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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

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Futures & Options 101: A Refresher

Futures and forward contracts provide a fixed price in advance of a specified delivery date. Option contracts provide the buyer with the right-but not the obligation-to transact at a specified price and date. While forwards typically settle with physical delivery, futures, options and other derivatives frequently "cash" settle based on the difference between the initial contract price and a the price at expiration/exercise.

Futures, options and related derivative contracts are frequently bought and sold many times in advance of expiration or delivery. While forward contracts and non-exchange traded options can be traded between institutions outside of CFTC regulation, futures and exchange traded options are typically regulated by the CFTC.*

* The CFTC was created in 1974 under "The Commodity Exchange Act" to regulate certain defined futures, options and other financial contracts.

Even where index prices may have been created, unhedgeable basis differentials still may exist. And, to the extent that these become material, forward markets become meaningless. In new electricity markets where the locational prices are highly unpredictable, market participants have complained of difficulty in hedging their price risk at the delivery location. This occurs in spite of attempts to provide a hub price based on the weighted average price of a specified group of locations because there is little correlation between the hub price and the various locational delivery prices. 2

A final factor that inhibits liquidity in electricity markets is a lack of confidence in RTO clearing practices and financial assurance policies. The visible financial failure in California has stifled development of financial markets and potential entry by financial traders that are critical to market liquidity. Financial market traders require a high level of confidence that they will not be impacted adversely by a default in the market. They are accustomed to highly reliable and sophisticated clearing practices as provided by clearinghouses of commodity exchanges. For example, in the 75-year history of the Board of Trade Clearing Corporation (BOTCC), there has never been a default that has resulted in financial harm to members. 3 BOTCC and other exchange clearinghouses employ rigorous and highly responsible practices that have not been comprehended by today's RTOs.

Sometimes Imperfect Markets: Better Than Regulation?

Markets are rarely "perfectly competitive" but instead operate to continuously seek equilibrium. Much of today's structural debates center around accomplishing market ideals such as perfect price signals, absence of market power, perfect hedges, and no uplifts. The realities are that in any physical commodity market, "market power" 4 exists from time to time and always to some degree. Indeed, supply and demand imbalances motivate the equilibrium-seeking behavior of market participants. Both buyers and sellers can have market share when they command a large share of the market and/ or when supplies are either scarce or overabundant.

It is also very rare that any commodity can be consistently and perfectly hedged in forward markets. Some uplifts may exist in workably competitive markets, but significant price controls will defeat transparency and thwart the development of forward markets. 5 Instead of judging outcomes, the focus of