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# Electricity Economics

EW III
Vorlesungsmitschrift (WS 2006/2007)
Basiert vollstndig auf:
Stoft, Steven (2002): Power System Economics Designing Markets for Electricity; New York; Wiley

1.

2.

## Pricing Power, Energy and Capacity (Ch. 1-3) .............................................................................. 2

1.1.

What is Electricity?................................................................................................................ 2

1.2.

1.3.

1.4.

2.1.

3.

4.

5.

3.1.

3.2.

4.1.

4.2.

4.3.

4.4.

5.1.

5.2.

5.3.

5.4.

5.5.

1.

## Pricing Power, Energy and Capacity (Ch. 1-3)

1.1.

What is Electricity?

Electricity

water

Voltage ~

pressure

Generator

water pump

## Variables and Units

Working Summary
Readers wishing to gain only a working knowledge of
measurement units for use in later chapters should
understand the following.
Quantity

Quantity Units

Price Units

Energy

MWh

\$/MWh

Power

MW

\$/MWh

Capacity

MW

\$/MWh

Cost

Symbol

Cost Units

Fixed

FC

\$/MWh

Variable

VC

\$/MWh

Average

ACK = FC + cf x VC

\$/MWh

Average

ACE = FC/cf + VC

\$/MWh

Ratio

Symbol

Units

Capacity factor

cf

none

Duration

none

## Notes: Energy is a static amount while power and

capacity are rates of flow. The average cost of using
capacity, ACK, depends on the capacity factor, cf, which
is the fraction of time the capacity is used. The average
cost of energy, ACE, produced by a specific generator
also depends on cf.

Unit Arithmetic
Units-kilowatts, hours, and dollars-follow the normal laws
of arithmetic. But it must be
understood that a kWh means a (kW x h) and a \$ per hour
means a (\$/h).
Also note that 8760 hours per year has the value of 1,
because it equals (8760 h)/
(1 year), and (8760 h) = ( 1 year).
As an example, \$100/kWy =

\$100

1000kW

1 year

1.2.

[MW], 1W =

1J 1Nm
=
s
s

## Energy ~ flow x time of flow

[MW] x [h] = MWh
Attention: Energy is a normal measure of work (w)

J
J
x h = 106
x 3600s = 3600 MJ
s
s

MWh = 106

## or: 1 kWh = 3600 kJ

Commonly used: a mill (milli-dollar, 1/1000 \$), to convert: 80 \$/MWh = 80 mills/kWh
= 80\$ cents/kWh.

1.3.

Problem:

## How to determine the costs of a certain electricity supply, given that

generation capacity is measured in MW (apples) and electricity generation is
measured in MWh (pears).

Solution:
Conversion of capacity costs through screening curves and the overnight cost of capacity.

## The Overnight Costs of Capacity (OC)

OC ~ present value cost of the plant (if it had to be built over-night), in \$/kW

xh

8760h

in % =

## Capacity factor (cf) ~ load duration x 100 (0 cf 1)

Screening curve ~ Annual revenue requirement per kW (ARR) as a function of capacity factor:
-

## Figure 1-3.1 Use of screening curves to select a generator.

Converting OC FC/kWy
FC =

r OC
r OC

rT
1 e
1 1 /(1 + r ) T

## r ~ discount rate (%/year)

T ~ life of plant (years)
Table 1-3.1 Technology costs

Technology

VC

VC

OC

FC

FC

(MWh)

(/kWy)

(/kW)

(/kWy)

(/MWh)

Gas turbine

\$35

\$306.60

\$350

\$40.48

\$4.62

Coal

\$10

\$87.60

\$1050

\$106.96

\$12.21

## Screening curve: ARR = FC + cf x VC

Two Kinds of Average Costs: Capacitycost and Energy-cost based Screening Curves
Screening curve for capacity: average cost of using a plants capacity (D ~ average load duration)
ACK = FC + cf x VC = FC + D x VC
Screening curve for energy: fixed costs divided by cf + variable costs
ACE =

FC
FC
+ VC =
+ VC
cf
D

## Table 1-3.2 Fixed and Variable Cost of Generation

Overnight

Fixed

Fuel C

Capacity Cost

Cost

Cost

Heat rate

Cost

\$/kW*

\$/MWh

\$/MBtu

Btu/kWh

\$/MWh

1729

23.88

0.40

10,400

4.16

Coal

10212

14.10

1.25

9,419

11,77

Wind

919

13.85

---

---

533

7.36

3.00

6,927

20.78

Combustion turbine

315

4.75

3.00

11,467

34.40

Type of Generator

Variable

*Overnight capacity cost and heat rates are from DOE (2001a), Table 43. Plant not labeled advanced are conventional. Rental capacity
costs are computed from overnight costs, a discount rate of 12% and assumed plant lifetimes of 40 years except for wind and gas turbines
which are assumed to be 20 years. For simplicity, operation and maintenance costs are ignored.
**integrated gasification combined cycle: GuD-Prozess mit integrierter Kohlevergasung

1.4.

