U.S. Financial Transmission Rights: Theory and Practice
Author: Junjie Sun
Economics Working Paper No. 05008, Department of Economics, Iowa State University, November 2005
Abstract:
Financial Transmission Right (FTR) as a financial hedge instrument against volatile wholesale electricity prices has been widely adopted in the major U.S. wholesale power markets. However, the current literature often shows that FTR decreases efficiency and reduces social welfare. One main problem is that their models do not have a stochastic component. Since FTR is designed to hedge the uncertain profit streams that market participants face, it is no surprise to find that the absence of uncertainty renders the FTR being a source of inefficiency. The contributions of this paper are in two-folds. First, it provides a comprehensive review of both theoretical and empirical studies of FTRs in the current literature. Second, in this paper I present a simple two-node electric network model and show that once stochastic shocks are introduced the acquisition of optimal FTRs by the risk averse market traders will increase and in general will strictly increase the social welfare compared with the case where there are no FTRs available. This result presents a counterexample to the somewhat negative views about FTRs held by other economists in the literature and provides some economic explanations to the fact that FTRs are widely adopted as a financial hedge instrument in the major U.S. wholesale power markets.
Keywords: Financial transmission rights, Locational marginal price, Security-constrained economic dispatch, Risk hedging, Independent system operator, Congestion rent.
JEL Codes: G1, L9, D4