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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

overshadowed the more important need to provide robust and transparent markets for prescheduled energy and forward rights.

Electricity prices ought to do more than manage congestion. Most importantly, transparent forward markets are crucial to planning thermal generation and load as well as for making investment decisions. Most thermal generators need advance warning as to whether it is cost-effective to offer power or shut down. Forward prices are the signals that determine such behavior. From an economic perspective, the PJM system attacks the problem after the fact. It puts the cart before the horse. Volatile pricing may be necessary to balance the real-time market, but there is no economic rationale for base-load generators and consumers with inflexible load profiles to receive price signals to which they are unable to respond.

Commodity markets generally make a distinction between physical and financial trading. The debate over the electricity industry's market structure often has been characterized as a distinction between financial and physical trading, but the difference is meaningless. 15 No one can possess the electrons for more than a split second, and all contracting is effectively financial. 16 What matters is not the form of the contract, but the number of markets that are required, the time(s) that they are open, and their efficiency and transparency.

The precedents for the market structures in PJM and California were set in the past by the evolution of their respective systems. PJM evolved from a system of central control and "economic" dispatch. The California market, on the other hand, adopted many of the elements of a power pool, but also was broadly based on the bilateral trading experiment of the WSCC, which was the most mature market-based pricing system for electricity in the United States. In bilateral WSCC trading, the most important market is (and was) the prescheduled market. This market is conducted during the morning of each business day, and determines forward prices from one to three days in advance. The purpose of the prescheduled trading is to give participants adequate time to plan forthcoming operations. The drawback of this system is that it cannot account for real-time problems and constraints dispatchers face during grid balancing operations.

Nevertheless, regardless of how the grid is operated, price information must be available early enough to give market participants time to plan generation and load. The PJM system has depended on bilateral trading and contracts for differences (CFDs) settled against LMPs. These contracts would allow participants to plan for firm prices at specific nodes well in advance of actual market operations. This solution, however, compounds the transaction cost problems described earlier. To ensure a firm price at a specific delivery point, market participants would have to enter into two contractual arrangements instead of one. Unlike futures contracts, CFDs are not standardized. That just increases transaction costs. And, because CFDs are not traded on an exchange, their pricing and terms are unlikely to be transparent. Most importantly, there is little evidence that CFDs are widely available at reasonable cost. California's market structure with respect to forward trading is more robust than