The key behind the spark spread is to make use of derivatives to trace electricity generation economics. Just as a generator buys natural gas to produce and sell electric power at a certain gross margin, this process will be replicated similarly at the “paper” level through purchase of natural gas futures and sale of electricity futures.
This spread is primarily of interest to hedgers — that is, power generating companies that wish to fix their margin by selling electricity futures and buying natural gas futures. Speculators, too, may find the spark spread opportunistic because of high volatility of electric power and gas prices. However, because electricity futures were introduced relatively recently (Nymex has been trading them since 1996), they lack liquidity. This prevents many speculators from becoming active players in this market.
As far as OTC electricity exchanges are concerned, they are not sufficiently accessible to a large number of investors. However, considering the trading profits that can be uncovered in such a volatile commodity, electricity futures remain promising in view of the rapidly developing spot market.
An electricity futures contract gives one of the parties an opportunity to receive a certain amount of megawatt-hours at a specified price and place during a certain month. Under a five-by-eight contract, its owner receives electricity in off-peak hours (from 11 p.m. to 7 a.m.) during a certain month, five days a week (from Monday to Friday). Under a five-by-16 contract, the contract owner receives electricity in the peak hours (from 7 a.m. to 11 p.m.) during a certain month, five days a week (from Monday to Friday). Under a seven-by-24 contract, the owner receives electricity during a certain month, daily and ‘round-the-clock.
There are several varieties of spark spreads. The so-called “dark” spark spread reflects the economics of a coal-fired power plant. There is also the “clean” spark spread that takes into account the need for the generators to obtain carbon dioxide emission allowances. An investor wishing to trace the electric power generation economics considering the cost of emission allowances will have to buy (sell) futures that have such allowances as their underlying asset, in addition to natural gas futures.
The “clean dark” spread means the same as the “clean” spark spread, but in relation to coal-fired (as opposed to gas-fired) power plants. The “clean dark” spread is an important indicator reflecting the profitability of a coal-fired generating facility. Given that the coal burning process results in emission of more than two times the carbon dioxide, the cost of obtaining emission allowances for such facilities is fairly high.
Whether a spread is purchased or sold depends on what we do with the end product (that is, electricity futures). Accordingly, if the investor wishes to buy a spread, he buys electricity futures and sells natural gas futures. He will do the opposite on a sale.
For a spread to be calculated correctly, a few concepts should be introduced first. Electricity prices are measured in kilowatts per hour (kWh) or megawatts per hour (MWh), while gas prices are measured in British thermal units (mmBtu). Apart from these two concepts, there is another concept important for calculating the spread value.
The so-called “heat rate” shows how many mmBtu are required to generate 1 MWh of electric energy that is specific to each particular generating facility. The essence of this concept has to be explained in greater detail. Indeed, no generating facilities today have 100% thermal efficiency. Convention is to use thermal efficiency of 49.13% for gas-fired plants and 38% for coal-fired plants. Thus, plants with 100% heat efficiency would consume 3.41 mmBtu to generate 1 MWh of electric power. Plants with 49.13% efficiency, accordingly, will use about 6.94 mmBtu.This value measured in mmBtu/MWh will be the “heat rate.”