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Paper Electrons and Power Pools: Complementary Markets for a Deregulated Environment

Fortnightly Magazine - July 1 1995

step in the right direction, but electricity futures would depend on allowing returns to match the risks companies choose to take.

Regulatory boundaries have inhibited trading (em state commission jurisdictions are often too small to build competitive structures. Ultimately, the markets would evolve to create larger, deeper, spot markets with competitively defined boundaries. Strong market reform must pave the way for an electricity futures market. Power pools offer a smooth, but rapid market reform path.

Electricity does present significant technological challenges. For example, electricity requires much stronger system control than either natural gas or oil. Electricity remains difficult and expensive to store. Electricity travels faster than traders can think, making it difficult to rely on unstructured, real-time market clearing mechanisms. Loop flow matters. Electrons stubbornly refuse to follow contract paths, choosing instead the laws of physics. System controllers must have instant access to generation ancillary services (e.g., spinning reserves, reactive support) and transmission control technology (e.g., reactors, capacitors). Electricity system stability depends on instantaneously balancing voltage, amperage, wattage, and frequency across all nodes in an interconnected power grid using advanced telemetry (em

cavalier free-riders can cause cascading blackouts, costing billions.

Finally, the market may not need electricity futures. Many competitive markets exist without futures. Electricity swaps and forward markets or natural gas futures might provide a more efficient substitute. Since few electricity industry participants have developed trading skills, futures liquidity might be low. Extended periods of low price volatility, delivery disputes, and bad luck might also derail a contract.

The Solution:

Deep, Liquid Pools

A well-structured power pool like the one proposed by San Diego Gas & Electric (SDG&E) could become the cornerstone of a competitive electricity market and provide a foundation for electricity futures. A deep, liquid pool with broad participation, flexible rules, and low barriers to entry certainly will not restrict the development of futures. The highly restrictive U.K. pool that originally granted market power to the generators and excluded traders is the exception that proves the rule (em a power pool should be a mechanism to promote competition, rather than reinforce oligopolistic behavior. A robust futures market can exist side by side with a forward contracts for differences (CfD) market. Many existing markets, including the New York Stock Exchange, testify that bilateral and auction markets can exist side by side.

Most who criticize the ability of a power pool to promote futures trading seek to undermine the power pool for other reasons (for example, speculators seek less

efficient markets to enhance trading profits). Power pools offer market efficiency, technical control, and fairness advantages over a pure bilateral approach.

The basic power pool model2 requires an independent system operator (ISO) to provide system control services, operate the transmission grid, and manage bidding markets. The ISO will have instant access to a pool of flexible generating capacity, transmission control technologies, and advanced DSM tools to maintain system reliability.

The ISO will create an energy bidding market to ensure economic dispatch. The pool will be open to all market participants on a real-time basis (em the depth and liquidity of the pool