## Power Supply and Demand (Ch. 1-4)

Load-duration curve: measures the number of hours per year the total load is at or above any given
level of demand

## Screening Curves and Long-run Equilibrium

Figure 1-4.3: Using screening curves to find the optimal mix of technologies

2.

2.1.

## Ancillary Services and the System Operator

Bulk Generation
competition
Balancing ~ maintaining system frequency (50Hz or 60 Hz)
in cases of generation decrease or load increase
free-rider problem:

supply:

demand:

## must be maintained/regulated by system operator

Voltage Support
Voltage sags when too much reactive power is taken out of the system, must be injected by capacitors,
or synchronous condensers.
Black Start Capability
Ability to self-start (when the system goes down)
The System Operator Service (SO)
Coordination of ancillary services, monopoly
Independent system operator (ISO): nonprofit, independent
Trans Co: for-profit system operator
Unit Commitment
Who tells generators when to turn on, how much to produce at each point in time, and when to turn
off?
Two approaches:

(bilateral)

Some examples:

Pool Co:

Nodal pricing:

Bilateral:

## Transmission Congestion Management

Problem: How to allocate scarce transmission capacities?
7

## Price = marginal costs + shadow price of congestion

2 options:
Central dispatch (nodal prices determined by ISO, who gains congestion rent)
Decentralized, bilateral trading of TR (transmission rights), private companies earn rent
2 further options:
financial transmission
physical transmission rights
Risk Management and Forward Markets
Centralized (stock market) vs. decentral (OTC)
Electricity Transmission, Distribution
natural monopolies (subadditive cost curve), for a long time to come
regulation required
Retail Supply
possible, but what gains to expect?
Table: Power Market Segments

Service
bulk generation
balancing service

Competition

Regulation/Centralization

Hybrid

x
supply

demand

voltage support

supply

demand

black-start

supply

demand

(frequency)

capability
system operator

service
unit commitment
transmission congestion

bilateral

nodal, pool

TRs

management
risk management

electricity

transmission/distribution
retail supply

3.

3.1.

## Demand, Supply, Surplus

Perfect Competition

Definitions

Agents act competitively, have well-behaved costs and good information, and
free entry brings the economic profit level to zero.
Act Competitively
To take the market price as given (be a price taker).
Well-Behaved Costs
Short-run marginal cost increases with output and the average cost of
production stops decreasing when a suppliers size reaches a moderate level.
Good Information
Market prices are publicly known.

Allocative efficiency:

## Priced such that total surplus (welfare) is maximized.

Productive efficiency: Production costs have been minimized given total production.
Overall efficiency:

## Allocative and productive efficiency.

Figure 1-5.2 Total surplus equals the area between the demand curve and the marginal cost curve.

3.2.

## Marginal costs in a Power Market (Ch. 1-6)

Economic tells us to set price at marginal costs, but what is marginal cost?
Aggregate supply curve ~ horizontal sum of individual generators supply curves

Figure 1-6.2: Adding individual supply curves horizontally to find the market supply curve. If B is continuous, A + B is also.

## Left- and Right-Hand Marginal Costs

Problem:

The costs of producing one unit additional may be different from the
savings of production one unit less.

Definitions:

## Left-hand marginal cost (MCLH)

The savings from producing one less unit of output.
Right-hand marginal cost (MCRH)
The cost of producing one more unit of output. When this is impossible, MCRH
equals infinity.
The marginal-cost range (MCR)
The set of values between and including MCLH and MCRH.

Result:

## Competitive Suppliers Set output so MCLH P MCRH

A competitive producer sets output to a level at which its marginal-cost range,
MCR, contains the market price, P, whether or not that is the competitive price.
A Marginal-cost Example
Four suppliers can each produce 100 MW but no more.
Each supplier has constant marginal cost (MC) up to this limit.
10

1.

2.

3.

1.

2.

3.

4.

## P is greater than the cost of the last unit produced (\$60/MWh).

In both case the marginal-cost rule for competition is
MCLH P MCRH*
This is sufficient to determine the competitive market price and output.

MCLH is the savings from producing one unit less. MCRH is the cost of production one unit more and is
considered arbitrarily high, or infinite, if another unit cannot be produced.

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4.

4.1.

## Reliability and Investment Policy

The issue:
Create sufficient incentives for generators to invest in installed capacity (ICap), which the market
may not provide.

