations. For each realization the spot price is computed according to expression (5), and from

the 1000 realizations the covariance measures and the forward price in (12) are computed.

Figure 1 displays the bias in the forward price implied by expression (12), as a percentage of the

expected spot price, for differing degrees of cost function convexity and levels of demand risk. For quadratic

costs (c=2) the bias is always negative, with the forward price less than the expected delivery date spot price,

and increases in absolute magnitude as demand risk increases. Quadratic costs imply a linear supply schedule

and, given normally distributed demand, that the skewness of wholesale prices is zero. As a consequence

only the variance of prices is relevant, and the equilibrium forward price decreases as demand becomes more

variable.

With convex marginal costs (c > 2) and normally distributed demand, the distribution of spot power

prices becomes positively skewed, and the skewness increases rapidly with demand variability. Figure 1

shows that the bias in equilibrium forward prices is then negative for low levels of demand risk, but reaches a

minimum and becomes positive at higher levels of demand risk. The minimum is reached sooner and the

13
equilibrium bias is larger if the production cost function is more convex. This reflects that retail revenue risk

dominates when demand variance is small, but that the production cost risks increase with skewness and

dominate when demand risk is large.

Mean power demand varies substantially across times of day and across seasons. To investigate the

implications of the model with respect to variation in expected demand, we conduct simulations in which

E(QD ) is varied from 75 to 125, while the standard deviation of demand is varied from 1 to 40. For brevity,

and in light of the empirical evidence presented in Section IV below, the simulations reported are limited to

cost convexity of c=4.

The simulation results displayed on Figure 2 show that the model implies that the equilibrium forward

power price increases monotonically relative to forecast spot prices when expected demand increases. The

sensitivity of the forward power price to mean demand is greater when the standard deviation of demand is

larger, and the largest forward bias is obtained when both expected demand and variability of demand

variability are greatest. The intuition is that either higher mean demand for given demand risk, or higher

demand risk for given mean demand, imply an increased likelihood of high demand realizations and price

spikes, increasing the skewness of the wholesale price distribution.

D. Testable Hypotheses.

The model developed here makes the following testable predictions regarding the forward premium

(i.e. the bias in the forward as a predictor of the delivery-date spot) in power prices:

H1: The equilibrium forward premium decreases in the anticipated variance of wholesale

prices, ceteris paribus.

H2: The equilibrium forward premium increases in the anticipated skewness of wholesale

prices, ceteris paribus.

Though our primary testable implications are stated in terms of power prices, the underlying state

variable is power demand. The simulations conducted above demonstrate that the model also supports the

14
following implications:

H3: The equilibrium forward premium is convex, initially decreasing and then increasing, in

the variability of power demand, ceteris paribus.

H4: The equilibrium forward premium increases in expected power demand, ceteris paribus.

The equilibrium premium in forward power prices is likely to vary in sign and magnitude on a

seasonal as well as a geographic basis. The probability distribution of spot power prices during the temperate

climates of spring and fall is likely to be characterized by lower mean demand, relatively low volatility and low

skewness. In contrast, the distribution of spot prices during winter and summer is likely to involve higher

mean demand, more price variability and greater price skewness. The model also predicts higher power

forward prices in geographic regions where the power system on average operates nearer to system capacity.

E. Optimal Forward Positions.

We next present expressions for producers’ and retailers’ optimal forward positions. These

expressions are useful in evaluating which firms have a comparative advantage in selling into the forward

market as compared to buying forward or abstaining from forward transactions.

E.1 Optimal Forward Positions for Producers

In the appendix we show that the optimal forward sale by a power producer is given, to a second-

order approximation, by:

E(QD ) PREM  xE(PW ) x −1  Skew(PW ) 

Q FPi = + +  , (14)
NP AVar(PW )  2a x   Var(PW ) 

where PREM is the excess of the forward price defined by (12) over the expected spot price.

A starting point for considering the power producer’s optimal forward position is its expected

physical production, E(QD )/NP . The optimal producer forward sale will equal expected output only if the

forward price is an unbiased predictor of the expected spot price and the distribution of wholesale prices

symmetric. Power producers optimally respond to a positive premium in the forward price by increasing

15
forward sales and vice versa. Finally, the optimal producer forward sale increases with the skewness of

prices, which serves to hedge its wholesale revenue stream.

Figure 3 illustrates the implications of expression (14), with c=4 and normally distributed demand.

The optimal forward positions displayed in Figure 3 have been scaled by the producer’s expected output, and

hence can be interpreted as its optimal hedge ratio. When expected demand and demand risk are low the

producer responds to the resulting downward bias in the forward price by reducing forward sales, and its

hedge ratio is less than one. However, as either demand risk or expected demand increases the producer

optimally increases its forward sales, in response to both the increasing equilibrium forward price and to

hedge its revenue stream.

