- Deregulated electricity markets and investments in intermittent generation technologies -

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1 - Deregulated electricity markets and investments in intermittent generation technologies - Silvia Concettini Universitá degli Studi di Milano and Université Paris Ouest Nanterre La Défense IEFE Seminars - December

2 Silvia Concettini IEFE Seminars - December /30 Outline 1 Policy framework Background Original contribution Which model? 2 3 Extensions

3 Silvia Concettini IEFE Seminars - December /30 Policy framework Policy framework Background Original contribution Which model? 1 Third Energy Package (2009): full liberalization of electricity industry Unbundling of transmission/distribution from generation and retail of competition in generation and retail Creation of spot electricity markets Objective: Optimal level of aggregate generation capacity and optimal technological mix 2 Climate and Energy Package (2009): commitment to low-carbon economy Reduction in greenhouse gas emissions Increase in the share of EU energy consumption produced from renewable resources Improvement in energy eciency Objective: A 20% share of EU energy consumption produced from renewable sources by 2020

4 Silvia Concettini IEFE Seminars - December /30 Background Policy framework Background Original contribution Which model? 1 A variety of models of competition for power generators: Spot market design and bidding behaviours: Green and Newbery, 1992 von der Fehr and Harbord, 1993 Fabra et al., 2006 Bidding behaviours and investment incentives: Murphy and Smeers, 2005 Milstein and Tishler, 2009 Fabra et al., 2011 = However competition in generation seems to be animated by new entrants investing in renewable technologies 2 A lack of models of competition between traditional and renewable generators

5 Silvia Concettini IEFE Seminars - December /30 Original contribution Policy framework Background Original contribution Which model? Dene a theoretical model of competition between traditional and renewable generators which embeds the following features: Production from some renewable power sources is subject to randomness Electricity from renewable sources is the rst to be brought on-line in spot markets because of merit order rule Investment and production from renewable sources are supported through publicly nanced schemes Use the model as an eective and easy-to-manage tool for assessing the impact and the desirability of incentives to production and investment in green technologies

6 Silvia Concettini IEFE Seminars - December /30 Literature review Policy framework Background Original contribution Which model? Imperfect competition for power generation preceded by an investment stage: 1 Capacity choice and Bertrand-Edgeworth competition (Kreps and Scheinkman, 1983) 2 Capacity choice and Supply function approach (Green and Newbery, 1992) 3 Capacity choice and Auction approach (Fabra et al., 2011) 4 Capacity choice and Quantity competition (Murphy and Smeers, 2005; Milstein and Tishler, 2012) = Strategic base-load investments may modify short run competition

7 Silvia Concettini IEFE Seminars - December /30 Which model and why? Policy framework Background Original contribution Which model? A modied version of the Dixit model for entry deterrence (1980) with Cournot competition in the post entry stage: Given the favourable merit order rule the renewable producer has a rst mover advantage in the investment game In the post entry stage a renewable and a traditional producers compete in quantities rather than in prices In quantity competition both rms are paid the same price as in a uniform price auction of real spot markets Randomness of electricity production from renewable source can be easily introduced

8 Silvia Concettini IEFE Seminars - December /30 Overview of main results Policy framework Background Original contribution Which model? The renewable producer strategically exploits merit order rule to behave as a sort of Stackelberg leader crowding out the production of its rival Including considerations about the average availability of installed capacity does not change preferences over strategies of renewable producer for most of the parameters' value The strategy chosen by renewable producer may benet consumers too depending on the value of average capacity availability The incentives for strategic behavior may be stronger even for small errors in the forecasting of the true value of capacity availability factor

9 Silvia Concettini IEFE Seminars - December /30 Assumptions Two rms: S (photovoltaic power plant) and G (combined cycle gas turbine plant) Capacities: k i, i = s, g Investment cost per unit of capacity: I i > 0, i = s, g Production cost per unit of electricity: c i, i = s, g, with 0 = c s < c g = c Average cost: I s > c + I g (cft. levelised cost of energy) Amount of electricity produced: q i, i = s, g Available capacity: xk s, where x is the realization of a random variable X [0, 1] whose expected value is E[x] = x Inverse demand function: p(q) = a bq, where Q = q s + q g [0, xk s + k g] G makes positive prots in any post entry equilibrium: a > 2(c + I g)

10 Silvia Concettini IEFE Seminars - December /30 Timing of the game The structure of the game is the following: 1 In the rst stage: Firm S chooses its capacity, k s The investment is irreversible 2 In the second stage: Firm G selects simultaneously capacity, k g, and production, q g Firm S can increase capacity prior to choose production, q s Solve the game by backward induction to nd the sub-game perfect Nash equilibrium Since q s and q g are strategic substitute, S never installs excess capacity in the rst stage (Bulow et al., 1985)

