Ensuring Generation Adequacy in a Competitive Electricity Market

1
Ensuring Generation Adequacy in a Competitive
Electricity Market

• Shmuel Oren
• University of California at Berkeley
• PUCT Workshop on The Need for Planning Reserves
  Margin Requirements
• Austin, Texas, September 24, 2001

2
What is Reliability

• NERC (National Electric Reliability Council)
  defines reliability as the degree to which the
  performance of the elements of the electrical
  system results in power being delivered to
  consumers within accepted standards and in the
  amount desired
• Reliability encompasses two concepts
• Security the ability of the system to withstand
  sudden disturbances. This aspect concerns
  short-term operations and is addressed by
  ancillary services which includeVoltage support,
  Congestion relief, Regulation (AGC) capacity,
  Spinning reserves, Nonspinning reserves,
  Replacement reserves.
• Adequacy the ability of the system to supply
  the aggregate electric power and energy
  requirements of the consumers at all times. This
  aspect concerns planning and investment and is
  addressed by Planning reserves, Installed
  capacity, Operable capacity or Available
  capacity.

3
Markets and Reliability

• Security and Adequacy are both compliments and
  substitutes. More generation reserves enables
  better security while a highly secure system can
  operate with less reserves.
• security is a public good (like fire protection,
  clean air, defense)
• adequacy can be treated as a private good (like
  auto, homeowners and life insurance).

4
Security

• Decisions concerning required amounts, dispatch
  and cost allocation need be centralized due to
  externalities and free rider effects.
• Can be provided through competitive procurement
  or self-provision of ancillary services.

5
Generation adequacy

• Decisions can be decentralized and left to the
  market.
• In theory, inadequate supply will result in high
  prices which in turn encourage new capacity.
• Reserve generation capacity beyond security needs
  is just a hedge against high prices.
• Customers should be allowed to decide how much
  they want to pay in order to protect themselves
  against the risk of shortages and high prices.
• Suppliers should decide how much to invest.
• These are individual economic and risk management
  decisions that, in theory, can be addressed
  through forward markets and hedging instruments .

6
Competitive Provision of Generation Adequacy

• Buyers decide how much they want to pay for
  capacity according to the price risk they are
  willing to assume or price level at which they
  are willing to be curtailed (buyers are
  responsible for providing curtailment technology
  or demonstrating ability to incur financial
  risk).
• Generators diversify investment risk through
  forward supply contracts that systematically link
  capacity payments to an obligation to supply
  energy at a pre-specified strike price
  (generators are liable for supplying contracted
  energy or compensate the buyer at VOLL).
• Generators that do not receive capacity payments
  (uncontracted) are entitled to sell their energy
  at free market prices which can go as high as
  VOLL.
• Generation gets built if market value of capacity
  (as reflected by contract markets) exceeds cost
  of new generation.

7
Competitive Provision of Generation Adequacy
(contd)

• Demand can participate in mitigation of price
  risk by avoiding capacity payments (not
  contracting) and subjecting their load to
  curtailment (or self-curtailing) during high
  price periods.
• VOLL can be set administratively or replaced by
  demand side response to price signals. VOLL
  serves both as a price cap for uncontracted
  energy and as a penalty for contracted but not
  delivered energy.
• The role of regulatory agencies is reduced to
  ensuring that load serving entities and
  generators have the resources (financial or
  physical) to meet their obligations.

8
Key questions

• Can we rely on the market to provide investment
  incentives for adequate planning reserves?
• What mechanism will provide an income stream that
  can sustain reserve generation capacity?
• Will capital markets operate efficiently to
  sustain an adequate amount of generation
  investment?
• Is an unrestricted energy market in which
  scarcity rents feed new investment politically
  feasible?
• What mechanism should be used (if any) to
  restrain market power and transfer of wealth
  between producers and consumers while investment
  catches up with scarcity?
• What should be the risk management obligation of
  an LSE

9
Alternative Approaches to Ensuring Generation
Adequacy

• Rely on energy markets. (California, Nordpool)
• Consumers and suppliers interact through
  unrestricted energy spot markets.
• Energy spot and future energy prices provide
  price signals and compensation for capacity
  investment.
• Technology mix and generation capacity are
  determined by entry and exit of suppliers and by
  customer choice of desired price risk.
• Shortcomings
• Shortages my result in high prices and political
  baclash
• Large transfer of wealth from consumers to
  producers while capacity is added in response to
  shortages

10
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• Capacity payments (old UK system, Argentina,
  Spain)
• Generators receive capacity payments based on
  availability, technology, VOLL, LOLP to incent
  investment and availability.
• Shortcomings
• Payoff to incumbents but does not reassure
  investors
• Results in over investment and too low energy
  prices that reinforce the need for capacity
  payments
• Supresses demand side response since scarcity
  rents are covered by capacity payments

11
Energy Market With and Without Capacity Market
Energy Price (/MWh)
Demand at 700 - 800 p.m.
Price at700-800 p.m. without Capacity payment
Price at700-800 p.m. with Capacity payment
Demand at 900 - 1000 a.m.
Price at 900 - 1000 a.m.
Demand at 200 - 300 a.m.
Price at 200 - 300 a.m.
GEN 5
GEN 6
GEN 4
GEN 1
GEN 2
GEN 3
Q1
Q2
Optimal Capacity
Capacity with capacity payments
MW
12
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• ICAP obligation (PJM, New York, New England)
• Central agency (ISO or Regulator) specifies
  requirements for planning reserves based on
  traditional planning tools.
• Load serving entities have to meet a monthly
  prorata ICAP obligation
• ICAP markets allow supplier to trade reserves and
  efficiently reallocate the reserves
  requirements.
• Shortcomings
• Capacity market and energy market may not be in
  equilibrium (capacity price does not reflect the
  value of producing energy)
• Short-term supply and demand for capacity are
  inelastic so there is either excess (zero price)
  or shortage (infinite price)

13
Setting Prices vs. Quantities for Capacity
This figure is due to Larry Ruff
14
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• Hedging obligation
• load serving entities are required to provide
  hedges in the form of forward contracts and/or
  call options (with strike prices set by the
  regulator) for up to X of peak load
• Hedging obligations can be met by contracting
  with generators, curtailable load or financial
  securities.
• The availability of alternative means for meeting
  hedging obligations maintains the linkage between
  energy and capacity prices and creates demand
  elasticity for capacity that will discipline
  capacity prices
• Shortcomings
• Does not guarantee iron in the ground
• Not yet implemented

15
Summary

• Capacity payments undermine the potential gains
  of deregulation by leading to over-investment,
  wrong technology choices, and foreclosure of
  demand-side options.
• Short term ICAP markets driven by ICAP
  obligations are inherently unstable and lead to
  artificial disassociation between energy and
  capacity prices
• The role of capacity payments and ICAP
  obligations in ensuring adequacy of supply can be
  fulfilled by risk management approaches and
  hedging instruments that permit diverse choices
  and promote demand side participation.
• Hedging obligations can replace ICAP obligation
  in protecting the public from excessive exposure
  to price risk but the value of capacity as a
  hedge for price risk should be determined by the
  market.
• Regulatory intervention should focus on promoting
  market confidence through rules that facilitate
  liquid markets for energy risk management
  instruments and credibility of long term
  agreements.

16
Recommendation

• Option 4 The commission should establish a
  minimum reserve margin level and a mechanism for
  maintaining that level. The Commission should
  implement the reserve margin mechanism as soon as
  it is formally established
• Buy insurance when you are young and healthy
  (avoid the California syndrome)
• Excess capacity can disappear quickly if
  unutilized generation losses money)
• Mechanisms that rely on markets to set capacity
  value will result in low capacity prices when
  reserves exceed required margin (assuming no
  market power).
• A hedging requirement will provide demand
  responsiveness that will discipline capacity
  prices and prevent market power abuse through
  withholding.