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How obscured spot prices, unhedgeable basis differentials, unreliable and financially insecure clearing practices inhibit market liquidity.
While much effort has been expended in translating the complex engineering paradigm of vertical integration and economic dispatch to parallel market structures, there has been little focus on the infrastructure required to support an efficient overall market structure for electricity. The recent "RTO Week" sponsored by the Federal Energy Regulatory Commission (FERC) touched on some of the RTO market design issues that either thwart or facilitate forward markets for electricity. However, to date there has been little clarity as to how the physical and financial markets would work together to eliminate the need for continued price regulation, as FERC has proposed. 1
RTO infrastructure decisions, to the extent they facilitate robust and liquid forward and spot transacting, are the key to establishing a well-functioning electricity market. As in other U.S. commodity markets, equilibrium-seeking behavior in both the financial and physical markets is desirable in that it enables the market to "self-correct" supply and demand imbalances and obviate the need for price regulation. Given these broad objectives, RTO designers and policymakers should strive to implement an infrastructure that supports three key market attributes: (1) transparent and reliable delivery markets; (2) a reliable index for cash settlement; and (3) financially secure clearing practices.
Self-Correcting Markets- What Is Required?
U.S. commodity markets operate from certain core structures and in these fully-functional markets, a greater proportion of transaction volume occurs in the forward markets and the spot delivery represents a residual, or optimizing, market. Buyers and sellers can use the financial markets to hedge their price exposures and speculate as to the value of spot prices at the time of delivery, and therefore have less incentive to "game" the physical markets. Nonetheless, the physical spot market plays a crucial role as the index against which many of the forward transactions settle (). As forward trading volume builds and liquidity improves, spreads between the purchase and sale price tend to narrow over time. Thus, market depth and liquidity are key to supporting equilibrium-seeking behavior and self-correcting markets.
It is no secret that the forward markets for electricity offer less liquidity and transparency than other commodity markets. Futures contracts, a useful barometer of market maturity, were first introduced by NYMEX at PaloVerde and COB in 1996, but have had very small trading volumes relative to physical deliveries. Subsequent hub contracts introduced by the CBOT and NYMEX have witnessed even less success. Hence, the electricity markets in North America seem to have become "uncoupled" in the sense that forward and spot markets do not appear to work in tandem to facilitate an optimally functioning market. As mentioned in the introduction, we believe there are three key challenges that must be addressed to improve from the current state: (1) transparent and reliable delivery markets; (2) a reliable index for cash settlement; and (3) financially secure clearing practices.
Several factors hinder the development of a reliable spot index in electricity markets. First, the spot price is obscured by the tendency to mitigate ISO balancing