Global Viewpoint: An Engineer in the Commodity Trading Pit

I was invited by the management of the New York Commodity Exchange to view its operations and to learn how electricity would be traded among investors whose sole purpose is to make money. Standing on the trading floor amidst the chaos that is so familiar to TV viewers who watch the evening financial newscasts, I wondered how an engineer could possibly fit into this alien environment. The noise level was so high that my hostess's conversation was incomprehensible to me.

And yet, I experienced an unmistakable exhilaration that was driven by the high level of energy generated among the traders, who were shouting and gesticulating with hands, fingers and eyes. Each movement signaled a desire to buy or sell, to agree on a price or to close a deal that was duly recorded - within a minute of the trade - by the pit clerk seated within a protective barrier that separated him from the crush of bodies milling about.

In the quiet of her office, my hostess responded to my question about how a trader could possibly know if energy would be available at any particular time and how the trader could be sure that it could be delivered. I was assured that there was a buyer for every offer to sell and there was an offer to sell whenever there was a buyer.

This reality was hard for me to comprehend, since planning engineers had always studied system capabilities in detail for the purpose of making long-range plans for adding capacity in both generation and transmission. Here, I was confronted with a scenario where it appeared traders were gambling on future outcomes to make agreements regarding system capabilities and power transfers. No technical analyses were required, only financial dealings. What I had been observing was the usual commodity trading in oil, natural gas, propane and a host of other products for which the Exchange, the largest physical commodities futures exchange in the world, has become famous. Trading will commence for electricity futures sometime during the first quarter of this year.

In a conversation with people at Duke/Louis Dreyfus, which is a partnership for power marketing, I was told that my perception about the risks involved in making long-term commitments was erroneous regarding availability and means for delivery. Contracts are made with guarantees to back up these commitments. The notion that traders are gambling on the future is also erroneous. Instead, calculated business risks are being taken along with measures that manage those risks. The mercantile exchange underscored these principles by noting that the Exchange operates as the mechanism for risk management in a competitive market that enhances price volatility.

The Exchange recognizes an electricity market that comprises the eastern U.S., western U.S. and Texas. It has approved terms and conditions for two contracts that represent major market centers at the California/Oregon border and at the Palo Verde switchyard in Arizona. These sites were selected to ensure that the futures contract is poised to coincide with the industry's need for a price reference and a risk management tool. Which contract is to be used will depend on industry consensus as to which is the strongest reference point as the cash market evolves.

A set of contract terms has been established involving the contract unit, which has been set at 736 MWh; the delivery rate, which has been set at 2 MW throughout every hour of the delivery period; and the delivery period, which is defined as 16 on-peak hours between 6 a.m. and 10 p.m. Trading in the delivery month ceases on the third business day prior to the first day of the delivery month. Prices are to be quoted in U.S. dollars and cents per megawatt hour with a minimum price fluctuation of US$0.01 and maximum permissible price per megawatt hour of US$3.00 above or below the preceding day's settlement. The electric utility industry is learning a whole new vocabulary relating to the exchange of power in a

business that will now encompass a financial component different from our usual power economics analyses.

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