11 Silvia Concettini IEFE Seminars - December /30 Strategy A - Small capacity The renewable rm instals a small capacity in the rst stage: k A s x (a + c + I g) 2I s 3bx 2 q A s = x (a + c + I g) 2I s 3bx q g q A g = x [a 2(c + I g)] + I s 3bx Ȓ s (q g) p A = x (a + c + I g) + I s 3x Π A s = [x (a + c + I g) 2I s] 2 9bx 2 q g A x*k s A q s A R s (q g) R g (q s) q s Π A g = {x [a 2(c + I g)] + I s} 2 9bx 2 Figure : in case A

12 Silvia Concettini IEFE Seminars - December /30 Strategy B - Large capacity The renewable rm instals a large capacity in the rst stage: k B s a + c + Ig 3bx q B s = a + c + Ig 3b q g q B g a 2(c + Ig) = 3b Ȓ s (q g) p B = a + c + Ig 3 q g B B Π B s = (a + c + Ig)((a + c + Ig)x 3I s) 9bx R s (q g) q s B x*k s R g (q s) q s Π B g [a 2(c + Ig)]2 = 9b Figure : in case B

13 Silvia Concettini IEFE Seminars - December /30 Strategy C - Intermediate capacity The renewable rm instals an intermediate capacity in the rst stage: k s = x (a + c + I g) 2I s 2bx 2 q C s = x (a + c + I g) 2I s 2bx q g Ȓ s (q g) q C g = x [a 3(c + I g)] + 2I s 4bx R s (q g) p C = x (a + c + I g) + 2I s 4x A B Π C s = [x (a + c + I g) 2I s] 2 8bx 2 x*k s R g (q s) q s Π C g = {x [a 3(c + I g)] + 2I s} 2 16bx 2 Figure : in case C

14 Silvia Concettini IEFE Seminars - December /30 Optimal strategy 1 Strategy C is preferred to A if: Π C s = [x (a + c + I g) 2I s] 2 8bx 2 > [x (a + c + Ig) 2I s] 2 9bx 2 = Π A s For x Firm S prefers to anticipate investments 2 Strategy C is preferred to B if: Π C s = [x (a + c + I g) 2I s] 2 8bx 2 > (a + c + Ig)((a + c + Ig)x 3Is) 9bx = Π B s Case 1: for x when a + c + I g < 6I s Case 2: for x 6Is when a + c + Ig 6Is a+c+ig Functional relation between prots and x is dierent

15 Silvia Concettini IEFE Seminars - December /30 Comparative statics How does the pay-o of strategies B and C change with respect to the average availability of capacity? For strategy B: Π B s x [ (a+c+ig)((a+c+i g)x ] 3I s) = 9bx (a + c + Ig)Is x = 3bx > 0 For strategy C: [ Π C s x = ] [x (a+c+i g) 2I s] 2 8bx 2 x = Is(a + c + Ig) 2bx 2 2I2 s 2bx 3 > 0 2Is a+c+ig < x < 1 and 2I s < a + c + I g

16 Silvia Concettini IEFE Seminars - December /30 Results Proposition The renewable producer is strategic and exploits merit order rule to behave as a Stackelberg leader. Given the organization of spot electricity market, rm S is able to manipulate short run market outcomes: it installs a larger capacity than the one resulting from a one stage Cournot game it partially crowds out G production (and investments if already sunk) it does not take advantage of its position to its maximum extent Lemma For most of the parameters' values the average availability of installed capacity does not change S's preferences between strategies.

17 Producer vs consumers The strategy with the lowest price guarantees the larger consumer surplus (the demand is monotone) C Firm S C = B C The value of x determines which strategy leads to the lower price x* 0 x = 6I s a + c + I g 1 Strategy C is preferred by consumers if: x > 6Is a+c+ig Consumers B C While strategy C is preferred by S if: x* 0 x = 6I s a + c + I g 1 x 6Is a+c+ig Figure : Preferences over strategies Silvia Concettini IEFE Seminars - December /30

18 Silvia Concettini IEFE Seminars - December /30 Producer and consumers Proposition Merit order rule may lead to an equilibrium which benets both the renewable producer and consumers. Strategy C benets both consumers and producer if: Lemma investment cost in renewable capacity is relatively low (Case 2) the average capacity availability factor is larger than a certain threshold A public intervention which reduces S investment cost increases the likelihood of this outcome. The average availability of capacity depends on technology and weather conditions and cannot be exogenously increased A reduction in S investment cost decreases the threshold that x must exceed for consumers to prefer strategy C (x > 6Is a+c+ig )

19 Silvia Concettini IEFE Seminars - December /30 Ex post prots Investment choices are taken on the basis of the average value of capacity availability, x Production of S may be adjusted according to the realized value of x The ex post prots are the pay-o of S when it has invested in capacities k C s k B s and it produces according to the real value of x: or Π s = (a bq B,C g bxk B,C s )xk B,C s I sk B,C s G produces the lower quantity between its installed capacity and its optimal production given the electricity supplied by S: q B,C g = a b max (x, x )k B,C s 2b c I g The ex post prots are random because they depend on x which is a random variable

