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 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 not optimized. 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 restructured electricity markets should be on the creation of a market structure that functions to seek equilibrium. This will necessarily involve some trade-offs against engineering accuracy.

1. In the Federal Energy Regulatory Commission Strategic Plan 2001-2005, Making Markets Work; Sept. 25, 2001 Revision B, a key challenge identified is to foster nationwide competitive energy markets as a substitute for traditional regulation.
2. To the extent that locational marginal pricing results in significant and unpredictable basis differentials, as demonstrated by PJM Eastern hub, forward markets are illiquid.
3. See http://www.botcc.com for description of clearing practices at BOTCC on behalf of the CBOT and as linked to and adopted by worldwide clearing corporations.
4. Market power is the ability of an entity to profitably raise or lower market price levels for a sustained period of time.
5. For example, CalPX block forward markets at SP15 and NP15 functioned reasonably well and continued to gain depth through the summer of 2000 despite locational variations and some uplifts. However, forward trading ceased in November of 2000 coincident with FERC's proposed order to, among other things, institute $150 bid caps.

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