Two-settlement Systems for Electricity Markets under Network Uncertainty and Market Power*

We analyze welfare and distributional properties of a two-settlement system consisting of a spot market over a two-node network and a single energy forward contract. We formulate and analyze several models which simulate joint dispatch of energy and transmission resources coordinated by a system operator. The spot market is subject to network uncertainty, which we model as a random capacity derating of an important transmission line. Using a duopoly model, we show that even for small probabilities of congestion (derating), forward trading may be substantially reduced, and the market power mitigating effect of forward markets (as shown in Allaz and Vila 1993) may be nulli®ed to a great extent. There is a spot transmission charge re¯ecting transportation costs from location of generation to a designated hub whose price is the underlying for the forward contract. This alleviates some of the incentive problems associated with the forward market in which spot-market trading is residual. We ®nd that the reduction in forward trading is due to the segregation of the markets in the constrained state, and the absence of natural incentives for generators to commit to more aggressive behavior in the spot market (thè`strategic substitutes'' effect). In our analysis, we ®nd that the standard assumption of``no-arbitrage'' across forward and spot markets leads to very little contract coverage, even for the case with no congestion. We present an alternative view of the market where limited intertemporal arbitrage enables temporal price discrimination by competing duopolists. In this framework, we assume that all of the demand shows up in the forward market (or that the market is cleared against an accurate forecast of the demand), and the forward price is determined using a ``market clearing'' condition.