We analyze welfare properties of two-settlement systems for electricity in the presence of network uncertainty and market power. We formulate and analyze several models which simulate the different market designs adopted or proposed for many electricity markets around the world. In particular, we examine the extent to which a two-settlement system with zonal aggregation in the forward market facilitates forward trading, as well as the welfare and distributional implications of having such zonal aggregation in the presence of network uncertainty. Using a duopoly model over simple two- and three-node networks, we show that for even small probabilities of congestion, forward trading may be substantially reduced, and the market power mitigating effect of forward markets (as shown in Allaz and Vila, 1993) may be nullified to a great extent. We find that the imposition of a delivery requirement on the forward contract in the form of a spot transmission charge alleviates some of the incentive problems associated with zonal aggregation. Even with the imposition of the spot transmission charge, we find that some reduction in forward trading persists due to the segregation of the markets in the constrained state, and the absence of natural incentives for generators to commit to more aggressive behavior in the spot market. In our analysis, we find that the standard assumption of ‘no-arbitrage’ across forward and spot markets leads to very little contract coverage even in the no congestion case. We provide an alternative view of the market where we assume that all of the demand shows up in the forward market, and is aggregated to determine the forward price using a ‘market clearing’ condition.

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