FUTURES, FUTURES, AND TVA
Michael A. S. Guth, Risk Management Consulting, and Tzvetan Zafirov, MBA graduate of Kenan-Flagler School of Business
© Copyright 2004 by Michael A. S. Guth. All Rights Reserved. No portion of this site, including the contents of this web page may be copied, retransmitted, reposted, duplicated, or otherwise used without the express written permission of Dr. Michael Guth. Reprinted from The Desk (Feb. 22, 2002) with permission of the publisher, Scudder Publishing Group, LLC. www.scudderpublishing.com.
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MICHAEL A. S. GUTH, Ph.D., J.D.
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Financial Economics Homepage || Attorney at Law Homepage
Michael A. S. Guth, Risk Management Consulting, and Tzvetan Zafirov, MBA graduate of Kenan-Flagler School of Business
The lack of liquidity in the Tennessee Valley Authority (TVA) electricity futures contract represents a colossal failure of the Chicago Mercantile Exchange, which was acquired by the Chicago Board of Trade (CBOT), to compete with the power futures contracts sponsored by the New York Mercantile Exchange (NYMEX). Instead of actively promoting its futures contract at TVA, CBOT seems reconciled to let the contract wither away from a lack of transactions. Signs of illiquidity in the TVA futures contract have become salient. Over the past year, broker quotes for TVA forward and futures contracts have dried up. Energy brokers no longer provide any option quotes for electricity products delivered at TVA.
It is in the nation’s interest that the CBOT establish successful power futures contracts. Otherwise, NYMEX will have a monopoly on energy futures contracts and will exert monopoly power to try to force power marketing firms to transact over the exchange. A viable CBOT futures contract represents a check on the power of NYMEX and its ability to select which regions of the country shall have power futures hubs.
For some, it may appear surprising that a futures hub that extends across the entire state of Tennessee and dips into parts of Alabama, Georgia, and Mississippi should not be heavily traded. Indeed the TVA territory has contiguous boundaries with eight states[1] and thirteen direct interconnects to other electric utilities.[2] Thus, in theory plenty of electric utilities and power marketing firms should want to trade the TVA futures product. But in practice, the TVA futures contract has sustained little interest from utilities or power marketing firms. The reasons for the lack of interest in the TVA futures contract are manifold. Chief among these reasons would be a decision by TVA’s managing board that the federal electric utility would not make markets in the futures contract trading in its own backyard.
History of the TVA futures hub
To understand the TVA board’s decision, it is necessary to retrace how the TVA futures hub came into existence. In 1997, emboldened by the success of the NYMEX futures contracts at Palo Verde (in California), the California-Oregon border (COB), and at PJM (Philadelphia-New Jersey-Maryland), the head of TVA’s trading floor began lobbying NYMEX to create a futures contract with a hub at TVA. In 1998, NYMEX turned down TVA’s request and opted instead to create futures hubs directly north (Cinergy) and directly west (Entergy) of TVA.
NYMEX competes with the Chicago Mercantile Exchange for futures trading business across a wide variety of commodities. In 1998, when the NYMEX turned down its futures hub request, TVA’s visionary trading floor manager, Heinz-Dieter Waffel, then approached the Chicago Mercantile Exchange about creating a futures contract with a hub defined by TVA’s territory. This time TVA was successful. In 1998, the Chicago Mercantile Exchange created the futures contract at the TVA hub, as well as one at Commonwealth Edison (COMED) in Chicago. The Chicago Mercantile Exchange merged with, and was absorbed into, the Chicago Board of Trade (CBOT). Consequently, power traders refer to the TVA and COMED electricity futures as “CBOT contracts.”
No sooner was the TVA futures contract hub created than TVA’s three-person managing board, with members appointed by the President of the United States, voted to prohibit the agency from trading in the TVA-hub futures contracts, “except for hedging purposes.” The board’s decision effectively prevented TVA from making two-way prices in the futures market defined over its own territory. No other electric utility or power marketing firm had as good information as TVA about historical and projected electricity prices in the Tennessee River valley area. Consequently, no other firm had an incentive to make markets in TVA futures, and this void of a TVA futures price market maker has never been filled.[3]
The TVA board limited the agency’s involvement with futures to simple “hedging” in part because (1) a 1957 TVA Act passed by Congress restricts the federal government agency from competing directly with the private sector, and (2) the agency has historically been managed conservatively with a big bureaucracy, and not like a nimble power trading firm. One of the constraints that condition (1) imposes is that TVA can only sell power to one of the original 13 (regulated) electric utilities with a contiguous border to TVA’s territory. If TVA were to take open positions in TVA futures contracts, one or more of the contracts might settle with TVA providing power to some entity other than one of the 13.
However, that problem could be solved if TVA used a broker. A broker could restrict TVA’s offers to sell power to one of the 13. Neither TVA nor the counterparty would know in advance who the other party was before the contract was executed, but broker limitations on counterparties could enable TVA to trade futures without violating the congressional act. Note: the congressional restriction only applies to sales of power by TVA; the agency can purchase power from any firm, regulated or unregulated.
The second condition about the agency being managed conservatively is somewhat of a misnomer. A prudent, conservatively managed firm would have effective risk management policies. TVA’s policy basically amounts to burying its head in the sand and largely ignoring developments in the futures and options markets. Thus, the agency continues to absorb the financial consequences of the summer heat cycle. If summer temperatures are unseasonably hot, then TVA makes money. If temperatures are mild in the summer, TVA loses money. The summer of 2001 was mild, and TVA reported a loss just like it has for mild summers for the past two decades. The futures and options markets in power might just as well not exist as far as TVA is concerned. The agency is still trading power and using a business model and philosophy that has permeated the agency for fifty years.
