DESIGNING AND TESTING MARKET RULES 5.1 Design for Competiti e !ri"es
In economics, it is well said that the markets should be designed to produce competitive prices, but especially in electricity markets, competitive prices sometimes appear disconcertingly high. Opening wholesale electricity markets, in which energy is purchased for subsequent delivery to those who use it, has been accompanied by concerns that such markets fail to be competitive. The California electricity market “meltdown in the summer of !""" brought with it numerous accusations of inadequate competition and analyses of the role that it may have played in creating price spikes and destabili#ing the market. $hile most designers remain loyal to the ideal of competitive prices, many decide to redefine them to be lower at times, and some believe that they are %ust not right. Competitive prices sometimes include a scarcity rent much greater than needed to cover the concurrent fi&ed cost payment. In a competitive unrestricted market, s"#r"it$ rent is the difference between the value to consumers of the most valuable '$h that cannot be supplied due to limited generation capacity (i.e., the marginal demand)side offer accepted* and the marginal cost of the most e&pensive '$h served. +carcity rents represent the market mechanism needed to signal resource shortages and provide incentives for new investment in resources. In a long)run equilibrium, if we allow generators to collect such scarcity rents by letting demand)side bids set the clearing prices in times of shortage, then the scarcity rents should be e&actly what are required to cover the amorti#ed fi&ed cost of the marginal generating unit. ,urthermore, if the technology mi& is optimal, i.e., least total cost, then the combination of scarcity rents and infr#m#rgin#% profits, which amount to the difference between the market clearing prices and the respective marginal costs, will e&actly cover the amorti#ed fi&ed cost of each generation technology in the capacity mi& in the long run. +carcity rents are necessary for suppliers to cover their fi&ed costs, which, can be thought of as a constant flow of cost equivalent to the cost of renting the power plant. In power markets the scarcity rents fluctuate dramatically and consequently, the competitive prices are too high sometimes and lower other times. ,ederal -lectricity .egulatory Commission (,-.C* proposed a p#$&#s&'i( auction design in the hopes of holding prices below their competitive level. The pay)as)bid rule is currently used in the -ngland and $ales spot market. +everal early proposals for the California -lectricity market also had this intent. In a pay)as)bid auction, prices paid to winning suppliers (those competitive suppliers selected to provide power supply in any given time period / along with the price and other terms of the power sale* are based on their actual bids, rather than the bid of the highest priced supplier selected to provide supply. ,or this reason, pay)as)bid auctions are also known as “discriminatory auctions” because they pay winners a different price tied to the specific prices offered in their bids. 'any schemes have been proposed to hold prices down to variable cost, and given sufficient regulatory authority they can be effective. Consequently it is important to understand that reducing price in the short run will increase it in the long run. This is not true if prices remain at or above the competitive level, but the competitive price pays higher and lower cost producers e&actly the same when they both are needed at the same time. ,-.C0s scheme was intended to hold baseload prices well below the competitive level. The -fficient)Competition .esult states that competitive price will, over the long run, induce the right investment in both baseload plants and peak load power plants.