E.2 Optimal Forward Positions for Power Retailers.

In this model, producers are homogeneous, reflecting the fact that each shares the same production

technology and sells into the same wholesale market. Retailers, in contrast, are heterogeneous if the

probability distribution of local demand varies across firms. To investigate the role of cross-sectional

variation in local demand characteristics for optimal retailer hedge positions, consider the ordinary least

squares regression of local demand on the average of system demand:

QD
Q Ri = ρ i + β i +εi , (15)
NR

where βi = Cov(Q Ri , Q D )/N R Var(Q D ) . This “power demand beta” measures the sensitivity of retailer i

demand to average system-wide demand. We assume that the errors from this regression are independent of

total system demand, QD . 15 Using this assumption, the Appendix shows that the optimal retailer forward

position can be expressed, to a second-order approximation, as:

PREM   Skew((P W )  
Q FRj = − E(Q Rj ) + + β *j Z + Y   , (16)
AVar(P W )   Var(P W )  

15 The regression errors are, by construction, uncorrelated with system demand. Our stronger assumption assures
that the regression errors are also uncorrelated with the wholesale price, which is a non-linear function of demand. In
16
  βj  N
where β *j =  x  P

[ ] 
 , Z = PR xE(P W ) x −1 − xE(P W ) x , and Y =  PR

x(x − 1)
E(P W ) x − 2 −
x(x + 1) 
E(P W ) x −1  .
 a  N R   2 2 

Note that since x is less than or equal to one, the term Y is strictly negative.

The first term on the right side of (16) is the forecast demand load. However, the retailer optimally

purchases forward a quantity that matches its expected demand only when the premium in the forward price

is zero and local demand is uncorrelated with system demand. The second term on the right side of (16)

reflects the response to the bias in the forward price. The third term on the right side of (16) reflects

systematic demand risk. If demand risk is not systematic ( β j = 0) the third term is zero. Within the third

term, Z is positive when the retail price exceeds the expected spot price. Positive Z reflects retail revenue

risk, which the retailer hedges by increasing its quantity sold forward (i.e. decreasing the quantity purchased

forward), if the demand risk is systematic. In contrast, any positive skewness in the price distribution

increases the importance of risk in the costs of purchasing power, and leads to a reduction in the optimal

quantity sold forward (i.e. an increase in forward purchases), if the risk is systematic.

Figures 4 and 5 present the results of simulations, again assuming normally distributed demand and

c=4, that illustrate the implications of expression (16) for the optimal forward position of power retailers.

Figure 4 presents optimal hedge ratios (forward positions relative to expected demand) for a retailer whose

demand risk is non-systematic, i.e., its power beta is zero. Figure 5 presents optimal hedge ratios for a

retailer with a high degree of systematic power demand risk, as indicated by a power beta of 2.0.

The retailer with non-systematic demand risk chooses a hedge ratio that differs from (negative) one

only as a response to the bias in the forward price. As a consequence its purchases forward an amount

greater (less than) its expected sales if the forward price is downward (upward) biased.

The retailer with systematic demand risk optimally deviates further from a hedge ratio of (negative)

one. When demand risk is small and expected demand is low this retailer is more concerned with revenue

the absence of this assumption expression (16) contains two nuisance terms involving correlations between the
regression errors and functions of the wholesale price.
17
risk, reducing its forward purchase, and in extreme cases may even sell forward. As expected demand or

demand risk increases the retailer with systematic demand risk rapidly increases its forward purchases,

reflecting an increased desire to hedge purchase costs against the possibility of wholesale price spikes.

IV. Preliminary Empirical Evidence on the Pricing of Power Forward Contracts.

A. Issues in Testing Forward Pricing Hypotheses in Power Markets.

Empirical testing of the hypotheses developed here is limited by the fact that the markets are new and

data is scarce. The newness and uniqueness of the wholesale power markets raise the possibility that

observed forward prices will reflect the inexperience of industry participants, and may differ from the pricing

structure that will be observed in a longer run equilibrium. A learning phenomenon of this type was

documented by Figlewski (1984), who reported that market prices for stock index futures initially deviated

significantly from theoretical values, but converged toward predicted values after a few months of trading.

