Electricity is an increasingly influential part of the United States economy. Yet as the second largest energy component of the US consumer price index (CPI), it is not directly included in any existing major commodity indices. At a more global level, the transition to green electricity means growing investor demand for exposure to power as a commodity. Until recently, that has been difficult to do.

Now ICE, with methodology licensed from the Carbon Neutral Investment Company (CNIC), has developed an index with the dual benefits of diversification and reliable exposure to one of the world’s biggest commodity markets. The ICE Carbon Neutral Power Index (the “Index”) has a rules-based methodology and provides a benchmark with exposure to North America’s power markets.

J.C. Kneale, ICE’s Vice President of North America power, natural gas and NGLs, notes that power is perhaps one of the most volatile energy commodities traded. “ICE’s new Index takes a 12-month view, smoothing out much of the near-term volatility,” he says. “It also provides an environmental focus for people looking for ways to invest in the transition from fossil fuel electricity to more renewable sources. Over time, as the mix in energy generation changes, so will the mix in the Index.”

Explaining the Carbon Neutral Power Index

Physically delivered electricity, also called “spot electricity”, is traded throughout the U.S. on an hourly, daily, and day-ahead basis. The U.S. has several major Independent System Operators (ISO) across the country, and there are hundreds of sub-locations within each ISO.

These disparate physical markets generally do not move in complete lockstep. A cold winter in New England tends to mean a cold winter in the Mid-Atlantic but has no effect on Texas or California.

Weather diversification, along with different demand profiles (industrial versus retail) and different supply profiles (the types of generation in each region) keeps spot power prices uncorrelated to the other physical markets.

This means there are many electricity contracts traded in North America; choosing the most appropriate for inclusion in the Index is critical, says Preston Peacock, Senior Director of Index Product Management at ICE Data Indices.

“It’s important that we look at contracts that are most actively traded,” Peacock says. “We look at the various hubs (ISOs/RTOs) across the United States and the types of contracts in each. Then we look at a minimum volume requirement, which is an average daily volume of 300 contracts traded, to ensure the Index is both transparent and replicable, as well as representative.”

“From there, the question is about weighting different contracts. You take all the electricity production in contracts that qualify, across the hubs, and then weight them on how much electricity is generated.”

As a result, the Carbon Neutral Power Index aims to capture the diversity of contracts across the country.

The Index offers the advantage of smoothing volatility, which is relevant given some hubs – Texas, for example – have recorded huge variations in electricity prices in a relatively short period.

In addition, the Index is constructed to reflect power market “backwardation” – a phenomenon where near-dated futures are priced higher than the longer-dated futures. The Index sells the near-dated futures and replaces them with longer-dated futures as the former reach expiration. By capturing this dimension of power futures contracts, the Index methodology arguably provides a more complete measure of electricity market dynamics.

Benefits

For investors, the Carbon Neutral Power Index provides exposure to one of the biggest sectors in the U.S. economy, and one of the biggest energy components of the CPI.

“Historically, power was very utility driven and not at the forefront of consumer spending and savings. But as the market has been deregulated, and we’ve entered the era of ESG, there is now much more awareness of how much power prices affects total spend in a household.

Critically, the Carbon Neutral Power Index can provide unique diversification. Electricity is not correlated to any traditional asset class, including equities, bonds, and other commodity indices.

As the U.S. moves towards a renewable power grid, electric vehicles are gaining in popularity, new homes are hooking up to power instead of natural gas, regional bans on gas-engine lawn equipment are being implemented, and a host of new regulations are changing the landscape for electricity. With less future demand for oil, natural gas and other carbon-intensive commodities, electricity will likely gain in usage and importance. The Carbon Neutral Power Index aims to reflect this change.

Finally, the decreasing use of natural gas and crude oil in favour of power will further reduce the correlation of electricity to traditional commodity indexes and commodity energy subindexes, with the Carbon Neutral Power Index providing a viable alternative.

The future

The Carbon Neutral Power Index has the potential to be one of the key macro indices for the economy.

“We have this growing realisation that electricity is fundamentally important to the economy in all kinds of ways, not the least being the whole climate transition story,” Peacock says.

“It’s making visible what’s previously been a mostly invisible part of the economy. We knew it existed but there wasn’t a robust methodology to create the right index.”

Kneale adds: “Electricity is such a fundamental expectation in society and most of our traditional commodity indices have never had exposure to it. Electricity is becoming even more important as we continue the electrification of everything.”