Equilibrium Market Power Modeling for Large Scale Power Systems

Benjamin F. Hobbs,

M.IEEE, Udi Hehnan, and Jong-Shi Pang

review of economic equilibrium models for simulating imperfect competition among electricity producers is presented in this paper. The presentation will emphasize the application of a model using a linearized DC grid is formulated using the concept of Cournot and supply-function games, and the resulting models are solved as a linear complementarily Both POOLCO and bilateral-type markets program (LCP). can be simulated. Properties of the solutions are to these models are analyzed. The presentation will include applications to the Eastern Interconnection that explore how transmission limitations and possible mergers might affect the equilibrium prices and market shares calculated bythe model. Imfex TermsElectricity competition, Electricity generation, Market models, Strategic pricing, Complementarity, Cournot, Eastern interconnection.

,4bstract-A

ability to unilaterally manipulate pricesmarket poweris an important concern in restructured power markets. Transmission limitations are an important source of this market power [44]. This panel presentation describes applications and properties of one approach to modeling such markets: equilibrium modeling. To provide context for this presentation, this presentation summary presents a detailed review of approaches to equilibrium modeling and their application. (For other reviews, see [34,47 ].) H. EQUILIBRIUM
MODEL FORMULATIONS

T HE

1, INTRODUCTION

A. De$nition of Equilibrium bfodeling Approach The models applied in this presentation are based upon a general approach of defining a market equilibrium as a set of prices, producer input and output decisions, transmission flows, and consumption that simultaneously satisfj each market participants first order conditions for maximization of their net benefits while clearing the market (suppIy = A solution satis$ing those conditions will have demand). the property that no participant will want to alter their Smeers [47] decision unilaterally (a Nash equilibrium). concludes his survey of energy market models by arguing that explicit statement and solution of equilibrium conditions is a promising theoretical and computational approach to modeling strategic behavior. Although it is well recognized that no modeling approach can precisely predict prices in imperfect markets, there appears to k agreement that such models are

indispensable for gain 1ing insights on modes of behavior and relative differences in efficiency, price levels, and other market outcomes of alternative market designs. Equilibria for the models are obtained by deriving firstorder conditions for each player, adding market clearing conditions, and solving them simultaneously. The first order (Kuhn-Karesh-Tucker/KKT) conditions for an optimization problem MAX F(x,y) subject to G(x,y) = 0, H(x,y)~O, x> Oare: O~. J_ dF/& - J8G/& @H/& ~ 0; dF/2y - A3G/dy - p3H/dy = O; G(,y) = O; O SF lH(x,y)z O where 4 and ~ are the dual variables for constraints G and H, respectively, and J_ is interpreted thus: {0< x J-f(x) ~ 0) is shorthand for: {x> 0: f(x) 50: and xf(x) =0) The equations associated with the nonnegative variables x Many and P are called complementarily conditions. equilibrium models of power markets created by combining the ICKT conditions for all the market participants and then adding equality conditions to represent clearing of the market. A problem that includes both equalities and complementarities is termed a mixed complementarily problem, or MCP, Iff(r) is afflne, then the MCP is a linear MCP (or mixed LCP), Note that the use of first-order conditions to define equilibria implies that each players optimization problem is convex. This is not true of many power operations and planning problems, such as, unit commitment or planning discrete facilities. In general, when there are lumpy decisions, KKT conditions defining a solution do not exist Nonetheless, we will and neither will market equilibria. usually assume that the problems can be approximated as being convex. If this approximation is at times unrealistic, it is at least partially compensated for by the ability to analyze large systems. The direct solution of the market equilibrium conditions by complementarily methods has important computational advantages. Large LCPS and even nonlinear MCPS with thousands of variables and complementarily conditions can be Examples include solved using available MCP software. implementations of Lemkes algorithm and the MILES and PATH solvers within GAMS [21], as well as many contemporary algorithms based on advanced nonsmooth Newton methods. For a summary of various possible algorithms, see Ferris and Pang [19]. These algorithms

