If you need to catch up, Find the entire power markets 101 blog series here
We’ve come a long way learning about the grid, the history of power and ISOs, the dual-settlement market, and generation. In our last two installments of this series, we’ll dive into the financial markets. In this one, we’ll discuss the purpose of financial power markets.
In this blog post, we will discuss financial markets, a unique aspect of deregulated markets. As you might recall, markets were deregulated and ISOs and RTOs were created to offset the natural monopolies that resulted from vertically integrated utilities. In regulated markets where utilities have a natural monopoly, their primary mandate is to provide reliable electricity. Economic efficiency is not their primary concern. In fact, utilities are guaranteed a set percentage of profit on their spendings, so in some cases, they may actually be incentivized to spend money and resources in a way that is not necessarily economically efficient.
However, in deregulated markets ISOs exist in order to dispatch generation and deliver electricity in the most efficient and economical way possible. SCED (security-constrained economic dispatch) is one of the ways that ISOs accomplish this. ISOs use sophisticated computer systems to monitor the grid and send out signals, dispatching generating units much more efficiently than human dispatchers. SCED dispatches generation owned by physical participants. Physical participants buy or sell actual electricity, they have a physical need to use the power grid and transmission services. They are often utilities, load-serving entities (LSEs) or independent power producers (IPPs).
The other way that ISOs and RTOs achieve their mandate of economic efficiency is through financial participants. Financial participants do not own generation to supply electricity, nor do they intend to remove large amounts of electricity from the grid. Financial participants primarily provide liquidity in the markets. Markets are only liquid if there is someone to buy a product or asset, and the value of the product is not truly determined until a product or asset is sold. By allowing financial participants to take part in the markets, it helps to ensure that there are plenty of buyers and sellers in the markets, providing liquidity.
Hedging & Price Convergence
Financial markets are also a mechanism for hedging. Hedging is a way for market participants to offset the risk of another position they have taken. Financial markets provide a way for physical asset owners to hedge. By allowing financial traders to participate in the markets, it also encourages further competition which helps lead to price convergence. Ideally, ISOs want the day-ahead market to match the real-time market exactly, which would result in price convergence. Financial traders identify inefficiencies in the market, moving the ISO closer to that price convergence. Financial traders also serve the purpose of assuming some of the risk involved. In a way, they are providing insurance to other market participants.
In summary, by allowing financial participants to take part in the markets, ISOs are helping to facilitate:
Look out for our last post in this series where we will discuss some of the physical and financial trading types in power markets.