Efficiency and Liquidity in the Electricity Market: A Preliminary Analysis

Following varying degrees of deregulation of the New South Wales and Victorian electricity markets, consumers in those states have faced market determined prices, and since September 1997 instruments for risk management, in the form of electricity futures contracts, have been available. This paper addresses two important questions in relation to these new markets. The first is whether the electricity futures prices, determined on the Sydney Futures Exchange, reflect all publicly available information as fully as possible. This issue is investigated by the forecast error approach, which permits a test of the semi-strong efficient markets hypothesis (EMH). Rejection of this hypothesis would imply that agents are responding to price signals which are not of the best possible quality, so that unarbitraged profit opportunities remain, and some misallocation of resources could occur. The second question addressed is whether there is evidence of increasing returns to liquidity in this market. Liquidity is measured here by the standard deviation of market clearing prices, and a simple binomial model is employed to generate the hypothesis of increasing returns. An implication of support for the hypothesis of increasing returns is that larger markets could be expected to grow further, and contracts with smaller volumes could be expected to disappear. This would apply also to multiple contracts in the same commodity. The results suggest first, that the EMH cannot be rejected, and second, that there is no significant relationship between volume and liquidity in these markets at this stage.