4.4

WHEELING POWER

Wheeling is the act of physically transporting electricity from one location to another. Wheeling trades require a physical transfer of electricity over power lines rented from a third party. Because of the way the electricity markets set their prices, adjoining markets can have very different prices of electricity. This is particularly true if the generation stacks of the two areas are different. Most regions set power prices based on the cost of operating their most recently activated generator. There can be a big price difference between regions when one region has most recently activated a natural-gas-fired generator and the other a coal-fired generator.

The purpose of wheeling is to get low-cost power into high price areas. There is a trade-off between the long-distance transportation of power and local generation. A substantial amount of power can be lost in transmission. Additionally, widespread power grids have many more points of failure than compact power grids. However, sometimes long-distance transportation is necessary. Many types of power generators have restrictions on where they can be located. For example, a natural gas cogeneration plant needs to be located adjacent to a large user of the steam. Nuclear power plants are often located far away from the communities they serve. Hydroelectric plants need to be located on a river at a dam. As a result, certain electrical generation choices necessitate the long-distance transmission of power.

A chart of average prices demonstrates the variability of electrical prices around the United States (Figure 4.4.1). Compared to low-priced regions, high-priced regions pay twice as much for their power on the average. During peak demand periods, the disparity may be even greater.

Figure 4.4.1 Average residential power prices (Source: U.S. Energy Information Administration)

In a deregulated power market, trading helps determine when it is economically worthwhile to build transmission lines. These lines connect areas of low-cost generation to high-priced consuming regions. Private investments—wheeling trades—pay for the construction of power lines, and those investors make profits from their investment. Eventually, as enough transmission capacity between the low-cost areas and high-priced areas is built, prices will converge. In this way, free market trading determines the right level of investment.

In a physical sense, a wheeling trade involves building a power line to connect two separate areas. Most of the time, the cost of the trade is proportional to the cost of building the power line. Once the power line is constructed, its owner has the option of transporting some amount of power (the amount that the power line can physically handle) between the two regions. Since power lines are not free to build, there is a strong economic incentive for investors to build power lines that will have the biggest economic impact at the lowest cost.

For valuation purposes, wheeling trades can be modeled as financial options. After paying an up-front cost to rent the line, a trader has the option of transporting power over that line. The actual benefit is unknown at the time power line is rented. The up-front cost is similar to an option premium. The variable costs associated with transportation (line losses and any variable expenses) are similar to a strike price. The potential profit depends on the price difference between the two regions. When the profit is greater than the transmission costs, it is profitable to transmit power over the transmission line.

From a trading perspective, wheeling deals are interesting because they allow traders to buy an option for the physical construction cost of a power line rather than on the financial value of the option. This is a key aspect of trading physical products. Option premiums can be extremely expensive. If the construction costs are affordable, physical investments provide an alternate way to get the same financial exposures at a much lower cost.

In most cases, the cost to rent a transmission line is proportional to the cost of building and maintaining the power line. If there is only one power line operator in a region, the rental price will probably be subject to government regulations for nondiscriminatory pricing. The logic is that if a lot of people want to rent power lines, there shouldn’t be a competitive auction over a limited resource. Instead, the power line operator should be forced to build more power lines and charge back that cost to the investor groups.

Long-Distance AC Transmission

The most common way of transmitting power across long distances is to use overhead high voltage, alternating current electrical lines. When power is transmitted across a power line, some of the power gets converted into heat. The amount of energy lost to heat is proportional to the square of the current. The primary way to reduce transmission losses is to decrease the current on a power line. The primary way to decrease the current is to increase the voltage.

Voltage and current combine to determine how much power a transmission line carries. Transformers can be used to modify the current and voltage of AC power lines, converting high current power into high voltage power. Transformers only work on AC power lines, which is why AC transmission is more common than DC transmission.

Transformers use magnetic induction to alter the current and voltage on a line while keeping the total power constant. The scientific principle behind a transformer is that magnetic fields create electrical currents and vice versa. It is possible to use an electrical current to create a magnetic field, and then use that magnetic field to create another electrical current at a different voltage. Transformers are typically composed of two coils of conductive wire wrapped around a shared core. Starting and stopping the current on one wire will induce a current on the other coil.

Long-Distance DC Transmission

An alternative to AC power transmission is high voltage direct current (HVDC) power lines. HVDC power lines have been used successfully around the world to transfer power over extremely long distances. Typically, these power lines are lower cost than AC power lines and lose less power in the transmission process. These lines are also commonly used to transfer power between unsynchronized AC power grids or through long distances underwater.

On the downside, DC power has to be converted into AC power at the endpoint. No one uses high voltage DC power in a residential setting. It is extremely dangerous, and the voltage can’t be stepped up or down using a transformer. A normal DC to AC conversion can result in a 5 to 10 percent loss in power. These conversion losses have to be weighed against reduced transmission losses. As a result, HVDC is usually only used for extremely long-distance transmission where AC transmission losses are much larger than conversion losses.

Another disadvantage of a DC transmission is that multiple endpoints are problematic. Whenever any energy is removed from a DC transmission line, the voltage on the entire line will drop. Because DC voltage can’t be increased by transformers, a DC power line with more than one endpoint won’t have a constant voltage across the line. As a result, it can be very difficult to build an interconnected grid of HVDC power lines. Because of this, HVDC power lines are primarily long-distance, point-to-point connections.

