Risk aversion and the efficiency of the New York independent system operator’s market for transmission congestion contracts

The deregulation of electricity industries has generally separated the provision of generation from its subsequent transmission. However, the physical nature of electricity generation and delivery creates special problems for the design of efficient markets, notably the need to manage delivery in real time and the resulting volatile congestion costs. In theory, two broad approaches exist for implementing transmission congestion management: (i) a centralised point-to-point (PTP) structure, in which derivative transmission congestion contracts (TCCs) are traded, and (ii) a decentralised approach, in which trading rights exist only on the heavily congested links of the network. Since the latter mechanism focuses on the bottlenecks of the grid, which are fixed by the underlying network topology, it defines a small number of tradable rights, thereby enabling market participants to hedge transmission congestion risk more efficiently. By contrast, while the TCC-based approach, as implemented in New York, provides market participants with a potentially effective hedge against volatile congestion rents, it, nevertheless, results in prices paid for TCCs that are systematically divergent from the resulting congestion rents for distant locations and at high prices. Such inefficiency can be explained in part by the low liquidity of TCC markets and the deviation of TCC feasibility requirements from actual energy flows. It could also be the case that market participants over-pay in this environment out of risk aversion. Analysis of data from the New York TCC markets from 2000 to 2001 indicates that, on aggregate, market participants were only slightly risk averse (or even risk seeking, depending on the utility function employed). As a result, the very design of these markets, rather than the behaviour of market participants, leads to the observed discrepancy between forward and spot prices.