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

TLDR: In this article, the authors studied the effect of speculators on production decisions and price levels in New York's deregulated electricity market and showed that, after the market opened to purely speculative traders, the forward price of electricity in western New York was significantly higher than the expected spot price.

Abstract: 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 past 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 significantly higher than the expected spot price. I show that, after the market opened to purely speculative traders the forward premium significantly decreased. In addition, the forward price of transmission (the price difference between two geographically distinct points) ceased to differ significantly 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 firms' production decisions. Absent speculators, the model predicts that firms 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 firms 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 find that, after controlling for other market changes, the forward price-cost margins of firms in western New York did, in fact, significantly decrease after speculators were allowed to enter the market.