Abstract
We test the efficiency of the California electricity reserves market by examining systematic differences between its dayโ and hourโahead prices. We uncover significant dayโahead premia, which we attribute to market design characteristics. On the demand side, the market design established a principalโagent relationship between the markets' buyers (principal) and their supervisory authority (agent). The agent had very limited incentives to shift reserve purchases to the lower priced hourโahead markets. On the supply side, the market design raised substantial entry barriers by precluding purely speculative trading and by introducing a complicated code of conduct that induced uncertainty about which actions were subject to regulatory scrutiny. We use a highโdimensional vector moving average model to estimate the premia and conduct correct inferences. To obtain exact maximum likelihood estimates of the model, we develop a new EM algorithm that seamlessly incorporates missing data and applies directly to general moving average time series models. Our algorithm uses only analytical expressions: the Kalman filter and a fixed interval smoother in the E step and least squaresโtype regressions in the M step. Copyright ยฉ 2007 John Wiley & Sons, Ltd.