Kenneth R. Zimmerman, Ph.D. Senior Analyst Oregon Public Utility Commission

1. The Regulation of US Electricity Markets and the “Efficient Market Hypothesis:” A Story of Failure and Backtracking Kenneth R. Zimmerman, Ph.D. Senior Analyst Oregon Public Utility Commission ken.zimmerman@state.or.us

2. Efficient Market Hypothesis (EMH) • Even the weakest version of EMH asserts that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong version asserts that prices reflect all publicly available information and instantly change to reflect new information. • Its proponents claim that because of EMH it is not possible to consistently outperform the market by using any information that the market already has, except through insider trading or other informational subterfuge • In the EMH information is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future. Markets are rational because of EMH • The results in markets are often summarized by the phrase “random walk” to show more clearly that rational markets, EMH markets, cannot be outguessed or manipulated by using secret or limited information SASE 2010 Meeting Philadelphia

3. EMH and Wholesale and Retail Electricity Markets • As described above both the wholesale electricity and natural gas markets created by FERC and the retail electricity markets created by states (but dependent on FERC wholesale constructions) use EMH as a foundation • In that case information about electricity prices in these markets should be fully available, transparent, and reliable. Also with EMH as a foundation it should not be possible for any agent to manipulate prices in these markets except through the use of insider information • Similarly, states generally assumed in creating retail electricity markets (and the few natural gas markets constructed) that EMH was how markets were supposed to and did operate SASE 2010 Meeting Philadelphia

4. EMH Fails in Electricity Markets • But EMH appears not to have lived up to its expectations • Almost since the outset lack of clear, transparent, and reliable information about prices and the data and decisions that underlie prices has been a topic of concern in the wholesale and retail electricity and natural gas markets • Accusations about manipulation of electricity and natural gas prices by various markets agents have been the norm also • With the exception of clearly visible manipulation of prices by state legislatures, FERC, RTOs, and the US Congress, there has been little effort to identify or prove manipulation by agents selling and purchasing natural gas or electricity. In part this lack of effort is a result of the difficulty in clearly identifying actions that are and are not manipulative agents’ intentions in taking actions • Clearly the concerns about information uncertainty and reliability, and price manipulation cannot be resolved or even fully explained through laws, orders, policy statements, or workshops SASE 2010 Meeting Philadelphia

5. Removing EMH from Electricity Markets • It appears neither policy makers nor economists understand wholesale or retail electricity and natural gas markets and their workings • Both appear to assume that EMH is valid and controls the functioning of these markets • But if EMH does not explain these markets what does? This is a complicated question • This paper presents a short overview of some of the efforts of FERC, RTOs, states, and Congress to answer this question, mostly without success • Giving up the belief in EMH is certainly a move in the right direction. It would clear the path for detailed descriptions of how these markets function, what interests actors pursue, and how actors calculate to obtain their interests • Regulators and policy makers with this agenda are both more effective and more humble. Both make them more effective regulators and make the markets they oversee more likely to create prices that satisfy the interests of all market participants SASE 2010 Meeting Philadelphia