The most electrifying trade of 2021 (not crypto)

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Hey there, and apologies for the month-long hiatus. I took some time to work on a shorter-term opportunity that I’m very excited about but man did I miss writing, so I’m very glad to be back in the saddle. This piece is near and dear to my heart as it combines aspects of financial markets and microeconomics with electricity, just a few of my favorite things. Before diving into the electricity trading portion, I want to establish a clear understanding of key financial products: commodities and derivatives.

What are commodities?

A commodity is a raw material typically produced in high volume with no specific product differentiation (like a Mac computer or Tesla) that can be bought and sold on a market. In agriculture, commodities include things like corn, soybeans, and wheat. In energy, natural gas, crude oil, and electricity are commodities. Commodities can be traded on markets just like any other good but are transacted in a specific format called a futures contract. These contracts specify a volume of the commodity to be traded at an agreed-to price per unit for delivery on a specific date in the future. Once the contract is written between the buyer and the seller, the contract becomes a tradeable good in and of itself and can pass from person to person based on the perceived value of the contract’s terms.

There are two important ideas to keep separate here. The first is that producers of commodity goods can lock in revenue for their goods in the future by agreeing with a counterparty on price, volume, and date of delivery. If the price closer to delivery date goes down, the seller is protected from that decline; if the opposite happens, the seller misses out on some upside. In general, though, the seller would rather have guaranteed revenue in the future than take the risk of future fluctuations in commodity prices, given they know their internal return requirements to break even on production of the commodity.

The second important idea is that once a contract is written, it is also tradeable as an entity itself: what is being bought and sold when this contract changes hands is the rights to the delivery of the physical goods whenever the contract comes due. In college, I had a friend in my investment club who liked to joke that he was going to buy a lean hog commodity contract in my name for delivery on my birthday — in other words, he was threatening to sic 100 live pigs on me as a birthday gift. He’s a great guy and thankfully never made good on his threat, but that’s effectively what he was “gifting” me by buying a contract from someone in my name — rights to the delivery of the physical good on the stated contract date.

Commodities comprise a lot of the input costs across a wide swathe of industries and thus changes in their prices ripple across the economy. Increasing wheat or soybean prices increase the cost of goods further down the supply chain relying on them, like groceries and restaurant meals. Increasing lithium and heavy metal prices increase battery, electric vehicle, and semiconductor prices. An example that many Americans are familiar with is crude oil commodity prices– when the price of crude oil goes up, the price we all pay at the pump for refined gasoline goes up, too. It’s important to nail down the key concepts of commodities so that we can better understand how electricity fits into and differs from this model.

What are derivatives?

The other, related topic I’d like to cover is derivatives. I find the easiest way to understand this is by returning to the basic Calculus definition of a derivative: simply, the rate of change in some variable Y over a given time period: ∆Y / ∆t. With this definition in mind, now think about some asset, say a stock. Suppose, over the next 3 months, you believe the price of the stock will decline by $5 — and let’s suppose you believe that strongly enough that you want to make a bet that at least a $5 decline will occur. How could you make this bet? By buying a derivative, which is basically just an agreement that guarantees the buyer exposure to the change in the value of the asset over some time t rather than exposure to the actual underlying asset. Examples of derivatives include put and call options, collateralized debt obligations (of 2008 Bear Sterns fame), and futures. While derivatives may seem like they are lower risk because they don’t directly expose you to an asset, they can actually be incredibly risky because you are betting on the probability that some discrete event occurs, which could be impacted by a near infinite number of other factors outside your consideration. This differs from a bet on the overall quality of some asset which, though more knowable than probabilities, is also probably not a 100% fully-informed bet.

Electricity as a case study

Just like other commodities, electricity can be traded. Unlike other commodities, however, electricity is produced and consumed instantly and cannot be physically stored (for now, at least) in the way barrels of oil or bushels of wheat are. This introduces some interesting dynamics into electricity markets which are not present in other commodity markets. Before I dive in, here are some important definitions and actors that will be helpful to get straight.

• 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.

