Can Forward Commodity Markets Improve Spot Market Performance? Evidence from Wholesale Electricity

Abstract

Forward markets are believed to aggregate information about future spot prices and reduce the cost of producing the commodity. We develop a measure of the extent to which forward and spot prices agree in markets with transaction costs. Using this measure, we show that day-ahead prices better reflect real-time prices at all locations in California's electricity market after the introduction of financial trading. We then present evidence suggesting that operating costs and input fuel use fell after the introduction of financial trading on days when the nonconvexities inherent to the production and transmission of electricity are especially relevant.

Keywords: Wholesale Electricity Markets, Virtual Bidding, Financial Trading, Forward Commodity Markets, Transaction Costs

JEL Classification: G18, L94, Q48