Trading Electricity Profits: A Chance for Hedge Funds to Deliver Real Alpha Returns
The US power market, a potential alpha driver according to investment expert Karl Rogers, is fraught with inefficiencies that impact electricity trading. These inefficiencies stem from a combination of aging infrastructure, transmission constraints, regulatory and market design issues, and challenges integrating renewable energy and electrification goals.
Aging Transmission Infrastructure
Rising transmission charges result from outdated infrastructure that requires upgrades and expansions to handle new energy loads and renewable integration. This causes higher costs and transmission congestion, limiting energy flow and market efficiency.
Renewable Energy Integration Challenges
Many states pursue aggressive renewable and electrification goals, but delays or shortfalls in meeting these goals reduce available supply and lead to inaccurate market forecasts. The grid operator's planning may not fully account for missed renewable targets, causing supply shortages and price spikes.
Grid Fragmentation and Limited Interconnections
The US grid is divided into largely disconnected regional systems. This fragmentation prevents efficient sharing of resources across regions, reducing resilience and increasing the risk of localized shortages. For example, Texas's isolated grid worsened the 2021 winter storm impacts due to lack of imports from other regions.
Market Design Issues
Current wholesale electricity markets use capacity markets to ensure resource adequacy, but offer caps on price limit generators' ability to fully recover investments during scarcity, leading to a "missing money problem." This can reduce investment incentives for new generation and transmission capacity, further hampering reliability and market function.
Rising Demand and Electrification
Increasing electricity demand driven by electrification of sectors such as transportation and ports adds to system load without proportional supply expansion. This mismatch can increase prices and trading volatility if supply cannot keep pace.
These inefficiencies affect electricity trading by increasing price volatility, causing market uncertainties, limiting capacity availability and liquidity, and restricting interregional trading opportunities.
Trading Products in the US Power Markets
The Local Marginal Price (LMP) is the price of electricity and is made up of two main components: Grid-wide energy price and individual congestion component. The Up-To-Congestion (UTC) and Virtual products are hourly contracts that lock in a price in the Day Ahead (DA) market for the next day's Real Time (RT) market. UTCs are a spread trade that cancel out the grid-wide energy component and isolate the congestion component, while Virtual products involve buying or selling one node and being open to both the energy component and the congestion component. Only one of the tradable products within the US power markets can be traded via the traditional exchanges, with the futures product being traded on the ICE. All other products are traded directly with each ISO.
The Role of Hedge Funds
Hedge funds trade these medium-longer term products close around the $100 million to $150 million AUM mark. The US power market fits within the investment philosophy of Karl Rogers, Founder of ACE Capital Investments, due to its inefficiencies and the lack of ETFs or Indices for accessing its returns.
The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group.
[1] NREL. (2019). Analysis of Market Inefficiencies in the U.S. Wholesale Electricity Markets. Retrieved from https://www.nrel.gov/docs/fy20osti/77712.pdf
[2] NERA Economic Consulting. (2018). Report on the Missing Money Problem in PJM. Retrieved from https://www.nera.com/-/media/files/publications/2018/03/nera-report-on-the-missing-money-problem-in-pjm.pdf
[3] Brainard, S. (2021). The Texas Power Outages and the Future of the Electric Grid. Retrieved from https://www.brookings.edu/research/the-texas-power-outages-and-the-future-of-the-electric-grid/
- Given the challenges of renewable energy integration and market design issues in the US power market, active management strategies focused on technology and finance could potentially exploit price volatilities associated with these inefficiencies, offering unique investment opportunities for hedge funds trading in medium-longer term products.
- The use of innovative trading products such as Up-To-Congestion (UTC) and Virtual products in the US power markets could enable efficient active management by isolating grid-wide energy and congestion components, thereby providing a means to hedge against market uncertainties and capitalize on pricing discrepancies caused by inefficiencies in the power market.
