Different Approaches to Supply Adequacy in Electricity Markets. Abstract

Transcription

1 Dfferent Approaches to Supply Adequacy n Electrcty Markets JUAN ROSELLÓN* Centro de Investgacón y Docenca Económcas (CIDE) and Harvard Unversty Abstract Ths paper studes the electrcty market desgn long run problem of ensurng enough generaton capacty to meet future demand (resource adequacy). Reform processes worldwde have shown that t s dffcult that the market alone provdes ncentves to attract enough nvestment n capacty reserves due to market and nsttutonal falures. We study several measures that have been proposed nternatonally to cope wth ths problem ncludng strategc reserves, capacty payments, capacty requrements, and call optons. The analytcal and practcal strengths and weaknesses of each approach are dscussed. Introducton The recent electrcty power crses n Calforna, New York, Italy, Norway, Sweden, Brazl, Argentna, Chle and New Zealand have dramatcally showed the mportance of a relable electrcty supply. As of 000, generaton reserves have declned n most markets snce lberalzaton. Average reserves have also decreased n most IEA markets except for the UK An extreme case s Australa where there was sgnfcant ntal overcapacty but reserves drop sgnfcantly after the reform. In the cases of UK, Sweden and PJM reserves n 000 kept smlar to those observed at the tme of the orgnal reform, but n Norway there was a decrease of % from 99 to 000, and n Calforna a decrease of 7.5% from 990 to 998. The change n reserve margns has occurred n most cases from a startng pont of large reserves so that current reserves generally reman above 6%, whch seems acceptable for relablty purposes. Lkewse, several of the examples of electrcty crses have been n systems that heavly depend upon hydropower. However, there s a growng concern on whether lberalzed markets wll be able to provde adequate ncentves for * Malng addresses: U.S.A.: John F. Kennedy School of Government, 79 JFK Street, B-34, Cambrdge, MA 038, U.S.A. Emal: juan_rosellon@harvard.edu. Mexco: Carret. Méxco-Toluca 3655, Lomas de Santa Fé, C.P. 00, Méxco D.F. Mexco. Emal juan.rosellon@cde.edu. I am grateful to Wllam Hogan for nsghtful comments. The research reported n ths paper was supported by the Repsol-YPF-Harvard Kennedy School Fellows program, the Fundacón Méxco en Harvard, and the Comsón Reguladora de Energía. Relablty n electrcty markets s usually understood as the sum of adequacy and securty standards. Adequacy (securty) s generally assocated wth the long run (short run). Securty descrbes the ablty of the system to deal wth contngences, whle adequacy refers to the ablty of the system to meet the aggregate consumer energy requrements at all tmes. Securty ncludes the so called ancllary servces (voltage support, regulaton capacty), spnnng reserves, black start capablty, etc.). See Sngh (00), and Oren (003). Annex 7. presents data on generatng reserves for IEA countres

2 suffcent nvestment n generaton capacty. Ths s partcularly problematc due to some ntrnsc characterstcs of electrcty markets such as: a) a short-term nelastc demand that mples that the (long-term) supply-demand balance cannot be acheved through a marketclearng prce; b) a lack of forward electrcty markets beyond one or two years; c) the favorable arena for strategc behavor due to the dffculty to get market clearng prces n tght stuatons, and d) fnal consumers do not feel the need to engage n long-term contracts because they are usually solated from spot prces by regulated tarffs. 3 Several measures have been proposed to ensure a suffcent amount of generaton capacty reserves. As shown n fgure, such measures mght be analyzed n terms of ther degree of centralzaton or decentralzaton wth regards to the amount of capacty and the prce of capacty (see Knopff, 00). In ths paper we carry out an analyss of each one of these measures both studyng ther theoretcal fundaments as well as ther nternatonal applcaton and assessment. Fgure Totally Centralzed vs. Totally Decentralzed Resource Adequacy We start analyzng two extreme approaches to resource adequacy and nvestment n capacty reserves. One extreme s a fully centralzed soluton where a vertcally ntegrated utlty centrally deals wth mbalances and manages congeston and ancllary servces usng ts own generaton resources. Ths s the wheelng model that s utlzed n the Unted States n areas that have not gone nto a compettve structure and that have no spot market (Hunt, 00). The Mexcan model s another example of centralzed supply adequacy 3 See Bouttes (004), and Vázquez et al (00). De Vres and Neuhoff (003) carry out an extensve analyss of the market and nsttutonal falures n the electrcty ndustry that mpedes the development of long-term contracts ncludng: lack of generators counter-partes to sgn long-term contracts, producers mperfect nformaton of the demand functon, regulatory uncertanty on whether the regulator wll mpose prce caps n perods of prce spkes, nvestment cycles due to long-lead tmes for new generaton facltes, generators market power, and so forth.

3 3 where prvate ndependent power producers sell energy to the state monopsony CFE under long-term power purchase agreements that are supported by government funds. 4 Another centralzed alternatve s the creaton of a moth ball (or strategc) reserve wth government subsdy and centralzed decsons regardng both amount and prce of capacty (see fgure ). The moth ball reserve would mply a strategc reserve of generaton capacty, 5 wth an operaton centrally controlled by the government and that would only be used durng emergences. There s of course a socal cost to ths procedure snce subsdes would be fnanced through publc funds at large. Supply of capacty reserves would then be categorzed as a publc servce oblgaton (Knopff, 00). An opposte extreme approach to resource adequacy s a fully decentralzed soluton where the market determnes the amount and prce of capacty resource that wll grant resource adequacy. Under such a soluton, the dfferent energy markets would be separated and a sequental equlbrum would be reached n the spot market, the forward energy market, the market for capacty reserves, and the forward transmsson market through the voluntary partcpaton of agents, and a mnmal supervson of an ISO (Wlson, 00). Fgure Dfferent decentralzed models have been tred nternatonally as n Texas, Calforna, Australan Vctora pool, and NETA n the Unted Kngdom. 6 The am has been n some cases (NETA) to get the system operator out of the spot markets, so that traders manage the spot market as well as manage congeston, and separate arrangements are set up for 4 See Carreón-Rodríguez, et al (003), and Madrgal and de Rosenzweg (003). 5 In Norway and Sweden there s drect ownershp of some peakng plants (Güllen, 000). 6 In England and Wales the exstng ntegrated system was substtuted wth an extreme verson of a decentralzed model that dscourages the use of mbalances and tradng n markets remote from the system operator. Accordng to Hunt (00) ths mples a reducton n the transparency of energy markets because mbalance prces do not reflect effcent contract prces.