Figure 2-1.1: The structural core of a power market determines reliability, price spikes, and investment

Two Cases:
a)

0 Demand elasticity

P
D

S
Q
no equilibrium
the market does not provide adequate reliability

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Fallacy 2-4.1

## The Market Will Provide Adequate Reliability

Contemporary markets, with their demand-side flaws and negligible demand
elasticity, would grossly under invest in generation without regulatory price
setting.

b)

D2
S

D1

P2

P1

Q1

Q2

## Equilibrium P-Q will be found

Temporarily very high price levels are possible (price spikes)
Price spikes suffice to recover fixed costs, generate investment

Result

## Energy and Capacity Prices Together Induce Investment

Investment responds to expected short-run profits, which are determined by
energy prices and (if there is an installed-capacity requirement) by capacity
prices. Regulatory policies determining these prices nee joint consideration.

13

4.2.

Fallacy 2-2.1

## Marginal-Cost Prices Will not Cover Fixed Cost

If the price paid to generators always equals their (physical) marginal cost, they
will fail to cover their fixed cost.

Figure 2-2.1: Continuous marginal costs and a nearly flat (elastic) demand curve for one supplier.

Revenue R=P x Q
Short-run profit ~ scarcity rent ~ producer surplus ~ inframarginal rent:
Scarcity rent = R Total variable costs.
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## Why the competitive price exactly covers fixed costs:

If not, producers have to leave the market, until a capacity shortage occurs, which raises prices, and
eventually induces investment.
Result:

## In the Long-run, Supplier Recover Their Fixed Costs

In a long-run competitive equilibrium, generators recover their fixed cost and no
more, even though price equals physical marginal cost (P=MC) at all times and
for all generators. Revenues that help cover fixed cost are called short-run
profits.
Restatement for Supply Curves with Vertical Segments
In a long-run competitive equilibrium, generators recover their fixed cost, even
though the market price is competitive and satisfies MC LH P MC RH at all
times and for all generators.

4.3.

## Optimal price spikes for peakers

Weaker version of the fixed-cost fallacy: long-run forces will assure that fixed costs are covered, but
this may lead to a short all in generation capacity under competitive pricing and varying demand.

## The supply side: base-load and peakers

Table 2-2.1: Costs of Available Technologies

Technology

## Variable Cost per MWh

Peaker

\$6

\$30

Base

\$12

\$18

Figure 2-2.2: Two technology screening curves showing capacity factors for which each technology is optimal.

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Demand side:

## Regulatory solution (average pricing)

Faced with this market, the traditional regulatory solution would be to set price to average cost, build
enough generation capacity to cover the full 8000 MW of peak demand, and use the screening curves
to determine that 6000 MW should be base-load capacity and 2000 MW should be peak capacity. this
last conclusion is determined by reading the screening curves to find that the trade-off point is at a
duration of 0.5 and then reading the load-duration curve to find that, at this duration, load is 6000
MW. The regulatory solution finds the optimal level of base load capacity but sets too high a level for
peakers capacity. Regulators have traditionally set price at average cost and this has prevented high
prices from dampening demand when power was scarce. Consequently, peak demand is higher than is
socially optimal. If the costs of peak usage were paid for entirely by the users of peak power,
consumers would consume less on peak. Because regulators use average-cost pricing, customers pay
more at all other times and more in total than they would pay if given the relevant choice.

## The optimal solution

The optimal solution is the same as the regulatory solution except that it takes into account the high
cost of serving peak load and the willingness to pay for this service. The optimal system will spend
some time with load exactly equal to generation capacity.
Average cost for peak energy produced:

## AC E = (\$6 / DPS + \$30) / MWh

Must be set equal to the value of power to consumers (\$1000)

6 / DPS + 30 = 1000
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## DPS 6 / 970 = 0,62% 54h / a

which corresponds to 25 MW below the potential peak of 8000 MW.
Optimal peaker capacity is 1975 MW = 9000 MW 25 MW 6000 MW (base load).

Figure 2-2.4: The load-duration curve flattened by high prices when load is limited.

## The aggregate price spike

Individual price spikes are conveniently summarized by the price-duration curve, which uses hourly
prices instead of hourly loads. The generator recovers fixed costs when the price is above its variable
costs. A peak price helps: if the peak of the price duration curve were \$ 1050/MWh, and it
dropped linearly to the variable costs of \$50/MWh, the average fixed cost recovery for the year would
be \$1000 x 0,5/2 = \$25/MWh.
Aggregate price spike PJM (1999): \$60.000/MWh, or \$6.85/MWh
PJM(2000): \$3.40/MWh
Definitions

## The (Aggregate) Price Spike

The (aggregate) price spike is the section of the markets price-duration curve
above the average variable cost of the most expensive-to-run, but still
The Price-Spike Revenue (Rspike)
The area of the price spike is the price-spike revenue. It is the average hourly
scarcity rent that would be earned by the most expensive invest-worthy peaker
during the year in question. It can be measured in \$/MWh.

