The most electrifying trade of 2021 (not crypto)

What are commodities?

What are derivatives?

Electricity as a case study

  • ISO: stands for Independent System Operator and is a not-for-profit entity responsible for market operations in a geographic region. ISOs handle activities like dispatch of power plants, balancing the grid in real time, and they are the central clearinghouse for all electricity trading activities. Part of their job is to dispatch the cheapest and, importantly, available, energy source on the grid to meet demand.
  • Locational Marginal Pricing (LMP): the cost associated with delivering an additional MW of electricity at a given location on the grid. LMP is comprised of 3 components: (1) Energy cost, (2) Congestion Cost, and (3) Losses. (1) is what a generator needs to get paid to break even on the production of 1 MW of power — this is kind of like the cost of goods sold for energy. (2) is the physical limitation imposed by transmission infrastructure of the grid, which basically acts as a constrain on supply at a given moment in time (i.e. only so many electrons can get on those wires at a time, creating an artificial supply ceiling). (3) is just the cost of electricity lost in transmission due to line loss, similar to costs associated with transportation / distribution in a hard goods business.
  • LSE: stands for Load Serving Entity, which is the retail energy provider or utility serving end users like a business or residential customers. LSEs buy electricity from wholesale markets to meet customer demand and are always optimizing for low costs of electricity, since they make their money on the spread between the price they get from wholesale markets and what they can charge end users like me or you on our monthly bill (though these rates are agreed to ahead of time, I’m not going to get into that here because it’s a separate conversation).
  • Capacity: a resource commitment for delivery to the grid in cases of demand surges, massive supply shortfalls, or other emergencies that cause a massive imbalance in supply and demand and put grid reliability at risk.

How can I invest?

  • UTC (up to congestion) & Virtuals: For some volume of power, in the DAM, lock in the price you think will prevail in tomorrow’s RT Market, by the hour. Tomorrow when the real-time price rolls in, hopefully you can sell at a higher price than what you locked in yesterday in the DAM and make the spread between the two. UTC is a version of this trade which only exposes you to the congestion aspect of LMP, while Virtuals focus on a single LMP and keep exposure to energy cost and congestion cost.
  • Futures: a bet on the end-of-day RT Market price of large electricity markets like PJM, ERCOT, etc.
  • Physical Flowing: arbitrage between the export price of one ISO and the import price of another ISO for electricity flowing across ISOs.

Takeaways

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