Energy arbitrage in a practical sense applies to electricity and natural gas trading in the wholesale energy markets. This strategy allows energy traders to speculate for profit, manage risk for offtakers, and contribute to market efficiency. There is also a type of market arbitration in the retail markets where brokers take advantage of forward curve dips to lock in target prices for their customers. In this article, we will explore the concept of energy arbitrage and how it applies to the market and consumers alike.
Energy Arbitrage In Electricity Trading
Arbitrage involves capitalizing on price discrepancies in the electricity markets either over time or across locations. Let’s explore the different types of electricity arbitrage trading in more detail.
Spatial Arbitrage
Spatial arbitrage involves buying electricity in the wholesale market at one location for a low price and selling it to another location for a higher price. These price differentials exist between markets based on real-time transmission congestion and supply and demand imbalances. The ability to send power from one place to another is executed through a mechanism known as wheeling power. This allows traders to buy in one RTO/ISO and sell to another interconnected transmission network. For example, power prices might be low in the MISO market due to oversupply and low congestion, but high in the PJM market. A trader might purchase electricity in the physical MISO market and wheel it to PJM for a profit.
Another example of arbitrage can occur within an RTO/ISO region. For example, congestion prices might be low in one zone on PJM, but high in another due to grid constraints. A trader can take advantage of this price differential through a Financial Transmission Rights contract, or FTR. The trader can purchase the FTR, or the rights to send power from one location to another over a single transmission line, and resell it when its value rises. Let’s assume the following example:
- Price at the source location = $60/MW
- Price at the sink location = $70/MW
The sink location is where the trader wants to sell the power. Let’s assume that he or she expects the price at the sink location to rise to $80/MW due to congestion, and purchases the FTR between these locations.
If the price at the sink location moves to $80/MW:
- Price at the source location = $60/MW
- Price at the sink location = $80/MW
The trader will earn a $10/MW profit by selling the FTR contract back to the market.
Temporal Arbitrage
Temporal arbitrage, on the other hand, involves buying electricity when prices are low and selling when prices spike. This often involves calendar spread trading where traders bet on the directional price of the market, without blindly assuming contract risk.
In April 2025, if a trader believes the market price for electricity will rise by August 2025, the trader might elect to enter into a time spread by shorting the May contract and going long on the August contract.
Trade:
- Short May 2025 at $60/MW
- Long August 2025 at $80/MW
The trader would be in the money if:
- May 2025 drops to $58/MW
- August 2025 rises to $90/MW
- Trader profits $2/MW on the May trade and $10/MW on the August trade
However, even if both prices rise, his/her risk is limited:
- May 2025 rises to $65/MW
- August 2025 rises to $90/MW
- Trader loses $7/MW on the May contract and gains $10/MW on the Aug trade
When both prices fall, he/she is still protected:
- May 2025 falls to $55/MW
- August 2025 falls to $75/MW
- Trader gains $5/MW on the May trade and loses $5/MW on the Aug trade
Risks Associated With Electricity Arbitrage
Electricity arbitrage, however, comes with an array of risks and should only be practiced by experienced traders.
Market Volatility
Electricity markets are inherently volatile. Since power is driven by real-time supply and demand, weather, and market constraints, prices can change rapidly in both directions. Furthermore, the drastic introduction of intermittent renewable energy generation has created an unknown variable in the market, which many traders are struggling to model. Electricity traders very rarely trade naked, or without a hedge, as they can quickly lose their entire capital in minutes.
Transmission Constraints
Transmission infrastructure is another variable that can drastically impact LMP prices throughout the grid. As congestion rises in certain regions, it can cause outages on transmission lines and create spikes in wholesale prices. Furthermore, there can be a great deal of mismatch between anticipated available transmission capacity and actual transmission capacity in the real-time markets.
Forecasting Errors
Poor load forecasting or modeling can lead to losing trades. As traders evaluate spatial arbitrage, they will model FTR values between delivery points. There is a great deal of risk in overcommitting or underutilizing purchased FTRs as they have expiration dates and cannot be carried forward.
Counterparty Risk
When dealing with a third party credit facility, there is risk associated with the stability of the firm. When large trades are executed on margin, the trader is counting on the counterparty to come through with its credit lines. If a counterparty defaults, the trader is on the hook.
Retail Energy Brokers
Electricity arbitrage is not only reserved for sophisticated energy traders. It’s a practice exercised by the most sophisticated retail energy brokers, in a sense. Energy brokers act as intermediaries between end users and retail energy suppliers, providing their clients with access to the deregulated markets.
Energy Futures Hedging
Brokers with access to futures market data can model these markets for key buying opportunities. For example, if they have a customer under a fixed agreement for the remainder of 2025, the broker can model the 2026 future calendar strip to identify when it’s trading at or below a certain strike price. When the 2026 curve is trading within a predefined zone, the broker can act and offer a contract renewal to their customer. This is a sophisticated hedging strategy that allows customers to beat the market and time their energy purchases.
Hybrid Supply Products
For large energy consumers on hybrid energy products, such as a block + index electricity product, energy brokers can monitor real-time and futures markets to help their customers meet budget goals. The broker might see trends in the market driving up certain hours in the real-time market and suggest the customer roll this index product into a fixed hedge. On the other hand, a sophisticated broker can help their customers dollar-cost-average fixed blocks over time, so the customer is not entirely at the mercy of the market.
Arbitrage vs. Hedging vs. Speculation
There is a distinct difference when it comes to energy arbitrage, hedging, and speculation. Let’s dive into each of these concepts in more detail.
Arbitrage
Arbitrage involves a strategy to generate risk-free profit from pricing inefficiencies in the market. This practice is almost exclusively practiced by energy traders.
Hedging
Hedging is a strategy that aims to protect against market exposure. This can be practiced in the wholesale markets as insurance against directional trades, or in the retail markets as protection from volatile price movements for customers.
Speculation
Speculation the higher-risk trading strategy that bets on the overall directional moves of the market. Speculation could be going long with a December 2026 natural gas futures contract with the hopes that prices rise by that time. If prices fall, or remain the same, the unhedged trader loses money.
Need Help With Your Energy Strategy?
Energy arbitrage presents businesses and energy traders with unique opportunities to profit from price differences in electricity markets. This strategy requires deep technical knowledge and comes with inherent risks. If you are looking for ways to manage your energy costs, partnering with an experienced energy brokerage firm can make all the difference. At Diversegy, our team of energy market experts has decades of combined experience managing energy market prices for our clients. Contact us today to explore custom-tailored energy solutions that align with your operational goals.
