Australian Economic Papers - 2002 - Avsar - Forecast Errors and Efficiency in The US Electricity Futures Market

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FORECAST ERRORS AND EFFICIENCY IN THE US ELECTRICITY
FUTURES MARKET
S. GULAY AVSAR
Victoria University of Technology
BARRY A. GOSS
Monash University
In March 1996 the US introduced electricity futures contracts which provided for delivery at the
California/Oregon border (COB) and Palo Verde switchyard. These were followed in July 1998 by
contracts which provided for delivery of electrical energy into the Cinergy and Entergy systems,
and in March 1999 by a contract for the Pennsylvania/New Jersey/Maryland (PJM) area. This paper
employs the forecast error approach to study the informational ef®ciency of these markets (the
model prediction and event studies approaches are not feasible). COB and Palo Verde spot and
futures prices are stationary, while Cinergy spot and futures prices are I(1) and cointegrated
(Entergy and PJM data were not utilised due to insuf®cient observations). All forecast errors,
therefore, are stationary. Estimation is by instrumental variables in the presence of a lagged
dependent variable and overlapping observations. For the period 1996 (04) to 1999 (12), with COB
and Palo Verde data, the ef®cient markets hypothesis (EMH) is rejected. This outcome is con®rmed
by cointegration of the COB and Palo Verde futures prices. A signi®cant M-GARCH term in the
forecast error relationship for both contracts supports the view that a time-varying risk premium
was present. A signi®cant negative relationship between forecast errors and volume for the COB
contract suggests that agents were still learning the true model driving this market, and that Stein's
`Bayesian error' was non-zero.
For the period 1998 (07) to 1999 (12), with COB, Palo Verde and Cinergy data, the EMH cannot
be rejected. Finally, an attempt is made to relate this study to the recent electricity crisis in
California.
I. Int ro duct ion
The United States was the ®rst country to introduce electricity futures contracts. On
March 29, 1996 the New York Mercantile Exchange (NYMEX) launched the California
Oregon Border (COB) and Palo Verde contracts. These two futures contracts call for the
S.G. Avsar is Lecturer, School of Communications and Informatics, Victoria University of Technol-
ogy, PO Box 14428 MC, VIC 8001, Australia. Email: gulay@sci.vu.edu.au. B.A. Goss is Reader,
Department of Economics, Monash University, Clayton, Vic 3800, Australia. Email: Barry.Goss@
buseco.monash.edu.au. Research reported in this paper was supported by a grant from the Strategic
Monash University Research Fund. Data employed were supplied by the New York Mercantile
Exchange. An earlier version of this paper was presented at the Conference on the Growth, Performance
and Concentration of International Financial Markets, Monash University in Prato, Italy, November
2000. Thanks are due to Keith McLaren, Brett Inder, Anne Peck, Jerome Stein and conference
participants for helpful comments; the usual disclaimer applies.
# Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden
MA 02148, USA and the University of Adelaide and Flinders University of South Australia 2001.
14678454, 2001, 4, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1467-8454.00138 by CCI RA - Grenoble Em, Wiley Online Library on [22/10/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
480 AUSTRALIAN ECONOMIC PAPERS DECEMBER
delivery of 736 megawatt hours (mwh) of electricity (864 mwh from October 1999 contract)
each calendar month. Delivery is to be made, during on-peak hours, at the California/Oregon
border of the Paci®c Northwest/Paci®c Southwest AC Intertie in the case of COB contracts,
and at the Palo Verde high voltage switchyard in the latter case.1 The Cinergy and Entergy
electricity futures contracts began trading on July 10, 1998, and the Pennsylvania/New
Jersey/Maryland (PJM) contract was launched on March 19, 1999. The Cinergy and Entergy
contracts call for the delivery of 736 mwh into the Cinergy and Entergy Transmission
Systems respectively, at any interface selected by the seller, and at the PJM Western Hub in
the last case. While the COB and Palo Verde contracts are directed at the western part of the
country, the Cinergy contract is concerned with markets in Indiana, Ohio and Kentucky, and
the Entergy contract is directed at an area which includes Louisiana, Arkansas, Mississippi
and Texas.
In the United States average monthly production of electric power in 1995 was 233.8
billion kilowatt hours (kwh), compared with Japan 58.3 bill. kwh, Germany 33.0 bill. kwh,
Italy 20.1 bill. kwh, Russia 69.1 bill. kwh, China 79.7 bill. kwh and Australia 13.5 bill. kwh
(Knight-Ridder Financial CRB Commodity Yearbook, 1996).
At the wholesale level the industry is to a large extent deregulated. A national electricity
grid has been created, and Federal law permits access to the national transmission grid by
utilities, which can sell outside their own geographical areas, and by independent system
operators. In the retail market, the extent of deregulation varies as between states. For
example California, Pennsylvania and Massachusetts permit retail customers to choose any
one of a number of suppliers, while other states, including Arizona, Illinois, Maryland, New
York, Ohio and Virginia, have passed laws to deregulate the retail market, although the
details of this deregulation are not yet fully implemented. A consequence of this hetero-
geneous progress in deregulation of the retail market is that the cash markets are more
developed in some areas (e.g. California and Pennsylvania) than in others (e.g. the North-
east). (See New York Mercantile Exchange: www.nymex.com and Environmental News
Network: www.enn.com). Moreover, in some states (e.g. California) there are inconsistencies
between deregulated wholesale markets and retail markets where temporary price freezes
apply to some suppliers (see also Section V and n. 4).
The movement toward deregulation was accelerated inter alia by the desire of large
industrial and commercial users to escape the high cost of electricity from some utilities,
especially in California and the Northeast. These costs re¯ect, in particular, expensive long
term contracts signed by utilities with independent producers, as a `hedge' against high price
forecasts for coal and oil, and also high cost nuclear facilities for the production of
electricity. This desire to escape has been made feasible by the development of small scale
gas turbine plants, which give large consumers the option to self-generate at costs which are
comparable with those of large coal generation plants (Van Doren, 1998, pp. 2±7).
In an economic environment in which wholesale electricity prices are competitively
determined, electricity futures contracts traded on NYMEX provide an important risk
management tool for producers, consumers and distributors of electricity. For example, a
generator can lock in current prices for future electric power production by selling futures
contracts (short hedger). An industrial consumer, by comparison, can hedge against the risk
1
Delivery is to be made at the rate of two megawatts (MW) per hour throughout the delivery period,
which comprises 16 on-peak hours (600 to 2200 hours). The delivery unit is determined by the number
of on-peak days in the delivery month (e.g. 27 on-peak days 864 MW; 24 on-peak days 768 MW);
see the web site www.nymex.com/contract/electric/spec.
# Blackwell Publishers Ltd/University of Adelaide and Flinders University of South Australia 2001.
2001 FORECAST ERRORS AND EFFICIENCY 481
of a rise in electricity input prices by buying futures contracts (long hedger), while an
electric power distributor, which may be long or short in the actuals market, can hedge spot
market price risks by taking a futures market position of opposite sign. Moreover, these ®ve
futures contracts now are accompanied by corresponding options contracts, thus providing
further risk management tools for agents with spot market commitments. For example, an
electric power producer can limit its exposure to falling spot prices by buying put options,
while being free to bene®t from upside gain. Alternatively, such an agent could lock in a
current price by buying put options and writing an equal number of call options of same
exercise price and expiration, thus taking a short position in synthetic futures. Similarly, an
electric power consumer can limit its exposure to rising prices by purchasing call options, or
can lock in a current price by buying call options, writing an equal number of identical put
options, thus creating a long position in synthetic futures.
This paper investigates the informational ef®ciency of the electricity futures market on
