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Making Markets Work: How ISO Rules Still Cause Problems

How obscured spot prices, unhedgeable basis differentials, unreliable and financially insecure clearing practices inhibit market liquidity.
Fortnightly Magazine - January 1 2002

markets and/or implement complicated bid structures. Second, the existence of unpredictable, highly granular locational prices can invalidate the hub price. A hub price is only as good as its ultimate correlation to the delivered price. The combination of these factors can defeat standardization, hinder the development of hub markets, and obscure prices such that there is no index against which forward markets can settle.

How Commodity Markets Work:
Overview-Spot and Financial Markets

The development of competitive commodity markets is a self-reinforcing evolution. Most commodity markets begin as relatively rigid entities in which producers and consumers enter into long-term contracts to ensure continuity of supply. Over time, imbalances between supply and demand will create opportunities for participants to buy and sell the commodity in an informal and unstructured spot market. A formal spot delivery market arises over time as buyers and sellers secure their marginal requirements outside of their long-term contracts and business practices become more standardized. As the benefits of transacting in the spot market grow, many buyers and sellers feel less constrained to contract long-term to assure certainty of supply or demand and will begin to seek more flexible arrangements that include a mix of spot and forward transactions. Eventually, transacting volumes in the spot market build and business practices standardize to the point where the spot price becomes a reliable index of the underlying value of the delivered commodity. At this point, financial forwards, futures and options come into being to allow buyers and sellers to manage term risk against the spot market.

Well-structured market architecture, then, is one that permits flexibility for market participants by offering a variety of transacting options over different time horizons. This is primarily achieved through the allocation of the three key market functions between the spot and forward markets-spot markets generally act to facilitate physical supply and demand equilibrium, while forward markets typically provide price discovery and risk transference. This allocation of functions between the spot and forward markets allows producers and consumers to gain physical and financial certainty in a manner that aligns with their risk preferences. Most end-use consumers-including electricity-desire price certainty and supply availability, while producers need demand certainty to optimize production and price signals to make the correct capacity investments. Well functioning markets provide participants-both supplier and consumer-with the necessary flexibility to achieve these objectives.

The key feature of a well-designed market architecture is the linkage between spot and forward prices. Integrated spot and forward markets operate as a system such that forward prices-as time horizons shorten-converge to the spot price. Thus, besides facilitating delivery, the spot market serves as the foundation for supporting forward transacting. If forward prices do not converge to spot prices, the ability to adequately hedge price exposures in the forward market is greatly hindered. In this situation, the forward and spot markets are "uncoupled," and forward liquidity is negatively impacted as participants seek certainty in the form of long-term contracts and over-the-counter (OTC) arrangements. Under these circumstances, the price discovery function of the forward market becomes less transparent and risk transference among market participants is