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Different indexes are used in electricity markets worldwide to represent the daily behavior of spot prices. However, the peculiarities of these markets require a careful choice of the index, based on mathematical formulation and its statistical properties. Choosing a bad index may influence the financial policies of market players, since derivative pricing and hedging performance can be deeply affected. In this paper with an initial theoretical analysis, we intend to show that the most widely used indexes (simple arithmetic average and weighted average with current volumes) are poor representatives of the spot market. We will then perform an analysis of the hedging strategy on a derivative instrument (an Asian option) written on a reference index. The resulting simulations, applied to OMEL (Spain) and EEX (Germany), are sufficiently clear cut to suggest that the decision to adopt an index to represent properly a market must be taken very carefully. Finally we will propose a new index (FAST index) and, after comparing it with the previous indexes, will show that both theoretically and practically this index can be taken as a good electricity market synthetic indicator.

The restructuring process of the electricity sector in many countries worldwide has been accompanied by the opening of competitive spot electricity markets. Derivative markets have been also introduced to meet the needs of hedging for private and public companies. Derivative markets have been modelled following the example of financial markets. Table 1 describes synthetically the major differences between electricity and financial markets (for energy markets in general see Lucia and Schwatrz, 2002 and Pilipovic, 2007). As is well known, electricity markets are relatively recent; liquidity is still low (compared to the extent of bilateral contracts), due to the limited storability and transportability of electricity; spot prices are highly dependent on temporal and local supply and demand conditions, business activity, weather conditions, etc. As a consequence, the “storage limitation” problem causes a highly volatile day-to-day behavior of the spot prices, far more volatile than in financial markets. Seasonality is also very strong, during the day (peak vs. off-peak hours), during the week, during cold and hot seasons. All these specific peculiarities make electricity markets hard to model. Therefore, extreme care should be given to any attempt to introduce specific instruments, which most of the time are necessary to make the market work. We refer in particular to the choice of the market index, which, we claim, can cause dramatic domino effects both on spot and derivative markets. The crucial point is that the currently used indexes are not representative of their market, as we will try to show. The properties a good market index should satisfy go back to “level zero” statistics (see for instance Balk, 1995 and Balk, 2008). By definition, a market index is a synthetic indicator: in the particular case of electricity markets, a daily index should reflect faithfully the behavior of the 24 hourly prices. In the presence of a derivative market, the choice of the market index, if possible, becomes even more crucial, as, in general, the index is the natural underlying variable for many derivatives. In this paper the issue of the electricity market indexes is discussed, as adopted in most markets worldwide. Through a simulated and historical series analysis the currently used indexes result to have serious drawbacks, both on the spot and the derivative side. We show that an index based on the arithmetic price average, adopted by electricity markets worldwide (Table 3), is weak from the statistical and economical point of view, it can be easily manipulated by a dominant player and is a poor underlying for derivatives, as we see in the case of an Asian option (see Section 3.1). On the other hand, an index based on the price average weighted by current volumes, adopted in Italy for PUN prices (Table 3) overestimates price changes and therefore is a bad underlying for hedging purposes (see Section 3.2). A new index (the FAST index1) is here proposed, which is based on the robust theoretical basis provided by axiomatic index number theory, describes the spot market faithfully and thus can be taken as a good underlying for derivatives (Section 4). In Section 2 the economical and statistical properties that a good market (electricity or financial) index should satisfy will be listed and commented. Section 3 contains the description of the indexes currently adopted in electricity markets worldwide. Their drawbacks will be highlighted. Section 4 is dedicated to the new proposal, the FAST index; by an historical simulation on the German and Spanish markets the hedging performance will be compared through an Asian option based on the three indexes analyzed here. Conclusions are drawn in Section 5.

In this paper we showed how the choice of an electricity index is a serious issue: the two indexes currently used worldwide present considerable flaws, that may prevent electricity markets from developing properly, both for spot and the derivatives. We propose a new index (the FAST index) which overcomes those drawbacks. It is worth observing that such a poor performance of arithmetic and weighted (current volumes) indexes are not confined to a theoretical exercise, since nowadays, as is seen in Table 3, both measures are currently used in most electricity markets. Thousands of markets participants are currently paying more than necessary to hedge against energy supply risk, while other thousands probably prefer not to enter the spot market and use bilateral contracts instead. An incorrect choice of the index may therefore discourage the growth of both spot and derivative electricity markets. We hope that this paper will contribute to opening an in-depth discussion on the topic and help electricity markets to develop smoothly and efficiently.