NYMEX. While there has perhaps been a surfeit of tests of the ef®cient markets hypothesis
(EMH) with futures market data, very little has been written on the performance of
electricity futures markets, although Goss and Avsar (1999) studied ef®ciency and liquidity
of the Victorian and New South Wales electricity contracts in Australia, which had their
inception in September 1997. In the case of the Australian contracts, which provide for
mandatory cash settlement, the authors did not reject the EMH, and there was no support for
the hypothesis of increasing returns to liquidity with the small number of observations
employed.
Walls (1999) studied the relationship between volatility and time to maturity for 14 COB
and Palo Verde futures contracts. He found inter alia that for 12 of 14 contracts there was a
signi®cant negative relationship between volatility and time to maturity. He found also that
for nine of the contracts studied, volatility varies directly with volume, conditional on time
to maturity.
Researchers in the area of futures markets have developed three main methodologies to
investigate whether prices in these markets re¯ect public information as fully as possible.
The ®rst of these is the model prediction approach, which compares model generated
forecasts of the spot price, post-sample, with forecasts implicit in a lagged futures price.
Second, the forecast error approach, which also utilises the predictive quality of futures
prices, seeks dependence between current and lagged forecast errors for a group of related
commodities or ®nancial instruments. Third, the event study approach, relates futures prices
to a series of announcements on key economic variables, such as money supply or balance of
payments. Key representative papers which employ these respective approaches are Leuthold
and Hartmann (1979), Hansen and Hodrick (1980) and Chance (1985). These methodologies
and their outcomes are summarised in Goss (1992, pp. 4±7).
In the case of US electricity futures contracts, the choice of methodologies is restricted:
there are too few monthly observations available to provide intra- and post-sample periods
for the model prediction approach, and there is no series of announcements on economic
variables with special relevance to the electricity market. The remaining option, the forecast
error approach, would not be an inappropriate choice: the ®ve electricity futures contracts
are traded on the same exchange, and each provides for the delivery of electric power, at the
same rate, at their respective delivery locations. They can be regarded, therefore, as contracts
for related commodities, in a relevant sense. Moreover, while this approach does have an
arbitrary element in the selection of variables, compared with the model prediction approach,
it does result in a test with power to reject the EMH. For example, Hansen and Hodrick
(1980) employed this approach and rejected the EMH for the Deutschmark, Swiss franc and
Canadian dollar against the US dollar, while Sephton and Cochrane (1990) rejected this
hypothesis for zinc, tin, lead and copper on the London Metal Exchange.
For these reasons, it has been decided to employ the forecast error approach to study the
ef®ciency of the US electricity futures market with respect to public information. Section II
discusses model speci®cation, Section III outlines the data employed and discusses issues of
stationarity, cointegration and estimation, while results are presented and evaluated in
Section IV. Some conclusions are presented in Section V.
II. A M o d e l S p e c i f i c at i o n
Futures prices are commonly interpreted as market anticipations of delivery date spot
prices, for both storable and non-storable commodities. An important difference between
these two classes of commodities is that in the case of non-storables, such as electrical
energy and ®nished live cattle, the amount of the current forward premium is not constrained
by marginal net storage costs as in the case of storable commodities, but is in effect
constrained by the production plans and price expectations of agents. Futures prices, in their
role as market anticipations, will be subject to forecast error if new information arrives
between the date of futures price quotation and the delivery date. Forecast errors (the
difference between the delivery date spot price and the preceding futures price) then contain
information, and in an ef®cient market this information would be impounded immediately in
current prices.
An ef®cient market is de®ned, for the purposes of the present discussion, as one in which
all information in a relevant information set, is re¯ected as fully as possible in current
prices.
Let
x t Ptl, t k ÿ Pt, t k (1)
where Pt, t k is the price of a futures contract at time t, for delivery at time (t k). Then the
expected price change in such a market is zero, because new information is, by de®nition,
random. That is
E(x t jö t ) 0 (2)
where ö t is the relevant information set at time t. In the context of the present discussion, ö t
is a set of public information, and the forecast error approach de®nes ö t as the prior forecast
errors for own and related commodities. Under the EMH, therefore, there would be no
systematic relationship between the current forecast error for the market under review, and
prior forecast errors for own and related commodities. In the relationship
X
n
A t k ÿ Pt, t k á â j A tj ÿ P tÿ
j
k, t e t k (3)
j1
P
the EMH would be addressed by testing the joint hypothesis H 0 (á, nj1 â j 0), where
At spot price at time t; á, â are coef®cients to be estimated; j 1, 2, . . ., n own and
related commodities; t is time in months; e is an error term.
The EMH is a joint hypothesis, embodying both rational expectations and risk neutrality.
Rejection of the EMH, therefore, does not, in the absence of further tests, indicate which
branch of the joint requirements is being contravened. Moreover, rejection of the EMH is
only a necessary, but not suf®cient condition for the demonstration of market inef®ciency. A
suf®cient condition for inef®ciency is that the model employed can be utilised for the
provision of risk adjusted pro®ts (Rausser and Carter, 1983; see also Leuthold and Garcia,
1992). Non-rejection of the EMH, by comparison, is no proof of market ef®ciency, but may
simply be the outcome of model mis-speci®cation. Since the rational expectations hypoth-
esis, which requires that agents fully and ef®ciently utilise all information, is a branch of the
EMH, any test of the EMH based on equation (3) is conditional upon a well behaved error
term. Rejection of the EMH due to a signi®cant intercept would be consistent with a constant
risk premium, although it may indicate a non-zero maturity basis, due, for example, to
delivery uncertainties. A time varying risk premium, also, would drive a wedge between
current futures and expected spot prices, although this would require explicit representation
if it were the suspected reason for rejection of the EMH.
III. Data , S tat i o n a r i t y, C o i n t e g r at i o n a n d E s t i m at i o n
Data
Futures price data are prices per mwh in US dollars and cents, observed on the ®rst
trading day of the month, for a futures contract two months prior to delivery. For example,
the price of the June 1996 future is observed on April 1, 1996. A lag of two months was
chosen because the future two months prior to delivery generally is the most heavily traded.
Futures contracts which are held to maturity (but which are not subject to delivery) are
settled on the fourth last trading day of the month prior to the delivery month. For example,
trading in the June 1996 future terminates on May 28, 1996. It is the settlement price on this
fourth last day which futures prices are anticipating, and these settlement prices are used as
proxies for delivery date spot prices. Data on both these variables were purchased on disk
from NYMEX. The sample period extends from inception of the COB and Palo Verde
contracts (March 29, 1996) to end December 1999, providing 44 monthly observations for
these two contracts, after allowing for a lag of two months.
With the inception of the Cinergy and Entergy contracts in July 1998, the above procedure
provides 17 monthly observations for these contracts, after allowing for a two month lag.
Observations for the Entergy contract, however, were deleted from the data set, because this
contract was traded too thinly for prices to be meaningful. With inception of the PJM
contract in March 1999, the above procedure would have provided only eight observations,
and so PJM prices were excluded from the data set due to insuf®cient observations.
Tests for stationarity and cointegration

