PWP-033 Dynamic Efficiency and the Regulated Firm: Evidence from Interfirm Trade in Electricity Markets

This paper presents an empirical analysis of the value of a coordinated market exchange mechanism. I present a model of e cient trading mechanisms under uncertainty, and develop a measure of the value of an inter rm trade agreement in the context of sequential `buy-versus-produce' decisionmaking by rms. The theory is applied to estimate the value of a formal trading institution in the California electricity market, where an interutility power pool has been proposed to restructure the electric power industry. I develop an empirical model of the optimal production and trading decisions for a rm in such a pool, and estimate state-contingent willingness-to-trade functions for each of the four major utilities in this market. With this information, I estimate the distribution of future costs that would obtain if an e cient exchange mechanism arbitraged away observed di erences between willingness-to-buy and willingness-to-sell among the sample rms. The principal nding is that with the simple, relatively state-independent bilateral contracts observed in this market, the sample rms achieve within 4% of the theoretical minimum expected costs available with a complete statecontingent exchange mechanism. This di erence represents an opportunity cost of approximately $250 million per year. I conclude with regulatory and managerial explanations for the absence of a more e cient state-contingent trading mechanism, and implications for deregulating electric power markets. Assistant Professor of Economics, Graduate School of Business, Stanford University, Stanford CA 94305-5015. E-mail: [email protected]. Thanks to Severin Borenstein, Richard Gilbert, Alvin Klevorick, Daniel McFadden, Ariel Pakes, and John Rust for helpful suggestions and discussions, as well as seminar participants at Berkeley, Harvard, Michigan, Northwestern, Stanford, Wisconsin, and Yale. Financial support from the University of California Energy Institute is gratefully acknowledged.