Modelling the relationship between spot and futures prices: an empirical analysis of the South African Power Pool
Date
2021
Authors
Mutembei, Kellyjoy Makena
Journal Title
Journal ISSN
Volume Title
Publisher
Strathmore University
Abstract
This study investigates the relationship between electricity spot and future prices in the South African Power Pool (SAPP). The objectives of the study included investigating whether forward prices in the SAPP are a true and unbiased estimate of the observable spot prices by determining whether or not a forward premium exists in the market. Investigating whether the forward premium (if it exists) can be explained by the behaviour of spot prices in the market in the period preceding delivery and lastly whether current future prices in the SAPP can be used to predict future spot prices in the market. The study used daily electricity spot prices in the SAPP for the period between April 1, 2017 and January 31, 2021 and electricity futures price data for weekly and monthly contracts during the same period. Relying on methodologies highlighted in the expectation hypothesis to describe the relationship between spot and futures prices, results indicate the existence of positive significant premiums in the market for the sample period. The premiums decrease with increasing maturity with the value of relative forward premiums ranging between 1.23 USD/MWh for peak weekly contracts to 0.46 USD/MWh for peak monthly contracts. Power purchasers in the SAAP are on average incurring a cost that inflates their cost of power by 0.24% to 1.23% depending on the hedging strategy they adopt and type of contracts they select. To explain the risk premia, the study followed methodologies highlighted in the General Equilibrium Model. Ordinary Least Square (OLS) regression results for forward premia modelling suggests that for some of the contracts in the SAPP, forward premiums can be at least partially explained by the mean, variance, standard deviation and skewness of the spot prices in the period preceding delivery. Particularly, the premiums have a negative relationship with average spot prices and a positive relationship with skewness. This implies that the higher the average spot price level, the lower the likelihood of overestimating future prices thus the lower the premium. Additionally, the higher the probability of upward price spikes, the higher the futures price thus the higher the premium. Lastly, to investigate forecasting ability of electricity futures in the SAPP, the study relied on the fundamentals of futures pricing suggested in the expectation hypothesis. Results reveal that future’s prices at the SAPP do not contain significant forecasting power over future spot prices in the SAPP. They reveal that variations in the forward premiums in the market are attributable to time varying risk premiums. The SAPP to a large extent relies on coal and nuclear power for electricity generation thus this could explain the reason why results led to the conclusion of the existence of time varying risk premiums.
Description
Research thesis submitted to Strathmore University in fulfillment of the requirements for the Master of Science in Mathematical Finance
Keywords
Forward premiums, General Equilibrium Theory, SAPP