The residuals of the estimated versions of equation (3) will be stationary if all variables in
this equation are stationary, or alternatively, if some of these variables are non-stationary,
this condition will be ful®lled only if these variables are integrated of the same order and are
conintegrated. To ascertain whether the variables in (3) are stationary, unit root tests were
conducted for the level form price variables for all three electricity contracts in the sample.
Augmented Dickey-Fuller (ADF) and Phillips-Perron tests were conducted, both of which
test the null of non-stationarity, against the alternative hypothesis that the variables are
stationary. ADF tests were conducted using the following general model
X
k
Ä Z t ì ât ã Z tÿ1 ö j Ä Z tÿ j v t (4)
j1
where Z is an economic variable; t is a time trend; ì is constant; â, ã, ö are coef®cients to

be estimated; j 1, 2, . . ., k; v t is assumed to be NID (0, ó 2 ). Inclusion of a time trend and
lagged values of Ä Z t in a speci®c test was determined according to whether serial
correlation was present in vt , and by general to speci®c modelling (see Maddala and Kim,
1998, pp. 19, 78). The hypothesis of a single unit root in Z t is addressed by testing the
hypothesis H(ã 0) in (4). In conducting the ADF tests, the time trend variable was
signi®cant in the tests for the COB and Palo Verde contracts, but not in the Cinergy tests. In
the ADF tests a one period lag of Ä Z t was employed, except for the futures price test for the
Palo Verde contract, in which a three period lag was used, and the same test for Cinergy,
where a two period lag was employed. A ten per cent level of signi®cance was employed
because of the small number of observations.
The outcomes of these tests are reported in Tables Ia and Ib. It can be seen that the futures
Table Ia Unit Root Tests: Augmented Dickey-Fuller
Variable Calculated Test Statistic 10% Critical Value Order of Integration

COB
Ptÿ k, t ÿ4:3279 ÿ3:1898 I(0)
At ÿ3:5169 ÿ3:1898 I(0)
A t ÿ Ptÿ k, t ÿ5:0756 ÿ2:6059 I(0)
Palo Verde
Ptÿ k, t ÿ4:1016 ÿ3:1931 I(0)
At ÿ4:4648 ÿ3:1898 I(0)
A t ÿ Ptÿ k, t ÿ5:4876 ÿ3:1898 I(0)
Cinergy
Ptÿ k,t ÿ1:9190 ÿ2:6927 I(1)
At ÿ2:1132 ÿ2:6745 I(1)
A t ÿ Ptÿ k,t ÿ3:7231 ÿ2:7042 I(0)
Table Ib Unit Root Tests: Phillips-Perron
Variable Calculated Test Statistic 10% Critical Value Order of Integration