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## The Competitive Solution

Recall the result according to which in the long-run, supplies (have to) cover their fixed costs. Thus,
scarcity rents have to equal fixed costs.

Figure 2-2.6: The load-duration curve flattened by high prices when load is limited.

Result

## Long-Run Equilibrium Conditions for Two Technologies

In the long-run, peakers and base load plants must cover their fixed costs from
short-run profits (inframarginal or scarcity rents). This implies two equilibrium
conditions:

FC peak = Rspike

In our example:

## \$60 = \$970 DPS and \$12 = \$6 + \$(30 18) D * pea ker

DPS = 0,62%
D * pea ker = 0,5

peaker capacity: 1975 MW

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Fallacy:

## Lon Marginal-Cost Pricing Causes a Capacity Shortage

If generators are paid marginal-cost prices, they will cover their fixed costs only
as the result of a serious and socially detrimental shortfall in generation
capacity.

Result:

## Marginal-Cost Prices Induce the Optimal Mix of Technologies

Short-run competitive prices, which equal marginal costs, provide incentives for
investment in generation technology, which lead to an optimal level and an
optimal mix of generation technologies.

4.4.

## Reliability and Generation

This section shows that the optimal level of installed capacity should not be such as to satisfy
demand all of the time, but that some level of load shedding is efficient. The installed capacity is
found to be optimal when the duration of load shedding is given by the fixed cost of a peaker divided
by the value of lost load (VOLL). The latter is a highly controversial concept.

## Operating Reserves and Contingencies

The possibility of short circuits or loss of generators or transmission lines is called a contingency. As a
consequence, frequency and voltage immediately begins to drop. Several layers of reserve are
structured such as to avoid if possible the forced shedding of load.
In Germany (see presentation by Graeber, 2005):

## Primary reserve (spinning reserve)

Secondary reserve

## Tertiary reserve (minute reserve, non-spinning reserve)

Operating reserves are required to maintain system security by handling short-term disturbances to
the system. Planning reserves are required to maintain system adequacy by meeting annual demand
peaks. These two types of reserve are considered the basic inputs to the generation side of system
reliability. (The transmission side of reliability is not considered in Part 2). Although security and
enough security to reduce periods of involuntary load shedding to 1 day in 10 years. A system that
maintains security for all but one day in 10 years must have adequate installed capacity.

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## Two kinds of reserves:

Operating reserve

Planning reserve

security:

## by engineers but: what price?!

Definitions:

Security
The ability of the electric system to withstand sudden disturbance such as
electric short circuits or unanticipated loss of system elements (NERC, 1996).
The ability of the electric system to supply the aggregate electrical demand and
energy requirements of the customers at all times, taking into account scheduled
and reasonably expected unscheduled outages of system elements (NERC,
1996)

## two technologies: base and peaker

load will never be shed unless it exceeds the amount of operable generation capacity

## assumption: operating reserve policy is always effective in providing as much security as

possible given the systems installed capacity

K [MW]:

## installed generation capacity

g [MW]

generation outages

L [MW]

Lg [MW]:

Operating reserves:

OR K g L = K - Lg

It is assumed that excess interruptions are not correlated with the level of operating reserves
LL = max (Lg-K , 0) = max (-OR, 0)
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## the greater K, the smaller LL

increasing K: cost of LL , but cost of serving load

Assumption:

## Load is Shed Only to the Extend Necessary: LL = max( Lg K ,0)

Systematic (nominal) lost load (LL) equals the amount by which augmented
demand, L, and generation of service, g. Systematic refers to losses that are
correlated with Lg-K.

## How to Determine the Optimal Load Shedding?

Increasing K reduces the cost of lost load, but increases the cost of serving load conflict of interest:

Average cost of serving load: AC = FC peak + DLS xVC peak because DLS is small
(0.03%), the second term can be ignored

As K increases DPS decreases. For Low values of K, VLL x DLS will be greater than FCpeak, and it will
cost less to increase K than will be saved by the reduction in lost load. For high values of K the reverse
is true, and at the optimal K, the cost saved equals the cost of installing another megawatt of peak
capacity. The condition for optimal K is

## VLL xDLS = FC peak

Policy can control neither VLL nor FCpeak, so must control DLS. The optimal value of DLS is given by

## DLS * = FC peak / VLL

21

A reliability policy that induces investment when, and only when, DLS < FC peak / VLL will be
optimal, at least according to the Simple Model of Reliability.

Result 2-3.1:

## Optimal Duration of Load Shedding Is DLS * = PC peak / VLL

In a power system that satisfies Assumption 2-3.1, the optimal average annual
duration of load shedding, D*LS, is equal to FC peak / V LL , where FCpeak is the
fixed cost of a peaker and VLL is the cost per MWh of lost load (VOLL). Only
load shedding that is affected by K is included in D*LS..