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permit application of strategic market models to large systems with thousands of power plants and hundreds or even thousands of constrained! transmission interfaces. B. Applications of Equilibrium Modeling Approach Numerous studies have used equilibrium models to address market power in power markets, many considering competition in both energy and transmission services. The studies can be classifieti by the market clearing mechanism used (centralized/POOLCO or decentralizedbilateral); the representation of the physical characteristics of the electric network; and the assumed type of interaction between rival power producers. Regarding market clearing mechanisms, most studies have implicitly or explicitly assumed a centralized bidding process supervised by a PX or ISO [e.g., 12,37]. This process results in a set of publicly disclosed market clearing prices. There have also been shldies that model bilateral trading [28] and the market power that large power traders might exercise [49]. It has been shown, however, that if there is perfect competition among power traders so that they arbitrage away any non-cost based price differences between different locations, then POOLCO and bilateral trading systems yield the same equilibria under either perfect competition [7] or Coumot competition [36]. Turning to the physical representation of the electric network, many studies disregard transmission constraints altogether [e.g., 1,22, 54]. Others use a transshipment network that ignores KirchhofTs voltage law [2,6,28]. These simplifications may eliminate the opportunity to analyze the unique market manipulation opportunities in electric networks. To correct this shortcoming, some studies have used AC [18,55] or linearized DC [e.g., 12,26,27,33 a,37] load flow models. DC models are more widely applied not only because of their ,inearity, but also because numerical tests have found that their congestion costs are excellent approximations if thermal constraints are the main concern [31]. The final classification-the type of interaction assumed among rival generators and other playershas a crucial impact on model results. Power producers can be intensely competitive or they may collude. Seemingly arcane distinctions in assum~tions concerning player interactions can result in large changes in economic equilibria and policy implications. For example, there has been extensive debate [32,38,50] regarding the proper way to measure and analyze competition in networks and how strategic behavior by producers will manifist itself. What conclusions result depend heavily on the assumptions made. Thus, there is an advantage to modeling frameworks that can accommodate a range of degrees of competitiveness. C. Types of Strategic Interaction in Equilibrium Models
We next define several types of strategic interaction, most of them being familiar concepts from game theory and industrial organization [20,43,53]. They differ in how each player f anticipates that rivals will react to its decisions

concerning either prices p or quantities q. Our models will be designed to represent the fill range of these behaviors. The definitions below refer to competition among suppliers, so q is referred to as sales or output. But more generally, analogous games can be defined between suppliers and consumers, and among consumers; q can therefore also refer to purchases. Also, we temporarily disregard the fact that demand is temporally and spatially distributed. In addition, these definitions omit the effect of contracts for differences upon marginal revenues [23]. Finally, these definitions assume that all players get the market clearing price; however, a pay your bid (first price) auction is soon to implemented in the UK. Strategic models for such auctions can base revenue on the players bid [8,41]. CNo Market Power)/Bertrand: G Pure Competition Just q~ in firm fs revenue pq~ is a decision variable; p is taken as fixed. Thus marginal revenue MR (= 6jq~&) in firm fs first-order profit maximization conditions equalsp. Generalized Bertrand Stratew (or Game in Prices): Here, pqf = pf qfi~ , p.f*), where pf is f s decision variable, p< is the vector of prices offered by other firms, and q~ is a function of all prices. The asterisk on p+ * indicates that facts as if its rivals prices wont change in reaction to changes in f s prices. For a homogeneous good, f can sell as much qf as it wants to (up to the market demand) if p~ s (lowest delivered price among rival producers); otherwise, q~ = O. But for heterogeneous goods (such as green and non-green power), there may be nonzero cross price elasticities, and q,@fip.J will take on other forms. Cournot Strategy (or Game in Quantities): pqf = p(qf +q<*)q~ where P( ) is the inverse market demand tinction and q+ is the quantity supplied by firms other than j The asterisk means that f acts as if it believes that qq is fixed. Thus, the first order condition for profit maximization will have the following marginal revenue term: , MR = +q~$J = P + (4/4)(1 + dlflc%~ = p +- (C+ldj(l +-0) Collusion: If f colludes with another supplier g, then they might maximize their joint profit, equal to p(qf + qg q-id(qf+qJ minus the sum off S and gs COStS. ~his formulation makes the cooperative game theory assumption of transferrable utility; that is, side payments without transaction costs are possible.) Other collusive models result from other assumptions. Stackelberg: If firm f is the leader, and if suppliers other than fare followers whose supply response top is correctly anticipated by f to be q.~~~), then fs revenue can be expressed as p(qf +q.JT@))qj. Stackelberg games in which f is a leader and its followers are instead customers for its output or suppliers of its inputs will have other formulations. Often, qJT@) is a nonsmooth function resulting from solution of equilibrium conditions. General Conjectural Variations: Here, pq~p(qfiq.<qj)q~ ; the output from firms other than f is assumed to be a