6 4nfortunately. There is. a need for a mechanism such as . $hile this is recommended. few designs are implemented without claims that they produce 6the correct incentives6 and 6efficient outcomes. The window for receiving bids in .+2+*. especially when gambling with sums that can run into the billions of dollars. at present in the Indian conte&t.re-. The test procedure can be broken into three steps. a more modest course of testing is presented here.1 T2e )ottom&Line Test of M#r+et R. 'odel the cost functions of the players in the market.+2+ would be based on the principle of “pay) as)bid and the amount payable would be for the despatched quantum at the bid price of the participant.1. Compute the cost increase of serving the load under proposed rules. most market rules can be tested . +imilarly. 7o design should be implemented without this minimal level of testing. which is called the 6bottom)line test6 because it tests the effect of a market design on the total cost of supply. to maintain grid security. time)block)wise stack of the bids received from all the power e&changes.re-. The prices payable to the providers of .pport An"i%%#r$ Ser i"es / . The window for receiving bids in . and it sets a minimum standard. The stack to be prepared on the principle of merit order of bids. when such designs are tested against even the best)behaved hypothetical situations. for ensuring grid safety and security.1 !#$&#s&)i( !ri"ing in Conte*t to In(i#n E%e"tri"it$ M#r+et It is seen that there is some surplus generation capacity lying unutili#ed at some point of time but at the same time load shedding is being carried out by the utilities.1 Testing of M#r+et (esign In a turbulent environment such as the restructuring of the 4.5. new market designs are nearly always conceived and implemented without rigorous testing.SAS0 to utili#e these un)despatched1 surplus capacities to enhance the power supply to the grid. etc. when required. It does not provide a cookbook procedure. Compute the minimum possible cost of serving the target load level.1. 5.requency +upport 2ncillary +ervice would be the service offered through bids by a generating station or any other authori#ed entity on behalf of the generating station to make itself available for dispatch and get dispatched1 scheduled by the nodal agency to support the system frequency. sugar industries. electric industry.en"$ S. If consumer response to price (demand elasticity* is important for the rules being tested. The nodal agency would be responsible for preparing combined bid area)wise.%es 1. under certain conditions. but it provides a structure that is often missing. In fact a complete absence of testing is common5 however. there is captive generation capacity available with industrial users like steel industries. The bids to be invited on a day ahead basis for which the window would be open for submitting bids considered for despatch ne&t day.requency +upport 2ncillary +ervice market to be opened after closure and clearance of the day)ahead market (32'* in the power e&changes. therefore. . .+. . then the bottom)line test must be modified by e&amining the decrease in total surplus caused by the design instead of the increase in cost. 5. which are lying un)utili#ed and could be harnessed to supply to the inter)+tate grid at the time of utter need to maintain grid security. 2 moderately rigorous test would involve a laboratory simulation of the market design. they do not always live up to their claims. aims to stabili#e the grid frequency by ma&imi#ing unutili#ed generation and minimi#ing load shedding.en"$ S. The bids to be invited on a day ahead basis for which the window would be open for submitting bids considered for despatch ne&t day.ortunately.pport An"i%%#r$ Ser i"es /. 3. !.requency +upport 2ncillary +ervice market to be opened after closure and clearance of the day)ahead market (32'* in the power e&changes.

'odeling elastic demand would complicate the computation of benefits and is not relevant to the benefits being claimed. but with practice.or a particular specification of the test model. 2ssume for simplicity that generation can be located near either city. Step 14 Comp. This may not be true when a rule is first put in place. step ! always gives a simple answer that is %ust one number. These are specified in the final sub)section which uses the details of the model to compute costs. To perform a 6bottom)line test.igure <.ting Cost . . The basic bottom)line test which focuses only on supply costs will be sufficient. 7o e&cuse should be accepted for a more comple& or less precise answer although it may be useful to test several variations of the.6 first determine what costs and benefits are relevant. 8ack of demand elasticity confers market power on suppliers. . Step 34 Comp. and the model needs at least one wire and two generation locations to evaluate the design. and they are connected by a transmission line as shown in .ting Costs.m Cost The bottom)line test requires computing the minimum cost of producing and delivering the power required to meet a fi&ed level of demand. +uppliers will react to market rules. so to counteract the effects of inelastic demand. -conomics enters the test process at this point by dictating the assumption that suppliers will ma&imi#e their profits.enerally a little mathematics will simplify the process. the relevant costs are (:* the cost of generation including its dependence on location.: Step 14 ). In principle this can be done by trying all ways of producing the required output. Then consumer benefit is unaffected by market rules and drops out of the test procedure. . suppliers should simply be assumed to behave competitively.:. A useful economic model must include both.i%(ing t2e Mo(e% #n( Comp. E*#mp%e4 2ssume that there are two cities in the market. is generally the best appro&imation available. The first test of a design should be as simple as possible.ting Minim. The profit ma&imi#ing assumption is key to economics.igure <. and this reaction must be predicted.%es The behavior of suppliers must be considered when computing the effect of the rules on the total cost of delivered energy. and most designs are not efficient in the presence of market power. The bottom)line test is only intended to test designs for competitive markets.adequately under the assumption of completely inelastic demand. and the cost is= > :"1'$h ( `?<"1'$h appro&imately* for capacity .n(er t2e !ropose( R. and (!* the cost of wires. suppliers should learn how to ad%ust their behavior to the rule and ma&imi#e their profit. Step 14 Mo(e%ing Costs #n( )enefits 9asic economics always assumes market participants will act to ma&imi#e their benefit net of costs. and though not precisely true. so cost and benefit functions must be specified to calculate the predicted behavior. In this case.

