The wholesale market is where the energy commodity — gas or electricity — is initially traded. By understanding how this process works, you may be able to negotiate with your retailer to reduce one of your key costs. But this requires an understanding of the wholesale market and what steps you can take to minimise the risks faced by your retailer.
In this section
What drives electricity price volatility
Energy market prices are extremely volatile, so it is important to understand the factors that drive the prices of wholesale energy up and down. Understanding the market drivers can help you judge if the energy price offered by a retailer is fair and reasonable. It can also help you improve the price you negotiate with your retailer.
The main drivers of volatility include:
- Matching supply and demand: One of the principal drivers of price fluctuations in electricity wholesale markets is the need to continuously and instantaneously match supply with demand. In times of high demand, more expensive electricity generation is used because electricity cannot be stored economically.Hydro-power is the exception to this as potential energy can be stored in hydro reservoirs and converted to electrical energy when it is most profitable for hydro-power plant operators.
- Energy consumption: There are two aspects of demand that are important for prices: the total volume consumed and the load profile, or how that volume is spread over time. Price levels are affected by the amount of available capacity in the system and the demand on the system. Generators use forecasts of future consumption to decide what type and how much new capacity they should have. If actual consumption is different from the forecasts, wholesale prices will be impacted. For example, if actual consumption is higher than expected during periods of constrained capacity, prices are likely to be higher. If actual consumption is lower than expected, prices are likely to be lower.
- Load profile:The way electricity demand fluctuates from one period to the next is an important determinant of both wholesale prices and network prices. The greater the volatility or peakiness of demand, the greater the need for more expensive forms of supply. Peaky demand requires more responsive and expensive generation to be brought online. It also requires network service providers to construct more network capacity in parts of the network that are likely to become heavily loaded. Demand side response activities can allow investment in capacity to be deferred, and provide an opportunity for users to be paid for this demand side response ‘service’. Further information about these opportunities can found in the demand management section of this website.
- Generator outages: Generators shut down for regular maintenance. Maintenance is typically scheduled at periods where prices are expected to be low. However, unexpected generator outages can also occur. During unexpected outages, more expensive capacity is dispatched and this can cause sudden increases in wholesale prices.
- Fuel commodity prices: Rising coal and gas prices increase the input costs of fossil-fuel generators, pushing up wholesale prices.
- Weather:There is 9 GW of hydro-power capacity connected to the National Electricity Market, which is around 15–20% of total capacity. Prolonged drought can have a significant impact on power supply by constraining the availability of hydro-power plants in Victoria, the Snowy Mountains region and Tasmania. Some coal-fired plants that use freshwater for cooling can also be impacted, constraining supply.Both energy consumption and load profiles are also influenced by the seasons. For example, use of air conditioners is driven by extremes in temperatures, with the highest levels of peak demand typically occurring during the hottest summer days.
Gas price volatility
There have been a number of recent developments in gas markets that have influenced wholesale gas price volatility. These developments could significantly affect gas prices into the future.
Demand for natural gas as a fuel for electricity generation has been increasing, partly because extreme peak demand for electricity has become more volatile due to increasing use of residential air conditioning and partly due to government schemes encouraging decarbonisation of electricity production.
Secondly, the burgeoning Liquefied Natural Gas (LNG) industry has had a significant impact on domestic natural gas prices. For example, in Western Australia where LNG exports increased by 7.4% in 2009–10, domestic natural gas prices have increased significantly because LNG exports provide gas producers with an alternative market to domestic supply. A similar trend may occur in Queensland and NSW, following development of an LNG terminal to export Coal Seam Gas (CSG).
While companies report that price movements in the gas markets are not as volatile as in the electricity markets, gas end users, particularly larger consumers, still manage their exposure to market movements either by:
- passing the price risk onto retailers or producers and paying a contract premium; or
- accepting gas market price exposure, and taking responsibility through accurately forecasting and managing demand to minimise their reliance on short-term markets.
Futures and Forward Contracts
Understanding how retailers use the futures and forward markets to reduce the risk they face in the wholesale market can help end users negotiate more favourable retail contracts.
Retailers purchase significant volumes of electricity in the wholesale market and sell packages of smaller volumes to its customers. The price they pay in the wholesale spot market is highly volatile, ranging from minus $1,000 to $12,500 per MWh, while the price they receive from customers is largely fixed over designated time periods. This exposes retailers to a high degree of financial risk.
