Financial power is a commodity which trades in the form of a financial index swap. Also known as
a contract for differences, an index swap is a financial instrument in which a trader buys or sells a commodity
at a fixed price, which then settles (sells back out or buys back in) against an index. In other words, you either buy a fixed price
and sell back at the index price, or sell a fixed price and buy back at the index. To make things
slightly less murky, imagine an index of the amount of money lost each day by companies whose
employees spend time at work surfing E2. If you think it's going to amount to $70 million on any
given day, then you would be willing to buy a swap against that index for $69 million or sell a swap
for $71 million. When the index indeed settled at $70 million (aren't you smart?), you would collect
$1 million. Similarly, with financial power, there is an index of the average
price of power in a given region that settles each day. People trade against their idea of where that index will
price. Options on swaps are known as swaptions.
As of today, the only power markets that trade financially are in the Northeast. Simply, in order
to trade financially, there must be an index against which to trade. The only markets in which an
index exists are those operated by an ISO (Independent System Operator). At present, there are five
ISO's operating on the US power grid: Cal ISO (California), ERCOT (Texas), NEPOOL (New England),
NYISO (New York), and PJM (Pennsylvania, New Jersey, Maryland, Delaware, and parts of Washington,
D.C., West Virginia, and Ohio). Mature financial power markets have only developed around the latter
three Northeast ISO's.
PJM and NEPOOL are primarily traded as physical power. The only dominant use of financial power
instruments are in the real-time, balance-of-the-day markets. Traders of these markets are
speculating on the average for the on-peak (16 hour period from 7 AM through 11 PM) price. Both PJM
and NEPOOL publish a clearing price of power in 5 minute increments, so traders can track where the day
has averaged so far. The full 16 hour period (known as the bal-day) continues to trade even as the
index liquidates. In the case of PJM, cash (intra-month) and forward financial markets also exist,
but there is very little trading activity there (with the notable exception of the dailies--power for
next day delivery).
NYISO, however, trades almost exclusively as a financial product. NYISO actually has three
different indexes for the clearing price of power: the real-time market, the hour-ahead market (HAM),
and the day-ahead market (DAM). New York cash and forward markets trade against the DAM index, while
the bal-day product trades against the real-time index. NYISO is split into different zones, of
which only three actively trade. These are the West, Hudson Valley, and New York City zones, known
to traders simply as zone A, G, and J respectively.
Unfortunately, there is very little liquidity in either the NYISO or NEPOOL markets. Mostly, that
lack of trading activity is a function of the lack of health in the power trading industry in
general. As recently as a year ago, both of those markets were far more active. PJM, however, is
one of the most liquid markets in all power trading. The PJM bal-day market, while relatively small
in terms of net megawatts per trade (since you're only trading one day at a time instead of entire
months), enjoys the highest volume in terms of number of trades of any power market, physical or
The future of financial power trading is closely linked to the health of the power industry in
general. The jury is certainly still out on whether it will survive at all. Without a significant
number of counterparties, markets wither and die. Even the PJM bal-day market, with the highest
activity of any power market, is almost entirely driven by only 10 power trading shops. Should the
industry rebound, however, the future is bright for the further development of financial power
Already, the Intercontinental Exchange (the primary electronic platform for energy trading, known
primarily by its acronym ICE) has attempted to develop an index for the Cinergy power hub against
which financial contracts could trade. That particular market died on the vine, but the very fact
that people were interested enough to encourage ICE to develop an index is encouraging. Also, the
FERC has taken significant steps towards trying to expand the ISO format beyond the five markets
mentioned earlier. As the ISO structure expands, additional indexes will exist against which
financial contracts can trade. Also, most traders prefer financial contracts to physical.
Settlement is easier, there are none of the delivery risks associated with physical commodity
trading, and there are no scheduling costs. While it will take years, financial power will
ultimately come to dominate the face of the power trading business.
The contents of this wirteup were derived from personal knowledge accumulated as a power trader at a major energy trading shop.