The relationship between forward prices of fossil fuels and electricity

This paper investigates the relationship between electricity forward prices and fossil fuel forward prices in the electricity markets of The Netherlands and Germany using one month and one year forward contracts. Daily settlement prices of forward contracts for base load, peak load and off peak electricity are used, as well as daily settlement prices of forward contracts of natural gas and coal. Analysis are performed by testing for cointegration using the augmented Engle-Granger (1987) test. When cointegration relationships are established, an error-correction model is used to determine how forward prices react on deviation from the long-term equilibrium price level. The results for using one year forward contracts show cointegration between Dutch off peak electricity and coal and German off peak electricity and natural gas. Using one month forward contracts, cointegration relationships are established for the Dutch market between forward prices of base load, peak load and off peak electricity and gas and forward prices of off peak electricity and coal. For the German energy market, cointegration relationships exist between forward prices of the fossil fuels gas and coal and forward prices of base load and peak load electricity. By looking to the volume of transported electricity per hour and available electricity generating capacity in The Netherlands, the marginal fuel is determined. For more than 99% of the examined hours, natural gas is the marginal fuel for generating electricity in The Netherlands which explains the established cointegration relationships. Due to lack of data it is not possible to perform this analysis for Germany. The error-correction models show forward electricity prices show a significant reaction on deviations in the equilibrium of fossil fuel forward prices, hereby confirming the results of Emery and Liu (2002) and providing support for the use of models allowing indirect storage to explain electricity prices.