(This second power flow is in the opposite direction and cancels the first."""1h for energy C <"" '$ & >A1'$h B >!. but this does not affect the charges. supply would be physically less than demand and the market would not clear. and for reliability purposes assume the minimal line capacity is <"" M5. because the e&ploitation of market power can significantly erode the consumer benefits that would be e&pected to result from the transition from regulated to competitive markets. 5.$ transmission line will be built to supply 90s peak load. In wholesale power markets.ule :1A. no power line is needed to facilitate trade. The generators located at 9 would have @1A. 2ssume peak load on the system is :?.""" '$ of generation at A and A""" '$ of generation at 9. In particular. $hile proper market design is important. if they were located in the minimal cost arrangement %ust described. the generators at 9 are charged three times more than the generators at A. Step 34 .orward contracts and obligation of suppliers."""1h for generation capacity C :". Consequently a A .n(er t2e !ropose( R. the generators at A would have :/A. of their flow assigned to the line from A to 9 because by . The long)run consequence of this dynamic is that all new generators will locate at A and all e&pansion of e&isting generators will take place at A. 9ecause the above model assumes that generators cost the same at either location. a player is said to have market power if it is pivotal5 which means that it is so large relative to the pool of other suppliers and to demand that. One of the important conditions is that structural market power must be eliminated or effectively mitigated. This is the minimum total cost of serving the load. In this case.m Cost.3 M#r+et !o6er 'arket power is defined as the ability of a supplier to profitably raise prices above competitive levels and maintain those prices for a significant time period. of their flow assigned to that line. 'arket Fower in power markets can be effectively mitigated or reduced by the following techniques= a.""" '$ located at city A and A""" '$ located at city 9. Step 14 . the cheapest arrangement is to locate them where they are needed.3. 2ssume the average hourly load is :".1 Design to Re(. without it. A is the cheaper place to locate. . it will be replaced with a generator at A because. The total long)run cost of power in this model is found by summing three components as follows= :?. the success of competitive electricity markets depends first and foremost on structural conditions that do not distort market outcomes. of it goes to the !<D of load at 9. $henever a generator is retired at 9.* 9ecause charges are proportional to flow."""1h ) for line capacity for a total of >@?!. generators will pay different transmission charges depending on their location. .in(ing Tot#% Cost ."""1h."e M#r+et !o6er /M#r+et !o6er Mitig#tion0 Competition is good public policy as it encourages efficiency and price transparency. assume that line capacity costs >A1'$h ( `?<"1'$h appro&imately*.%es 4nder the proposed transmission pricing rules. 5.""" '$ & >!"1'$h B >!"". all generating plants will be located at A. This brings total cost under the proposed design to >@E?.""" '$ & >:"1'$h B >:?".""" '$.""" MW with :!."""1h. That is eight times bigger than the <"")'$ line required for reliability in the least)cost configuration. An e&tra @<"" '$ of line costs an e&tra >:A. In the long run."""1h.in(ing t2e Minim.and >!"1'$h (`:@""1'$h appro&imately* for energy. This increases the total cost of energy by the cost of the e&tra transmission line. that is :!. The market power issue is of particular interest to policymakers and legislators as they consider electric power industry restructuring. counting transmission charges. This is a sufficient model of the relevant costs.

in which only two firms compete to sell a given good in a market. c.pp%iers4 -lectricity forward contracts represent the obligation to buy or sell a fi&ed amount of electricity at a pre)specified contract price. each firm must consider how the quantity it produces might affect the quantity it sells.0 True supply)curve bidding differs from this prescription by setting price above marginal cost but below the price cap for some quantities. and the true supply)curve type. 8ong)run consequences. traditionally defined by the industry as "?="" ) !!="". Consider the case of a 3uopoly.pp%$&C.r e )i((ing4 2 second factor reducing market power below the level predicted by the Cournot model is that suppliers do not bid in the Cournot style. The daily “off)peak period is the remaining hours of the day. 4ncertainty of demand which causes supply)curve bidding. electricity forwards differ from other financial and commodity forward contracts in that the underlying electricity is a different commodity at different times. Imperfect competition can be modeled using either a Cournot 'odel. d. A Cournot bid curve will set price to marginal cost up to some Cournot quantity limit and then set price at the price cap beyond that. refers to more than %ust a formal bidding procedure in which a price is specified at a number of output levels. where the buyer is obligated to take power and the seller is obligated to supply. the market price is a parameter over which firms have no control and each firm should increase its production up to the point where its marginal cost is equal to the market price. This is a qualitatively different strategy and is referred to as 6supply)curve bidding. “On)peak electricity refers to the electricity delivered over the daily peak)period. If both firms must decide simultaneously how much to produce. 8ike Cournot competition.or6#r( Contr#"ts #n( 7'%ig#tion of S. in which firms decide how much they produce or a 9ertrand model. 2lthough the payoff function (:* appears to be the same as for any financial forwards. Consider a forward contract for the on)peak electricity on day T. each of them will estimate the e&pected production of the other. at certain time in the future (called maturity or e&piration time*.6 It is important because the use of this bidding strategy reduces market power relative to the Cournot +trategy. In other words. 9etter market design . The payoff of a forward contract promising to deliver one unit of electricity at price . known as the forward price. in which firms decide at what price they sell their production. 5. 8et us assume that firm : estimates that the . In supply)curve equilibrium.rnot Mo(e% In a perfectly competitive market. at a future time T is= Fayoff of a . The settlement price ST is usually calculated based on the average price of electricity over the delivery period at the maturity time T. This is the standard 7ash equilibrium concept. The best e&ample of the benefits of forward contracts is provided by the residual obligations of regulated utilities to serve their 6native load. ST is obtained by averaging the :? hourly prices from "?="" to !!="" on day T. $hen competition is not perfect.6 however.8 Co.b. electricity forwards are custom) tailored supply contracts between a buyer and a seller. +upply)curve bids come in two types= the Cournot type. In this case.6 Dem#n( Un"ert#int$ #n( S. %ust as in Cournot equilibrium.orward Contract B ( S T − F * (:* where ST is the electricity spot price at time T. each supplier plays a strategy that is optimal given the other player0s strategy. supply)curve competition is defined in terms of a game played between suppliers. They do not simply bid quantities but instead bid supply curves. 6+upply)Curve 9idding.

