NCPA - National Center for Policy Analysis

California Should Have Treated Electricity Like Pork Bellies

March 5, 2001

Like hog bellies and orange juice, electricity, natural gas and other forms of energy are all commodities. But commodity markets for wholesale energy producers and buyers have only been established recently. And the types of contracts, called hedges, typically used in other commodity markets to protect against price fluctuations are also new. If California energy officials had systematically used these contracts, called options or derivatives, it would likely have lessened the crisis there, a Cornell University researcher says.

For reasons that are unclear, but may have to do with flaws in the regulatory structure or the inexperience of market participants, no one in California hedged risks with energy derivatives, according to Philip Protter, professor of operations research at Cornell.

Speaking to the American Association for the Advancement of Science, Protter said options are "[a] type of insurance against unlikely but potentially harmful financial is a new kind of insurance without actuarial tables. But it is insurance, nevertheless."

  • In California, electricity commodity options would have given utilities the right to purchase excess capacity from power-generating companies in the future at an agreed-upon price.
  • Buyers of commodities deal in futures contracts or option contracts, hoping to hedge against possible price fluctuation.
  • They can effectively lock in the higher price with a derivatives contract, such as a put option.

Neither party knows what the price of electricity will be months or years ahead, but utilities might be willing to forgo the possibility of future price decreases in return for a guarantee the price won't rise. The power generating companies might forgo price increases for the assurance the price won't fall.

"They could have used options as a type of long-term insurance against the very events that transpired, provided, of course, they could have found sellers of those options," says Protter.

Source: Philip Protter, "Modeling Financially Risky Assets with Mathematics: A Little History and Some Explanations," Conference Paper, February 19, 2001, American Association for the Advancement of Science.

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