Liquidity and risk premia in electricity futures

Highlights: • Analysis of liquidity and risk premia in New Zealand electricity futures • Market liquidity has been increasing over time. • Maximum bid-offer spread policy associated with higher liquidity structural breaks. • Time-varying premia are driven by potentially inefficient behaviour. • Liquidity risk affects risk premia in longer-dated futures. - Abstract: Research on electricity futures markets has to date not explored the role that market liquidity may play in determining risk premia. Further, no detailed empirical examination of both liquidity and risk premia in the New Zealand electricity futures market are discernible. Using data from October 2009 to December 2015, we address these gaps in the literature. We find that liquidity has been gradually increasing and that a policy intervention to impose a maximum bid-offer spread was associated with liquidity-enhancing structural breaks, but this was evident only in the nearest-to-maturity futures contracts. Further, we develop models to explain risk premia that include a range of risk factors, which we categorise as either statistical, physical market, production cost or liquidity variables. From this analysis, we document significant time-varying premia that are driven by potentially inefficient behaviour. Finally, we find that liquidity risk does affect risk premia, but generally only in the case of longer-dated futures.