4 4 ancllary servces. Typcally, the prmary ncome for recovery of capacty costs s the dfference between the market clearng prce and the generators margnal cost (scarcty payments). Hunt (00) argues that the basc problem of a decentralzed model s precsely that t ends up creatng prvate markets not only for spot energy, but also markets for congeston energy, markets for mbalance energy, and markets for ancllary servces. She states that all these markets deal wth the same energy product, and n an effcent market all these products would end up beng traded at the same prce. 7 In realty, these prces do not converge, and alternatvely hgher prces, shortages, bureaucracy and new transacton costs are created. Ths vew s endorsed by Joskow (003) who shows that wholesale market desgns that separate energy and ndvdual ancllary servce markets have performed poorly and have made electrcty markets subject to unlateral behavor that leads to prce ncreases. Calforna dd an actual separaton of fve electrcty markets (Hunt, 00). Some theoretcal studes try to fnd the optmalty condtons for such an approach (e.g., Wlson, 00, and Chao and Wlson, 00). However elegant n theory, 8 the electrcty ndustry practce has clearly shown the nconvenence of separatng the dfferent markets. Borensten (00) also agrees that electrcty markets do not fulfll the condtons for full competton to work, so that decentralzed sequental and effcent equlbrum of the dfferent electrcty markets s mpossble. Market power and volatlty are really nherent to electrcty markets snce demand s dffcult to forecast and nelastc. Lkewse, supply faces bndng constrants at peak tmes, and t s nelastc and very costly to store. Ths mples that short-term prces are extremely volatle so that small changes n demand or supply condtons lead to prce bursts, and even small-share generators can exercse market power. Borensten then clams that the best way that regulators can handle market power s through long-term forward contracts between power buyers and sellers together wth realtme prcng. Forward contracts help to lower the average prce pad n both spot and forward markets, whle real-tme prcng also makes the demand curve flatter. 9 Knopff (00) descrbes another market-based mechansm for resource adequacy based on subscrpton of capacty. The desred generaton capacty would be decentrally determned (see fgure 3). When demand approaches supply every consumer s restrcted to the peak capacty contracted n advance from generators. Peak capacty can be sold by each generator n any amount, and the prce for ths capacty s left to the market. Wth ths soluton both the prce and the quantty of peak capacty would also be decentrally determned. 0 However, at ths moment, such a soluton s not techncally feasble. 7 Ths s theoretcally confrmed by Carreón-Rodríguez and Rosellón (004) whch show that prces n the capacty reserves, peak capacty and non-peak capacty markets converge to the same prce n a model that separates these three markets. 8 For example, Chao and Wlson (00) analyze the two-part Calfornan procurement aucton for the market of spnnng reserves. One part of the aucton was desgned for makng capacty avalable, whle the other part was for supplyng ncremental energy. A scorng rule s meant for comparng bds, whle a settlement rule for payng accepted bds. The revelaton prncple appled to ths model makes that each supplers optmal energy bd reveals ther true margnal cost. Addtonally, the ISO and the generators are not requred to agre on the probablty dstrbuton of dspatched energy 9 Most of the recent electrcty reform proposals also promote the use of demand sde bddng measures (see for example Commonwealth of Australa, 00) 0 Carreón-Rodríguez and Rosellón (004) develop a two-stage olgopolstc model where generators decde frst f they should enter to the long-term reserves market or the spot market. If they go nto the spot market, they decde n the second stage to supply ether peak or non-peak capacty. Therefore, both amount and prce

5 5 Fgure 3 In the context of an ntegrated ISO that reaches a centralzed equlbrum n all the electrcty markets, De Vres and Neuhoff (003) analyze the energy-only market soluton. Such a soluton reles on the spot market run by the ISO to take care of resource adequacy so that prce spkes sgnal the need of nvestment n generaton capacty. De Vres and Neuhoff argue that there are nsuffcent ncentves for generators n an energyonly market to nvest n capacty whenever there exsts economc uncertanty, or fluctuatons n demand. Moreover, they show that when generators and consumers are rsk averse, the optmal level of nvestment from the perspectve of generators s below the level consumers wsh to fnance wth long-term contracts. The man reason s that market desgns do not have the nsttutons that permt long-term contracts to develop suffcently, and generators are restrcted n the amount of rsk that they can transfer to consumers. Lkewse, complete relance on prce spkes s not advsable because they are usually not poltcally acceptable, and they can also be manpulated by the generaton companes. Even more, electrcty markets that rely on short-term energy revenues mght lead to of long-run capacty reserves and peak capacty are set n the market. Also n a theoretcal framework, Murphy and Smeers (00) buld a closed-loop Cournot two stage game that descrbes a stuaton where nvestments n capacty reserves are decded n a frst stage whle sales n the spot market occur n a second stage. Both stages take place n olgopolstc markets. Ther framework does not nclude forward contractng. They fnd non-convextes n the frst stage of the problem (a fact common of b-level programs) but are able to conclude that a model wth a spot market has lower prces and hgher quanttes than a model wthout a spot market. Gülen (00) shows that f the probablty of lost load n the PJM market s day n 0 years, prce spkes n the range of $,000-$30,000 per Mwh are needed n an energy-only market. Energy-only markets work however n Australa and New Zealand wth maxmum prces between $,500 and $5,000.