## Figure 2-3.2: An augmented-load-duration curve.

Attention:

This is an area where engineers and economist disagree plainly. We present the
material Stoft, but will discuss several criticism of the concept from an
economic point of view.

In the most critical circumstance, when supply has reaches its maximum and load is being shed, the
system operator must choose how much to offer for additional supply. The standard regulatory choice
is to offer to pay the cost of additional generation. The market approach is to offer the value that
customers place on not being cut off. This value might be \$ 10.000(MWh while the cost of the last
unit of power produced might be only \$500/MWh. If the market is perfectly competitive, the cheaper
approach is to offer \$10.000/MWh and pay this much whenever load is actually shed. This is the price
determined by the intersection of supply and demand. Setting the price of energy in the spot market to
this price whenever load has been shed is VOLL pricing. This result depends on competition to
prevent market power, on risks of extreme prices being costless, and on the assumptions of the Simple
22

Model of Reliability described in Section 2-3.3. Even with these restrictions, the result provides a
basis for a more realistic analysis and explains why paying more than VLL, as suggested by no-pricecap advocates, is counterproductive.

Definition of VOLL
Conceptually, if the system could be operated for many years with its present pattern of load and its
present installed capacity, then the total loss of value to consumers (loss of consumer surplus) divided
by the accumulated MWh of lost load would equal average VOLL. But this average value is slightly
different from the marginal definition of VOLL that is needed for pricing policy. Marginal VOLL
measures the decrease in lost value divided by the decrease in lost load when installed capacity is
increased bay the small amount.

Definition:

## Value of Lost Load (VLL)

In a given system, let H be the average MWh of load that is shed and VH be the
average consumer surplus of power consumption. Let dH be the decrease in H,
and dVH the increase in VH, caused by a small increase in installed capacity.
Then, V LL = dV H / dH . Technically, this is marginal VOLL, but it is the
appropriate VOLL for present purposes and will be referred to simply as VOLL.
VLL is difficult to estimate, and defining the concept carefully does not lessen
this difficulty; however, is does allow the development of a theory of price
regulation in the face of market failure. The next section shows that VLL can be
the right price for inducing the investment needed to provide minimum-cost
reliability.

ATTENTION!

## Efficient rationing vs. stochastic rationing

Markets give optimal outcomes when they are competitive and have demand curves that truly reflect
consumer preferences. Because of the first demand-side flaw power-market consumers do not express
heir true demand and so the system operator needs to buy power on their behalf. This precludes the
optimal outcome promised by Adam Smith and modern economics for competitive markets, but the
use of VOLL pricing proves to be the best strategy given the limitations of the markets structure. This

23

result can be understood by investigating the relationship between VOLL and the true consumer
demand curve.

Most customers cannot respond to daily price fluctuations, so the short-run demand curve is
unobservable. If consumers were charged real-time prices and could respond to them without
transaction costs, they would use much less power at sufficiently high prices. As a crude
approximation of this unobservable demand curve, assume that demand for power is zero at
\$30.000/MWh and increases linearly to 20.000 MW at the retail price of power (see Figure 2-5.1). The
area under this curve measures the total value of power to consumers, the consumer surplus, in the
sense that consumers would pay that value for power but no more1. When the variable cost of power is
subtracted, the result is the total surplus of producing and consuming that power. When load is shed
there is a reduction in total surplus.
When load is shed, customers are disconnected without regard for the value thy place on power.
Consequently, the best assumption is that the demand curve of those remaining on the system is a
scaled-back version of the complete market demand curve. As an example, Figure 2-5.1 shows the
demand function scaled back 10%. Since demand of every value is called back 10%, the total
reduction in net social value is \$30.000.000/h. Dividing this by the 2000 MW of load shedding gives
the (net social) value of lost load, which is \$15.000/MWh2. Because consumer surplus is so much
greater than the variable cost of power, and because consumer surplus is such an uncertain value, the
distinction between consumer surplus and total surplus can be ignored.
The reduction in consumer surplus caused by 1 MWh of shed load is VLL . When load shedding is
optimal, a reduction of installed capacity would cost consumers as much in lost value as would be
saved by the reduction in capacity. According to Equation 1-3.2, the average cost of supplying peak
energy during the period of load shedding is AC E = FC peak / DLS + VC peak . Given the approximate
nature of the present calculation and the smallness of VC peak relative to FC peak / DLS , the variablecost term can be ignored. Thus, the condition for optimal load shedding is
Lost consumer surplus = savings from reduced capacity

V LL = FC peak / DLS

To obtain this revenue from customers, it would be necessary for a perfectly discriminating monopolist to set

price at different levels for different MWh of power. This revenue is the most consumers would pay voluntarily.
2

This is not a long-run calculation but represents the consumer surplus relative to a sudden disconnection.

