Convergence and Volatility in Power Markets

[WITH CODE] Exploring the convergence of Day-Ahead and Real-Time prices.

Hello and welcome back to another paid post!

Today we will take a look at the structural mechanics of the Texas power grid by diving into a fundamental spread.

Let’s dive right in.

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The Volatility Risk Premium

Power plants are massive, slow-turning gears. Turning them on takes hours, sometimes days, and once they are spinning, shutting them down is costly and inefficient. On the other side of the plug, millions of people are flipping light switches and cranking air conditioners based on the whims of the weather and the time of day.

Because we haven’t yet mastered large-scale electricity storage, the grid must be perfectly balanced in real-time. To manage this, markets like the Electric Reliability Council of Texas (ERCOT) and other Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) operate in two distinct stages: the Day-Ahead Market (DAM) and the Real-Time Market (RTM).

As the names suggest, the Day-Ahead market is essentially a financial commitment, while the Real-Time market is the physical reality. In a perfectly efficient world, these two prices should converge. But in the real world, plans often diverge from reality, leaving a gap that traders call the Day Ahead/Real-Time (DART) Spread.

This post explores a fundamental convergence bidding strategy: a Virtual Increment Bid (Virtual INC). By selling power in the Day-Ahead market and buying it back in Real-Time, we are effectively betting that the market’s fear of tomorrow is greater than the actual cost of the grid’s physical reality.