With those definitions straight, let’s dive into how electricity markets work. There are 3 primary markets that ISOs manage: the Day Ahead Market (DAM), the Real-Time (RT) Market, and the capacity market. If the world were a simple place, LSEs would simply buy electricity at whatever the electricity spot price is, then turn around and sell it to the customer at a markup. But electricity spot prices are extremely volatile, so LSEs hedge by using the DAM. The DAM and RT Market focus on shorter time horizons (tomorrow and today, respectively), while the capacity market focuses on ensuring there’s a safety net in case of tail events, also known as grid reliability.

To illustrate, let’s walk through what happens in preparation for tomorrow’s process of serving electricity to customers, from the perspective of the DAM. In the DAM, the entities producing power (generators, wind or solar farms, coal plants, etc.) bid in the price at which they will sell their energy to the grid, based on what these producers estimate their hourly marginal cost of generation will be over the next day.

On the other side, LSEs look to buy supply at whatever price their internal models tell them makes sense given the amount of electricity demanded and the rate agreements established with customers. The ISO sorts through all the generators’ bids and orders them from lowest to highest per unit of energy bid, building out the electricity supply curve. Then both sides of the market settle at a range of LMPs, which vary by location on the grid due to different congestion costs and losses, and given the grid-wide raw energy cost determined by the ISO’s supply curve.

Now fast forward and it’s the next day. The market has settled and supply and demand are matched, lights are on, factories are humming, everything seems great. Then all of a sudden, demand at 3pm spikes slightly above what LSEs had predicted they would need for that period, leading to a shortfall in supply available to serve the higher load. Here is where the RT Market comes into play, by offering utilities and retail energy providers the option to transact in real-time to fulfill the shortfall and ensure their customers are served power when they need it. As I mentioned earlier, the spot price of electricity is extremely volatile so transacting in real-time is higher risk than doing so in the DAM for retail energy providers / utilities. In a perfect world they would never need to buy in real-time, since it diminishes the ability to predict costs and could negatively impact profit margins. But customers tend to get angry when they turn their lights on and find the power is out, so the RT Market serves an important role of making sure there’s supply available when demand is miscalculated.

Now I’ll return to capacity markets, which fall outside of the day-to-day market decisions of generating entities and LSEs. Capacity markets exist to ensure long-term reliability of the grid and to incentivize long-term investment in building more generating capacity for future load increases. Ultimately, capacity markets are an insurance policy against tail events that endanger the entire grid — as in you hope you never need it, but when you need it you are very glad you have it. The ways capacity markets are incentivized to develop is covered in this awesome podcast by Colleen Metelitsa, James McGinniss, and Duncan Campbell of DER Task Force, so I won’t belabor it here and instead recommend you take a listen. The important thing to take away from capacity markets is that they are the current best option for capacity backup when a low probability, high damage event occurs and endangers grid reliability.

How can I invest?

Now that the markets are laid out, what sorts of products can someone actually buy to make bets on the prices of electricity? There are two major buckets: short-term products and long-term products. On the short-term side:

• 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.

On the long-term side, the primary tradeable product is a longer time horizon version of the UTC & Virtuals products. Instead of locking in hourly pricing in the DAM and making the spread against the actual RT Market prices, you make the spread between the average DAM price for a month in the future and the observed DAM price in that month once it is realized. This trade can be replicated at a quarterly or annual level, too.

Takeaways

My biggest takeaway is that tradeable electricity products will probably not be on Robinhood anytime soon, and that’s probably a good thing. That said, I think it’s key to understand how electricity gets traded because if the trades don’t happen in an economically efficient way on a marketplace that’s fast and reliable, the impacts are massive: hospitals and schools won’t have power, business will be forced to shut down, and communities will be plunged into darkness.

My second biggest takeaway is that the way electricity markets are structured relies on the structure of the legacy electric grid, with its centralized power generation and monopolistic distribution. In the future, the ascendency of distributed energy resources will change the underlying assumptions that determine energy prices at the wholesale level, since an increasing share of generating capacity will not be on the centralized wholesale side but rather on the distributed, customer side of the meter. That ought to have some interesting implications for the business models of LSEs, and I plan to explore that next.