Integrating financial and physical contracting in electric power markets

Against the background of continuing restructuring of the U.S. electric power market, this paper considers the integration of financial and physical contracting under various models of market structure and transmission pricing. We begin with a delineation of the objectives which we believe, implicitly or explicitly, underlie the move towards restructuring. These include transparent and efficient markets for both long-term and short-term transactions, dynamic efficiency and innovation, customer-focused operations, and system integrity. We use these objectives to derive a number of important policy implications for the restructured power markets including clear ownership boundaries and regulatory incentives for market participants to operate in a commercial manner, and transparent rules and incentives for efficient contracting and pricing. We point out the implications for decreased competition and increased regulatory transactions cost from proposals which do not satisfy the stated requirements for commercial operations (e.g., recent proposals for nodal pricing of transmission service coupled with highly complex settlement and reconciliation procedures among participants). We then describe a general approach which does satisfy the prima facie requirements of market transparency and economic incentives. This approach is based on zonal and ex ante transmission pricing, regulated for-profit transmission service providers (TSPs), and permissive market intermediation. We indicate for this approach, under various models of the Independent System Operator (ISO), how financial and physical contracting could be integrated and how regulation of TSPs could be accomplished. The required contracting includes financial instruments (spots, forwards, futures, and performance contracts) encompassing longterm and short-term energy contracts, asset-use and resource supply contracts, ancillary service contracts, investments in generation and transmission assets, load-management and demand-side management contracts, and contracting for other market-mediated services required for the efficient configuration and operation of the power market. We conclude the paper with a discussion of some open research questions.