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East vs. West: Comparing Electric Markets in California and PJM

While neither is perfect, the former has done better than its critics would admit.
Fortnightly Magazine - July 15 2000

to trading. An auction is held without having to pay the auctioneer. In reality, of course, there are transaction costs associated with the operation of every market. Sometimes these costs are formal, as in an exchange or brokerage fee, while other times they are measured by the personnel time and effort required to find a counter-party and agree on the price and other terms of trade. Most markets operate through bilateral trading, so search time and information costs are important. Even though these per-unit costs may be high, if the number of buyers and sellers is limited and the commodity varies in quality and location, bilateral trading is likely to have the lowest transactions cost. Usually a formal exchange is cost-effective only if the volume is high. Exchanges require product standardization, a large number of buyers and sellers, and incentives for rapid turnover and trading.

When transportation costs are variable (depending on market outcomes) instead of a fixed amount, the transactions cost of bilateral trading can be high. Assume for a moment that buyers and sellers sort out prices and other contractual terms for delivering and receiving power on various nodes along the grid. The negotiations do not, however, take account of the impact of their collective decision on congestion, since transmission costs will be unknown until the power is actually scheduled. The initial market-based solution may prove infeasible or prohibitively costly. Furthermore, this solution would provoke another round of market negotiations and possibly another infeasible solution. Both PJM and California rely on a central authority combined with market bids to determine price differentials by zone or node in the presence of congestion.

Forwards and Futures: The Crucial Ingredient

The system of combined grid management and spot market operations adopted in PJM frequently has won praise as the most efficient market structure. Yet this emphasis on centralized control may not offer the most promising solution to the riddle of achieving price transparency and certainty for such a time-sensitive good as electricity.

Last year, for example, William Hogan endorsed PJM's combined model when he commented on the FERC's initial RTO proposal that ultimately led to Order 2000. The FERC's proposal, he said, "contains the elements of an efficient market design built around a system operator that coordinates the spot market. That is the only design we know of that is both internally consistent and actually works." 12

Meanwhile, the California system has been criticized: "The bottom line is that California's transmission pricing makes it needlessly difficult for its ISO to relieve congestion and makes consumer prices needlessly high." 13 Commissioner William Massey was even more pointed in comments wrote in January on a proposal by the CAISO for pricing congestion. He stressed that the FERC's order "sends a strong signal to the California ISO to move toward locational marginal pricing as it considers a comprehensive replacement congestion management approach." 14

These comments, however, are based mainly on theory and concern about the engineering problem of congestion management. Their focus on resolving the congestion quagmire is not wrong, but it is incomplete. It has