Efficiency of the California electricity reserves market

Abstract

AbstractWe test the efficiency of the California electricity reserves market by examining systematic differences between its day‐ and hour‐ahead prices. We uncover significant day‐ahead premia, which we attribute to market design characteristics. On the demand side, the market design established a principal–agent relationship between the markets' buyers (principal) and their supervisory authority (agent). The agent had very limited incentives to shift reserve purchases to the lower priced hour‐ahead markets. On the supply side, the market design raised substantial entry barriers by precluding purely speculative trading and by introducing a complicated code of conduct that induced uncertainty about which actions were subject to regulatory scrutiny. We use a high‐dimensional vector moving average model to estimate the premia and conduct correct inferences. To obtain exact maximum likelihood estimates of the model, we develop a new EM algorithm that seamlessly incorporates missing data and applies directly to general moving average time series models. Our algorithm uses only analytical expressions: the Kalman filter and a fixed interval smoother in the E step and least squares‐type regressions in the M step. Copyright © 2007 John Wiley & Sons, Ltd.