I['•UTTERWORTH II~E I N E M A N N Resources Policy. Vol. 21, No. 4. pp. 283284. 1995 Copyright © 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4207/95 $10.00 + 0.00 Prospects for an electricity futures market A comment Joost M E Pennings and Willem J M Heijman Wageningen Agricultural University, Hollandseweg 1, 6706 KN Wageningen, The Netherlands In a recent article in this journal Tussing and Hatcher (1994) have argued that the market for power sales will be unlikely to foster and sustain a viable futures market until significant policy changes are executed. They conclude that because of the market structure of electricity, dominated by vertically-integrated organizations, there is no need for futures contracts. In this article we show that the hedging effectiveness of electricity futures is high compared with tradi- tional commodities such as crude oil. Introducing electricity futures will therefore change the market structure of the electricity business. Moreover, electricity futures can contribute to an efficient implementation of environmental policy. On a futures market, transactions to do with commodity characteristics, time and location of delivery, and unit of trading are standardized. This standardization process is very complicated as far as commodities are concerned, especially with respect to location of delivery and com- modity characteristics (such as sort and form). This con- trasts with a futures market for electricity. Electricity is a perfectly homogeneous 'commodity' ie the underlying commodity is identical to the commodity in the cash market, implying that there are no problems with respect to delivery from a futures market perspective. Electricity futures have therefore, in contrast to traditional com- modities such as crude oil, low residual risk at maturity of the futures contract (Black, 1986), which results in a relatively high hedging effectiveness compared with other commodities (Pirrong et al, 1994). This character- istic is important for utilities that wish to reduce price risk. The utility might use a cash forward contract or a futures contract to manage its price risk. The advantages of cash forward sales/purchases over hedging in futures are fairly clear. As with futures, the price level is fixed before delivery, but unlike hedging in futures, there is no further adjustment of the firm's return as a result of any subsequent change in the basis, l Moreover, the cash for- ward contract can be tailored more closely to meet the firm's needs, eg with respect to quantity, quality and place and time of delivery as well as other terms (Paul, 1976; Nelson, 1985; Antonovitz and Nelson, 1988). These advantages of cash forward sales/purchases over hedging in futures do not apply to electricity. In this case, the advantages of futures markets - the highly or- ganized methods of trading with the extreme standard- ization of terms resulting in buyers having widespread and low-cost access to sellers (and vice versa) and great integrity of the contract - are not affected by the dis- advantages of futures vis-d-vis cash forward contracts mentioned above. This implies that electricity futures are a more suitable price risk management tool for util- ities than cash forward contracts. These characteristics of electricity futures will have a positive impact on the minimum variance hedge ratio which has a one-to-one relation to the hedging 1Where the basis is defined as the local spot price minus the futures price. Resources Poli(:v Volume 21 Number 4 December 1995 283