COB
Ptÿ k,t ÿ3:1902 ÿ3:1868 I(0)
At ÿ3:2758 ÿ3:1882 I(0)
A t ÿ Ptÿk, t ÿ5:0217 ÿ2:6048 I(0)
Palo Verde
Ptÿ k,t ÿ2:7486 ÿ2:6021 I(0)
At ÿ2:9853 ÿ2:6030 I(0)
A t ÿ Ptÿ k, t ÿ4:6526 ÿ3:1882 I(0)
Cinergy
Ptÿ k, t ÿ2:2548 ÿ2:6745 I(1)
At ÿ2:1132 ÿ2:6745 I(1)
A t ÿPtÿ k, t ÿ7:1644 ÿ2:6927 I(0)
and spot prices are unequivocally I(0), according to both tests, for the COB and Palo Verde
contracts, and that both price variables are unambiguously I(1) for the Cinergy contract. The
question arises then whether the futures and spot prices are cointegrated for the Cinergy
contract. To provide an answer to this question, a Johansen maximum eigenvalue test was
conducted, which tests the hypothesis that the number of cointegrating vectors m is at most
equal to q (where q , n, the number of I(1) variables in the relationship) against the speci®c
alternative m < q 1. The results of this test, which are given in Table II, suggest that there
is one cointegrating relationship between spot and futures prices for the Cinergy contract.
The implication of these unit root and cointegration tests is that the forecast errors for all
three contracts are expected to be stationary, and this is con®rmed in Tables Ia and Table Ib.
Estimation
There are three issues which need to be borne in mind in the estimation of the coef®cients
of equation (3). First, equation (3) contains a lagged dependent variable as regressor. For
example, if the left side of (3) is the current forecast error for the COB contract
(A t k ÿ Pt, t k ) then the right side includes the prior forecast error (A t ÿ Ptÿ k, t ) for COB
and other contracts. This will render the prior forecast error for COB (A t ÿ Ptÿ k, t ) correlated
with the error term for that period e t, and with prior errors, with the result that the least
squares estimator is biased, although that estimate could be consistent under certain
conditions (Grif®ths et al, 1993, pp. 450±51). Second, with k 2 in equation (3) and
futures prices sampled monthly, there are overlapping observations. This creates a ®rst order
moving average effect (MA(1)) in the residuals of (3): random shocks do not work their way
through the system in the current period, but require one further period to do so. The
presence of MA(1) effects on the residuals can be detected quite well by the Durbin Watson
test. Third, the prior forecast errors on the right side of (3) are determined simultaneously in
the same national electricity market. The future, however, cannot cause the past, and e t k is
not contemporaneously correlated with (A t ÿ Ptÿ k, t ). Nevertheless, as Hodrick (1987, p. 44)
points out, these regressors are not strictly exogenous, and so least squares estimates will be
inconsistent.
In light of this discussion, and in order to obtain consistent estimates, the coef®cients of
equation (3) were estimated by instrumental variables.2 These estimates are biased for the
reasons stated above. These estimates will be more ef®cient the greater is the correlation
between the instruments selected and the regressors in (3). (The estimations referred to in
this paper were executed with the program E-Views 3.1 (Lilien, et al., 1995).
Table II Johansen Maximum Eigenvalue Test
No. of Cointegrating
I (1) Variables Calculated Test Statistic 5% Critical Value Vectors: m
Cinergy
Ptÿ k, t 25.1658 19.96 m0
At 9.0923 9.24 m<1
2
In the presence of ®rst order serial correlation the instruments were obtained by lagging each
regressor one further period, i.e. by two periods in total.
I V. R e s u lt s
Coef®cient estimates
Equation (3) was estimated with k 2 months, and with the various contracts designated
as follows
j 1 for COB
2 for Palo Verde
3 for Cinergy
These values of j correspond to the subscripts of the coef®cients of the regressors in ( â j ).
Five versions of equation (3) were estimated: for the sample period 1996 (04) to 1999 (12)
two versions were estimated, one with current forecast errors for COB as dependent variable,
and one with Palo Verde as dependent variable (40 observations after adjusting endpoints).
For the sample period 1998 (07) to 1999 (12) three versions of equation (3) were estimated
with COB, Palo Verde and Cinergy current forecast errors as dependent variables respec-
tively. A correction for ®rst order autocorrelation was made for versions (1) and (2).
The estimates of these coef®cients are provided in Table III, together with the number of
observations (N), the calculated ÷ 2 value to test the hypothesis H 0 (á, â j 0), and the
Durbin-Watson statistic. A ten per cent level of signi®cance again has been employed to test
the EMH, because of the small sample size. It is clear from Table III that for the sample
period 1996 (04) to 1999 (12) (40 observations) the EMH can be rejected at the ten per cent
level of signi®cance, while for the shorter sample period (1998 (07) to 1999 (12), 14
observations) the EMH cannot be rejected.
Diagnostic tests on residuals

The diagnostic tests on the residuals of the ®ve estimated versions of equation (3) suggest
that these residuals are not serially correlated, are stationary and are normally distributed
(see Appendix 1). The Ljung-Box Q Statistic, which tests the hypothesis that all autocorrela-
tion coef®cients, up to lag 20 for versions 1 and 2 (lag 12 for the shorter sample in versions
3, 4, 5) does not indicate the presence of autocorrelation. The calculated Phillips-Perron
statistic tests the null of a single unit root in the residuals in various versions of equation (3),
and this null is rejected in all cases, at the ten per cent signi®cance level. The Jarque-Bera
statistic tests the null that the residuals are normally distributed, and this hypothesis cannot
be rejected.
Con®rmation of these outcomes was sought, using an alternative methodology. It is
possible to address the question of market ef®ciency using a cointegration approach.
MacDonald and Taylor (1988, p. 236) showed that if the prices for two separate commodities
are cointegrated, then this implies that the EMH should be rejected. Conversely, if there is
evidence that the prices of two commodities are not cointegrated, this implies that the EMH
cannot be rejected. Accordingly, a Johansen maximum eigenvalue test (as described above)
was executed ®rst for the sample period 1996 (04) to 1999 (12) to investigate the question of
cointegration between COB and Palo Verde futures prices. The results of this test, reported
in Appendix 2, suggest that there is one cointegrating relationship between these variables,
which is consistent with rejection of the EMH using the forecast error methodology. Second,
the Johansen maximum eigenvalue test was conducted for the sample period 1998 (07) to
2001
Table III Coef®cient Estimates: Equation (3)
FORECAST ERRORS AND EFFICIENCY