To hedge against the financial risk and provide themselves with greater price certainty, generators and retailers use financial contracts such as electricity forwards and exchange-traded products. The prices specified in these contracts vary over time, meaning it is possible to negotiate a better retail contract when the forward price for energy is low relative to historical prices. Consequently, large end users can find it useful to routinely monitor publicly available contract price information and use this as a reference for determining ‘value’ in retail price offers.
Electricity forwards are a type of contract in which generators and retailers set the terms and conditions for trading electricity at some point in the future. These contracts set a strike price, which is the net price the seller receives and purchaser pays, taking into account both the contract price and the spot price. They can also be tailored to specify other conditions, such as the total volume of power traded over specified time intervals.
Forward contracts work by allowing the contracting parties to set up a cash payment mechanism that operates in parallel with the volatile gross pool wholesale market and provides price certainty. This means that if the gross market spot price is:
- higher than the strike price, the seller in the forward contract pays the purchaser the spot price minus the strike price
- lower than the strike price, the purchaser in the forward contract pays the seller the strike price minus the spot price.
This method for effectively fixing the price sellers receive and purchasers pay is called Contracts for Differences. They provide a form of electricity price risk insurance tailored to meet the specific needs of individual market participants and play an important role in underpinning the financial stability of the National Electricity Market.
Forward contracts, also referred to as ‘over-the-counter’ (OTC) products, can be traded either directly between the parties or through an intermediary or broker, who finds each party the most attractive contract. OTC contracts are not limited to forward contracts, but can include complex options or combinations of options and forwards.
End users may also enter into OTC contracts either directly or through an intermediary as part of their energy purchases. This could allow the user to deal directly with an electricity generator, thereby avoiding or reducing costs imposed by energy retailers. However, this approach is only likely to be suitable for large energy users who are able to accurately forecast their demand and energy consumption, and who have the capability to manage demand within the constraints specified in the forward contract.
NEM electricity futures and options are another method used by energy retailers to lock in some price certainty. A future is an obligation to buy or sell electricity at a specified time in the future at a specified price. An option is a right, but not an obligation, to buy or sell electricity in the future at a specified price.
Futures and options are standardised products that are traded on the Australian Securities Exchange (ASX) outside the NEM Rules. They differ from OTC contracts as:
- the prices and volumes are made public and so the market is transparent;
- liquidity is increased by the participation of financial companies such as hedge funds or investment banks; and
- the exchange requires the deposit of an initial margin as collateral against credit risk which is updated to match prices daily until the position crystallises at expiry. This lowers the level of default risk compared to some OTC contracts where the OTC counterparties do not enter into similar credit cover arrangements.
The range of exchange-traded products available on the ASX Energy website includes:
- Base Load Electricity Futures, which is for 1 MWh based on a base load profile. The base load profile is defined as the NEM base load period from 00:00 hours Monday to 24:00 hours Sunday over the duration of the Contract Quarter.
- Peak Period Electricity Futures, which is for 1 MWh based on a peak-period profile. The peak-period profile is defined as the NEM peak-period from 07:00 hours to 22:00 hours Monday to Friday (excluding Public holidays, as determined and published by the Australian Stock Exchange) over the duration of the Contract Quarter.
- Strip Futures Products, which is defined as a trade where consecutive traded quarters of a futures product (with the same volume for each of those traded quarters) are bought or sold simultaneously.
- Quarterly Base $300 Cap Products, which are 1 MWh on a Base Load profile for the respective States (NSW, QLD, VIC and SA) over the duration of a Calendar Quarter.
Australian exchange-traded electricity products are considered to be ‘thinly’ traded but turnover volumes have been steadily increasing. Recently, caps are being used over the longer term (3 years plus) whereas the bulk of futures have an expiry date of one year or less.
Detailed price and volume information on electricity futures trades can be accessed at a fee through the d-cyphaTrade data centre. Information can also be sourced by:
- subscribing to the free daily email notification service offered by d-cyphaTrade
- accessing price and volume informationfor some electricity futures products published in the AER weekly electricity market reports
- obtaining information on electricity futures price and volume from your energy retailer or an energy broker.
How retailers use futures and exchange-traded products
Retailers use futures and exchange-traded products to hedge against the price volatility of the wholesale electricity market and to provide greater price certainty.
Retailers are likely to purchase futures contracts after signing a supply agreement with an end user. This means the price end users pay can reflect the prices for these products at the time of completing the agreement. End users can therefore benefit from negotiating contracts when the price for futures and exchange-based products is low.
In doing so, end users should be mindful that future contract prices are unpredictable and tend to be influenced by extreme volatility in the spot market, even though futures contracts can apply to delivery of electricity well beyond the period when the spot price volatility occurs.