20 Silvia Concettini IEFE Seminars - December /30 Expected value of ex post prots To calculate the expected value of ex post prots let us use a generic probability density function for x, P (x) for x [0, 1], such that: 1 E[f] = f(x)p (x)dx 0 The expected values of ex post prots are then: E[Π B,C s ] = 1 Π B,C (x)p (x)dx 0 E[Π B s ] = A2 18b AIs 3bx + A2 18bx 2 (2x 2 2E[x 2 ] + M) E[Π C s ] = B2 8bx 4 (2x 2 2E[x 2 ] + M) where: 1 M = x max (x, x )P (x)dx 0 A = a + c + I g B = 2I s Ax

21 Silvia Concettini IEFE Seminars - December /30 of strategies Recalling that E[x] = x and Var[x] = E[x 2 ] E[x] 2 we rewrite ex-post expected prots as: E[Π B s ] = A2 18b AIs 3bx + A2 (M 2Var[x]) 18bx 2 E[Π C s ] = B2 (M 2Var[x]) 8bx 4 The condition for strategy C to be ex-post preferred to strategy B may be reduced to (after some manipulation): ˆx 2 s(s 1) < 1 6s + 5s2 4s 2 (M 2Var[x]) where I = 6I s, ˆx = I A and s = x ˆx

22 Silvia Concettini IEFE Seminars - December /30 An example Consider the probability density function of a uniform distribution dened as: P (x) = 1 2ɛ for x ɛ x x + ɛ 0 otherwise The inequality which determines the optimal ex post choice of renewable producer becomes: ˆx 2 s(s 1) < 1 4 (s 1)(5s 1)(4ˆx2 s 2 + ˆxsɛ 2ɛ 2 ) How does the optimal strategy of S change ex post?

23 Silvia Concettini IEFE Seminars - December /30 Some simulations 0.2 B=C 0.2 B=C ε 0.1 C ε 0.1 C B B s s Figure : ˆx = 1 Figure : ˆx = B=C 0.2 B=C ε 0.1 C ε 0.1 C B B s s Figure : ˆx = 0.75 Figure : ˆx = 1.5

24 Discussion When parameters value are such that strategy B is never preferred ex ante Case 1 - the capacity cost is relatively large: For ˆx = 1.25 and 0.7 < x < 1 For ˆx = 1.5 and 0.8 < x < 1 B is ex post preferred to C for relatively large values of x When parameters value are such that strategy B may be indierent to C Case 2 - the capacity cost is relatively small: For ˆx = 1 and 0.5 < x < 1 For ˆx = 0.75 and 0.4 < x < 0.75 B is ex post preferred to C for relatively small values of x Silvia Concettini IEFE Seminars - December /30

25 Silvia Concettini IEFE Seminars - December /30 Results of ex post analysis Proposition Renewable producer preferences between strategies can be reversed even for small errors in the forecasting of the true value of capacity availability factor. The ex post analysis of pay-o highlights that: an ex ante analysis of the game must be coupled with an ex post analysis the negative eect on G production is larger if S adopt strategy B ex post analysis may bring renewable producer to take advantage of rst mover advantage to its maximum extent Lemma The strategic eect of spot market design on investment and production choices of renewable producer may be stronger according to the ex-post analysis of pay-o.

26 Silvia Concettini IEFE Seminars - December /30 Extension I Extensions Dominant rm-competitive fringe model (Carlton and Perlo, 2000): A three stage game The renewable rm is a price taker in the spot market and has a convex production cost function The renewable rm chooses among four strategies q g Ȓ s (q g) A B D R s (q g) C R g (q s) x*k 1 x*k 2 x*k 3 x*k 4 q s The assumptions of the model complicate the calculations Qualitative insights of the analysis are barely sensitive to changes in the market power of renewable producer

27 Silvia Concettini IEFE Seminars - December /30 Extensions II and III Extensions Use the model as a tool for assessing the impact and the desirability of public policies which promote investment in green technologies: Feed-in taris Partial subsidization of capacity costs Optimize a social welfare function within the model in order to assess: The optimal feed-in tari The optimal rate of subsidization of investment cost Competitive eects of policy measures

28 Silvia Concettini IEFE Seminars - December /30 Extensions A theoretical framework for studying strategic interactions between a traditional and a renewable power generators in a decentralized electricity market explicitly accounts for: the randomness of generation from some renewable power sources the merit order for ranking oers in spot electricity markets Competition is modeled as a modied version of the Dixit game (1980) with Cournot competition in the post entry stage

29 Silvia Concettini IEFE Seminars - December /30 Extensions The renewable producer exploits merit order rule to behave as a Stackelberg leader crowding out production of its rival The strategy chosen by the renewable producer may benet consumers too The ex post analysis of payos reveals that the incentives to strategic behavior may be even stronger A tool for assessing the impact and the desirability of public policies supporting green technologies

30 THANK YOU FOR YOUR ATTENTION - Deregulated electricity markets and investments in intermittent generation technologies - Silvia Concettini Universitá degli Studi di Milano and Université Paris Ouest Nanterre La Défense IEFE Seminars - December