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where X<@$Jis the reaction that f anticipates from its rivaLs to its own decisions. However, such equilibria (if they exist) are, strictly speaking, not considered to be Nash equilibria unless X.fl~ is constant (i.e., X.flj = X_J. Most of these types of games have found application to power markets. Collusion has been modeled, for example, as a cooperative Nash bargaining game [2] and as cooperative limit-pricing, in which existing firms collude to prevent new firms from entering [28]. Such limit-pricing has been credited with keeping a lid on prices in the UK [56]. Meanwhile, as previously noted, Stackelberg games have been used to represent the interactions between large power producers or transmitters (leaders) and smaller firms who are followers. In more competitive models, the most intense competition results from Bertrand competition [28,29,57], in G which each firm chooses a single price for each generator or Ew.@iL In this =, output W rivals isanticbated each area served, and believes that other firms will not (perhaps incorrect] y) to respond to price following function q.~); thus, pq~ = p(qJ +q.j@))qj This can be change their prices in response. In the absence of viewed as a generalization of Stackelberg models in that transmission costs and limits on generation and network flows, the Bertrand model causes price to fall to marginal the conjectured response may not equal the true response It can also be seen as generalizing the SFE costthe competitive result. However, in the presence of 9Y-TW method, next. The general rival supply ti.mction such constraints or costs, the generalized Bertrand model results, and prices can drifi above marginal cost and even approach is rarely used in market power simulations; fluctuate without end [6,29]. In the latter case, the only however, it has several advantages that make it worth considering. One is that q.fi) might be modeled as a equilibrium is a mixed strategy (probabilistic) one. smooth finction, ~implifing calculation of equilibria. A less intense form of competition is Coumot competition, where firms instead choose quantity to generate Others are discusseli below. or to sell as if rivals will not alter their quantities. Its . SUPPIY Function Ecluilibria (SFE) [35~ In this special simplicity and, in many cases, ease of computation have made case of the general rival supply fimction model, the decision variables for each firm~are the parameters qyof it a popular game concept in power market models [e.g., l,5,12,33a]. Another argument in its favor is that markets its bid function Pb(i~j/@. A market clearing mechanism involving long term commitments to capacity may show (e.g., the California PX) then determines p, and sets qf = Cournot-type behavior in the long run, even if the firms Pb b/91). AS a result, the revenue term in fs objective compete on price in the short run [57]. Variants on the fimction is (with some abuse of notation) p@~(jJ/qJ + Cournot theme include assumptions that each rival plant will Zz *J Pi] @J/9g*)) pi(j/@. The asterisk indicates that hold its output fixed, that power sold by rivals to each area in bids from other firms qg are treated as if they are fixed. a region is fixed, and that power flows induced by rivals are Let us now define the equilibrium of a game involving the fixed. For example, Oren [37] shows that under one above strategies [20,53]: particular set of Coumot assumptions concerning plant output Nash Equilibrium for a Game in X. Let Xl = & be and some network configurations, generators will set outputs variable(s) (strategies) under control of firm~ ~f be the to prevent transmission congestion in order to avoid paying space of feasible strategies for j X+ = {Xg, Vgzj); and congestion costs. Stofi [51] instead models a market in which fljfljx-~ be the payoff to f given the decisions of all rival sales to each area are assumed fixed [see also 43a], and firms. Then {Xj*,X+*} is a Nash Equilibrium (in pure shows that markets with apparently competitive HHIs can strategies) ifi yield prices well above competitive levels. Because Cournot Iqxf,xf2IZj(y,x.j)G % ~f ) bxf models assume that rivals do not respond to price, the results For Coumot games, Xf = q~; for generalized Bertrand games, are exquisitely sensitive to the elasticity and form of the Xf = pJ , and for supply function equilibria, XJ = qfi A market demand curve. As demand elasticities are now low generalized Nash equilibrium results if& = &(Xg) [50]. and uncertain in power markets (in part because of residual Important questions include whether the equilibria exist and regulation and the lack of real-time pricing), the Coumot are unique, and how they can be calculated. Equilibrium prices tend to be very high and uncertain. concepts can also be defined for games involving Stackeiberg It has been argued that the Cournot and Bertrand players, general conjectural variations, and general rival assumptions may be inappropriate for POOLCO-type supply functions by dei-1 ing {Xf*,Xf*}such that: n auctions, in which firms bid a supply function for each fl,.v. .Yjfll)) ~ flf(xj; ~.jfl~) ~xf E & ~f and generator or entire firm output. In this case, the choice X.J(X~*) X4*, df = variable is the bid fimctions parameters q. Therefore, SFE

iimction of q~ The marginal revenue term in the first order condition forj- S profit maximization is: MR = $q{&, p i- (@/~)(1 + e) = p + (+/@(l + @#@J= where I3is the cor,jectural variation. If 0 is constant and equals O, the Cournot game results. Meanwhile, 6 = -1 yields the pure competition/Bertrand game, while 6 = +1 is equivalent to collusion if~and g are identical firms (and the Coumot conjecture is applied to the output of other firms). If 0 equals the actual local response of rivals, then this is a consistent conjectures model [9]. Recent theoretical work [11] shows that some conjectural variations models are the reduced form of equilibrium strategies in games involving repeated playsuch as dailv . . Dower auctions. General Rival Supply Function (or Rival Price Reaction