6 6 shortfalls n capacty over tme that mght orgnate nvestment cycles where nvestment lags the demand n the market. Regulators worldwde are then very concerned that energy prces are not enough to cover generators capacty costs. Most markets have mplemented some type of resource adequacy measure. Texas has recently changed to generaton adequacy assurances, and FERC s Standard Market Desgn (SMD) also recognzed the adequate contracted provson of capacty reserves (FERC, 00). Calforna n 00 also changed ts market approach to capacty supply and prompted a proposal for an avalable capacty requrement (ACAP) to be mposed on load servng enttes (LSEs). It s therefore not surprsng that several methods have been formally studed n the lterature on ncentves for nvestment n reserve capacty such as capacty payments, capacty requrements, and capacty optons. The lterature on resource adequacy analyzes these mechansms n the context of an ntegrated ISO. We next study such mechansms. 3 Capacty Payments Capacty payments provde remuneraton to generators for makng avalable ther generaton capacty (whether they get dspatched or not). The prce of capacty s set whle the market determnes the amount of capacty avalable. That s, prces are centrally determned whle capacty decsons are decentralzed (see fgure 4). Capacty payments are collected from consumers through an uplft charge and determne the cost behavor of the frm but leave the amount of reserves uncertan. Oren (003) explans that capacty payments are rooted n the theory of peak-load prcng so that energy s prced at margnal cost and a capacty payment s used to recover the fxed capacty cost mposed on peakperod energy users. The optmalty condton s such that the shadow prce of the capacty constrant s equal to the ncremental cost of capacty. Capacty payments have been used n Argentna, 3 Chle, Colomba, Peru, Span (together wth blateral capacty contracts), and the Unted Kngdom. 4 Two dfferent knds of capacty payments have been appled n the nternatonal practce: fxed payments and fluctuatng payments. Fxed per MW payments have been mplemented n Span, where the compensaton depends on the avalablty and the technology of the power plant, and n Argentna, where the Secretaría de Energía set a $0 MWH ($5 for base capacty and $5 for relablty) payment pad durng peak demand blocks (6am-pm durng workdays). However FERC has recently backed of and recognzed the State s jursdcton over resource adequacy measures. 3 Argentna changed to a capacty market n Wth the adopton of NETA n October 000, the UK abandoned capacty payments based on the loss of load probablty (LOLP) method along wth the pool system.

7 7 Fgure 4 Fluctuatng payments vary wth the need for reserve capacty. Although later rescnded under NETA, they were mplemented n the early UK (England and Wales) electrcty market. The market mert-order prcng rule s modfed durng perods of hgh demand when reserve capacty margns are low. In such crcumstance, the market prce s defned as the weghted average of two factors: the prce of the last accepted offer to generate (LAO) and the value of lost load (VOLL). The weght s the LOLP. The formula for the market prce s then market prce = LAO * (-LOLP) + VOLL * LOLP, where: 0 LOLP. The greater (lower) the surplus reserve capacty the smaller (hgher) s LOLP. Generators would deally add capacty when the expected sum of all these payments over all hours of the year s greater than the cost of nstallng new capacty. Ths formula also mples a prce cap for VOLL when the system s short of power. A man assessment of capacty payments s that they do not favor very much competton because they create artfcal rents that mght lead to ncreased market power n generaton. In a smple Cournot model, Carreón-Rodríguez and Rosellón (004) fnd the condtons under whch a fluctuatng capacty payment (as the one put n practce n the UK) mght lead to worse results n terms of consumer surplus, profts and net socal benefts compared to a system where the market prce s not artfcally ncreased and excess demand s satsfed n a regulated reserve (or standby) market. 5 They show that mplementaton of a bypass reserve market makes socal sense n terms of prces only f 5 A smlar approach to a standby market was appled n Vctora, Australa, wth oblgatons to ensure capacty n an energy-only market.

8 8 there s a large effcency gap between old and new generaton plants. In such a case, the mplementaton of the capacty-payment soluton would only create artfcally hgh rents that could provde ncentves for a development of olgopolstc generaton markets (the mathematcal dervaton of these results s presented n annexes 7. through 7.3). In a smlar effort, Joskow and Trole (004) analyze the effects of an uplft charge of an ISO to recover the costs of resources. They do so n the context of a general model that studes the effects on the theorems of welfare economcs of market falures as those exstng n electrcty markets. They fnd that capacty payments grant neffcent results: When the uplft charge s appled both to peak and off-peak perods, large ISO purchases dscourage the buld up of base load capacty and push down the peak prce. For small purchases, off-peak capacty decreases when the uplft s appled n both peak and off peak perods, and the peak capacty decreases when the uplft s only appled durng the peak perod. In a model of mperfect nformaton, Oren and Soshans (003) analyze payments for reserve capacty n a jont day-ahead energy and reserves aucton. Reserves are procured through the energy market usng energy only bds, and capacty payments are made based on the generator s opportunty cost. Oren apples the revelaton prncple to show that generators have an ncentve to understate ther costs so as to capture hgher capacty rents. 6 Such theoretcal assessments are confrmed n practce by the case of Argentna that substtuted ts fxed capacty payment mechansm for a hybrd system of payments and contracts because fxed payments were found to dstort the mert order dspatch and negatvely affected the long-term fnancal stuaton of thermal generators. In the UK, the LOLP system was manpulated by large players at the end of the pre-neta perod. 7 In several other countres, capacty payments have also led to constructon of neffcent peakng unts, promote the use of one fuel over others, and elmnated the ncentve for avalablty durng crss of defct supply. Lkewse, Sngh (00) asserts that, as n any prce-cap procedure, settng the optmal level of capacty payments s very dffcult, and Knopff (00) ponts out that a practcal problem of fluctuatng capacty payments s that varatons n such mechansm happen n the short run, whereas the relevant tme for nvestment n capacty reserves s the long term. Addtonally, Gülen consders that the LOLP method s not adequate for largely hydro-based systems (as Brazl) as the LOLP would be very small durng wet seasons, whch would lead to dsproportonate low revenues for thermal generators. Hunt (00) then clams that any capacty adder should be desgned to reflect the value of the plant to the system, whch s n turn affected by the technology plant composton n such a system. Capacty payments mght be combned wth prce caps to protect consumers (Internatonal Energy Agency, 00) because when capacty s pad separately there s no need that prce spkes remunerate reserve capacty. Hobbs, B. F., Iñón, J. and S. E. Stoft (00) show that the result of such combnaton could be a reducton n prce volatlty wthout affectng average prces and reserves. However, prce caps can also have a locatonal nfluence on generators that would seek hgh prce-cap areas. 6 See also Newbery (995). 7 See Green (004).