Version (Dep.Var.) á^ â^1 â^2 â^3 r^ N Calc. ÷ 2 DW
(1) (COB) 1.4258 ÿ0:5343 0.3445 ± 0.2408 40 7.043 1.9888
(1.242) (ÿ0:992) (0.405) (1.582)
(2) (Palo Verde) 1.7405 0.1483 ÿ0:6155 ± 0.6727 40 18.768 1.8884
(0.885) (0.508) (ÿ2:311) (5.022)
(3) (COB) ÿ0:9588 0.9195 0.3870 ÿ0:1459 ± 14 0.266 2.0329
(ÿ0:130) (0.252) (0.195) (ÿ0:206)
(4) (Palo Verde) 23.6282 ÿ13:3516 2.7309 2.6358 ± 14 0.00295 1.8601
(0.044) (ÿ0:045) (0.042) (0.045)
(5) (Cinergy) 7.0837 ÿ4:7407 2.4693 0.5203 ± 14 1.274 1.8586
(0.325) (ÿ0:515) (0.447) (0.378)
Estimation is by IV; N is number of observations; t statistics in parentheses; r
^ is the estimated AR(1) coef®cient; critical (0.10) ÷ 2 (3) 6.25; (0.10) ÷ 2 (4)
7.78.
487
1999 (12) to investigate the possibility of cointegration between the futures prices for the
COB, Palo Verde and Cinergy contracts. The results of this test, reported in Appendix 2,
suggest that there are no cointegrating relationships between these three futures prices,
which is consistent with non-rejection of the EMH with the tests based on forecast errors.
The question arises, in the two cases for which the EMH was rejected, why this rejection
occurs. It was emphasised above that the EMH is a joint hypothesis, embodying essentially
the rational expectations hypothesis and the assumption of risk neutrality. The question is,
therefore, which branch of this joint hypothesis is contravened, or indeed whether there is
evidence against both rationality and risk neutrality. Consider ®rst the issue of risk neutrality.
A signi®cant intercept term in the estimation of equation (3) would be consistent with the
presence of a constant risk premium. In Table III, for Versions 1 and 2 of equation (3), the
estimates of á are not signi®cant. It has been decided, therefore, to represent a time varying
risk premium as the conditional standard deviation of the residuals of equation (3) (see
Engle, Lilien and Robins, 1987), and to test the hypothesis that the coef®cient of this
standard deviation is signi®cant [ H 0 (ø 6 0)], against the alternative hypothesis that it is not
signi®cant [ H 1 (ø 0)]. The augmented version of equation (3) is
X
2 p
A t k ÿ Pt, t k á â j (A tj ÿ P tÿ
j
k, t ) ø ht e t (5)
j1
where k2
j 1 for COB
2 for Palo Verde
ø is a coefficient to be estimated
h t Var(e t je tÿ1 ), i:e: h t is the conditional variance of e t :

The Akaike Information Criterion suggested that the conditional variance of e t should be
represented as a GARCH process for Version (1) of equation (5) (see Bollerslev, 1986), and
as EGARCH process for Version (2) (see Nelson, 1991), to capture the evidently asymmetric
relationship between news and volatility in the latter case. General to speci®c modelling
resulted in a GARCH (2, 1) model for Version (1), and an EGARCH (1, 1) model for Version
2 (see Maddala and Kim, 1998, pp. 78, 191). The mean equation for Versions (1) and (2) are
therefore as represented in equation (5), while the variance equation for Version (1) is
h t á0 á1 e2tÿ1 á2 e2tÿ2 â1 h tÿ1 (6)
and the corresponding variance equation for Version (2) is

e tÿ1 e tÿ1
ln h t á0 á1 p â1 ln h tÿ1 ã1 p (7)
h tÿ1 h tÿ1
Equations (5), (6) and (7) were estimated by maximum likelihood (ML), and the results are
presented in Table IV, where it can be seen that the hypothesis H 0 (ø 6 0) is not rejected,
thus supporting the view that a time varying risk premium was present in these markets
during the period 1996 (04) to 1999 (12).
Although there is evidence that the assumption of risk neutrality does not hold during the
longer sample period, it is possible also that the assumption of rational expectations is
violated. In this paper it is not possible to test the rational expectations hypothesis (REH)
2001
Table IV Coef®cient Estimates: Equations (5), (6), (7)y
Version (Dep. Var.) á^ á^0 á^1 á^2 â^1 â^2 ^