There is a substantial empirical literature that tests forward and futures pricing theories in stock,

bond, foreign exchange, and commodity markets. The research designs employed typically seek to identify

the ex ante premium in the forward price by measuring the ex post differential between forward prices and

realized delivery date spot prices, which equals the ex ante premium plus random noise. A common

difficulty, however, is that random shocks to asset prices are large compared to any premium in the forward

price, so that tests conducted in smaller samples lack statistical power.16 This difficulty is compounded in the

case of electricity markets because of the short time series of available data and due to the unusually large

variability of prices.

B. Research Design and Data Description

We adopt an alternative empirical procedure that exploits the fact that spot electricity prices are

16 For example, Fama and French (1987) conduct tests of whether futures risk premiums are nonzero using between
nine and eighteen years of data from twenty-two commodity markets. They conclude (page 73) that “the large
variances of realized premiums mean that average premiums that seem economically large are usually insufficient to
18
determined by demand for consumption and supply from production at each point in time. 17 Specifically, we

use realized daily demand (load) and price data to estimate parameters of the power production function, and

then obtain estimates of expected spot prices by month using the fitted cost curve and average load data by

calendar month. Forward premia can then be estimated simply as the difference between observed forward

prices and cost-based estimates of expected delivery date spot prices.

We examine power forward contracts for the Pennsylvania, New Jersey, Maryland (PJM) and the

California Power Exchange (CALPX) markets. We focus on these two markets because they are the first

markets to implement centralized dispatch and real time market pricing of power, and because daily load,

spot, and forward price data is available for these markets.18 Each market is governed by an independent

system operator (ISO), who assigns generation to meet power demand. The ISO uses supply schedules

submitted by producers to dispatch generation assets to minimize the cost of meeting power demand while

maintaining system reliability.

The available PJM data cover the period April 1997 through December 1999. For CALPX, data is

available from April 1998 through December 1999. Figure 6 displays average daily on-peak (7 a.m. to 11

p.m.) PJM spot power prices. This illustrates the volatility of spot power prices, including price spikes

during the summers of 1998 and 1999. On July 6, 1999, for example, the average on-peak spot power price

was $583 per MWh. Table 1 displays average on-peak spot power prices by calendar month in both markets.

These display clear seasonalities attributable to demand variation and the inability to store electricity, with spot

prices highest in the summer.

We begin by estimating the parameters of the power production function using daily price and load

data. Our model implies that spot prices are given by equation (5). Taking logarithms, parameters of the

infer that expected premiums are nonzero” and “the evidence is not strong enough to resolve the long-standing
controversy about the existence of nonzero expected premiums.”
17 Prices for storable commodities, in contrast, are determined not only by supply from current production and
demand for current consumption, but also by supply from or demand for inventory.
18 Spot price and load data are obtained from the web sites www.calpx.com and www.pjm.com, which also contain
additional information about the markets. Standardized futures contracts for delivery at several locations, including
Palo Verde (Arizona), California-Oregon Border, Cinergy (U.S. Midwest), Entergy (South-Central U.S.) and PJM are

19
production cost function can be estimated by the following linear regression:

ln( Pt ) = a + (c − 1) ln( Q t + d t ) + ε t , (17)

where Pt is the daily average on-peak spot price, Qt is daily load, and a and c are parameters to be estimated.

Monthly indicator variables denoted dt are included to account for the fact that the power supply function

varies seasonally as producers schedule planned maintenance outages during periods of low expected power

demand. In this specification, c estimates the degree of convexity in the cost function. A value of c greater

than two implies that the spot prices will be positively skewed, even if the power demand distribution is

symmetric.

Applied to daily PJM data from April 1997 through December 1999, the estimated value for c is 4.67

(t-statistic = 32.1), indicating a significant degree of convexity in the cost function. The regression R-

squared is approximately 60%, indicating that variation in load and the simple cost function in expression (1)

capture a substantial portion of the variation in spot prices. For CALPX over the period April 1998 to

December 1999 the estimated value for c is 5.07 (t-statistic = 28.3), and the model explains almost 70% of

the variation in spot power prices.

Having estimated the cost function based on daily realizations of price and load, we next estimate

expected spot prices by month as fitted values from (17), contingent on average load for the calendar month.

The standard deviation and skewness of spot prices are estimated on a monthly basis, using differences

between actual daily prices and these cost-based estimates of expected prices. Table 2 reports the resulting

average of the expected spot prices, as well as the standard deviation and the standardized (by dividing by the

standard deviation cubed) skewness in spot prices by season. (Winter is defined as the first three month

period of the year, spring the second three month period, etc.)

