Futures pricing in the Nordic electricity market

Abstract

This master's thesis examines the behavior of electricity spot and futures prices and the futures premium in the Nordic electricity market. The objective of the study is to identify, whether a nonzero futures premium exists in the Nordic electricity market, and to gauge its economic significance and the factors affecting its behavior. Furthermore, the forecasting ability of electricity futures over the future spot price is examined, and finally the existence of arbitrage opportunities is tested by constructing synthetic futures and comparing their prices with actual futures prices.

The data in this study consists of daily electricity spot prices in the Nord Pool power exchange for years 2000 - 2011, and electricity futures price data for weekly, monthly, quarterly and yearly contracts during the same period. The price data is complemented by coal price data and Nordic level data on water reservoir levels and electricity demand, which are the variables used to examine the behavior of electricity prices and the futures premium.

The results show that the futures premium in the Nordic electricity market is nonzero and positive for the time period 2000 - 2011, generally increasing with contract maturity. The futures premium exhibits very high variation, but on average the relative futures premium ranges from being close to zero with weekly futures to levels above 20 percent for yearly futures.

The OLS regression analyses show that deviations from historical water reservoir levels have an inverse relationship with electricity spot and futures prices so that above average water reservoir levels have a negative impact on electricity prices, and vice versa. Coal price and the overall electricity demand exhibit a positive relationship with electricity prices, and the influence of all these physical factors diminishes with the futures' time to maturity, being the strongest for shorter maturity futures and weak or inexistent for futures with longer maturities.

On the contrary, deviations from historical water reservoir levels indicate a positive relationship with the futures premium, this relationship being negative for coal price and electricity demand.

Furthermore, consistent with the expectations theory, electricity futures seem to possess strong explanatory power over the future spot price in the Nordic electricity market, whereas no evidence of time-varying risk premiums is found.

Finally, the comparison of synthetic futures prices to actual futures prices reveals that with yearly futures the mean relative price difference is close to zero, indicating that no opportunities for arbitrage exist, but for quarterly and monthly futures the price difference is different from zero on average, reaching a maximum mean value of 2.0% for 1-month contracts. This indicates that opportunities for risk-free profits may exist for arbitrageurs using synthetic futures to mimic the actual futures contracts. These arbitrage opportunities continue to prevail when transaction costs are at levels below two percent of the futures price, although their economic significance is low.