TVA raised its rates in 1998 ostensibly to pay down its massive $28 billion debt from stalled construction of nuclear power plants. Four years later, the proposed debt reduction is well behind schedule. TVA’s current debt sits at $27 billion, and TVA’s lack of control over its revenues is due to inadequate risk management policies and poor financial planning. With falling interest rates, TVA has been refinancing its bonds like gangbusters, but the apparent savings in financing costs were offset by increasing costs in other areas. TVA has over 28,000 MW of generating capacity, yet it ranks towards the bottom of power marketers. But enough has been said about TVA the government agency. We turn now to the performance of the TVA-hub futures contract, which has no direct connection to the federal utility.
Evidence of an Illiquid Hub.
If a picture is worth a thousand words, the following table summarizes a thousand words about the CBOT futures contract defined for delivery at TVA. Over the period Jan. 1, 2000 – Jan. 17, 2002, the Cinergy futures hub had not 5 times the volume of power transacted as TVA, but fifty times the volume of the TVA hub! Similarly, the PJM futures hub has experienced more than forty times the volume of power transacted at the TVA hub. The paucity of traded volumes bodes ill for the future of CBOT’s futures contract at TVA.
Power - Traded Volumes (in thousand MWh)[4]
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Hub |
Jan-01-2000 – Jan-17-2002[5] |
November
30, 2001[6] |
January
17, 2002[7] |
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Cinergy |
646,850 |
65 |
82 |
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PJM |
567,886 |
49 |
68 |
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Nepool |
151,476 |
7 |
32 |
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Entergy |
108,740 |
17 |
49 |
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Palo Verde |
44,287 |
7 |
26 |
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COMED |
23,552 |
4 |
20 |
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TVA |
13,100 |
12 |
8 |
Cinergy is a tiny hub geographically; it is centered around Cincinnati. How could such a small geographic hub whip the pants off the 800-pound gorilla of a hub defined over the entire Tennessee River valley? One could argue that the Cinergy hub is strategically located between power flowing to and from the Northeast and the Midwest. But that would raise the question of why the TVA hub, which is immediately south of Cinergy, does not acquire more transactions as strategically located between the Midwest and the South. Population trends show more people are migrating to the South, yet the TVA futures hub has not benefited from those changing demographics one iota.
Of course, one difference between the contracts is the sponsors: CBOT sponsors the TVA futures hub, NYMEX sponsors the Cinergy futures hub. Can better marketing and support by NYMEX explain the better performance of the Cinergy hub over the TVA hub? By comparison, the other CBOT power futures hub at COMED is also performing poorly, although the two-year volume of transactions at COMED has been twice that of TVA. Maybe CBOT needs to revise completely its business model for power futures.
Conclusions
Unlike the TVA hub, which has 13 interconnects, American Electric Power (AEP), is natural hub with at least 18 and as many as 26 interconnects -- depending on how electric cooperatives and members of smaller pools are counted. Back in the early days of power futures trading (1996-1997), the Power Team at PECO realized AEP was a natural hub, and they allegedly made hundreds of millions of dollars in revenue by moving power across that hub. We recommend that CBOT drop its futures contract hub location at TVA and instead establish a futures hub at AEP before NYMEX or the over-the-counter market does so.
The federal agency TVA needs to set an example for other electric utilities by expanding its transmission line capacity, its number of direct interconnects, something else that will induce more power marketing firms to access power flowing through the Tennessee River valley. If the TVA futures contract withers away from a lack of interest, it will be an indictment of poor planning and site selection on the part of CBOT but also a blow to the industry leadership of TVA. The rate payers of the Tennessee River valley have a right to expect more than a bureaucratic management style from TVA. If TVA wants to be an industry leader, the agency needs new risk managers who know how to take profitable positions in the futures markets.
Progress Energy is located in Raleigh, NC, and the western service territory for the firm’s regulated subsidiary, Carolina Power & Light, is directly east of TVA’s region. Due to the firm’s close geographic proximity to TVA, we would like to use the TVA futures price (plus a transmission adder) as a proxy for prices in the Virginia-Carolina (VACAR) region. Within the Middle Office of Progress Ventures, the unregulated subsidiary of Progress Energy, we have previously marked to market numerous deals in the Carolinas using a pricing formula based on the TVA hub. But the declining deal flow and lack of liquidity associated with the TVA futures hub has forced us to seek alternative marks and to put the TVA futures contract on a liquidity watch.
This liquidity watch is analogous to a credit watch, with further downgrading possible as events transpire. For now we have established liquidity limits for the TVA hub products (and for all hub products for that matter). However, the liquidity limits we impose on our trading floor for TVA are much lower than our liquidity limits for hubs such as Cinergy, PJM, and Nepool. We wish our power marketing friends at TVA the best of luck in establishing more transactions at the TVA hub. But in the meantime, the liquidity limits will help protect our trading floor from losses due to a potential flight to liquidity and away from illiquid TVA hub products.
© Copyright 2004 by Michael A. S. Guth. All Rights Reserved. No portion of this site, including the contents of this web page may be copied, retransmitted, reposted, duplicated, or otherwise used without the express written permission of Dr. Michael Guth. Reprinted from The Desk (Feb. 22, 2002) with permission of the publisher, Scudder Publishing Group, LLC. www.scudderpublishing.com.