Skip to main content
diversification.com
← Back to F Definitions

Financial transmission rights

What Are Financial Transmission Rights?

Financial transmission rights (FTRs) are financial instruments used in organized electricity markets to hedge against the risk of transmission congestion charges. These rights do not grant the holder physical access to the transmission system or the ability to schedule power delivery; rather, they provide a financial entitlement to receive or an obligation to pay a sum based on the difference in electricity prices between two specific points on the transmission grid. As such, FTRs fall under the broader category of energy markets and serve a critical risk management function for market participants. They are a form of derivative product designed to offset financial losses incurred when the flow of electricity is constrained, leading to varying prices across different locations.

History and Origin

The concept of financial transmission rights emerged as electricity markets in the United States began to deregulate in the late 1990s. With the advent of competitive wholesale markets, the efficient allocation and pricing of transmission capacity became crucial. The Federal Energy Regulatory Commission (FERC) played a pivotal role in this evolution, promoting open access to the transmission grid. FERC Order No. 888, issued in 1996, mandated non-discriminatory open access to transmission services, which facilitated the formation of Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) to manage regional grids and wholesale power markets9.

Within this framework, the problem of transmission congestion arose. When demand for transmission capacity exceeds available supply on a particular path, congestion occurs, leading to different electricity prices at various locations (known as Locational Marginal Pricing or LMP). To mitigate the financial exposure of market participants to these volatile congestion charges, FTRs were introduced. The PJM Interconnection, one of the first and largest Regional Transmission Organizations in the U.S., was among the pioneers in implementing FTRs. Later, FERC further solidified the importance of FTRs by issuing Order No. 681 in 2006, which required transmission organizations with organized markets to offer long-term Firm Transmission Service and associated financial rights to market participants, often in the form of FTRs8,7.

Key Takeaways

  • Financial transmission rights (FTRs) are financial instruments that hedge against the risk of transmission congestion charges in electricity markets.
  • They provide a financial payment based on locational price differences, not physical delivery of electricity.
  • FTRs help market participants manage price volatility caused by grid congestion.
  • They are typically acquired through auctions conducted by Independent System Operators (ISOs) or Regional Transmission Organizations (RTOs).
  • While FTRs can offer a valuable hedge against congestion costs, their effectiveness can be influenced by market design and liquidity.

Formula and Calculation

The value of a Financial Transmission Right (FTR) is directly tied to the difference in Locational Marginal Pricing (LMP) between its specified source and sink points on the electricity grid. An FTR entitles the holder to a payment equal to the product of the FTR's awarded megawatt (MW) quantity and the LMP difference over a given period.

The calculation for the payout of an FTR obligation for a specific hour can be expressed as:

FTR Payout=FTR MW×(LMPSink−LMPSource)\text{FTR Payout} = \text{FTR MW} \times (\text{LMP}_{\text{Sink}} - \text{LMP}_{\text{Source}})

Where:

  • (\text{FTR MW}) = The megawatt quantity of the Financial Transmission Right.
  • (\text{LMP}_{\text{Sink}}) = The Locational Marginal Price at the delivery point (sink) of the FTR.
  • (\text{LMP}_{\text{Source}}) = The Locational Marginal Price at the receipt point (source) of the FTR.

If the LMP at the sink is higher than the LMP at the source, the FTR holder receives a positive payment, offsetting potential congestion charges. Conversely, if the LMP at the sink is lower than the LMP at the source, the FTR holder incurs a payment obligation. This direct correlation makes FTRs an effective hedge against adverse price spreads caused by transmission congestion.

Interpreting Financial Transmission Rights

Interpreting Financial Transmission Rights primarily involves understanding their purpose as a financial offset to transmission congestion costs. An FTR's value is realized when there's a price difference between its designated source and sink nodes. If the price at the sink is higher than the price at the source, the FTR generates revenue for its holder, effectively reimbursing them for the congestion charges they might incur when moving power across that path. This makes FTRs valuable to entities that plan to transport electricity from a lower-priced generation area to a higher-priced load area.

Conversely, if the price at the sink is lower than the source, the FTR incurs a loss for the holder. This underscores that FTRs are not merely a source of income but a financial obligation that requires careful risk management. Market participants holding FTRs monitor real-time and Day-Ahead Market LMP differences to assess the profitability or cost associated with their FTR positions. Their effectiveness lies in their ability to provide predictability and financial certainty in a grid often subject to unpredictable congestion.

Hypothetical Example

Consider an electricity market participant, PowerCo, which operates a power plant in Zone A (source) and sells electricity to customers in Zone B (sink). Historically, the transmission line between Zone A and Zone B experiences frequent transmission congestion, causing the price in Zone B to often be higher than in Zone A. PowerCo wants to mitigate this price risk.

In an annual FTR auction, PowerCo bids for and acquires a 100 MW Financial Transmission Right (FTR) from Zone A to Zone B for a specific year. Let's assume the FTR clearing price in the auction was $5/MW-hour.

On a particular day, due to line outages, the transmission path between Zone A and Zone B becomes congested.

  • The Locational Marginal Pricing (LMP) in Zone A is $40/MWh.
  • The LMP in Zone B is $60/MWh.
  • The congestion charge for PowerCo's physical power flow from Zone A to Zone B would be $20/MWh ($60 - $40).