For example, if HVDC power lines are built to connect a major solar installation in the Desert Southwest to two points on the East Coast of the United States, as in Figure 4.4.3, it would be very difficult to reroute any of that power from one point to another. If the rerouting were to be done on the East Coast, it would be necessary to convert the DC power to AC power and transmit it using the AC transmission grid. It would only be possible to reroute the DC power from the point of origin in the Desert Southwest. However, building direct transmission lines to connect every generation station to every user is an operational nightmare. If there were thousands of generation locations, it would be impossible to control the power grid from any centralized location.

Figure 4.4.3 Point-to-point HVDC transmission

Trading Example—Wheeling Trade

A power company examines a wheeling trade to transfer power from the upper Midwest (where coal is the marginal fuel) to the southern United States (where natural gas is the marginal fuel). To a large extent, this trade is a bet on natural gas prices being much more volatile than coal prices.

1. The Opportunity. Low-ash, low-sulfur coal from Wyoming provides the midwestern United States with an abundant supply of low-cost fuel for electricity generation. The marginal fuel for the area is coal, and power prices do not see large fluctuations. In the southern United States, most power plants burn natural gas. The price of natural gas is much more volatile than coal. As a result, a transmission line between the Midwest and southern United States is a way to benefit from the different volatilities.

2. The Intuition. Renting a transmission line is like buying an option on natural gas. It will benefit from high volatility. Even if the average cost of power is the same in both regions, the natural-gas-fired areas will see much greater swings in prices and there will be periods where it is profitable to export electricity from the Midwest to the Gulf Coast.

3. The Strategy. A large number of trades will need to be made in the spot market to take advantage of the higher volatility. Seasonal trades are possible in the futures market. For example, hot summer weather begins earlier and lasts longer in the southern United States. It is possible to import power from the Midwest during periods when the Midwest is cool and the southern United States is experiencing hot weather.

4. The Risks. Renting a power line is a lot like buying an option—the biggest risk is in overpaying for the right to transmit power. Since this transmission line is long volatility, it may be possible to sell natural gas options or lock in seasonal trades using futures. There will be a substantial amount of operational risk due to the necessity of scheduling physical transactions.

5. Executing the Trade. A long-term rental agreement is a direct contract between two parties. Additionally, every time the power needs to be transferred, it will be necessary to schedule deliveries, transmission, and sale of the power. This requires a trading desk capable of handling all of the necessary paperwork. There is a high degree of operation risk in this trade.

Spread Trades Compared to Wheeling Trades

The key to a wheeling trade is the ability to transmit power between two regions. If electrical transmission isn’t available, it is impossible to buy power in one market and resell it in another. Instead, all purchases must be sold back into the same market where the power was originally purchased.

Location spread trades are a financial speculation on the relative prices between two areas without having transmission available. These trades are a financial version of a wheeling trade. However, spread trades don’t involve the physical transportation of power. As a result, they don’t benefit from the ability to build a transmission line to obtain an option-like exposure at the cost of constructing a power line. Traders will often examine both physical and financial trades to identify the lowest cost transaction.

In many ways, location spread trades are much easier than wheeling trades. With a location spread, it is not necessary to arrange for physical purchases or sales of power. Everything can be done financially and settled in cash. Of course, the primary benefit of the wheeling trade is lost too. With a wheeling trade it is possible to buy power in one location and deliver that power to a different location.

Trading Example—Location Spread Trade

The market is expecting that the snow will melt at its normal time in early April. A trader thinks that this consensus is wrong and that the snow will melt early this year.

1. The Opportunity. U.S. government meteorologists predict that warm water temperatures in the Pacific will bring an early warm front to the Pacific Northwest leading to an early thaw.

2. The Intuition. Normally, power prices in the Pacific Northwest reach their low in April when snow in the nearby Cascade mountain range melts. During that time, the rivers in the region swell to capacity and the local dams need to open fully to avoid major flooding. This causes the hydro plants to run at full capacity 24 hours a day regardless of consumer demand. The hydroelectric plants can’t be turned off nor their power generation reduced because this would flood nearby communities.

3. The Strategy. The trader decides to make this trade as a locational spread between California (NP-15) and Pacific NW prices (MID-C) for March. He wants to benefit from higher California prices (long NP-15 price) and lower MID-C prices (short MID-C) than are expected by the market.

4. The Risks. A major risk in the position is that natural gas prices will decline. Natural gas is the marginal fuel for the California generation stack. As a result, the price of power in the California market is determined by natural gas prices. If those prices drop, the price of electricity in California will also drop. Another risk is the assumption that a spread trade is appropriate here. An early warm front and cheap power from the Columbia River is more likely to cause a decline in California power prices than an increase. The long position in California power doesn’t make sense. An outright position in MID-C power might be less risky than this locational spread.

5. Executing the Trade. The trader would enter the trade using March futures (buying NP-15 peak power contracts and selling MID-C peak power contracts). When he wanted to get out of the position, he would have to make the opposite trades. Unlike a wheeling deal, these power trades can’t be settled by transmission—it is necessary to close out the position by trading.

6. The Results. If the futures prices have changed by the time the trade is liquidated, the trader will make money. However, he can’t hold on to the position until the physical delivery date. This trade has to be liquidated prior to the expiration of the futures contracts.