Expected spot prices are highest in the summer, in both markets. For PJM expected prices are similar

across the other three seasons, while in CALPX fall prices are somewhat higher than winter or spring prices.

traded on the New York Mercantile Exchange and the Chicago Board of Trade. However, trading activity in the
futures has been thin, and load data is not readily available for these markets.
20
In PJM, the standard deviation of spot prices peaks in the spring and summer months. As expected, given

the convexity in the cost function, the standardized skewness coefficient is also positive and greatest during

the spring and summer months. For CALPX, the standard deviation of spot prices is greatest in the summer

and fall, and standardized price skewness is, by far, highest in the summer season.

Since the standardized skewness coefficient is the third moment of spot power prices normalized by

the cube of the standard deviation in spot power prices, the seasonal increase in standardized skewness

implies that unstandardized price skewness increases during the summer more rapidly than price variance.

The model therefore implies an upward bias in power forward prices for summer delivery. The model

predicts that the bias in the forward price should be small or negative when price variability is moderate and

price skewness is low. In light of the estimates reported on Table 2, we anticipate small or negative bias in

power forward prices for spring and fall delivery. We test whether the data is consistent with these broad

predictions by examining seasonal variation in the bias of forward prices.

C. Evidence on Forward Power Pricing.

Daily observations on one month power forward contracts are obtained from Bloomberg. Each

forward contract calls for the continuous delivery of power throughout the delivery month, rather than

delivery at any particular time during the delivery month.19 Bloomberg reports forward prices for PJM

delivery, but not for CALPX delivery. As a surrogate, we use Bloomberg data on forward prices for Palo

Verde, Arizona, delivery. Power delivered to Palo Verde is often routed into the California market.

Figures 7 and 8 display monthly averages of one-month forward prices and expected spot prices

(calculated from the estimated cost function) by delivery month for the PJM and CALPX markets, using all

available forward data. Figure 9 displays the average forward bias, computed as the difference between the

forward price and the expected spot price, by month for each of the markets. In each market the forward

price is biased upward in the summer months, but the bias in the forward price is much smaller during the

19 More specifically, the contract calls for delivery during each weekday, on-peak, hour of the delivery month.
21
other seasons. This is consistent with the model prediction that high skewness in spot prices will lead to an

upward bias in the forward price.

There is also some evidence of a learning effect in the PJM market. In the summer of 1997, the one

month forward price was below the expected spot price. The first highly-publicized spikes in wholesale

power prices occurred during June of 1998. Subsequently, one month forward power prices for summer

delivery lay considerably above expected spot prices, while forward prices for non-summer delivery were

little changed relative to 1997. This is consistent with the reasoning that market participants learned of the

degree to which summer power prices are positively skewed, and that the consequences of price skewness at

times of high mean demand then became embedded in forward prices.

Table 3 reports the average bias in the forward price in each market by season, computed from

monthly data for April 1998 through December 1999. Also reported are simple t-statistics for the hypothesis

that each seasonal mean is zero. The bias in the forward price is largest during the summer, averaging over

$17 per MWh in PJM and over $5 per MWh in CALPX. Despite the small (21 monthly observations per

market) sample sizes, t-statistics readily reject that the average premium in forward power prices for summer

delivery is zero. These results are consistent with those reported by Pirrong and Jermakyan (1999), who

document that summertime day-ahead prices (which are technically short-maturity forward contracts) exceed

forecasts of next-day spot prices in the PJM market. In contrast, the average premium during seasons other

than summer tends to be near zero, with the exception of a significantly negative mean bias for CALPX

during the fall season.

Finally, we provide some more specific evidence on the validity of the model with a regression

analysis of the average monthly forward premium on demand variables. To improve statistical power in the

small sample, each daily load observation is normalized by dividing by the sample mean load for the market,

and the regression is estimated as a pooled system. We compute monthly means and standard deviations

from the normalized daily load observations, and estimate the following regression:

22
PREMit = α 0 + α 1 DUMCALPXit + α 2 MEANit + α 3 STDit + α 4 VARit + ηit ,

(17)

where PREMit is the difference between the one month forward price for delivery in month t and the cost-

based estimate of expected spot price in month t for market i, DUMCALPXit is an indicator variable that

equals one for CALPX observations (included to allow for omitted market-specific variables), MEAN it is the

average normalized load for month i in market t, STDit is the standard deviation of daily normalized market i

load during month t, and VAR it is the square of STDit . The theory predicts that the forward premium should

increase with mean demand (α 2 >0). It also predicts that the forward premium should be convex, initially

decreasing (α 3 <0) and then increasing (α 4 > 0) in demand risk.

The results of estimating (17) are reported on Table 4. Each coefficient estimate is of the predicted

sign, but only the estimate on mean load is statistically significant. The regression adjusted r-square statistic

is 33%. This confirms the results of the seasonal analysis and indicates that the premium in forward power

prices for summer delivery is associated with high mean power demand. High mean demand, in turn, gives

rise to positive skewness in spot power prices. In view of the small sample size and the presence of

substantial multicollinearity among the predictive variables, we view these results as providing encouraging

preliminary support for the model presented here.