8et us now consider the case in which there are n firms competing in the market...actoring out on the left)hand side and multiplying the second term by ... + y n (<* . $e can e&press this relation directly in the form of a reaction function= e y: = f: ( y ! * (!* +ince firm ! follows a similar process to optimi#e its production.. as they observe the market and gather more information. we also have e y ! = f ! ( y: * (@* 2t first. the estimates that each firm makes of the production of their competitor may be incorrect or inaccurate. If we define the market share of firm i as and use the definition of elasticity. we get  y Y dπ (Y *  dc( y i * π (Y *: + i = dy i  Y dy i π ( y *  (J* The right hand side of equation (J* is equal to the marginal cost of production of firm i. their productions reach the Cournot -quilibrium= y: = f : ( y ! * y ! = f ! ( y: * H H H H e (A* Once this equilibrium is reached... Gowever. 4ltimately. The total industry output is Y = y: +.... e ma& π ( y: + y ! * y: − c( y: * (:* y : where π ( y: + y ! * represents the market price that would result from the e&pected total output e ( y: + y ! * . then equation (J* can be written as ... they revise their estimates and ad%ust their production accordingly. neither firm would find it profitable to change its output.e production of firm ! will be equal to y ! . This ma&imum is achieved when d { yi × π (Y * − c( y i *} = " dy i (E* or π (Y * + y i dπ (Y * dc( y i * = dy i dy i Y 1Y (I* . like all the other firms. . seeks to ma&imi#e its profit= y: ma& { y i × π (Y * − c( y i *} (?* where the market price π(Y * is a function of the total industry output.. The optimal production of firm : thus depends on its estimate of the production of firm !.irm.irm : then sets its production at a level y: that ma&imi#es its e&pected profit.

-&plain whyL :!.π (Y * :−     si ε (Y *   dc( y i * = dy i   (:"* This e&pression suggests that when the market share of firm is not negligible. Gow market power is e&ercised or controlled in competitive electricity marketL :". $hy pay)as)bid auction design is better than the scarcity rent mechanism in electricity marketL A. Review Questions for University Exams :. $hat do you understand by market powerL -&plain in detail how market power is mitigated in competitive electricity marketL I.ules for testing the market designs in liberali#ed electricity market. it ma&imi#es its profit by setting its production at a level where its marginal cost is less than the market price. -&plain with proper illustrations the 9ottom)8ine Test of 'arket . suppliers bid supply curves instead of bidding quantities. -&plain Fay)as)9id Fricing in Conte&t to Indian -lectricity 'arket. 2ctions aimed at reducing market power therefore have to be initiated by regulatory authorities representing the interests of the customers. E. It is interesting to note that one firmKs ability to e&ert market power benefits all the firms in the market because it raises the price at which price)taking firms sell their products. -&plain in detail the design for competitive prices in liberali#ed electricity market. $hy supply curve bids increases competition in power marketL . !. $hy market designs in restructured power system or liberali#ed electricity market are testedL -&plain in detail the testing of market designs in competitive electricity market. 3efine supply)bidding curve. ?. In competitive electricity market. $hat do you understand by scarcity rent and inframarginal profitsL @. <. -&plain in detail the design to reduce market power in electricity marketL J. Gow it can be used to reduce market powerL ::.

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