CSEM WP 121 Speculative Trading and Market Performance: The Effect of Arbitrageurs on Efficiency and Market Power in the New York Electricity Market

While the effect speculators have on forward premiums (the difference between forward and expected spot prices) has been widely studied, there has been very little focus on the effect speculators have on competition in the product market. I study the effect speculators have had on production decisions and price levels in New York’s deregulated electricity market. For the Þrst two years of its operation, the market, which opened in November 1999, restricted trade to producers and retailers of electricity. During this period, the forward price of electricity in western New York was signiÞcantly higher than the expected spot price. I show that, after the market opened to purely speculative traders, the forward premium signiÞcantly decreased. In addition, the forward price of transmission (the price difference between two geographically distinct points) ceased to differ signiÞcantly from the expected spot price of transmission. I present a theoretical model to help understand these price relationships and other possible effects of speculators on market prices and Þrms’ production decisions. Absent speculators, the model predicts that Þrms with market power will price discriminate between the forward and spot markets for electricity, resulting in the forward price being higher than the expected spot price. This discrimination in the market for electricity will result in the forward price of transmission under-predicting the spot price of transmission. When speculators that prevent Þrms from price discriminating are added to the model forward price-cost margins decrease. Using detailed data on the marginal costs of generation units in New York, I test these predictions of the model, and Þnd that, after controlling for other market changes, the forward price-cost margins of Þrms in western New York did, in fact, signiÞcantly decrease after speculators were allowed to enter the market. ∗E-mail: [email protected]. I would like to thank my advisor Severin Borenstein, as well as James Bushnell, Meghan Busse, Richard Gilbert, Matt Lewis, Aviv Nevo, Catherine Wolfram and everyone at the University of California Energy Institute for advice and Þnancial support.