24

Solving for DLS gives the condition for optimal load shedding

D * LS = FC peak / VLL
which is exactly Result 2-3.1
Is the Market Equilibrium Optimal?
Having characterized the optimal duration of load shedding, the market equilibrium under VOLL
pricing must now be examined to see how it compares. Result 2-2.2 gives the long-run equilibrium
condition for investment in peakers as

FC peak = Rspike
The right side is the price spike revenue, which in this case is V LL DLS .Solving for the equilibrium
duration of load shedding gives D e LS = FC peak / V LL , so equilibrium and optimal load shedding are
the same.

Figure 2-5.1: The market demand function and the value of lost load.

Result:

## Within the Simple Model of Reliability, VOLL Pricing Is Optimal

Under the Simple Model of Reliability defined in Section 2-3.3, which ignores
both risk and market power, VOLL pricing would induce optimal investment in
generating capacity and thus optimal reliability. This assumes an optimal shortrun security policy.

## VOLL pricing: summary

Definition: Value of Lost Load (VLL)
H

VH

dH

decrease in H

## caused by a small increase in

dVH

the increase in VH

installed capacity
25

VLL = d VH / dH

optimal solution for the Simple Model of Reliability: will induce competitive suppliers to invest
in an optimal level of generating capacity

value that consumers place on not being cut off: determined by the intersection of supply and
demand setting this price (whenever load is shed, i.e. for D*LS) is VOLL pricing
(regulatory!)

drawbacks:
- average pricing
- difficult to estimate
-

price risk

market power:

2 price caps:

supplier S:

2,000 MW

AVCS:

\$ 50/MWh

p*:

\$ 100/MWh

## short run profit with full output: = \$(100-50)/MWh*2000 MW

= \$ 100,000/h

suppose S can push the price to the cap by withholding 1,900 MW 3 and
produces 100 MW:
a)

## price cap is \$ 500/MWh:

= \$(500-50)/MWh*100 MW = \$ 45,000/h less than half of profit at
full output

b)

## price cap is \$ 20,000/MWh:

= \$(20,000-50)/MWh*100 MW = \$ 1,995,000/h more than 20 times
higher than profit at full output

VOLL pricing provides strong incentives for the exercise of market power!

because the actual load of 18,200 MWplus his capacity of 2,000 MW equals/ exceeds the available

load in the system (20,000 MW), so the price cap will be paid to supplier
26

Technical Supplement
Misestimating VLL may cause a relatively small decrease in the overall efficiency of the power market.
To demonstrate this, assume that VLL has been estimated to be \$15.000/MWh and consider two
possibilities: (1) actual VLL could be \$1500/MWh, or (2) it could be \$15.000/MWh. How much
inefficiency is associated with each possibility?
Using \$6/MWh for the fixed cost of a peaker as in previous examples and the three values of VLL ,
three optimal load-shedding durations may be calculated using Equation 2-5.1.
Table 2-5.1: Results of Errors in Estimation of VOLL

VOLL

Duration, D * LS

K in MW

Comment

\$150.000/MWh

D * LS = 0.35 h/year

55.000

## Possible optimal value

\$15.000/MWh

D * LS = 3.50 h/year

50.000

Assumed value

\$1.500/MWh

D * LS = 35.04 h/year

45.000

## Possible optimal value

These optimal durations must be translated into installed capacities using a load-duration curve. The
steeper that curve, the greater the error in the installed capacity level and thus the greater the resulting
inefficiency. PJMs load-duration curve will be used for this example after exaggerating its steepness
enough to prevent any chance of underestimation. The installed capacity levels corresponding to the
calculated duration are shown in Table 2-5.1.
If the true value of VLL is \$150.000, then 5000 MW too little capacity would be installed with the
result that too much load would be shed. From Figure 2-5.2 it can be seen that excess load shedding
would be less than one third of 3.5h x 5000 MW, or about 7000 MWh. Using the true VLL of
\$150.000 and dividing by 8760h/year gives a reliability cost of \$120.000/h. If the true value of VLL is
\$1.500, then 5000 MW too much capacity would be installed with an excess fixed cost of \$6/MWh x
5000 MW which equals \$30.000/h.
Returning to the first possibility, the cost of the extra lost load is partially compensated for by the
reduced cost of installed capacity, again \$30.000/h. So the net excess reliability cost in this case is
\$90.000/h. The total cost of serving load in PJM is about \$30/MWh x 30.000/h, or \$900.000/h. If VLL
was actually \$150.000, while VOLL pricing was based on an estimated VLL of \$15.000, the resulting
excess reliability cost would be 10% of the total cost of power. Because the steepness of this loadduration curve has been exaggerated, the actual cost of such a mistake in PJM might be considerably
less.