Ø ã^1
(1) (COB) 14.2990 ± ± ± ÿ0:2033 ÿ0:4688 ÿ2:7131 ±
(14.152) ± ± (ÿ1:737) (ÿ3:479) (ÿ17:907)
(1) h t ± 10.6599 0.4921 0.4853 ÿ0:4275 ± ± ±
(3.907) (4.724) (7.021) (ÿ3:400)
(2) (Palo Verde) 99.9383 ± ± ± ÿ0:2838 0:1608 ÿ28:161 ±
(34.830) (ÿ2:823) (2:397) (ÿ29:664)
(2) In h t ± 3.4497 0.0134 ± ÿ0:0553 ± ± ÿ0:3818
(624.801) (0.959) (ÿ12:394) (ÿ153:430)
y
Estimation is by ML; the number of observations is 42; asymptotic t statistics are in parentheses.
489
directly, because the paper does not employ a simultaneous model of spot and futures price
determination in which the REH is embedded. Instead evidence will be sought that agents
are still learning the true model driving the economy, i.e. that agents have not yet formed
rational expectations.
In Stein (1986, pp. 163±65) the forecast error, de®ned there as in this paper, is sub-
divided into three components: these are the `Bayesian error', the ùnavoidable error' and
the risk premium. In Stein (1986) the Bayesian error is due to inef®cient use of information
by agents, and this source of error converges to zero as agents learn the true model, and the
subjective expectations of agents converge to the objective distribution of prices. Moreover,
in Stein (1986, pp. 72±74) it is shown that the variance of the Bayesian error is inversely
proportional to sample size. Second, the unavoidable error is due to random shifts in demand
(Stein, 1986, p. 164), and the expected value of this error is zero. Third, the risk premium is
said to be due to net hedging pressure and insuf®cient speculation (Stein, 1986, pp. 161,
163±64). An attempt has been made above to model the risk premium, and with the expected
value of unavoidable error at zero, attention can focus on the Bayesian error. In what follows
monthly volume will be taken as a suitable proxy for Stein's `sample size', and evidence of a
negative relationship between forecast errors and volume will be interpreted as evidence that
agents are still learning the true model, and have not formed rational expectations. In
equation (8) the hypothesis H 0 (ã , 0) will be tested against the alternative hypothesis
H 1 (ã > 0)
A t ÿ Ptÿ k, t è ãVt e t (8)
where è, ã are parameters to be estimated; V monthly volume of trading in electricity
futures contracts for COB, Palo Verde.
The volume variable, however, is I(1) for both COB and Palo Verde contracts: for COB
the Phillips-Perron unit root test statistic is ±1.9950 (10% critical value ÿ2:6021), while
for Palo Verde the Phillips-Perron statistic is ÿ1:5907 (same critical value). To render the
residuals of (8) stationary, the ®rst difference of volume was employed, and the hypothesis is
addressed that forecast errors vary negatively with changes in volume, as expressed in
equation (9)
A t ÿ Ptÿ k, t ö1 ö2 ÄVt e t (9)
Equation (9) was estimated by IV for the COB and Palo Verde contracts, the errors were
represented as ARMA (2, 2) and ARMA (1, 1) processes respectively, and the hypothesis
H 0 (ö2 , 0) was tested against the alternative hypothesis H 1 (ö2 > 0). These estimates are
provided in Table V, where it can be seen that the hypothesis H 0 (ö2 , 0) is not rejected for
the COB contract, but is rejected for Palo Verde. This evidence suggests that, at least in the
case of COB, agents are still learning the true model driving the market, and have not
formed rational expectations during the sample period employed.
With the rejection of the EMH for the full sample period 1996 (04) to 1999 (12), and non-
rejection for the sub-period 1998 (07) to 1999 (12), the question is whether agents were
engaged in learning the true model driving these markets during the ®rst sub-period 1996
(04) to 1998 (06). If so, the evidence should favour rejection of the EMH during the ®rst
sub-period. Non-rejection of the EMH for the ®rst sub-period coupled with rejection for the
full sample period would mean that an explanation would have to be sought in terms of other
factors, such as a structural break in the data, for these contrasting outcomes for the COB
and Palo Verde contracts.
To investigate the learning issue, equation (3) was estimated for sub-period 1, when COB
Table V Coef®cient Estimates: Equation (9){
Contract Coef®cient Variable Estimate t statistic DW

COB ö1 constant 1:0758 4:457
ö2 ÄVt ÿ0:0010 ÿ2:687
AR (2) 0:3598 1:614
MA (2) ÿ0:8948 ÿ6:204 1.9902
Palo Verde ö1 constant 1:1473 0:9870
ö2 ÄVt ÿ0:0006 ÿ1:226
AR (1) ÿ0:2541 ÿ1:393
MA (1) 0:8120 8:846 1:9178
{ Estimation is by IV; 39 observations after adjusting endpoints; DW is the Durbin Watson statistic.
and Palo Verde contracts only were traded. Tests for stationarity with COB and Palo Verde
spot and futures price data indicate that spot and futures prices for both contracts are non-
stationary for sub-period 1, although for both contracts the current forecast errors are I(0)
(see Appendices 3A and 3B). Estimates of equation (3) for sub-period 1 are provided in
Appendix 4, together with estimated
P2 autocorrelation coef®cients and calculated ÷ 2 statistics
to test the hypothesis H 0 (á, j1 â j 0). The calculated ÷ 2 statistics suggest that, at the 10
per cent level of signi®cance, the EMH cannot be rejected for either contract.3
This outcome for sub-period 1, when compared with that for the full sample period, is not
compatible with the view that agents were learning the true model from 1996 (04) to 1998
(06). It suggests, rather, that some other factor, such as a structural break, had an impact on
the data.
It is plausible to test for structural change during 1998, ®rst because the Cinergy and
Entergy contracts were launched in July 1998, and second because 1998 was a year of
especially low net additions to generating capacity in California (see Kahn and Lynch, 2000,
p. 22). In this paper the test of Chow (1960) is employed to test the hypothesis that a single
structural break occurred in the COB and Palo Verde data at end (06) 1998.
The Chow test addresses the null hypothesis of structural stability against the alternative
hypothesis of structural change, for stationary variables with a single known break point.
The test assumes that the variables are homoscedastic, and was executed in this case by
estimating equation (3), with COB and Palo Verde data, for the full sample period, and for
the sub-periods (04) 1996 to (05) 1998 and (07) 1998 to (12) 1999. The resulting F statistics
to test the null of stability are, for COB as dependent variable, F 0:1075 ( pr value 0.954),
and with Palo Verde as dependent variable, F 0:1348 ( pr value 0.937). In neither case can
the null hypothesis be rejected, and these tests do not support the view that a structural
change occurred in these data at end (06) 1998. The explanation for the contrasting
outcomes in tests of the EMH, between the ®rst sub-period and the full sample, therefore,
must be sought elsewhere.
It is suggested that these contrasting results of tests of the EMH can be explained in part
by the monthly trading volumes of the COB and Palo Verde contracts, which both begin a
continual decline after (06) 1998 ( observation 27, see Figures 1 and 2). It will be recalled
that in the discussion above on the `Bayesian error' of Stein (1986), monthly volume was
3
A correction for ®rst order autocorrelation was made for the Palo Verde contract, and for second
order autocorrelation for COB. The diagnostic tests, reported in Appendix 5, indicate that the residuals
of these regressions are stationary, normally distributed and not autocorrelated.
20,000
16,000
Contracts / Month
12,000
8,000
4,000
0
Apr-96 Oct-96 Apr-97 Oct-97 Apr-98 Oct-98 Apr-99 Oct-99
Figure 1. Volume ± California Oregan Border

