Dutch electricity futures market analysis: the effect of illiquidity on the risk premium

This analysis examines the futures market for electricity in the Netherlands with a focuson the last period before maturity of the contract. As electricity cannot be stored thepricing of futures differs from other energy commodities by including a risk premium. Theanalysis splits the electricity market in base and peak contracts and finds presence of the riskpremium in the Dutch power market, which is shown to be negative on average. A negativerisk premium indicates a discount on prices of futures contracts over the average spot priceduring delivery. Differences between peak and base contracts are found as the last monthbefore maturity closes in. Base futures risk premia turn out to switch positive but the riskpremia on peak futures remains negative. With the negative overall risk premium a discountis given on the futures price as time to maturity is far away, but when time to maturitycloses in the discount diminishes. Next the returns from rolling forward the contract, the rollreturns, are examined. Rolling forward the contracts provides positive returns on average butnegative ones near maturity which demonstrates that close to maturity contracts are worthless than longer to maturity contracts. The decreasing discount over time but negative rollreturn near maturity indicates that holding a contract longer increases value but only up toa point where holding the same contract diminishes value compared to holding next monthscontract. Finally through testing multiple regression models on three different liquidityvariables a link is established between liquidity in the market and the risk premium. Anincreased liquidity in all tested cases, except for one, reduced the discount on future prices.Vice versa more illiquid markets increased this difference through a negative relationshipwith the risk premium.