Testing for Market Efficiency with Transaction Costs: An Application to Financial Trading in Wholesale Electricity Markets

With risk neutral traders and zero transaction costs, the expected value of the difference between the current forward price and the spot price of a commodity at the delivery date of the forward contract should be zero. Accounting for the transaction costs associated with trading in these two markets invalidates this result. We develop a statistical framework to test whether profitable trading strategies exploiting systematic differences between spot and forward market prices exist in the presence of trading costs. We implement these tests using the day-ahead forward and real-time spot locational marginal prices from California’s wholesale electricity market. We use our statistical tests to construct an estimate of the variable cost ∗H. John Heinz III College, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213. Email: [email protected]. †Program on Energy and Sustainable Development and Department of Economics, Stanford University, 579 Serra Mall, Stanford, CA 94305-6072, e-mail: [email protected]