25,000
20,000
Contracts / Month
15,000
10,000
5,000
0
Figure 2. Volume ± Palo Verde
employed as a proxy for Stein's sample size. Bayesian error, which re¯ects the inability of
agents to make ef®cient use of information, varies inversely with sample size. It is suggested
in this case, therefore, that the decline in trading volume implies a reduction in the ability of
agents to make full use of available information, and possibly may account, at least in part,
for rejection of the EMH for the full sample period.
V. C o n c l u s i o n s a n d R e l e va n c e t o R e c e n t E x p e r i e n c e
This paper investigates whether US electricity futures prices re¯ect public information as
fully as possible. The forecast error approach, which assumes that a relevant set of public
information can be represented by prior forecast errors of own and related commodities, is
employed to test the ef®cient markets hypothesis (EMH). Estimation is by instrumental
variables, in order to obtain consistent estimates, in the presence of a lagged dependent
variable with serially correlated errors.
For the sample period 1996 (04) to 1999 (12), when the California-Oregon Border (COB)
and Palo Verde contracts were traded, the results suggest the EMH should be rejected. A
Johansen cointegration test suggests that the futures prices for these two contracts, which are
I(1) variables, are cointegrated, which is consistent with these results. The signi®cance of the
conditional standard deviation in the mean equation suggests the possible presence of a time
varying risk premium. A negative relationship between forecast errors and volume, at least
for the COB contract, indicates that agents have not formed rational expectations but are still
learning the true model driving the market.
For the sample period 1998 (07) to 1999 (12) during which the Cinergy contact also was
traded (Entergy data were not employed because of insuf®cient trading volume), the results
suggest that the EMH cannot be rejected. A Johansen cointegration test suggests that the
futures prices for these contracts are not cointegrated, which is consistent with these results.
(Data for the Pennsylvania-New Jersey-Maryland contract, which began trading in March
1999, were not employed, because of an inadequate number of observations of the prices of
this contract).
The policy implications of these results are likely to be of greater signi®cance to investors
in power generating facilities rather than to retail consumers of electricity. Investors are
likely to be interested in knowing whether the price signals to which they respond are
misleading, with respect to their implications for resource allocation. The interest of retail
consumers, however, is more likely to identi®ed with the level of electricity prices, rather
than with non-rejection of the EMH. While an objective of deregulation may be to provide
consumers with lower prices, in practice deregulation is no guarantee that electricity prices
will not, on occasions, reach high levels, as the recent experience of California shows (see
Australian Financial Review, 10 January 2001; pp 1,8; Environmental News Network, 12
August 2000: www.enn.com).
What is the relationship between this study and recent experience in California, where
retail rates for some residential consumers are twice the US national average, wholesale
prices at certain times in June 2000 were more than seven times wholesale prices at
comparable times in June 1999, and interruptions and blackouts occurred. High electricity
prices experienced recently in California re¯ect inter alia the market structures for the
determination of wholesale and retail prices, and for the supply of electricity. In particular,
the real time market, where the Independent System Operator (ISO) acts as a `buyer of last
resort', can result in very high prices if peak demand exceeds the available supply bid into
the day ahead market through the California Power Exchange (PX) (see Kahn and Lynch,
2000). Moreover, shortage of supply evidently was a factor leading to high prices experi-
enced recently (e.g. June 2000). It is noteworthy that during the period 1996±99 only
672MW was added to generating capacity in California, which represents an increase of
1.2% in the pre-existing capacity of 55,500MW. Peak demand, in contrast increased by
5,522MW or about 10 per cent during the same period (Kahn and Lynch, 2000, p. 22).
The link between this study and recent Californian experience is two fold. First, the spot
and futures prices employed in this paper should provide market signals to power plant
investors about the desirability of new investment in generating capacity. As the unit root
tests for COB in the period 1996 (04) to 1998 (06) indicated, both prices were I(1) during
this period (see Appendices 3A and 3B), and Figure 3 shows that COB prices had an upward
trend. Kahn and Lynch (2000, pp. 6, 22) claim that investment in new capacity in California
1996±99 was discouraged by both state and federal regulatory policies.
Second, during the recent period of high wholesale prices for electricity in California, it is
not clear whether purchasers of electricity in the wholesale market hedged against price
rises, and whether these cost savings were passed on to retail consumers.4 Indeed, Kahn and
50
40
30
US$ / MWH
20
10
0
Figure 3. Spot Prices ± California Oregon Border
4
Retail customers of some California power companies (e.g. Paci®c Gas and Electric Company (PG)
and Southern California Edison Company (Edison) are insulated from rises in wholesale prices by a
temporary freeze in retail rates. Customers of companies for which the rate freeze had ended prior to
June 14, 2000 (such as San Diego Gas and Electric Company) were exposed to the effects of higher
wholesale prices. (Kahn and Lynch, 2000, pp. 11±13)
Lynch (2000, pp. 18, 170) assert that the ISO is restricted in its ability to use ®nancial
instruments to reduce its price exposure, and that utility distribution companies are similarly
placed. It is suggested by the present authors that risk management through hedging should
be mandatory for buyers and sellers of electricity in the wholesale market in California, and
that cost savings achieved through hedging should be passed on to retail consumers. This
would reduce some of the short term pain in California. Medium term measures, such as
allowing the ISO to enter into long term contracts, and long term policies, such as
encouraging creation of new generator capacity, and improving transmission lines, then can
be employed to address the dif®culties.
A p p e n d i x 1 D i a g n o s t i c Te s t s o n R e s i d u a l s : E q u at i o n (3)
Version 1 Version 2 Version 3 Version 4 Version 5