9 9 4 Capacty Requrements Capacty requrements are set as an oblgaton to mantan a certan amount of reserve capacty. Such an amount s centrally determned through an admnstratvely forecast of demand, and s usually mposed by the ISO (or the regulator) to LSEs. Conversely to capacty payments, the prce s decentrally determned by the market once the amount of reserve capacty s set (see fgure 5). LSEs must buy enough capacty tckets to meet the expected peak load of ther customers multpled by (+X), where X s the expected reserve margn that wll cover an estmated level of relablty to cope wth random outages. The tckets are sold by generators who are usually allowed to export ther reserve capacty to other markets. Wth a capacty requrement, the regulator s able to control the reserve level but the cost remans uncertan (IEA, 00) Fgure 5 Capacty requrements are used n the Pennsylvana, New Jersey, Maryland (PJM), New York and New England markets where an oblgaton s mposed on LSEs to arrange for Installed Capacty (ICAP). In partcular, PJM put nto practce a bd-based, day-ahead and month-ahead ICAP markets. 8 LSEs are requred to buy ICAP n order to be able to serve loads, and they can trade ther ICAP wth other LSEs. The ICAP requrements can be met by LSEs through self supply, blateral transactons wth supplers, capablty perod auctons (several month strp), monthly auctons, defcency-spot market auctons, and so 8 On October, 998, PJM ntated monthly and mult-monthly capacty markets, whle daly capacty markets ntated ther operaton n 999.

10 0 forth. Capacty resources can be exported from (or mported to) the PJM area. Generators sell a recall rght that enables PJM to recall energy exports from capacty resources when requred. When capacty s recalled, the suppler s pad the market prce for energy. The system operator determnes demand through the choce of oblgatons of LSEs, whch must own or purchase capacty resources greater than or equal to ther expected peak-load plus a reserve margn. If an LSE s short of capacty, t pays a penalty that equals the daly amount of defcency n capacty tmes the number of days. When the system tself s short of capacty, the defcency charge s the double of the capacty defcency rate (equal n 003 to USD per MW-day). 9 Oren (003) then proposes to vew long-term reserves as a prce nsurance and be treated as a prvate good but wthn the framework of a centralzed provson of the ISO that mposes mandatory levels of such nsurance on LSEs. These mandatory rules would compensate for several obstacles that consumers face when choosng an adequate level of protecton, such as technologcal barrers on meterng control, poltcally barrers to set electrcty tarffs effcently, and so forth. For a market based on operatng reserves backed by hgh prces Stoft (00) shows that optmal nvestment n generaton capacty depends on the nverse relatonshp between capacty requrements and the purchase prce lmt on the system operator: the hgher the reserve requrement the lower the optmal prce lmt. 0 Cret and Fabra (004) make a theoretcal analyss of the PJM ICAP market. They buld a two-stage game theory model. In the frst stage, pror to the realzaton of demand, generators compete n the capacty market and receve ther payments for the capacty amounts they commt. In the second stage, once demand s realzed, generators compete n the domestc and foregn markets. When there s excess demand, the regulator recalls the supplers commtted capacty resources, whch are pad at market prces. Fnally, supplers get ther payments for the energy sold. Cret and Fabra analyze ths game for the monopoly and the perfect competton cases, and also study the role of the regulator n choosng the capacty requrement as well as n settng a capacty prce cap. Cret and Fabra derve several results from ther model on:. The opportunty costs of commttng capacty resources.. The frm s optmal behavor n the capacty market. 3. The regulator optmal decsons regardng capacty prce caps and the optmal reserve requrement. In ther frst result, Cret and Fabra show the trade-off that a generator faces between commttng more resources to the capacty market aganst the foregone revenues from exports (n the case of beng recalled). The dfference between the foregn and domestc prces then determnes the opportunty cost of commttng capacty resources. The second result shows that two types of equlbra are possble for the frm s optmal behavor gven 9 The capacty defcency rate ndcates the annual fxed cost of a combuston turbne n PJM plus transmsson costs (PJM, 003). 0 Stoft (00) also shows that n a perfectly compettve market a prce cap equal to the average value of lost load results n an optmal level of nvestment n generaton capacty. Ford, 999; Hobbs et al. 00 also dscuss the need for prce caps when markets do not clear. More specfcally, the opportunty cost s also a functon of the probablty of recall, the amount of resources needed by the system to assure resource adequacy, and the ntensty of prce competton n the energy market.

