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The Role of Power Exchanges in Restructured Electric Markets

Fortnightly Magazine - October 1 1999

credible reference price; (2) enhance market efficiency through transparency, creation of hourly markets and concentrated liquidity; (3) improve the equity of deregulation by letting small consumers and sellers participate equally with larger participants; and (4) protect against market power that could be exercised by existing utilities.

Many states have decided that incumbent utilities must be allowed to recover stranded investments and other costs as historically approved by state public utility commissions and federal agencies. Also, in some states, rules are structured to encourage utilities to divest generation resources. And in most states, existing utility providers retain the obligation to serve customers who do not choose to switch to other providers.

As retail markets are restructured, a power exchange can play a vital role in (1) separating the buying and selling functions of utilities that retain generation yet are required to provide competitive power prices for default service, (2) providing competitive power supplies that meet load shape requirements of default service providers that have divested generation resources, (3) providing benchmark prices to consumers, and (4) providing competitive price information that aids in determining market value of generation resources and resultant utility stranded costs. Thus, a power exchange can play an important role in ensuring a smooth transition to competition.

Furthermore, in competitive retail electricity markets, a power exchange can facilitate entry by smaller-volume energy services providers (ESPs). ESPs and specialty firms are granted the same access to power supplies at competitive prices as those of the largest firms in the market. This ease of entry and exit stimulates innovation. Through judicious credit management, a power exchange can protect all participants from catastrophic defaults that may occur in bilateral contracting, while sheltering smaller participants from discriminatory treatment due to low capitalization.

Revealing Prices. In restructured electricity markets, the robust market and price discovery provided by an exchange are critical for consumers, regulators and financiers. In addition, an exchange provides a solid vehicle for determining stranded costs and cost-recovery. Assuming a large, liquid market, power exchanges can provide reliable market price information not available in bilateral markets and that is representative of a robust market. However, unless there are sufficient buyers and sellers and large volumes traded, exchange prices represent residual markets at best. is one reason why California's three IOUs were required to buy and sell through the CalPX during the transition period.Initially in California, IOU volumes traded through CalPX were predicted to reach almost 160 million megawatt-hours, or about 25 percent of the Western U.S. and Canadian market. created a significant draw for the other 60 entities that joined CalPX to trade. Because of its transparency and volumes traded, CalPX has become a primary source for price discovery in the Western wholesale market.[fn.6] Thus, one principle of exchanges is that liquidity begets liquidity. Without liquidity, an exchange has no market and cannot provide credible market prices. The initial must-buy/must-sell requirement instituted in California for the transition period thus was an insightful jumpstart that ensured the liquidity necessary for CalPX to provide a viable market and representative market clearing prices.Cutting Trader Risk.[fn.7] The price