23
V. Conclusions.

Forward contracts for electricity cannot be priced by typical “cost-of-carry” relations, because

power is not storable. We take an equilibrium approach, and obtain the implication that the forward power

price will generally be a biased forecast of the future spot price, with the forward premium decreased by the

anticipated variance of wholesale spot prices and increased by the anticipated skewness of wholesale spot

prices. Simulations confirm that the model implies that forward prices will exceed expected spot prices when

either expected demand or demand volatility are high, due to the positive skewness induced in the spot power

price distribution.

Though we focus on the pricing of forward contracts, there is anecdotal evidence that positive price

skewness (or price spikes) affect the pricing of electricity options as well. For example, Krapels (2000)

asserts (page 24) that:

“It is common knowledge, however, that traders in many OTC electricity options markets have
become so fearful of being physically “net short” (having agreed to deliver electricity in the future at
an earlier agreed-upon price) when one of the price spikes occurs that they place extremely high
volatility assumptions into the pricing of OTC electricity call options”.

We also analyze producers’ and retailers’ optimal forward positions to gain insights into optimal risk

bearing, showing that optimal positions depend on statistical properties of power demand and spot prices,

including forecast demand and measures of “power demand betas” and price skewness. Finally, we provide

some preliminary empirical evidence on wholesale power prices. Consistent with the implications of the

model, we document a positive bias in forward power prices for summertime delivery, while the bias in

forward prices for spring and fall delivery is zero or negative. Regression analysis also indicates that the

forward premium increases with mean demand, as predicted.

Though we focus explicitly on hedging decisions and equilibrium in wholesale electricity markets, we

believe that some insights obtained in this analysis will prove useful for a broader set of hedging problems.

Previous studies considering forward hedging strategies, including Rolfo (1980), Anderson and Danthine

24
(1981) and Hirshleifer and Subrahmanyam (1993), develop expressions showing that optimal forward

positions depend on the covariance of revenues (price times quantity) with price. We extend the analysis by

making endogenous both market prices and output decisions, which leads to the implication that price

skewness is relevant to hedging decisions. Our conjecture is that equilibrium analysis will show the skewness

of primary variables to be relevant in a broad array of commodity-hedging applications. It also should be

noted that skewness arises in this model due to interactions among endogenous variables, and not by

assuming a higher-order utility function (as for example in Kraus and Litzenberger (1976)).

The summertime forward premia documented here for the power markets are large relative to those

that have been documented for other commodities (e.g., Fama and French (1987)). This suggests that the

power markets are not well-integrated with the broader financial markets, i.e. that outside speculators are not

a significant presence in these markets. A lack of integration may be due to informational setup costs (as

discussed by Hirshleifer (1988)) associated with learning about power markets, or due the lack of good

benchmark price indices on which to base cash-settled derivative contracts, as suggested by Ong (1996). It

will be of interest to see if mechanisms are developed to facilitate the sharing of power price risk with outside

speculators, and if risk premia decline as a consequence.

25
 Appendix:

A. Forward Pricing:

Substituting the expressions for the covariance between the “but for hedging” profits and wholesale spot price from

text equations (10) and (11) into the expressions for the optimal forward positions taken by retailers and producers

from text equation (9), the optimal quantities sold forward can be rewritten as:

* PF − E(PW ) 1  1  Cov(PWx , PW )
QFPi = + 1− , (A1)
AVar(PW ) a x  c  Var(PW )

for producers and

* PF − E(PW ) Cov(QRj, PW ) Cov(PW QRj , PW )

QFRj = + PR − , (A2)
AVar(PW ) Var(PW ) Var(PW )

for retailers. The market clearing forward price can be determined by equating the sum of the forward positions

across retailers and producers to zero:

NR NP
PF − E(P W ) Cov(QD , PW ) Cov(PW Q D , PW )
∑Q F*
+ ∑ Q FPi = N R + PR −
*

Rj
j=1 i =1 AVar(PW ) Var(PW ) Var(PW ) (A3)
P − E(PW ) N P  1  Cov(PWx , PW )
+ NP F + 1− =0 ,
AVar(PW ) a x  c  Var(PW )

NR
where we have used the properties of covariances and the fact that ∑Q
j=1
Rj = Q D in writing the expression. Solving

(A3) for PF , using the result that PW = a Q D/N P ( )

c −1
, and letting N = (N R + N P )/A , the market clearing forward price

can be written as:

PF = E(PW ) −
NP
[
cPR Cov(PWx , PW ) − Cov(PWx+ 1, PW ) , ] (A4)
Nca x

which is text equation (12). Also, let

PREM = PF − E(PW ) = −
NP
[ x
cPR Cov(PW , PW ) − Cov(PW
x +1
, PW ) ,] (A5)
Nca x

denote the premium in the forward price as compared to the expected delivery date spot price.

