Typically, in competitive electricity markets, the vertically integrated utilities that were responsible for ensuring system reliability in their own service territories, or groups of territories, cease to exist. The burden falls to an independent system operator (ISO) to ensure that enough ancillary services (AS) are available for safe, stable, and reliable operation of the grid, typically defined, in part, as compliance with officially approved engineering specifications for minimum levels of AS. In order to characterize the behavior of market participants (generators, retailers, and an ISO) in a competitive electricity market with reliabililty requirements, spot markets for both electricity and AS are modeled. By assuming that each participant seeks to maximize its wealth and that all markets cledar, we solve for the optimal quantities of electricity and AS traded in the spot market by all participants, as well as the market clearing prices for each.

California's restructured electricity markets opened on 1 April 1998. The former investor-owned utilities were functionally divided into generation, transmission, and distribution activities, all of their gas-fired generating capacity was divested, and the retail market was opened to competition. To ensure that small customers shared in the expected benefit of lower prices, the enabling legislation mandated a 10 percent rate cut for all customers, which was implemented in a simplistic way that fossilised 1996 tariff structures. Rising fuel and environmental compliance costs, together with a reduced ability to import electricity, numerous plant outages, and exercise of market power by generators drove up wholesale electricity prices steeply in 2000, while retail tariffs remained unchanged. One of the distribution/supply companies entered bankruptcy in April 2001, and another was insolvent. During this period, two sets of interruptible load programmes were in place, longstanding ones organised as special tariffs by the distribution/supply companies and hastily established ones run directly by the California Independent System Operator (CAISO). The distribution/supply company programmes were effective at reducing load during the summer of 2000, but because of the high frequency of outages required by a system on the brink of failure, customer response declined and many left the tariff. The CAISO programmes failed to attract enough participation to make a significant difference to the California supply demand imbalance. The poor performance of direct load participation in California's markets reinforces the argument for accurate pricing of electricity as a stimulus to energy efficiency investment and as a constraint on market volatility.