Electricity Markets: How Many, Where and When?

Most markets compromise the economist’s ideal of matching the marginal benefits to consumers with the marginal cost of supply for incremental purchases because individual buyers and sellers are aggregated over space, time and/or other product attributes like quality or reliability. These aggregations into discrete market segments are designed to facilitate transactions by reducing search and distribution costs, and they may enhance the competitiveness of each market segment by encompassing a larger number of buyers and sellers, but at some loss of precise efficiency matches. Furthermore, as individual market segments grow in size, the price differences across their boundaries may also increase which can raise the transactions costs associated with increased arbitrage. These are important considerations for electricity markets since significant physical, operational and capacity barriers separate and define these markets over space and time. Thus principles for the optimal structure of these markets are developed, and in particular, it is shown that forward markets with lead times longer than the gestation period required to construct new generation capacity are essential to insure efficient subsequent spot markets. By comparison, if these forward markets occur only after new construction is begun, as with existing installed capacity markets, spot market prices may be higher. Similarly, the extent of separation and spacing of markets across regions and control areas, particularly in the face of transport congestion or operational boundaries, is important for enhanced efficiency.