Since PowerCo has a 100 MW FTR, the FTR payout for that hour would be:

(\text{FTR Payout} = 100 \text{ MW} \times (\text{$60/MWh} - \text{$40/MWh}) = 100 \text{ MW} \times \text{$20/MWh} = \text{$2,000})

This $2,000 FTR payout offsets the $2,000 in congestion charges PowerCo would have paid for its 100 MW of power flowing from Zone A to Zone B. In this scenario, the Financial Transmission Right acted as a perfect hedge, neutralizing the impact of congestion costs on PowerCo's profitability for that hour.

Practical Applications

Financial transmission rights (FTRs) are primarily applied within organized electricity markets to manage financial exposure to transmission congestion. Their main practical applications include:

  • Congestion Hedging: The most direct use of FTRs is to provide a financial hedge against congestion charges. Load-serving entities (LSEs) and generators use FTRs to lock in a financial position that offsets the variable costs associated with price differences caused by grid constraints. The PJM Interconnection, for example, extensively uses FTRs (and Auction Revenue Rights which convert to FTRs) to provide market participants with the ability to offset congestion costs incurred in its Day-Ahead Market6,5.
  • Price Certainty for Bilateral Transactions: Market participants engaged in long-term power purchase agreements or other direct energy sales between a source and a sink can acquire FTRs to gain price certainty. This allows them to effectively fix the transmission component of their costs, reducing exposure to volatile spot market prices driven by congestion.
  • Revenue Adequacy for Transmission Owners: The revenues generated from FTR auctions often help fund the operations and maintenance of the transmission system. In some markets, these revenues are used to compensate holders of Auction Revenue Rights, which are initially allocated to firm transmission customers.
  • Signaling Investment: While primarily financial, the prices of FTRs in auctions can provide signals about where transmission capacity is most constrained and valuable. High FTR prices on a specific path might indicate a need for new transmission infrastructure, providing economic signals for future investment. The New York Independent System Operator (NYISO), for instance, continuously evolves its market design to ensure that such signals are efficient and contribute to reliability4.

Limitations and Criticisms

While Financial Transmission Rights offer significant benefits for managing transmission congestion risk, they also come with limitations and criticisms:

  • Basis Risk: FTRs are typically settled against Day-Ahead Market Locational Marginal Pricing (LMP) differences. However, real-time prices can diverge significantly from day-ahead prices due to unforeseen events like forced outages or sudden demand shifts. This difference, known as basis risk, means that FTRs may not provide a perfect hedge against all congestion costs, particularly those that manifest in the real-time market3. Academic research highlights that even in theory, FTRs may not serve as a perfect hedge against congestion charges2.
  • Revenue Adequacy Issues: In some instances, the total congestion revenue collected by the Independent System Operator (ISO) or Regional Transmission Organization (RTO) may be insufficient to cover all FTR payouts. This "revenue inadequacy" can occur if the actual system conditions (e.g., unexpected outages) deviate substantially from the models used to award FTRs. When this happens, FTR holders might receive prorated payments, reducing their effectiveness as a full hedge.
  • Complexity and Strategic Bidding: FTR markets can be complex, requiring sophisticated modeling and bidding strategies from participants. This complexity can create barriers to entry for smaller participants and potentially lead to strategic bidding behavior aimed at influencing FTR prices or creating artificial congestion, which could impact market efficiency and fairness1.
  • Allocation Challenges: The initial allocation of FTRs or underlying Auction Revenue Rights can be contentious. Determining who has priority for these rights, especially those supported by existing transmission capacity, can impact different market participant groups, such as load-serving entities versus financial speculators.

Financial Transmission Rights vs. Congestion Revenue Rights

While both Financial Transmission Rights (FTRs) and Congestion Revenue Rights (CRRs) serve the purpose of hedging against transmission congestion costs in electricity markets, their terminology and specific market mechanisms differ across various Independent System Operator (ISO) or Regional Transmission Organization (RTO) jurisdictions. Essentially, FTRs are the term predominantly used by ISOs like PJM Interconnection and the New York Independent System Operator (NYISO), while CRRs are the equivalent instruments used by the California Independent System Operator (CAISO). Both provide a financial offset for the difference in Locational Marginal Pricing between a source and a sink, meaning they function as a financial hedge rather than a physical right to transmit power. The confusion often arises because the underlying economic function is identical, but the specific names are jurisdiction-dependent.

FAQs

What is the primary purpose of Financial Transmission Rights?

The primary purpose of Financial Transmission Rights (FTRs) is to provide market participants with a financial hedge against the costs associated with transmission congestion in electricity markets. They help stabilize the financial impact of varying electricity prices across different locations on the grid.

How do I acquire Financial Transmission Rights?

Financial Transmission Rights are typically acquired through auctions conducted by Independent System Operators or Regional Transmission Organizations that manage wholesale electricity markets. These auctions can be annual, monthly, or long-term, allowing participants to bid for rights over different time horizons.

Do Financial Transmission Rights grant physical use of the transmission lines?

No, Financial Transmission Rights are purely financial instruments. They do not grant the holder any physical right to transmit power or physically schedule electricity across the transmission system. They only provide a financial payout or obligation based on price differences due to transmission congestion.

Can FTRs result in a payment obligation for the holder?

Yes, FTRs can result in a payment obligation. If the Locational Marginal Pricing (LMP) at the FTR's designated sink point is lower than the LMP at its source point, the FTR holder will owe a payment, reflecting a "reverse" congestion scenario or negative price spread. This is why they are considered a financial instrument with both potential gains and losses.