Test COB Palo Verde COB Palo Verde Cinergy
Ljung-Box Q Stat.
Calculated ÷ 2 12:915 10:399 14:472 15:001 9:8800
Probability 0:843 0:942 0:272 0:241 0:626
Phillips-Perron Test
Calculated PP Stat. ÿ6:1000 ÿ5:7631 ÿ3:3965 ÿ3:0943 ÿ3:0862
10% Critical Value ÿ2:6069 ÿ2:6069 ÿ2:7042 ÿ2:7042 ÿ2:7042
Jarque-Bera Test
Calculated Test Stat. 1:6820 0:2640 0:6959 0:5074 0:6750
Probability 0:4313 0:8764 0:7061 0:7759 0:7135
A p p e n d i x 2 C o i n t e g r at i o n o f Fu t u r e s P r i c e s
Calculated Test 5% Critical

Test Contracts Statistic Value Null Hypothesis
Johansen Maximum COB 39.241 25.32 m0
Eigenvalue
Palo Verde 9.544 12.25 m<1
Johansen Maximum COB 41.987 42.44 m0
Eigenvalue
Palo Verde 18.338 25.32 m<1
Cinergy 6.491 12.25 m<2
A p p e n d i x 3 A Un i t Ro o t Te s t s : Au g m e n t e d D i c k e y- Fu l l e r
Sub-period 1996(04) to 1998(06)
Calculated Test 10% Critical Order of

Variable Statistic Value Integration
COB
Ptÿ k, t ÿ3:0905 ÿ3:2474 I(1)
At ÿ2:6544 ÿ3:2367 I(1)
A t ÿ Ptÿ k,t ÿ4:3719 ÿ2:6318 I(0)
Palo Verde
Ptÿ k, t ÿ2:3214 ÿ3:2474 I(1)
At ÿ2:3134 ÿ3:2367 I(1)
A t ÿ Ptÿ k, t ÿ3:7815 ÿ2:6318 I(0)
A p p e n d i x 3 B Un i t Ro o t Te s t s : P h i l l i p s - P e r r o n
Sub-period 1996(04) to 1998(06)
Calculated Test 10% Critical Order of

Variable Statistic Value Integration
COB
Ptÿ k, t ÿ1:8324 ÿ2:6290 I(1)
At ÿ2:2049 ÿ3:2321 I(1)
A t ÿ Ptÿ k,t ÿ3:4585 ÿ2:6290 I(0)
Palo Verde
Ptÿ k, t ÿ1:6470 ÿ3:2321 I(1)
At ÿ1:8349 ÿ3:2321 I(1)
A t ÿPtÿ k,t ÿ3.2085 ÿ2.6290 I(0)
2001
A p p e n d i x 4 C o e f f i c i e n t E s t i m at e s : E q uat i o n s (3):
S u b - p e r i o d 19 9 6 (0 4 ) t o 19 98 (0 6 )
Coef®cient Estimates: Equations (3): Sub-period 1996(04) to 1998(06)
Version (Dep.Var.) á^ â^1 â^2 ^1

r ^2
r N Calculated ÷ 2 DW
(1) (COB) 2.5020 0.2586 ÿ0:5500 0.4564 ÿ0:5042 25 3.666 2.0145
(1.699) (0.489) (ÿ0.915) (1.814) ÿ(2.985)
(2) (Palo Verde) 2.7165 0.0647 ÿ0:5503 0.6224 ± 26 3.411 1.7864
(1.416) (0.116) (ÿ0.868) (3.706)
Estimation is by IV; N is number of observations; r ^2 are estimated AR(1) and AR(2) coefff®cients respectively; t statistics are in parentheses; DW is
^1 and r
Durbin-Watson statistic; Critical (0:10)÷ 2 (3) 6:25.
497
A p p e n d i x 5 D i a g n o s t i c Te s t s o n R e s i d u a l s : E q uat i o n ( 3)
Sub-period 1996(04) to 1998(06)
Version 1 Version 2
Test COB Palo Verde
Ljung-Box Q Stat.
Calculated ÷ 2 9:3974 10:355
Probability 0:495 0:585
Phillips-Perron Test
Calculated PP Stat. ÿ4:7630 ÿ4:6397
10% Critical Value ÿ2:6348 ÿ2:6318
Jarque-Bera Test
Calculated Test Stat. 1:0206 0:7496
Probability 0:6003 0:6874
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14678454, 2001, 4, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1467-8454.00138 by CCI RA - Grenoble Em, Wiley Online Library on [22/10/2022].

I. Int ro duct ion

III. Data , S tat i o n a r i t y, C o i n t e g r at i o n a n d E s t i m at i o n

Tests for stationarity and cointegration

where Z is an economic variable; t is a time trend; ì is constant; â, ã, ö are coef®cients to

Table Ia Unit Root Tests: Augmented Dickey-Fuller

Variable Calculated Test Statistic 10% Critical Value Order of Integration

Table Ib Unit Root Tests: Phillips-Perron

Variable Calculated Test Statistic 10% Critical Value Order of Integration

Table II Johansen Maximum Eigenvalue Test

2 for Palo Verde

Diagnostic tests on residuals

FORECAST ERRORS AND EFFICIENCY

 2 for Palo Verde

h t  Var(e t je tÿ1 ), i:e: h t is the conditional variance of e t :

Version (Dep. Var.) á^ á^0 á^1 á^2 â^1 â^2 ^

Table V Coef®cient Estimates: Equation (9){

Contract Coef®cient Variable Estimate t statistic DW

Figure 1. Volume ± California Oregan Border

Figure 2. Volume ± Palo Verde

Figure 3. Spot Prices ± California Oregon Border

Version 1 Version 2 Version 3 Version 4 Version 5

Calculated Test 5% Critical

Sub-period 1996(04) to 1998(06)

Calculated Test 10% Critical Order of

Sub-period 1996(04) to 1998(06)

Calculated Test 10% Critical Order of

Coef®cient Estimates: Equations (3): Sub-period 1996(04) to 1998(06)

Version (Dep.Var.) á^ â^1 â^2 ^1

Sub-period 1996(04) to 1998(06)

Bollerslev, T. 1986, `Generalized autoregressive conditional heteroskedasticity', Journal of

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2 for Palo Verde

h t Var(e t je tÿ1 ), i:e: h t is the conditional variance of e t :