11 the value of the capacty prce cap, and the reserve requrement set by the regulator. When the prce cap s too low, the generator s opportunty costs wll not be covered and a capacty defct would arse (capacty defct equlbrum). When the prce cap s hgh enough capacty resources are able to cover the needed capacty requrement (market clearng equlbrum). Fnally, Cret and Fabra show that the regulator should always set the capacty requrement equal to peak demand so as to fully avod the rsk of shortage, and to set the capacty prce cap equal to the frm s opportunty costs of provdng full capacty commtment. Cret and Fabra s results show the fraglty of the ICAP system, whch crucally depends on the capacty prce cap and the capacty requrement. The admnstratve calculaton of the latter varable s a subjectve one, 3 whle the optmalty of the former varable depends on the market structure of fnancal transmsson rghts (FTRs) snce the opportunty cost of the generator s gven by the prce dfference between the domestc and foregn markets: f the FTR s subject to market power that wll be reflected n the ICAP market. In practce, ICAP mechansms have faled to provde nvestment sgnals when they are most needed. ICAP markets were subject to market manpulaton 4 that caused prce spkes n 000 n PJM. The pool was defcent some days n June, July and August 000 snce owners of capacty ncreased ther exports for perods when external prces surpassed the PJM market prce. In January 00, there were prce spkes of more than $300 MWday wth a defcency n system capacty. Furthermore, hgh market concentraton n capacty ownershp has also been observed. In New England, Joskow (003) has showed that the scarcty rents generated are far below from what would be necessary to attract reserve peakng capacty to nvest (or contnue operaton) so as to supply the needed operatng reserves and energy durng scarcty condtons. 5 Ths means that the combnaton of an ISO spot market wth ICAP markets has not been capable to provde enough ncentves to attract generatng capacty to mantan adequate relablty levels. Smlar results have been obtaned for the New York ISO (Patton, 00). The ICAP system s flawed n part because t derves from short-term adequacy concerns rather than long-term, and snce t depends on a subjectve estmaton of a rght Joskow and Trole (004) also buld a model that shows how a combnaton of capacty requrements wth capacty prce caps mght potentally restore nvestment ncentves. Even n the presence of market power, a (Ramsey) optmum can be acheved when: () LSE capacty requrements can be met both by peak and base load generators, () capacty requrements are determned usng the demand from all consumers, and the capacty prces reflect the prces pad by all retal consumers, and () the market for peakng capacty s contestable. However, ths result s not true when there are more than there states of nature (where two state of nature are off-peak and peak ). In such a case strct prce-cap regulaton mght be used to allevate market power off-peak and allow peakers to recover ther nvestment (Joskow and Trole, 004, pp ). 3 There have been efforts to mprove the calculaton of the capacty requrement. For example, n the New York ISO a demand curve s proposed to be constructed as an alternatve to an ICAP market that ntends to ncrease resource relablty by valung addtonal ICAP above the fxed capacty requrement (Harvard Electrcty Polcy Group, 003). 4 ICAP gves ncentves n the short run for manpulatng the avalablty of plants to ncrease revenue. Antcompettve behavor s potentally hgher when capacty and system constrants are bndng. Another practcal problem of ICAP s the nteracton among systems wth and wthout capacty requrements, whch mght lead to neffcent dstortons. (IEA, 00). 5 The average scarcty rents n New England of $0,000 Mw-Year are very low compared to the fxed cost of a new combuston turbne bult to provde reserve capacty estmated n between $60,000-$80,000 Mwyear (Joskow, 003).

12 capacty level whch depends on generaton stocks, fuel prces, load shapes, and elastcty of demand for reserves. Also, snce ICAP s combned wth the possblty of exportaton of capacty, the value of the ICAP depends on the prce dfferences across the adjacent markets. Furthermore, ICAPs have not provded ncentves to buld new generaton facltes and, conversely, have contrbuted to keep old neffcent plants n place (Harvard Electrcty Polcy Group, 003). 6 PJM has then been lookng to modfy ts ICAP system by developng a new methodology for peak load oblgaton, and by changng the month-ahead and day-ahead markets to a prce-taker aucton whle retanng mandatory partcpaton n the day-ahead market. Lkewse, the ISO New England proposed a new locatonal nstalled capacty (LICAP) market snce the capacty markets n New England were regsterng at certan tmes prces of zero whle generaton n constraned areas needed to be valued more hghly (Davs, 004). 7 The LICAP proposal ncludes basng prces n demand curves for Mane, Connectcut, metropoltan Boston, and the rest of New England. New prces are to be phased-n through capped ncrements n a fve-year perod. These proposals have been wdely opposed by LSEs and other consumers snce n ther opnon-- t wll only produce huge transfers from LSEs to generators, wthout provdng long-term ncentves to ncrease new generaton (Davs, 004). FERC s orgnal SMD (FERC, 00) also crtczed ICAP requrements and proposed nstead the use of resource adequacy requrements wth targeted curtalments, penaltes for undercontractng, and long-term contractng mandatory measures (FERC, 00). Chandley and Hogan (00) argue that ths s a further flawed polcy because there s no objectve way to solve the resource-adequacy problem n accordance wth SMD wthout ncurrng the many dffcult ssues faced n ICAP desgn. They thnk that the best soluton would be to allow prces to clear the energy and reserve markets (so that scarcty costs are properly sgnaled) 8 whle allowng fnancal hedgng contracts and demand-sde measures. Accordng to Chandley and Hogan, FERC should not mandate the replacement of ICAP mechansm whle totally dscouragng a market-clearng alternatve for reserve capacty markets. 5 Call Optons As seen n the prevous secton, capacty requrements have the problem of artfcally settng a capacty requrement and the value of mantanng such a capacty. Call optons are proposed as an alternatve system that would represent a more real value of capacty (Vázquez et al, 00), and that bundles generaton adequacy wth prce nsurance. The desred capacty s centrally determned, whle prce s decentrally determned but consumers are hedged aganst huge prce spkes (see fgure 6). Typcally, the system operator would purchase call optons from the generators n a compettve bddng process 6 Joskow and Trole (004) theoretcally show that the neffcent dspatch of resources procured by the ISO n order to be used durng reserve scarcty condtons wll lead n the long run to substtuton of base load unts by peak unts. 7 Cret and Fabra (004) deduce from ther theoretcal model the possblty that capacty markets clear at zero prces f there s no spread between natonal and foregn prces. 8 Ths s of course confronted wth the poltcal motvaton to keep prces low. However, from a strctly economc pont of vew, the experence n ndustres dfferent from the electrcty ndustry s that the best cure for hgh prces s hgh prces (Harvard Electrcty Polcy Group, 003, p.8).

