Lewis Evans explains the connection between, and roles of hedge and spot markets in allocating water to its most valued use in electricity

By Lewis Evans*

Water is valuable.¹

The value of water is a topic of national importance.

There are common misconceptions that water is free and that high spot prices in dry years routinely benefit generators at the expense of electricity users.

Neither is true.

A key to determining the socially desirable value of water in electricity production and the management of water in dry years is the interaction of many different buyers and sellers in the spot and hedge markets.

‘Water is valuable’ explains that, just like other commodity markets, the electricity wholesale market consists of spot and hedge markets.

These markets must both be present for commodity markets to function well.

Hedges are fixed-price long-term agreements at which the bulk of electricity is exchanged.

The spot market places a price on electricity that is not hedged. It does so in every half-hour period of the year.

It prices exchanges between buyers and sellers of electricity that is not sold under a long-term agreement.

It exchanges mismatches of supply and demand. Mismatches must occur² under long-term fixed-quantity agreements because supply of electricity must equal demand at every instant in time and forecasts of demand and supply cannot be perfect.

Because of variation in rainfall, temperature and any system outages, predictions of demand and supply can vary from outcomes in periods of time that may be very short.

The monograph also explains how the interaction between buyers and sellers produces the value of water in electricity use, and how the spot price of electricity measures this value.³

Water is scarce.

In electricity, it is scarce at any point in time because hydro generators must decide whether to use it then or store it for later use.

It is also scarce because water and gas generation substitute for each other in critical peak periods.

The value of another unit of water is determined jointly with the cost of additional gas generation. In addition, mention is made of the obvious additional fact that water is a scarce resource in the wider economy beyond the electricity market, and that its use in electricity is now in competition with other uses.

It explains why competition among buyers and sellers in the electricity market is a good framework for water trading that will see water flow to its most socially valued uses.

Who really benefits from dry years?

There is confusion about who benefits and who loses from high spot prices, particularly those prices that are related to dry years in which reservoir inflow levels are low.

Commentators such as Wolak⁴ have suggested that the prices are due to market power and that generators particularly benefit.

In fact these prices represent the socially desirable value of water in allocating scarcity under a workably competitive market. But who really does benefit or lose in these situations?

The accompanying graph of electricity prices shows these periods well. As the monograph explains, the spot prices in Figure 1 give us the value of water at those points in time.

The ‘who’ of who benefits from dry years is, in fact, a mix of demand and supply entities (retailers, generators, industrial and large commercial firms) that use electricity intensively and have ability and interest in managing electricity use. Equivalently, in New Zealand they manage hydro water variation.

The scarcity of water (and in other periods its plenty) is managed by market participants holding hedge contracts and trading unhedged amounts in the spot market.

Let’s see how this is done.

Suppose in 1998 generator A (GenA) entered a hedge with a large industrial entity B (IndB) for 100 units of electricity (MWH) at $50 per MWH for each trading period for the years 2000, 2001 and 2003.

This hedge is shown in Figure 1 as a straight line.

Typically the hedge would work as follows. GenA receives and IndB pays $50 per MWH for 100 MWH per trading period no matter what the spot price is or how much they supply or use. GenA puts its generation in and IndB takes the electricity it wants out of the spot market, but the spot price of the 100 MWH is not the price of the transaction: it is fixed at $50. If GenA produces 100 MW each trading period then it receives the price of $50 on all units it sells. If it produces less (say, 80 MWH) then it gets its hedge contract of $50 on 100 MWH and will buy 20 MWH at the spot price to meet that quantity of the hedge agreement. If IndB consumes 90 (or 110) MWH then it sells (or buys) 10 MWH from the spot market at the spot market price.

What would have been the effect of the dry year of 2003 on our hypothetical market participants? The hedge is a contract that is present throughout the period of its term. If GenA produces 100 MWH and IndB consumes this, there is no effect at all from the high spot prices of 2003: the transaction price is $50. If GenA is a hydro generator and the low inflows reduce its ability to supply 100 MWH, then it must make up the short fall by buying in the spot market at spot market prices: in this case it would be a loser from the water scarcity. If IndB has the ability to economise on production (for instance by closing plant for maintenance during the dry period and reducing its use of electricity to 30 MWH), then it pays $50 for 100 units and puts 70 back in the spot market for which it gets paid the high spot market price. In this case IndB makes a profit gain. Of course, other realistic scenarios include mixes of generators and demand entities benefiting and losing from high price episodes.

To complete the picture we should consider the case when inflows are relatively high (as in 2000). Here GenA still receives, and IndB pays, $50 for 100 units even though the spot price is much lower (see Figure 1). If our hydro generator in this ‘year of plenty’ produces 130 units of electricity, it will sell 30 units at the low spot price. But it will get $50 for the 100 units.

It is this ‘insurance feature’ that ensures hedges of various forms will be offered and accepted for a considerable share of electricity traded. The strike price ($50 in our example) will be agreed between seller and buyer and can be expected to be in the vicinity of the expected average spot price looking forward from 1998 to 2000-2004. A hedge may take a contract form or be the result of vertical integration of retail and generation, but the story is the same. The terms and numbers of hedges can be expected to balance these insurance concerns across locations⁵ as well as time.

The winners and losers in dry and wet periods are a mix of entities on both the supply and demand sides of the market. Typically these entities have the ability and incentive to actively manage electricity price/quantity fluctuations. The public accounts of all five major generators in the New Zealand market simply do not show that generators make relatively high profits in dry periods. This is illustrated by Figure 2. It shows none of Wolak’s monopoly rents, and it is consistent with the balance of hedge and spot markets.

High-price episodes coinciding with dry periods are fully consistent with the New Zealand electricity market being workably competitive and achieving a socially desirable allocation of water, gas and uses to demand. They do not imply profitable periods for generators.

In sum

Most wholesale electricity traded today in New Zealand will be exchanged at hedge prices.

The spot prices apply to non-hedged quantities and they are critically important in allocating water to relatively socially beneficial uses in dry, wet and average years.

They achieve this because the whole market is not fully hedged – as indeed it cannot be, if it is to serve over- and under-trading and allocate water in socially desirable ways.

It is the interaction among many buyers and sellers in both markets that enables the hedge market to achieve efficient insurance arrangements while New Zealand’s fluctuating water supply is applied to socially desirable uses.

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1 D Tam & L Evans (2013) ‘Water is valuable: the allocation of water and other resources in the New Zealand electricity market’ (available at http://www.iscr.org.nz/f882,23080/ Monograph_No4_07_13.pdf).

2 Market participants may also choose to buy and sell in the spot market and manage the associated price risk outside the wholesale electricity market. As a point of detail, all electricity traded in New Zealand among market participants must be transacted through the spot market. The hedge arrangements are entered into separately.

3 Strictly, the price of water in electricity is the value of an extra unit of water given the state of demand, storage, current inflows, gas value, etc in the electricity market.

4 Frank Wolak’s 2009 report to the New Zealand Commerce Commission is evaluated in a symposium on that subject published in New Zealand Economic Papers. See, for example: L Evans, S Hogan & P Jackson (2012) ‘A critique of Wolak’s evaluation of the NZ electricity market: Introduction and overview’ New Zealand Economic Papers 46(1) pp1-10.

5 Hydro-water fluctuation in the South Island may well differ from that of the North Island.

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Professor Lewis Evans is an ISCR Distinguished Research Fellow and a professor of economics at Victoria University of Wellington.

This piece is reprinted from the ISCR July 2013 CRT Newsletter #41 which you can access in full here.