26
A.1 Second-Order Approximation:

The function Pz (where z is a constant) can be approximated, by using a Taylor’s series expansion around the point
E(P), as:
 z( z − 1)  z ( z − 1)
P z ≅ E ( P ) z  1− z +  + z( 2 − z ) E ( P) z −1 P + E( P) z − 2 P 2 . (A6)
 2  2

Substituting expression (A6), letting z = x and z = x+1 in turn, into (A4), and using the properties of covariances, we
obtain
 NP 
P F = E(P W ) +  [ ]
 (x + 1)(E(P W ) x − P R E(P W ) x−1 ) Var(P W ) +
x 
 Nca 
(A7)
 N P  x + 1 x −1 x −2 
  (
x 
)(xE(P W ) − (x − 1)P R E(P W ) )  Skew(P W ) ,
 Nca  2 

which is equivalent to text equation (13).

B. Optimal Forward Positions:

Using expression (A6) with z = x+1 in combination with text equations (9) and (10) and the definition (A5), we obtain

E(P W )
x
PREM  xE(P W ) x −1   Skew(P W ) 
Q FPi = x
+ +   (A8)
a AVar(P W )  2a x   Var(P W ) 

for the optimal quantity sold forward by a power produer. Using a second-order Taylor series expansion of text

equation (6) at E(QD ) and the properties of expectations, we obtain the result that:

E(Q D)
E(P W ) x ≅ a x . (A9)
NP

Using (A9) with (A8) gives text (14).

Combining text equations (6), (9), (11), and (15), and using the properties of covariances along with the assumption

that the regression errors in (15) are independent of system demand, the optimal quantity sold forward by a power

retailer can be expressed as:

 βj N P 
Q FRj = − ρj +
PREM
+ (
 P R Cov(P Wx , P W ) − Cov(P W
x +1
)
, PW ) . (A10)
AVar(P W )  N R a Var(P W ) 
x

where ρ j is the intercept from the regression equation (15). Using expression (A6) with (A10) this can be

approximated as:

27
 * PREM   Skew(PW )  
Q FRj = −ρ j + + β *j,  W + Y   , (A11)
AVar(P W )   Var(P W )  

 β  N  x(x − 1) x(x + 1)
where β*j =  xj  P [ ] 
 , W = PR xE ( PW ) x −1 − ( x + 1)E (PW ) x , and Y =  PR E(P W ) x − 2 −

E(P W ) x −1  ,
 a  N R   2 2 

Finally, taking the expectation of text equation (15), and using the result along with (A9) in (A11), we obtain:

* PREM   Skew((PW )  
Q FRj = − E(Q Ri ) + + β *j  Z + Y   , (A12)
AVar(P W )   Var(PW )  

[ ]
where Z = PR xE(P W ) x −1 − xE(P W ) x , which is text equation (16).

28
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Pirrong, C. and M. Jermakyan, 1999, “Valuing Power and Weather Derivatives on a Mesh Using Finite
Difference Methods" in Energy Modelling and the Management of Uncertainty, Risk Books, 1999.

Rolfo, J., 1980, “Optimal Hedging under Price and Quantity Uncertainty: The Case of a Cocoa Producer”,
Journal of Political Economy, 88, 100-116.

Routledge, B., D. Seppi, and C. Spatt, 1999a, “Equilibrium Forward Curves for Commodities” Journal of
Finance, forthcoming

Routledge, B., D. Seppi, and C. Spatt, 1999b, “The Spark Spread: An Equilibrium Model of Cross-Commodity
Price Relationships in Electricity”, working paper, Carnegie Mellon University.

Shin, H. and R. Stulz, 2000, “Firm Value, Risk, and Growth Opportunities” working paper, Ohio State
University.

Smith, C. and R. Stulz, 1985, “Determinants of Firm’s Hedging Policies” Journal of Financial and
Quantitative Analysis, 20, 391-405.

Stulz, R., 1990, “Managerial Discretion and Optimal Financing Polices” Journal of Financial Economics, 26,
3-28.

United States Department of Energy, 1999, “Electric Power Annual 1998 Volume II: Executive Summary”,
Washington D.C. Document is available at www.eia.doe.gov/cneaf/electricity/epav2/epav2_sum.html.

