Risk Warning: Your Capital is at Risk.
Assuming you’ve read our guide on electricity as a commodity, you may be considering trading an electricity instrument with a regulated online broker.
This electricity trading guide offers insight on reasons why you may want to trade electricity along with the key price influences on electricity prices.
3 Reasons You Might Trade Electricity
Companies that provide electricity operate regionally. Therefore, electricity trades often depend on the specific economic, political, and regulatory factors in a particular country or region.
The most lucrative electricity trades are likely to occur in regions with a high population and industrial growth rates.
In general, these are the reasons traders should consider trading in the sector:
- Emerging Market Demand
- Advances in Alternative Energy Sources
- Portfolio Diversification
Emerging Market Demand
According to the International Energy Agency, by 2035 more than 90% of net energy demand will derive from emerging economies.
Demographic trends across the globe show migration patterns from rural areas into cities. In places such as China, rising industrialization has accompanied these population shifts.
The United Nations forecasts that by 2030, there could be a 36% increase in the number of global cities with populations over 1 million people. New cities will require increasing amounts of electricity to power businesses and homes.
Advances in Alternative Energy Sources
Advances in the procurement of wind, solar, hydroelectric and biomass sources of power are incredibly positive catalysts for the supply side of the electricity industry.
As these sources become cheaper and more readily available, electricity production costs should come down. At the same time, global demand for electricity should remain strong.
For regulated monopolies such as the utility industry, this could translate to a very favorable profit backdrop.
Trading a critical resource such as electricity is a way to add diversification to a portfolio. Many of the factors that move electricity prices are different than the factors that affect stock and bond prices.
In fact, for many segments of the economy, demand for electricity is inelastic. That is, regardless of prices, people need to consume electricity.
Where Can I Trade Electricity
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 73.90%-89.00% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Electricity Instruments: Ways To Trade
Electricity traders have several ways to trade this commodity:
The physical electricity market is a fragmented market with prices dependent on specific geographies. As a result, electricity is not commoditized globally the way other markets are.
However, these contracts usually have very light trading volumes.
Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions.
At expiration, all of these contracts are physically settled.
Trading futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.
These financial instruments trade as shares on exchanges in the same way that stocks do.
There is no ETF that offers direct exposure to electricity prices.
However, there are many ETFs that trade in the utilities sector including the following:
|The Utilities Sector SPDR ETF||iShares Dow Jones US Utilities ETF||iShares S&P Global Utilities ETF||PowerShares S&P SmallCap Utilities ETF||Vanguard Utilities ETF|
Shares of Electricity Companies
There are many publicly traded companies that operate electric utilities.
While trading shares of companies can be a leveraged way to gain exposure to electricity prices, many of these companies can react to other factors such as regional demand for their products, competition, production costs, and interest rates.
Furthermore, as regulated utilities, these companies have limitations on their abilities to raise prices.
Finally, factors such as company management and the overall stock market can also affect these trades:
Another way to trade shares of electricity companies is through the use of a contract for difference (CFD) derivative instrument.
CFDs allow traders to speculate on the price of companies involved in the electricity industry.
The value of a CFD is the difference between the price of the shares at the time of purchase and their current price.
What Drives the Price of Electricity?
The costs to build, finance, maintain and operate power plants represent the biggest components of electricity prices.
According to the US Energy Information Administration (EIA), electricity generation accounts for 57% of the cost of operating a plant, while distribution accounts for 32% and transmission 11%.
Specifically, these factors have the biggest effect on electricity prices:
- Energy Costs
- Power Plant Operations
- Transmission and Distribution System Costs
Electricity demand is often correlated with fuel demand. When the economy is strong, for example, industries demand greater supplies of electricity and fuel to operate.
Similarly, during harsh weather conditions, fuel demand to heat homes rises as does electricity demand (more people stay home and use appliances).
As a result, electricity prices often rise when energy prices are also rising.
Power Plant Operations
The construction, maintenance and operations costs of electricity power plants have a big effect on electricity prices. In tight labor markets, for example, construction and labor costs typically rise.
These higher costs often get passed on to electricity customers.
Transmission and Distribution System Costs
Transmission and distribution represent more than 40% of the cost of operating an electric power plant.
Accidents, harsh weather and wear-and-tear all have the potential to damage these systems and lead to costly repairs.
The cost of repairing these systems would generally get passed on to customers either directly through rate increases or indirectly through higher taxes in the affected areas.
Weather has the potential to either increase or decrease the cost of electricity depending on specific conditions.
Heavy rain and snow can provide water for hydroelectric power generation, while strong winds can provide a cheap source of fuel for wind turbines used to generate power.
On the other hand, severely cold weather is likely to raise electricity prices. First, severe weather is likely to create higher fuel costs and raise the cost of electricity production.
Secondly, such weather usually causes big spikes in electricity demand.
Factors such as electricity demand, availability of generation sources, fuel costs and power plant availability all affect the cost of providing electricity to customers.
In the case of electricity demand, the industry shows strong seasonal patterns.
During the summer months, demand for electricity rises as air conditioning systems receive heavy usage.
At the same time, many utility companies have to turn to more expensive generation sources to meet demands. The result is higher electricity prices.
Depending on the locality, electricity utilities have different regulatory requirements.
In some areas, utility commissions fully regulate prices, while in other areas, generators may be unregulated, while transmission and distribution costs are fully regulated.
Should I Trade Electricity Instruments?
There are several ways to gain exposure to electricity, and traders should consider the factors that move each of these instruments.
Electric utilities are one vehicle for trading in the sector.
However, while they pay large dividends and have low risk, they probably have less potential upside than trading electricity futures in high-growth and less regulated regions of the world.
There are three reasons electricity could perform well in the years ahead:
- Emerging Market Growth
- Alternative Energy Industry
- Global Growth
Emerging Market Growth
China, India, Brazil, the Middle East and Africa are among the many fast-growing countries and regions that are becoming more industrial and urban.
As populations in these regions migrate from rural areas into cities, demand for electricity is certain to grow.
Alternative Energy Industry
The alternative energy sector is expected to continue to innovate and create efficiencies.
As the cost of solar, wind, water, and other power sources declines, electricity production costs could fall. This could create a favorable profit environment for utility companies.
Global growth is a positive catalyst for electricity prices. As the world economy expands, electricity demand should grow.
However, traders should also consider the scenarios under which electricity does not perform well.
An economic slowdown that affects emerging markets could put a damper on electricity demand.
If you’ve familiarized yourself with electricity as a commodity, you may want to see our guide on electricity as a commodity for beginners.
Our team have also written a general energy commodity guide, along with other pages like: