Stateoftheart research project Optimal investment in marketbased energy electricity systems Market a

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State-of-the-art research projectOptimal
investment in market-based energy (electricity)
systemsMarket and regulatory issues

• Einar Hope
• NHH, Energy Forum EF
• EFS 2007, 23 March 2007

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Background

• State-of-the-art research project, financed by
  the Nordic Energy Research for 2007
  documentation in a report by the end of the year.
• Optimal investment in marked-based electricity
  systems one of the most important, complex and
  challenging problem in energy (economics)
  research and practical implementation in market
  design and policy, due to market characteristics
  of electricity and regulatory aspects electricity
  markets.
• Some preliminary observations and discussion
  here.

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Agenda

• The functioning of the Norwegian and Nordic
  electricity market with regard to (optimal)
  investment some observartions
• Economic characteristics of power sector
  investments market based versus network
  activities
• Market investment test potential sources of
  market failure in the value chain from generation
  to end-use, taking regulatory failure also into
  account
• Investment and security of supply/reliability
  issues.
• Implications for competition and regulatory
  policies

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Investment and the Nordic power market

• Experience mainly with the operation of a market
  based system within a given capacity. Large
  efficiency gains from liberalization. Will the
  market pass the optimal investment test?
• Large excess capacity in the former Nordic
  system.This was not the case, to the same extent,
  e.g. for the UK and the US markets prior to
  liberalization and deregulation.
  Approaching/exceeding binding capacity
  constraints in production and transmission
• Different principles for the handling of capacity
  constraints among the Nordic countries. Need for
  harmonization.
• Focus has been on the operation of wholesale
  electricity markets. Investments should be
  considered in the whole value chain more focus
  on investment in the end-use part of the system?

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Some characteristics of electricity as a commodity

• Multi-dimensional product energy(kWh),
  capacity(kW), voltage, frequency, security of
  supply, location etc).
• Demand elasticity price, income (short run -
  long run)
• Derived demand. Low energy cost in relation to
  total cost
• Seasonal variations year, day. Load curves
• Capacity adjustments. Hydro, thermal
• Long term investments. Generation, network
• Self service system

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Characteristics of electricity markets

• Electricity cannot be stored, homogeneous
  commodity
• Instantaneous balancing of supply and demand by
  system operator
• Very low short run elasticity of demand also
  long run derived demand price signals with a
  lag, limited real-time pricing. Also low short
  run supply elasticity
• Capital intensive, lumpy, irreversible and
  durable investment fixed cost, sunk cost. Long
  lead times
• Capacity constraints in transmission the network
  as a market
• Market power issues deriving from characteristics
  and properties of electricity

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Performance criteria Efficiency dimensions

• Static efficiency (operation)
• Cost efficiency
• Optimal use of total production and grid capacity
• Dynamic efficiency (investment/innovation)
• Optimal dimensioning of production and grid
  capacity and optimal mix of production
  technologies
• Introduction of new technology and products in
  the value chain (incentives for innovation)
• Facilitating market integration spacially,
  across energies, and in relation to other
  products/sectors
• Capacity enhancing investment versus investment
  in flexibility
• Security of supply reliability

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Economic efficiency and market failure

• Sources of market failure
• Public goods (security of supply of electricity)
• External effects in production and consumption
  (environmental issues wrt to production and use
  of el)
• Market imperfections
• Economies of scale (natural monopoly, the
  network)
• Monopolisation (concentration market power)
• Lacking or imperfectly functioning markets
• Competition monopoly regulations regulatory
  failure
• Imperfect information asymmetric information
• Uncertainty
• Market failure in energy markets prevalent

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Will the market secure optimal investment?

• Fundamental distinction between the market based
  part of the power system (production and trade)
  and the network part as a natural monopoly
  different economic characteristics
• The network as an instrument for trade in
  electricity and well-functioning markets can
  market and network activities be separated and
  considered in isolation?
• Why should not the market realize optimal
  investment? Identifying potential sources of
  market failure in terms of investment behaviour

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Potential sources of market failure in
electricity markets

• Characteristics of investment in power
  generation specific, irreversible, indivisible
  investments with long time horizon ? sunk costs ,
  high fixed costs in relation to variable costs,
  etc.
• ?Ex ante ex post considerations, uncertainty in
  investment decisions, risk evaluation,
  imperfections in capital markets (?)
• ?Economies of scale investment in large scale
  versus small scale technologies or systems
  decentralized investment e.g. in interruptable
  new renewable energy forms (wind, solar, waves,
  etc) and the need for backup capacity in a large
  scale system generation versus end-use
  investment, etc.

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Potential sources, cont

• Investment and environmental aspects/policies
• Identifying, valuing and internalizing
  environmental costs in investment analysis and
  decision making. Properties of different
  instruments and mechanisms for handling the
  environmental effects of energy production and
  use efficiently. Uncertainty with regard to
  energy and environmental policies, cf e.g.
  investment in gas fired power plants in Norway
  and CO2 regimes
• Investment in new renewable energy forms and the
  phasing in of such energies in the established
  energy system. Stranded costs in the
  established system?

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Potential sources, cont

• Exercising market power by incumbents
• Strategic entry barriers and entry deterrent
  behaviour, preemptive behaviour, foreclosure,
  etc.?
• Incentives for incumbents to invest in new
  production capacity profitability, rate of
  return on investment. Are they too risk averse?
  Ease of entry of independent power producers
  (IPPs) cf the UK experience
• Investment and ownership. Universal service
  obligations for (dominant) incumbents related to
  (public) ownership? Implications of
  cross-ownership for investment behaviour

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Potential sources, cont

• End-use investments
• Information for investment decisions by
  end-users, information asymmetries. Incentives
  measures
• Investment in decentralized production solutions,
  multienergy systems, flexibility in consumption,
  risk sharing contracts, real time pricing, etc
  barriers and imperfections in present system
• Regulatory aspects
• Uncertainty wrt property rights (concessions,
  e.g. wrt the ultimate ownership of hydro assets
  (hjemfall), ownership/privatization,
  establishing markets for trading of assets, etc
• The relationship between market and network
  regulation consequences of new regulatory
  regimes. Stranded cost?

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Tentative summing-up of market based investments
in production/trade

• Optimal rate of investment should be realized in
  a market based power system, on the condition of
• A reasonably stable and predictable energy policy
  and regulatory framework
• An effectively enforced competition policy for
  efficiently functioning markets
• A reservation wrt security of supply issues
  public good aspects
• Market failure versus regulatory failure
• Question will the markets be too cyclical wrt
  investment and reinvestment behaviour?

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Optimal network investment in a market based
power system

• The network as a market instrument
• The network as a natural monopoly
• Network characteristics in a market setting
• Observing physical laws wrt to power flows and
  network conditions
• Specific, irrversible investments
  indivisibilities (lumpiness) wrt investment and
  network capacity
• Network externalities, system effects
  internalizing externalities through network
  integration economies of scope through across
  network integration, e.g. gas
• Identification of capacity constraints in meshed
  networks under network integration
• Network/system operation versus network
  investment

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Some network investment issues

• Methods and criteria for evaluating optimal
  network investment in a market based power
  system cost-benefit analysis economic
  efficiency short-term versus long-term
• The incentives for network owners to undertake
  commercially profitable investment and the
  relationship between private and public
  profitability (economic efficiency)
• The relationship between overall investment
  planning for the network system and the
  implementation of an optimal investment programme
  for the total network division of labour and
  responsibility among involved parties, vertically
  and horizontally

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Some network investment issues, cont

• Degree of decentralization of investment
  decisions in networks (Merchant Transmission
  Investments) decision criteria, allocation of
  property rights, local market power, etc.
• Network investment versus production capacity
  investment location decisions wrt generation in
  relation to network load and power demand
• Methods for handling of capacity constraints in
  networks properties of different solutions
  relationship between capacity constraint handling
  and capacity investment

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Some issues, cont

• Network investment and network regulation
  incentive properties of different regulatory
  mechanisms and approaches wrt investment
• The relationship between national and super
  national (e.g. regional) investment planning,
  regulation and implementation of investment
  programmes in spacially integrated markets/the
  Nordic market
• ISO versus TSO models for network organization
  and system operation choice of model and
  implications for investment in the Nordic power
  network

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Brief summing-up of optimal network investment
and some questions

• Complex and partly unresolved issues,
  theoretically and practically
• (Optimal) network investment necessitates a
  planning and regulatory system clarify incentive
  properties of different systems, and a proper
  division of labour and responsibility among
  involved parties
• To what extent can investment decisions be
  decentralized?
• Given network properties and the market
  consequences of binding capacity constraints
  should networks be dimensioned with excess
  capacity?

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Investment issues wrt security of supply

• Definition of SoS Customers have access to
  electricity at the time they need it with the
  defined quality. (CEER WG on SoS)
• ReliabilitySystem operation without
  interruption and disturbance within the defined
  period.
• SoS as a public good how to secure the optimal
  provision of SoS?
• Short term issues framework and security
  criteria for grid planning and operation. Long
  term sufficient grid and generation capacities
• The energy and capacity dimensions of SoS in a
  hydro system

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Concluding remarks some measures

• Designing efficient markets for optimal
  investment in production and trade of electricity
• Clarify the relationship between market and
  network activities and properties wrt to
  investment and the market functions of the
  network
• Clarify conditions and regulatory measures for
  optimal network investment
• Clarify implications of spacial market
  integration wrt national solutions and policies,
  and implementing measures
• Clarify conditions and requirements wrt to SoS