U.S. Financial Transmission Rights: Theory andPractice

This paper reviews both theoretical and empirical studies of financial transmissionrights (FTRs) in the major U.S. wholesale power markets and provides a simple il-lustrative two-stage model to study the competitive behaviors of electricity generators(wholesale power sellers) and load serving entities (LSEs)(wholesale power buyers) andthe welfare effects of FTRs in the restructuring U.S. wholesale power market frame-work. The analysis focuses on a competitive two-node electricity network model wherethere is one generator and one LSE in each node with linear marginal cost and demandfunction, supervised by an independent system operator (ISO). In the first-stage ofmodeling, a no-rights benchmark model is developed to solve for the optimal quantityof power production and consumption and derive the locational marginal price for eachnode, which serve as the building blocks to solve for the optimal FTR hedge positionsin the second-stage model. Once a stochastic shock is introduced, the second-stagemodel shows that the acquisition of optimal FTRs by the risk averse generators andLSEs will increase and in general will strictly increase the social welfare compared withthe case where there is no FTRs available. This result presents a counterexample tothe somewhat negative views about FTRs held by other economists in the literatureand provides some economic explanations to the fact that FTRs are widely adopted asa financial hedge instrument in the major U.S. wholesale power markets.[...]