Testing for Market Efficiency with Transactions Costs: An Application to Convergence Bidding in Wholesale Electricity Markets

With risk neutral traders and zero transactions costs, the expected value of the difference between the current forward price and the spot price of a commodity at the delivery date of the forward contract should be zero. Accounting for the transactions costs associated with trading in these two markets invalidates this result. We develop statistical tests of the null hypothesis that profitable trading strategies exploiting systematic differences between spot and forward market prices exist in the presence of trading costs. We implement these tests using the day-ahead forward and real-time locational marginal prices from California’s wholesale electricity market and use them to construct an estimate of the variable cost of trading in this market. During our sample period, we observe the introduction of convergence bidding, which was aimed at reducing the costs associated with exploiting differences between forward and spot prices. Our measures of trading costs are significantly smaller after the introduction of convergence bidding. Estimated trading costs are lower for generation nodes relative to non-generation nodes before explicit virtual bidding and trading costs fell more for non-generation nodes after explicit virtual bidding, eliminating any difference in trading costs across the two types of nodes. We also present evidence that the introduction of convergence bidding reduced the total amount of input fossil fuel energy required to generate the thermal-based electricity produced in California and the total variable of costs of producing this electrical energy. Taken together, these results demonstrate that purely financial forward market trading can improve the operating efficiency of short-term commodity markets. ∗Department of Economics, Stanford University, 579 Serra Mall, Stanford, CA 94305. e-mail: [email protected] †Program on Energy and Sustainable Development and Department of Economics, Stanford University, 579 Serra Mall, Stanford, CA 94305-6072, e-mail: [email protected]