Market efficiency and risk premia in short-term forward prices Erik Haugom a, ⁎ , 1 , Carl J. Ullrich b a Lillehammer University College, NO-2624 Lillehammer, Norway, and the Norwegian University of Science and Technology, NO-7491 Trondheim, Norway b Virginia Tech, Pamplin College of Business, Department of Finance, Insurance, and Business Law, Blacksburg, VA 24061, USA abstract article info Article history: Received 2 January 2012 Received in revised form 10 July 2012 Accepted 9 August 2012 Available online 24 August 2012 JEL classification: G14 G13 Q47 L94 Keywords: Market efficiency Unbiased forward rate hypothesis Joint hypothesis problem Forward prices Electricity markets Using recursive estimation and rolling windows over extended sample periods we examine the time-varying relationship between spot and short-term forward prices in the Pennsylvania–New Jersey–Maryland (PJM) wholesale electricity market. We examine theoretical models of forward risk premia in electricity markets and show that recent data do not provide support for existing models. The results indicate that short-term forward prices have converged towards unbiased predictors of the subsequent spot prices. © 2012 Elsevier B.V. All rights reserved. 1. Introduction In forward markets the risk premium, defined to be the difference between the forward price and the expected spot price, plays a central role in understanding market dynamics. Since the introduction of finan- cial electricity markets, the relationship between electricity spot and forward prices has been subject to growing interest among researchers and practitioners. The well-documented properties of electricity prices, such as strong seasonality and price spikes, 2 have led researchers to develop equilibrium models to account for the stylized features of the underlying price process and to determine specific conditions that would induce a risk premium in forward prices. The seminal example of such a model is presented in Bessembinder and Lemmon (2002). For more than a decade, agents in the liberalized Pennsylvania– New Jersey–Maryland (PJM) market have had the opportunity to hedge against real time price fluctuations by taking positions in the short-term, day-ahead forward market. Longstaff and Wang (2004) use these short-term forward prices and the subsequent realizations of spot prices to test the model of Bessembinder and Lemmon (2002). Their results indicate that there exist significant risk premia in forward prices at PJM. As liberalized electricity markets have developed only recently, it is possible that risk premia have changed. We repeat the tests of Longstaff and Wang (2004) using the most recent data from PJM. We present re- sults based on rolling windows and recursively extended samples. To our knowledge, this is the first such attempt in the literature. These analyses enable us to test for time variation in the relationship between short-term forward prices and realized spot prices, and thus indirectly allow us to examine potential market learning as well as time variation in market efficiency and/or risk premia. We make three contributions. First, our analyses show that the simple reduced form models of higher order moments of the spot price or by demand characteristics as in Bessembinder and Lemmon (2002) are not supported by the recent data. Second, in contradiction to previous studies, we find a striking lack of evidence for significantly biased predictions in recent short-term electricity forward prices at PJM. Third, we provide evidence that including other information known to market participants does not significantly improve fore- casts of future spot price compared to forecasts based on the forward price alone. We conclude that either (1) market efficiency has in- creased, (2) risk premia are reduced, or (3) both, as agents have gained experience. Energy Economics 34 (2012) 1931–1941 ⁎ Corresponding author. E-mail addresses: erik.haugom@hil.no (E. Haugom), cullr@vt.edu (C.J. Ullrich). 1 Part of this work was completed while Haugom was a Visiting Scholar at Virginia Tech. 2 This arises from very inelastic short-term demand and the fact that electricity can- not be directly stored. Even though hydro-power can be indirectly stored in reservoirs and thermal power can be stored as coal or oil, these forms of storage are not available to speculators and consumers. 0140-9883/$ – see front matter © 2012 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.eneco.2012.08.003 Contents lists available at SciVerse ScienceDirect Energy Economics journal homepage: www.elsevier.com/locate/eneco