27

## In conclusion, it would appear to be safer to over-build than to under-build relative to an estimated

level of VLL . Either a dramatic underestimation of VLL or a dramatic overestimation of the optimal
duration of load shedding (3.5h/year when 0.35h/year is the correct value) would result in a
significant, though not dramatic, cost of unreliability.

## Operating Reserve Pricing

engineering suggests appropriate levels for operating reserves but how to determine prices?!

## Operating Reserve Pricing = substitute for VOLL pricing

sets prices at a relatively modest level when the system is short of capacity rather than to high
VOLL prices

required level of operating reserves ORR is set arbitrarily (external given by engineering)

## How to calculate OpRes prices?

Price is at the cap whenever the augmented load exceeds installed capacity less ORR:
Lg > K - ORR
I.e. the cap is paid as soon as OR is to be used for generation and not only when installed
capacity is short (as under VOLL pricing).
The long-run equilibrium condition (1) for two technologies (result 2-2.2, p. 128) is:
FCpeak = Rspike
= Pcap * DPS*
with a price cap including variable costs of the peaker. This is the maximum price paid to generators
during capacity shortages4 and thus no traditional price cap. DPS* is the time (duration) when
augmented load exceeds the installed capacity less operating reserves and taken from the expected
load duration curve. This is, of course, longer than D*LS (as used under VOLL pricing).

28

## The equlibrium condition yields

Pcap = FCpeak / DPS*
for the price cap. This price cap should include expenses for variable costs.
OpRes pricing induces optimal capacity, because for every level higher than Pcap, too much generation
will be built more than with a (extremely high) VOLL price cap.

29

5.

Market Power

5.1.

## Defining Market Power

Definitions:

Economic:
The ability to alter profitability prices away from competitive levels. (MasCollel et. al. 1995, 383)
Regulatory:
Market power to a seller is the ability profitably to maintain prices above
competitive levels for a significant period of time. (DOJ, 1997)
FERC (2000):
Market Power is defined as the ability to withhold capacity or services, to
foreclose input markets, or to raise rival firms costs in order to increase prices
to consumers on a sustained basis without related increases in cost or value.

## Withholding and the Price-Quantity Outcome

The basic strategy of withholding and the price-quantity outcome. Stoft (2002), p. 320.

Definitions

## Quantity withheld Qw:

Quantity withheld equals Q*(Pe)-Qe, which is the gap between the total amount
that would be produced by competitive suppliers at the monopolistic price Pe, an
the amount that actually is produced in the monopolistic equilibrium.

## Monopoly quantity distortion Qdistort:

30

The decrease in output, Q*-Qe, below its competitive level caused by the
exercise of monopoly power (<< Q*(Pe) Qe).
Monopoly price distortion Qdistort:
The increase in price, Pe -P*, above its competitive level caused by the exercise
of monopoly power.
The Markup, Pm:
Markup equals Pe - P*(Q), which is the gap between the marginal cost of
competitive suppliers supplying market quantity Qe, and the actual price in the
monopolistic equilibrium.

## Three Stages of Market Power

Market Power is a three step process:

An exercise,

## Stage 1: Strategic Exercise of Market Power:

The standard economic definition ignores stage 1 entirely and uses only price distortions from stage 2
and profitability from stage 3 to define market power.
Two components of market power strategy:

Quantity withholding

Financial withholding

In most cases, these are equivalent strategies; appearances are important. (raising bidding price from
\$35/MWh to \$40/MWh vs. shutting down half of output)
Stage 2: Price- Quantity Outcomes (see above)
Stage 3: Social Consequences of Market Power.
Profit (not just for the exerciser but for all suppliers)
Wealth Transfer (transfer from consumers to producers)
Dead-weight Welfare Loss (inefficiency resulting from monopoly power)

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Stage: An Exercise
Stoft (2002), p. 322
Strategy of Withholding:
Producing less than would be profitable, assuming all output could be sold at the market price. Not
acting as a price taker. This strategy may be executed financially by bidding high or physically by
curtailing output.

## Welfare Implications of Monopolistic Supply

Wealth transfer and dead-weight loss caused by the exercise of monopoly power.
Stoft (2002), p.333.

32

## How to show Market Power

Monopoly Power always causes the quantity withheld to be positive
The exercise of monopoly power causes actual output to be less than the competitive output at the
market price. Similar market price will be higher than the competitive price.
Competitive Equilibrium
A market condition in which supply equals demand and traders are price takers
When Assessing Monopoly Power, Ignore Demand-Side Flaws
Demand-side flaws prevent the market price from equaling the price that would result from a fully
competitive market. This will only tend to raise the market price except when a price cap is in effect.
Consequently any increase in price will alter price away from the competitive equilibrium and the
demand-side flaws can be ignored in the analysis of monopoly power.