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has been chosen as the basis of several power market models [e.g., 4,16,18,22,24,27,41,42,54,55,57]. The resulting equilibria generally lie between the Bertrand and Coumot resultsan intermediate level of competition. But sometimes equilibria are not unique, a large range of outcomes is possible; in general, the Cournot equilibrium will be their upper bound [3,24,35,52]. A drawback of these models, however, is that it is difficult to calculate an equilibrium; indeed, it may not even exist [4]. Most supply fimction studies have been designed for very simple systems (e.g., 1 to 4 nodes). ,kltematively, when a more realistic network has been consiclered, the model searched over only a handful of strategies to find the optimal strategy for each of two firms [18] or the bids have been restricted to a linear fimction with either jixed slope or intercept [27]. A fi.rrrdamentai problem is that the optimization problem each firm faces is nonconvex, and can possess multiple local optima, To our knowledge, there are no published power market models based on the general conjectural variations or general rival supply functions models. The major reasons appear to be the conceptual simplicity of Coumot models and the perceived appropriateness of SFE modeis for POOLCO markets. However, the two latter models also have serious limitations that make it worthwhile to consider alternative approaches. First, Coumot models do not give meaningfid equilibria when price elasticities are low or zer~as they oflen are for short run power demands, ancillary services, and short run supplies of transmission capacity. It is not reasonable, for example, to assume that a supplier will be able push prices arbitrarily high without any response whatsoever from rival suppliers. (Conjectural variation models share this problem with Coumot models when price elasticities are very low or zero; unless @ <-1, equilibrium prices will be very high or infinite.) Another criticism of Coumot models is that they usually predict that mergers will be unprofitable for the merged firms [17]. We will investigate if this flaw is shared by other models, In contrast to Cournot models, general rival supply fimction models give modelers the flexibility to build in more realistic supply responses. Although any particular supply response assumption will be somewhat arbitrary, it is still preferable to assuming significant price elasticities of demand for Cournot models when, in actuality, there is little or no price responsiveness in many power markets today. We suggest that the rival supply response implicitly assumed by each f be treated as a parameter that can be varied to explore how market power might be manifested and distort outcomes; it can also be empirically estimated from data on firm market shares and costs. It is worthwhile at a minimum to perform simulations under both assumptions to check whether alternative rival responses might qualitatively alter the conclusions. SFE models havt limitations of a different sort. Equilibria for SFE modek have proven ditlicuh to calculate for large systems with transmission networks and significant number of generators with limited capacity. The reasons are

that the optimization problem for each firm is inherently nonconvex (and hence a challenge to solve) and, further, equilibria may not exist. Unless strong restrictions are placed on the form of the bid functions (such as linear with only the slope or intercept being a variable), modelers have been forced to make unrealistic assumptions such as all firms having identical marginal cost functions. Therefore, although the asserted realism of the SFE conjecture makes it attractive for markets without significant transmission constraints, it is not a practical modeling method if realistic details on demand, generation, and transmission characteristics are In contrast, MCP models based on the Coumot desired. conjecture have been solved for very large systems, and those models can be modified to represent strategic interactions based on conjectural variations or general rival SUpply flmctions. D. Models Based on Direct Numerical Solution of Equilibrium Conditions Many of the models proposed above are based either on exhaustive enumeration of combinations of strategies (payoff matrices) which are then examined for Nash equilibria, or on closed-form solution of simple equilibrium models. Neither of those approaches can be used for large scale markets with many players and numerous transmission and other constraints. Numerical methods are necessary in these cases. Direct statement and numerical solution of equilibrium conditions has been the basis of several power market models in the literature. These previous models are briefly reviewed here. In an early paper, Schmalensee & Golub [43a] calculate a separate Cournot equilibrium for each of 170 US market areas without considering interactions with other areas or transmission constraints. Later work based on equilibrium conditions attempts to make market simulations more realistic by considering all market areas simultaneously while recognizing transmission. Several market models of this type have appeared in which generators behave competitively (that is, as price takers) rather than strategically [13,39]. For instance, Boucher & Smeers [7] derive equilibrium conditions for several variations of POO~CO and bilateraI markets under the assumptions of pure competition for hth energy and transmission services. They prove that most of those variations yield the same market prices and efficiency, confirming assertions by others [e.g., 33]. Their models include general linear constraints upon power flows, including DC load flow models and nomogram approximations. The result in Metzler et al, [36] that POOLCO and bilateral (with perfect arbitrage) markets yield
the same price equilibria for Cournot generators can be viewed as