13 3 that would cover the desred capacty. 9 The buyer exercses the opton f the spot prce s greater than the strke prce (and receves a premum equal to the dfference between the spot prce and the strke prce). 30 The strke prce of optons s used as a prce-cap n case of emergences, and hgh penaltes are mposed for falure to delver when the opton s called. Ths assures that the promsed capacty s really made avalable, especally durng the peak perods. The prce cap of a call optons system works as a protecton to consumers, whch wll assure that prces stay wthn a socally acceptable range so that the regulatory nterventon becomes a form of nsurance aganst prce volatlty. Compared to the ICAP system, the rsk s now changed to the system operator that now bears the uncertanty of whether the optons are used or not. Rsk s removed from generators that now face a more stable revenue horzon compared to an uncertan and volatle ncome for peak generaton. The expected generators ncome for prces above the strke prce equals the prce of the call optons, and the generators now receve a fxed payment for the opton. Prces and correspondng capacty payments are then derved as market based prema from the market players strateges for rsk management. Fgure 6 Oren (003) clams that the provson of supply adequacy through LSE s hedgng oblgatons captures several mportant features. If the LSE oblgatons are adjusted (say) monthly to reflect fluctuatons n forecasted peak demand, a secondary market for call 9 Alternatvely, LSEs could be the buyers of optons through self-provson from ther own controlled resources or blateral contracts wth generators. 30 The buyers of the call opton may choose the strke prce that suts ther rsk averson: hgh (low) strke prces have small (hgh) premums. Opton premums also work as substtute effcent sgnals compared to prce sgnals generated by ICAPs (Sngh, 00).

14 4 optons should emerge that would permt the tradng of call optons among LSEs. However, whle secondary markets permt the LSEs to adjust ther postons each month, prce volatlty n such markets ncreases the LSEs rsk. Oren proposes then to treat hedgng as another ancllary servce, allowng LSEs self provson through blateral contracts wth the ISO actng as a provder of last resort. The danger s of course that ths may nterfere wth ncentves n the contract market, and be perceved by LSEs as an alternatve to prudent rsk management. Oren (003) further alerts that n countres where there s not a well-developed nfrastructure of fnancal markets, LSEs or generators may assume more rsk than they mght relably handle. 3 In partcular, LSEs mght not be able to manage rsk n a socally optmal way, so that the regulator should need to set a mnmum contractng or hedgng level on LSEs. Then agan, ths would lead to non-market arbtrarness. Vázquez et al (00) analyze a call-opton mechansm for the electrcty market n Colomba. The regulator requres the system operator to buy a prescrbed volume of relablty contracts that allow consumers to get a market compatble prce cap n exchange for a fxed capacty remuneraton for generators. Ths enttles consumers to enough avalable generaton capacty. Relablty contracts then consst of a combnaton of a fnancal call opton wth a hgh strke prce, and an explct penalty for generators n case of non-delvery. 3 The regulator carres out a yearly aucton of opton contracts and sets the strke prce (at least 5% above the varable cost of the most expensve generator) and the volume of capacty to be auctoned (n terms of the expected peak demand and the avalable nstalled capacty). However, generators decde how to dvde ther total capacty nto dfferent blocks (frm, less-frm, new entrants, and least-frm) and how to prce each block, so that capacty assgned to each generator s a market result and not the outcome of an admnstratve process. The Vázquez et al proposal s very senstve to market power. Therefore, they propose for mplementaton n the Colomban electrcty market that: a) the maxmum amount that a generator can bd s lmted to ts nomnal capacty; b) portfolo bddng s not allowed; and c) the wnnng bds cannot transfer ther oblgatons of physcal delvery to other generators. 6 Concludng remarks Ths paper has surveyed the contrbutons made to the lterature on supply adequacy n electrcty markets. We studed the dfferent exstng approaches and descrbed ther analytcal propertes and mplementaton characterstcs. In assessng the dfferent alternatves, the trend n the lterature s to look for some knd of transtory regulatory nterventon that grants resource adequacy. However, Hunt (00) clams that capacty oblgatons or capacty payments can only be useful f hourly meterng, hourly prcng, and demand bddng are woefully nadequate and cannot be mplemented expedtously. Otherwse, the energy and the reserve markets should not be separated. The deal would be 3 Lkewse, the captal market mght not be able to provde the long term fnancng for generaton nvestments commensurate to the assocated rsk. Ths combned wth nexperence wth commodty tradng n the electrcty ndustry and the perceved regulatory rsk, mght rase the cost of captal so much that the nvestment level wll be far below than the needed for an effcent resource adequacy level (Oren, 003). 3 When the market prce p s greater than the strke prce s, and the generator s unable to honor ts oblgaton to produce, the generator wll have to pay an addtonal penalty pen (apart from the dfference p s). The addtonal penalty s ntended to dscourage even more bds not backed by relable capacty.

15 5 an ISO that runs day-ahead markets and spot markets that takes care of mbalances and reaches equlbrum of all electrcty markets n an ntegrated way. Market players would meet ther long run expectatons for the demand-supply balance n well-developed forward and futures markets. Energy and reserve prcng would take care of supply adequacy. However, n practce electrcty markets are usually mplemented together wth transtory resource-adequacy measures. Capacty payments and requrements alone have been found to be nadequate both n theory and practce. The most advanced developments n the lterature pont to the use of some type of hedgng nstruments such as call optons. Oren (003) even argues that capacty payments or requrements mght work effcently f combned wth rsk management approaches and hedgng nstruments that promote demand sde partcpaton. Regulatory nterventon would then be focused on promotng rules that facltate lqud markets for energy futures and rsk management. Notwthstandng, capacty mechansms desgned to be appled n the context of an electrcty market seem to be mssng a fundamental central ssue. If regulators set the type, level and locaton of capacty levels and payments there wll not be much left for markets to do. All that would be left s compettve procurement, very much lke what s done through tradtonal regulaton. So a fundamental dlemma s that electrcty markets wth generaton capacty mechansms mght exst n separaton but ther combnaton seem to be condemned to falure I owe ths observaton to Wllam Hogan.

