The impact of forward trading on the spot power price volatility with Cournot competition

Abstract

In this paper, we analyze the influence of forward trading on the volatility of spot power prices, in models where forward contracts are strategic tools used by energy producers to obtain profit security. We define volatility as the variance of the percentage change in spot power prices over a given time interval. As shown in Sapio (2008), volatility is related to stochastic fluctuations in preference and technology fundamentals, and is tuned by the price-elasticity of demand and supply, evaluated at equilibrium. We study two cases. First, we analyze the volatility implications of a model wherein the amount of forward trading is fixed, and producers compete a la Cournot. Fixed forward trading increases spot volatility, because forwards lower the spot price level, corresponding to a less elastic region of a linear demand function. However, if the amount of forward trading is endogenous, as in the two-stage model of Allaz (1992), producers can anticipate the spot market impact of stochastic shocks on fundamentals and 'sterilize' them. As a result, spot price volatility is closer to the value implied by an efficient market. Our theoretical results are illustrated by means of a simple simulation study.Electricity market; Cournot model; forward contract; volatility of spot price; elasticity;