Wolfram, C. 1999, “Measuring Duopoly Power in the British Electricity Spot Market”, American Economic
Review, 89, 805-826.

30
 30

25

20

Bias in Forward Price (%)

15
25-30
20-25
10 15-20
10-15
5 5-10
0-5
-5-0
0
-10--5
-15--10
-5

5
-10
4.4
3.8
-15
3.2 Production Cost Convexity
1
3

(C)
5
7
9
11

2.6
13
15
17
19
21
23
25
27
29
2

31
33
35
Demand Standard Deviation

37
39
Figure 1: Bias in Forward Power Price as a Percentage of the Expected Spot Price, as a function of Demand Risk and
Production Cost Convexity. Demand is normally distributed with mean E(QD ) = 100 and standard deviations as indicated on
the figure. The numbers of firms are set at NR = NP = 20. Variable costs for each producer are given by (a/c)( QD)c . The retail
price is set as PR = 1.2E(PW |c). To render average wholesale prices comparable across c, we set a = 30(NP / E(QD))(c-1). To
render risk premia comparable across c the risk parameter is set as A = 0.8/2c .

40

30
Bias in Forward Price (%)

20

30-40
20-30
10 10-20
0-10
-10-0
-20--10
0

124
117
-10 110
103
96 Expected Demand
-20 89
1
4

82
7
10

13

16

19

22

25

75
28

31

34

37

Demand Standard Deviation

40

Figure 2. Bias in Forward Power Price as a Percentage of the Expected Spot Price, for Varying Mean Demand and Demand
Risk. Demand is normally distributed with mean and standard deviations as indicated on the figure. The numbers of firms
are set at NR = NP = 20. Variable costs for each producer are given by (a/c)( QD)c , where a = 30(NP / E(QD))(c-1) and c is fixed at
4. The retail price is set as PR = 1.2E(PW |c). The risk relevance parameter is set at A = 0.8/2c .
 1.6

1.5

1.4

1.3 1.5-1.6
1.4-1.5
1.2 1.3-1.4
1.2-1.3
Optimal Producer Hedge
1.1 1.1-1.2
Ratio
1-1.1
0.9-1
1
0.8-0.9
0.7-0.8
0.9
0.6-0.7
124
117 0.8
110
103 0.7
Expected Demand 96
89 0.6

40
37
34
82

31
28
25
22
19
16
75
13
10
7
4

Demand Standard Deviation

1

Figure 3. Producer’s Optimal Forward Position Relative to Expected Production. Demand is normally distributed with mean
and standard deviation as indicated. The numbers of firms are set at NR = NP = 20. Variable production costs for each
producer are given by (a/c)( QD)c , with c fixed at 4. The retail price is set as PR = 1.2E(PW |c).

-0.8

-0.9

-1

-0.9--0.8
Hedge Ratio for Retailer -1--0.9
-1.1 with Non-Systematic -1.1--1
Demand Risk -1.2--1.1
-1.3--1.2
-1.4--1.3
-1.2

124
117
110 -1.3
103
Expected Demand 96
89 -1.4
40
37

82
34
31
28
25
22
19
16

75
13
10
7
4

Demand Standard Deviation

1

Figure 4: Optimal Forward Sale Relative to Expected Demand Load for a Retailer whose Demand risk is Non-Systematic.
Demand is normally distributed with mean and standard deviation as indicated. The numbers of firms are set at NR = NP = 20.
Variable production costs for each producer are given by (a/c)( QD)c , with c fixed at 4. The retail price is set as PR =
1.2E(PW |c).

32
 0.5

-0.5
Hedge Ratio for Dealer with 0-0.5
Systematic Demand Risk -0.5-0
-1--0.5
-1
-1.5--1
-2--1.5

-1.5
1
10
19
Demand Standard -2
Deviation 28

123
120
117
114
111
108
105
102
37

99
96
93
90
87
84
81
78

Expected Demand
75

Figure 5. Optimal Forward Sale Relative to Expected Demand Load for a Retailer whose Demand risk is Systematic, with
Power Demand Beta = 2. Demand is normally distributed with mean and standard deviation as indicated. The numbers of
firms are set at NR = NP = 20. Variable production costs for each producer are given by (a/c)( QD)c , with c fixed at 4. The retail
price is set as PR = 1.2E(PW |c).