16 6 7 Annex 7. Reserve Margns n IEA Countres

17 7

18 8 7. The Capacty Payment Model Let us frst study a smple stylzed verson a capacty-payment model. Assume that the nverse demand functon at a peak perod has the form: P ( Q) + P( Q) = a( bq( () where P (Q) s the nverse demand functon, Q s the amount of electrcty generated, a > 0 and b > 0 are postve constants, and k > 0 s a factor added to the prce of electrcty durng peak perods. 34 We assume there are only two frms, frm and frm. We then have Q = q + q (where q and q are the amounts of electrcty generated by frm and frm, respectvely). The cost functons are c ( q ) = c q for =, () where c s the margnal cost of power generaton for frm =,. Suppose that c < c. The proft maxmzaton problem for frm =, s then max q { } = max{ [ a + k) b( ( q + q )] q c q } q ( (3) The optmal quanttes of a Cournot duopoly and the market prce that solve problem (3) are * a( + c j c q = for =, (4) 3b( * * a( + ( c + c ) P ( Q) + P ( Q) = (5) 3 Gven these optmal values, profts for frm =, are [ a( + c c ] j j Π = (6) 9b( Therefore, the net socal beneft, equal to the sum of total profts plus total consumer surplus s NSB Π + Π + EC = { a ( ( c + c )[ 8a( + ( c + c )] 36c c } 8 = (7) 8b( 34 k would therefore contan terms such as cfalla and k factor of the 999 Mexcan reform proposal (see Carreón-Rodríguez and Rosellón, 00).

19 9 Note that that ths expresson s manly determned by the value of k (the term that artfcally ncreases the prce of electrcty) and the margnal costs of each frm. 7.3 The Regulated Standby Model Let us now formally analyze the regulated standby model n whch excess demand s satsfed n a reserve or standby market. Now frm s a monopoly n the pool market, whle frm s also a monopoly operatng n the reserve market. Frm only takes care of excess demand. Frm s nverse demand functon s gven by and ts cost functon s pˆ ( qˆ ) = aˆ bˆ q (8) ˆ c ( qˆ = q (9) ) cˆ ˆ The proft maxmzaton problem of frm s then: max qˆ { ˆ } = max{ ( aˆ bq ˆ ˆ ) qˆ cˆ qˆ } Π (0) qˆ In ths case, the equlbrum quantty and prce are aˆ cˆ qˆ = () bˆ ˆ ˆ ˆ * a + p ( qˆ ) = c () Then, profts are ( a c ) Π = (3) 4b Frm only operates to satsfy excess demand at peak perods. Ths frm faces an nverse demand functon of the form: and ts cost functon s p ( qˆ ) + pˆ( qˆ ) = aˆ( + kˆ) bq ˆ ˆ( + ) (4) ˆ k c ˆ( qˆ = (5) ) cˆ ˆ q Frm s proft maxmzaton problem s q { ˆ } = max{ [ pˆ( qˆ ) + pˆ( qˆ )] qˆ cˆ qˆ } max Π (6) q In ths case, the equlbrum quantty and prce are * aˆ( + kˆ) cˆ qˆ = (7) bˆ( + kˆ)

20 0 Then, profts are pˆ * aˆ( + kˆ) + ˆ ( qˆ ) + pˆ ( qˆ ) = (8) * c [ a( c ] Π = (9) 4b( Hence, the net socal beneft n the standby model s ( a c ) + 3[ a( c ] 3( NSB = (0) 8b( Now, gven that c c (snce the frms that operate n the pool are typcally more effcent than the frms that operate n the reserve market), we get aˆ cˆ ˆ( ˆ) ˆ * a + k c = qˆ = () bˆ bˆ( + kˆ) * qˆ a( + kˆ) cˆ bˆ( + kˆ) ˆ aˆ cˆ = bˆ bˆ( + kˆ) and aˆ cˆ ˆ * * p ˆ * ( qˆ ) ˆ ( ˆ ) ˆ ( ˆ = p q + p q ) = aˆ( + kˆ) + c () 7.4 Comparson of the Capacty Payment and Standby Models Once we have obtaned the equlbrum values for quanttes, prces, profts, consumer surplus and net socal benefts n both models, t s possble to compare under what condtons one polcy s superor to the other. For ths purpose we wll assume that generators n the capacty-payment and the standby models face the same cost and demand functons, that s aˆ = a bˆ = b qˆ cˆ = q, =, = c, =, We carry out the comparson both at the frm level and at the socal level. Total profts under the standby model are greater than total profts under the capacty-payment model f