a generalization of Boucher and Smeerss results to imperfect competition. Other models consider the possibility of strategic
behavior present conditions Each change by power a Cournot their model producers. that directly power assumes sales, Jing-Yuan SOIVeS market & Smeers the [33a] equilibrium network. will not on

for a bilateral producer output,

on a radial

that other producers they induce

or the flows

the

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network [a la 37]. Transmission tariffs can be set by a regulated body to recover grid costs using either distancedependent or postage-stamp fees. In general, the authors point out that such a system can have multiple equilibria with widely diverging effects on the profits and outputs of individual firms. That is, their MCP generally has multiple solutions. They then use a variational inequality (IV) solution approach to solve for one of the possible equilibria; the VI solution is proven to exist and be unique (even if there are actually multiple Coumot equilibria). In contrast, the MCP models defined in [26,48] have unique solutions, implying that the market equilibria are unique. This is made possible by making the simpli@ing assumption that each generator does not anticipate how its actions will affect transmission pricesi.e., the market for transmission services is effectively competitive. Smeers & Jing-Yuan [48] and Hobbs [26] present models of markets for energy and transmission services in which generators behave strategically in the energy market (Cournot), transmission capacity is rationed competitive y (a la Hogan [30] /Schweppe [45] or Cha&Peek [14]), power flows over a linearized DC network and no arbitragers exist to erase non-cost-based differences in energy prices at different lccations. These models [like 33a] can also include the possibility of generation capacity expansion. Existence and uniqueness properties of the market solution can be proven [36,48]. These formulations permit solution of large problems; e.g., Day and Hobbs [15] apply [26] to the UK power system, which involves 252 busses, 68 plants, and 352 lines. Two other market models explicitly include KKT conditions for Coumot producers for intertemporal power production decisions while omitting transmission constraints. Bushnell [10] considers how such producers would allocate hydropower over time. Meanwhile, Ramos et al. [40] model unit commitment over the course of a day. Other mcdels consider arbitragers/marketers. In [49], generators are competitive but a small set of Cournot arbitragers wield oligopsonist market power with respect to generators and oligopolistic market power with respect to power consumers. Versions of this model wtth thousands of variables have been solved for large systems in the EU. In contrast, the arbitraged bilateral model of Hobbs [26] represents Cournot generators, with the assumption that low barriers to entry mean that arbitragers behave competitively. A large scale version of the latter model has been solved for the Eastern Interconnection [25], considering 2728 plants, 829 producers, and 814 transmission flowgates.

basic Hobbs and Day & Hobbs models, the POOLCO and bilateral transaction (with perfect arbitrage) models yield the same equilibrium prices, profits, and total production by each firm The existence and uniqueness of these solutions has been proven. Also investigated are properties of solutions of models in which generating firms anticipate that prices for transmission services, allowances, and other inputs will change depending on much of those inputs are used by the firm. This relaxes the Hobbs [26] assumption that that generators naively believe that transmission fees will not change. The presentation will also summarize recent applications of the Helman et al. [25] version of the model to the Eastern Interconnection in which several issues are addressed, including the following: 1. In what control areas might transmission limitations between control areas result in significant local madcet power? 2. How do changes in the amount of transmission capability among control areas affect the ability to exercise market power? 3. How would mergers among generating companies aflkct equilibrium prices? IV. ACKNOWLEDGMENT The contributions by our collaborators Carolyn Metzler and Christopher Day are gratefully acknowledged. The opinicms expressed are the responsibility of the authors, and do not necessarily represent the positions of the finding agencies or employers of the authors, V,
[1] REFERENCES

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W.
Benjamin F. Hobbs

BIOGRAPHIES

has been on the faculty of the Johns Hopkins University since 1995. Prewously, he was on the faculty of the Department of Systems, Control, and Industrial Engmeerirrg at Case Western Reserve Umverslty. He M also o consultant to the FERC OtXce of the Economic Adwsor, Udi Helman ISan economist with the Federal Energy Regulatory Commlsslon. He is also a Ph.D student in the Department of Geography & Enwrorrmental Engmeermg at The Johns Hopkins Umverslty, Jong-Shi Pang is a professor in the Mathematical Sciences Department at The Johns Hopkins Umverslry, Prewously, he was a professor in the Schoc~lof Management at the University of Texas, Dallas,

0-7803-7173-9/01/$10.00 2001 IEEE

563 0-7803-7031-7/01/$10.00 (C) 2001 IEEE