33
 $ per MWh $ per MWh

1
10
100
Ap
1000

0
10
20
30
40
50
60
70
80
r-
M 97 1/1/98
ay
-9
Ju 7 2/1/98
n-
9
Ju 7
l 3/1/98
Au - 9 7
g-
Se 97 4/1/98
p-
O 97 5/1/98
ct
-
No 97
v- 6/1/98
D 97
ec
-
J a 97 7/1/98
n-
Fe 98
b- 8/1/98
M 98
ar
-9 9/1/98
Ap 8
r
M -98 10/1/98
ay
-9
Ju 8
n- 11/1/98

Expected spot price

9

34
Ju 8
l 12/1/98
Au - 9 8
g-
Se 98
1/1/99
Date

p-

Date
O 98
ct
- 2/1/99
No 98
v-
D 98 3/1/99
ec
-
J a 98 4/1/99
n-
Fe 99
b- 5/1/99
M 99
ar
-9

One month forward price

Ap 9 6/1/99
r
Figure 6. Average Daily On-Peak PJM Spot Power Prices

Figure 7. Expected spot and one month forward prices in PJM

M -99
ay
-9 7/1/99
Ju 9
n-
9 8/1/99
Ju 9
l
Au - 9 9
g- 9/1/99
Se 99
p- 10/1/99
9
O 9
ct
No -99 11/1/99
v-
D 99 12/1/99
ec
-9
9
 Figure 8. Expected spot and one month forward prices in CALPX

60
One month forward price

50

Expected spot price

40
$ per MWh

30

20

10

0
Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec-
98 98 98 98 98 98 98 98 98 99 99 99 99 99 99 99 99 99 99 99 99
Date

Figure 9. Bias in one-month forward price

50

PJM BIAS

40

30

20
Bias ($)

CALPX BIAS
10

0
Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec-
98 98 98 98 98 98 98 98 98 99 99 99 99 99 99 99 99 99 99 99 99

-10

-20
Date

35
Table 1. Monthly average on-peak spot power prices in the PJM and CALPX power markets. Reported are
equally-weighted means of daily prices observed during the indicated calendar months. The PJM data covers April
1997 through December 1999. The CALPX data covers April 1998 through December 1999.
Month PJM CALPX
January 22.50 25.05
February 18.91 22.70
March 22.13 21.93
April 23.64 27.82
May 27.18 23.96
June 39.65 24.66
July 83.66 40.08
August 36.54 47.54
September 27.89 41.45
October 26.99 42.70
November 23.66 37.22
December 20.72 32.97

Table 2. Seasonal average estimates of electricity spot price parameters. Expected spot prices are computed
on a monthly basis as the fitted value from text equation (17), evaluated at the mean load for the calendar month.
Standard deviations and standardized skewness are computed on a monthly basis using deviations of daily prices
from the monthly expected prices. Results reported are averaged across the three calendar months per season. The
data cover the period from April 1998 through December 1999.
PJM CALPX
Season Expected spot Standard Coefficient of Expected spot Standard Coefficient of
price deviation of skewness of price deviation of skewness of
spot price spot price spot price spot price
Winter 23.15 4.71 -0.27 23.11 1.99 0.64
Spring 24.25 26.13 2.24 24.25 6.32 0.37
Summer 37.32 61.13 2.71 39.44 20.27 1.84
Fall 23.41 4.54 -0.42 36.09 10.39 0.82

36
Table 3. Average bias in forward power prices, by season. Reported are mean differences between one month
forward prices and cost-based estimates of expected delivery-date spot prices. Expected spot prices are obtained as
fitted values from text equation (17), evaluated at mean load for the calendar month. Units are dollars per MWh.
The data cover the period from April 1998 through December 1999.
PJM CALPX
Season Mean t-statistic Mean t-statistic
Winter 1.62 0.31 0.33 0.11
Spring 0.61 0.16 0.18 0.09
Summer 17.33 4.71 5.17 2.50
Fall 2.02 0.55 -6.84 -3.33

Table 4. Regression of Monthly Bias in Forward Power Price on Mean Demand, Standard Deviation of
Demand and Variance of Demand, by Month. Reported are coefficient estimates obtained when estimating the
following regression:

PREMit = α 0 + α 1 DUMCALPXit + α 2 MEANit + α 3 STDit + α 4 VARit + ηit ,

where PREMit is the difference between the one month forward price for delivery in month t and the cost-based
estimate of the expected spot price in month t for market i, DUMCALPXit is an indicator variable that equals one for
CALPX observations, MEAN it is mean normalized daily load for month i in market t, STDit is the standard deviation
of daily normalized load during month t in market i, and VAR it is the square of STDit . Units for PREM are dollars
per MWh. The data cover the period from April 1998 through December 1999.
α1 α2 α3 α4
Coefficient -5.33 39.84 -28.41 432.44
t-statistic -1.85 2.25 -0.17 0.40

37