Can Financial Participants Improve Price Discovery and Efficiency in Multi-Settlement Markets with Trading Costs?

72 Pages Posted: 22 May 2019 Last revised: 21 Aug 2021

See all articles by Akshaya Jha

Akshaya Jha

Carnegie Mellon University

Frank Wolak

National Bureau of Economic Research (NBER)

Date Written: May 2019

Abstract

The introduction of purely financial participants into commodity markets is thought to yield forward prices that better reflect future spot prices, and ultimately, more efficient future production and consumption decisions. However, there are sizable transaction costs associated with trading in most commodity markets. This paper develops a statistical test of the null hypothesis that expected forward/spot price spreads cannot be arbitraged even after accounting for these transactions costs. We apply this test to hourly, location-specific day-ahead and real-time prices from California's wholesale electricity market. The implied trading cost required to reject the null hypothesis of no profitable arbitrage opportunities falls significantly after California allowed purely financial participation. Moreover, variable input costs per MWh of electricity produced fell by 3.6% in high demand hours after the introduction of purely financial participants. Combined, our evidence supports the hypothesis that the introduction of purely financial participants into the California wholesale electricity market decreased the average difference and the volatility of the difference between day-ahead and real-time prices, which ultimately lowered the total variable cost of serving demand

Suggested Citation

Jha, Akshaya and Wolak, Frank A., Can Financial Participants Improve Price Discovery and Efficiency in Multi-Settlement Markets with Trading Costs? (May 2019). NBER Working Paper No. w25851, Available at SSRN: https://ssrn.com/abstract=3391004

Akshaya Jha (Contact Author)

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

Frank A. Wolak

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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