21 5 a 5 a 5 c c c c c c b 8 b 9 b( 9 b( 36b( a 4 b 5 a ( 8 b (3) whle consumer surplus n the standby model s greater than consumer surplus under the capacty-payment model f 5 a 5 c c a k a c 5 c c 8 ( + ) + c + 8 b 8 ( k) ( k) (4) 36 b b Gven that c c, t s evdent from these equatons that profts, consumer surplus and net socal benefts are greater under the standby model than under the Englsh model the greater s the value of ( c c ). That s, the standby model provdes better socal and prvate outcomes for economes where the margnal cost dfference between modern and old plants s large enough. Moreover, both models can also be compared n terms of mpled electrcty prces. Accordng to (), the equlbrum reserve-market prce n the standby model s greater than the correspondng spot prce. However, what s the relaton between the former prce and the equlbrum prce of the capacty-payment model? It can be shown that p * * * q + q ) + p ( q + q ) > pˆ ( qˆ ) + pˆ ( qˆ ) (5) * ( whenever the dfference ( c c ) s suffcently large. That s, mplementaton of a bypass reserve market makes socal sense n terms of prces only f there s a large effcency gap between old and new generaton plants. In such a case, the mplementaton of the capactypayment soluton would only create an artfcally hgh rent that could provde ncentves for a development of olgopoly generaton markets. 8 References Borensten, S. (00) The Trouble Wth Electrcty Markets: Understandng Calforna s Restructurng Dsaster, Journal of Economc Perspectves, 6: 9-. Bouttes, J.P. (004), Roundtable Market Desgn and Competton n Electrcty, presented at IDEI-CEPR conference Competton and Coordnaton n the Electrcty Industry,, Jan. 6, 7. Carreón-Rodríguez, V.G. and J. Rosellón (00), "La Reforma del Sector Eléctrco Mexcano: Recomendacones de Polítca Públca", Gestón y Polítca Públca, Vol. XI, No.. Carreón-Rodríguez, V.G., and J. Rosellón (004), Incentves for the Expanson of Electrcty Supply and Capacty Reserves n the Mexcan Electrcty Sector, Mmeo. Carreón-Rodríguez, V.G., Jménez San Vcente, Armando, and J. Rosellón (003), The Mexcan Electrcty Sector: Economc, Legal and Poltcal Issues, Workng Paper at the Program on Energy and Sustanable Development of the Center for Envronmental Scence

22 and Polcy of Stanford Unversty (avalable at: Chandley, J. D., and W. W. Hogan (00), Intal Comments of John. Chandley and Wllam Hogan on the Standard Market Desgn NOPR, November, avalable at: Chao, H.P. and R. Wlson (00), Mult-Dmensonal Procurement Auctons for Power Reserves: Robust Incentve-Compatble Scorng and Settlement Rules, Journal of Regulatory Economcs, :, Commonwealth of Australa (00), Towards a Truly Natonal and Effcent Energy Market, avalable at Cret, A. and N. Fabra (004), Capacty Markets for Electrcty, Workng Paper, UCEI, CSEM WP-4. Davs, T. (004), New England Offcals, Utltes Yowl Over Installed Capacty Plan, The Energy Daly, Wednesday, March 4. De Vres, L. and K. Neuhoff (003), Insuffcent Investment n Generatng Capacty n Energy-Only Electrcty Markets, paper presented at nd Workshop on Appled Infrastructure Research (Regulaton and Investment n Infrastructure Provson-Theory and Polcy), TU Berln WIP, DIW Berln, October. FERC (00) Notce of Proposed Rulemakng. Remedyng Undue Dscrmnaton through Open Access Transmsson Servce and Standard Market Desgn, Docket No. RM , July 3.(FERC: Federal Energy Regulatory Commsson) Ford, A. (999), Cycles n Compettve Electrcty Markets: A smulaton Study of the Western Unted States, Energy Polcy (7): Green, R. (004), Dd Englsh Generators Play Cournot?,, Mmeo, Unversty of Hull Busness School. Gülen, G. (00) Capacty Payments, presentaton, nd Annual IAEE/USAEE North Amercan Conference, Vancouver 6-8 October. Harvard Electrcty Polcy Group, 003, Rapporteur's Summares of HEPG Thrty-Frst Plenary Sesson, May -. Hobbs, B. F., Iñón, J. and S. E. Stoft (00), Installed Capacty Requrements and Prce Caps: Ol on the Water or Fuel on the Fre, The Electrcty Journal, July, pp Hunt, S. (00), Makng Competton Work n Electrcty, New York, John Wley & Sons. IEA (00), Securty of Supply n Electrcty Markets: Evdence and Polcy Issues, OECD/IEA. (IEA: Internatonal Energy Agency). Joskow, P. (003), The dffcult transton to compettve electrcty markets n the U.S., Workng Paper, The Cambrdge-MIT Insttute Electrcty Project, CMI 8, Joskow, P. and J. Trole (004), Relablty and Compettve Electrcty Markets, paper presented at IDEI-CEPR conference Competton and Coordnaton n the Electrcty Industry,, Jan. 6, 7.

23 3 Knops, H. (00), Electrcty Supply: Secure under Competton Law?, proceedngs, nd Annual IAEE/USAEE North Amercan Conference, Vancouver 6-8 October. Madrgal, M, and F. de Rosenzweg (003), Present and Future Approaches to Ensure Supply Adequacy n the Mexcan Electrcty Industry, paper presented at the Power Engneerng Socety Meetng, IEEE, vol., pages , 3-7 July, Toronto,. Murphy, F. H., and Y. Smeers (00), Generaton Capacty Expanson n Imperfectly Compettve Restructured Electrcty Markets, CORE Dscusson Paper, 69. Newbery, D.M., (995), Power Markets and Market Power, The Energy Journal, Vol. 6, No. 3, pp Oren, S. (003), Ensurng Generaton Adequacy n Compettve Electrcty Markets, Energy Polcy and Economcs Workng Paper, UCEI, EPE 007. Oren, S. and R. Soshans (003), Jont Energy and Reserves Aucton wth Opportunty Cost Payment for Reserves, paper presented at IDEI-CEPR conference Competton and Coordnaton n the Electrcty Industry,, Jan. 6, 7. Patton, D. S. (00) Revew of New York Electrcty Markets, New York Independent System Operator, October 5, Summer. PJM, Montorng Market unt (003), State of the Market Annual Report, (PJM: Pennsylvana, Maryland, and New Jersey ISO) Sngh, H. (00), Alternatves for Capacty Payments: Assurng Supply Adequacy n Electrcty Markets, presentaton, nd Annual IAEE/USAEE North Amercan Conference, Vancouver 6-8 October. Vázquez, C., M. Rver, and I. Pérez Arraga (00), A Market Approach to Long-Term Securty of Supply, IEEE Transactons on Power Systems, Vol. 7, pp , May 00. Wlson, R. (00) Archtecture of Power Markets, Econometrca, 70: