Power Market Seams and the Role of Arbitragers in Market Design

Michael Giberson

For class tomorrow I’m reading up on things Enron and California power market melt-down related.

I’m a fan, for example, of Jonathan Falk’s 2002 article in the Electricity Journal on the infamous “Smoking Gun” memo which detailed Enron’s colorfully-named trading strategies like “get shorty” and “death star.” Among other things, Falk points out the several of the strategies provided arbitrage services between the many power markets in and around California, and at least some of the strategies likely helped the California market work more efficiently.

Richard J. Pierce, Jr. has what might be seen as a follow-up article in 2003, also in the Electricity Journal.  Pierce agrees with Falk that many of Enron’s strategies could be fairly described as  arbitraging the California market, but he also asserts that many of the strategies also could be fairly described a manipulative.  As a kind of aside, Pierce said, “If the California debacle has taught us nothing else, it should persuade us that arbitragers should never be given a role in structuring a market. They have a powerful incentive to maximize the flaws in the market design in order to maximize potential arbitrage profits.” (p. 40, emphasis added)

Pierce exaggerates a bit; it is unlikely that maximizing flaws will maximize potential profits.  Rather, some optimum amount of relatively minor flaws probably promises the most overall profit for arbitragers. But Pierce reminded me of the role that arbitragers have played on seams issues between the New York ISO and ISO New England markets.

For years, market monitors for the regions and some market participants have encouraged the New York and New England markets to exchange real-time market information and coordinate power flows as necessary to eliminate price distortions along the border between the markets. For years, other market participants (primarily traders participating in both markets) have continued to support alternative market changes that have the effect of continuing the special role played by traders in determining power flows between the markets. The Federal Energy Regulatory Commission has directed the markets to fix the seams issue in cooperation with market participants, but for years the ISOs have decided that other market changes were higher priority. For years, FERC has accepted that answer from the ISOs.

An estimate by Potomac Economics, external market monitor for the New York ISO, suggested that the net cost of power to New York consumers would have been $177 million lower in 2007 had the two markets better coordinated the power flows between the regions.* Still, the issue is not a priority at the ISOs or the FERC. Maybe when someone notices that efficient market-to-market coordination of power flows between regions would make better use of renewable power and demand-side resources participating in New York and New England markets, then we will see FERC make resolving this seams issue a higher priority. Until then, FERC and the ISOs continue implicitly to support the arbitragers’ favored approach to managing the seams.

(*See Table 1 on page 28 of Potomac’s “2007 State of the Market Report: New York ISO.”

DISCLOSURE: I contributed to the drafting of the 2007 market report as an employee of Potomac Economics last year before taking my current position at Texas Tech University. Of course, nothing I post here should be taken as expressing the views of either my former or current employer.)

4 thoughts on “Power Market Seams and the Role of Arbitragers in Market Design

  1. Not directly a comment, but you might be interetested in this:

    As the crisis gets bigger – it’s not just the banks now, all countries are staring bankruptcy in the face – the solution needs to get bigger, too. Nationalising western banks – if it happens – won’t help Mexico or the Ukraine. And if they fall, the domino effect could be catastrophic. So how about this suggestion (The Sander Solution):

    – x% of all bank and savings deposits in the OECD above, say $1000, are requisitioned as forced loans and placed in a special IMF fund.

    – This fund can be used to bail out countries …

    – … and to buy up insolvent banks. Because it isn’t national government doing it but the IMF, this might be politically acceptable.

    How easy this would be depends on the value of x%. If only 2% of deposits were to be “borrowed”, people would probably leave their money where it is rather than moving it out of the OECD. Much more, and there would have to be a swift and secret agreement and possibly even a 24-hour closedown of the banking system. possible, but unrealistic.

    The programme would ideally generate a few trillion dollars – enough to make it absolutely clear that the IMF and national governments have the funds to achieve turnaround.

    I’m afraid I can’t find numbers for this suggestion I don’t have access to the appropriate figures in order to enable to do the maths. Maybe you do?

  2. Per your comment about arbitrageurs and their role in market structuring, it’s worth reading Michael Lewis’ latest on Iceland, and in particular his observation that in a modern economy, once you recognize that markets are overvalued, there is vastly more money to be made by shorting the market than there is by playing the role of Cassandra.

    Shifting from Iceland to CA, it’s always struck me that – while Enron clearly crossed many legal lines – much of what they were blamed for was in fact a bad market design where – like Iceland in 2008 – there was a vastly greater incentive to arbitrage that market design than to help the regulators come up with a better model. In other words, those who designed the market bear a fair share of the culpability for those market failures that the press has laid at Enron’s doorstep.

  3. Sean is absolutely right about the market design. It is also definitely worth checking out the FERC reports on the crisis. Enron did everyone a bad turn by exploiting the situation so obviously, and in such a childish manner, but as I recall the actual amount of money that they extracted from the market was relatively small compared to other, more savvy, market participants.

  4. Let’s remember that the Western Crisis of 2000-2001 had a rather large physical cause that Enron had nothing to do with. Enron and others were shooting ducks in a barrel. Enron did influence the market design, however. Probably most of us who invested in the market knew we’d make a lot of money if hydro dropped before any new capacity was built. It did, and we did. Whose fault was it that this situation was set up with such foreseeable possibilities ahead? It was a case of bad regulation (prior to the market), bad planning (prior to the market), and bad luck.

    Better market design in California would have changed, but not prevented, the physical crisis with its cascading shortages, and might not have eliminated the resulting financial crisis.

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