The Effects of the Dysfunctional Spot Market for Electricity in California on the Cost of Forward Contracts

The unexpectedly high spot prices for electricity in the summer of 2000 that occurred in California led to a number of regulatory interventions. Initially, price caps were lowered in California from $750/MWh to $250/MWh during the summer. However, Out-Of-Market (OOM) purchases were still made above the price cap if capacity shortfalls occurred in the market run by the California Independent System Operator (CAISO). After evaluating the price behavior during the summer months, the Federal Energy Regulatory Commission (FERC) declared that the market in California was �??seriously flawed�?� and proposed a number of changes to the market rules. Two important proposals made by the FERC were 1) to require greater dependence on forward markets by entities with obligations to serve customers, and 2) to replace the price cap of $250/MWh by a new type of �??soft-cap�?� auction with the price cap at $150/MWh. Unfortunately, spot prices in the winter of 2001 were persistently much higher than the soft cap. These high spot prices created uncertainty that resulted in high premiums for risk and high forward prices. Hence, forward contracts executed at this time were very expensive for buyers, and many contracts were executed due to the directive of the FERC. After the FERC imposed a system-wide price cap on the whole Western Inter-Connection in June 2001, both the spot prices and forward prices for electricity returned to normal levels.

Earlier research has shown that the high spot prices of electricity in the winter of 2001 may have resulted from the new type of soft-cap auction combined with the high spot prices of natural gas delivered in California during the early part of the winter. The econometric analysis in this paper shows how forward prices for electricity responded in the winter of 2001, and concludes that uncertainty about the high prices for electricity and uncertainty about the supply of natural gas were both important. The relative effects of these two sources of uncertainty on forward prices vary by the date of delivery. The initial uncertainty about spot prices for electricity in the summer of 2000 increased the forward prices of electricity for summer deliveries more than for winter deliveries. In contrast, uncertainty about the spot prices of natural gas in the winter of 2001 increased the forward prices of electricity for all delivery months. Price shocks for electricity after the FERC intervened in the CAISO market had by far the largest effect on the forward prices for delivery in summer months.