Inefficiencies and Market Power in Financial Arbitrage: A Study of California's Electricity Markets

In the three years following the restructuring of the California electricity industry, 1998 to 2000, power trading occurred in both a day-ahead market and a real-time market. Despite the fact that the power traded in these two major markets was for delivery at the same times and locations, prices differed significantly in many months. We consider several explanations for persistent price differences between the markets. We conclude that uncertainty about regulatory penalties for trading in the real-time market caused most firms to eschew arbitrage between the two markets. The few firms that did carry out this (risky) arbitrage did not find it profit-maximizing to eliminate the price differences. Due to California’s electricity restructuring plan, the investor-owned utilities, which were the primary buyers of electricity, had little incentive to respond to the price differences. In the summer of 2000, however, when prices in both markets skyrocketed, we argue that the utilities’ incentives changed in a way that was consistent with one utility’s subsequent attempts to move demand between markets to minimize their purchase costs