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## Market Power on the Demand Side: Monopsony

Exercising monopsony power by withholding demand and by generating at a cost above the market
price.

Exercising monopsony power by withholding demand and by generating at a cost above the market
price. Stoft (2002), p.328.

5.2.

## Exercising Market Power

Market Power should be looked for only in the real-time markets. It should be looked for among
inframarginal as well as marginal generators. The amount of withholding should always be examined
along with the price increase
Long- run reactions to market power:
34

## Long-Run and Short-Run Market Power

Exercising market power by financial or physical withholding is a short-run strategy but one that may
be repeated over the long run. If it is repeated, there will be investment consequences that have not yet
been considered.

35

## Equilibrium installed capacity with market power. Stoft (2002), p.334.

Barriers to entry: not created by market participants and would not fit under any definition of market
power. Cost of barrier is passed through to customers.

## 5.3. Modelling Market Power

Concentration indicators
Absolute concentration : this is the case if a significant share of output is produced by a small number
of firms.
Common indices are:
The concentration ratio
is the share of the largest firms in the market with m denoting the number of firms taken , ai their
production, y denoting overall output and is the market share.
If CR(1) = 100% then the market is completely concentrated
If CR(m) = m/n, then the market shows minimum absolute concentration, n denoting the total number
of firms in the market

CR(m) = i =1
m

ai
m
= i =1 s i
y

## The Herfindahl Index

Maximum concentration: 1
Minimum concentration H > 0

36

According to EU Commissions Directorate-General for Competition, with an H below 0,1 the market
concentration can be characterized as low, between 0,1 and 0,18 as moderate and above 0,18 as high.

2
a
m
CR(m) = i =1 i = i =1 s i
y
m

## Relative indices of concentration / Lerners degree

Relative concentration: a low percentage of firms have a significant share of market. Example: The
Lorenz Curve, showing the percentage accumulation of the frequencies of a distribution plotted
against the percentage accumulation of the values of the distribution.

Gini-coefficient

F=

N 2V
2N

V = i =1 v i 0,5
N

Fmax =

N 1
2N

I G max = 2Fmax =

N 1
N

## Degree of monopoly according to Lerner:

m=

p GK p p(1+ 1/ xp )
1
1
=
=
=
p
p
xp
x/x

p/p

## Modelling Market Power

Monopoly and the Lerner Index.
Lerner Index or Price-Cost Margin (LX): If MC is a suppliers marginal cost calculated at its actual
level of output and P is the market price, then the Lerner index is defined by
LX= (P-MC)/P=1/e= -(dQ/dP)(P/Q).
The monopolist withholds output causing a price-cost markup (relative markup) equal to the reciprocal
of the demand elasticity. This is simply the result of profit maximization.

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## The Cournot Model.

Cournot Competition: Suppliers choose their quantity outputs. Price is determined by total supply and
the consumers demand curve. Suppliers maximize profits under the assumption that all other
suppliers will keep their outputs fixed.
The Lerner Index for a Cournot Oligopoly:
Lx=s/e,

## Herfindahl- Hirschman Index (HHI).

If this is the market share of the supplier, then
HHI = (Si)
The Average Lerner Index Equals HHI over Demand Elasticity
Average Lx= HHI/e
The share-weighted average Lerner index in a Cournot oligopoly is given by HHI/e.

Criticism of Indicators
Standard wisdom holds that HHIs below 1000 are certainly save- they are not. The HHI accounts for
only one factor, concentration, out of five key economic factors, that determine the extent of market
power
Four Factors that HHI ignores:
Demand elasticity (HHI of 1000 indicates Lerner Index of 10% if demand elasticity is 1)
The style of competition (Cournot competition is only one possible style of competition)
Forward contracting
The geographical extent of the market
Why the Lerner Index is unreliable
It compares price to marginal cost but measures both after the exerci3es of market power. In most
markets, marginal cost remains relatively constant when market power is exercised, and Lx increase
almost entirely because the price increases.
The effect of changes in marginal cost on the Lerner index depends on the relative steepness of the
supply and demand curves at the market-power equilibrium. If they are equally steep, then
withholding will lower marginal cost as much as it raises price.
Furthermore the Lerner index can be negative. Producing extra can raise marginal cost above the
market price and gives the utilities a negative index.

38

## Estimating Market Power

The Cournot Approach
In power markets, the HHI is nearly irrelevant as an indicator of market power. The Cournot model is
probably the best available model. It can account for transmission constraints that cause the market to
have geographic extent.
Forward contracts
Demand elasticity
But:
Models of supply curve competition are still ambiguous and intractable
Demand elasticity is unknown
Cournot approach is by definition unable to account for the style of competition
Cournot approach is unable to account for demand elasticity

5.4.

## Demand Elasticity and Supplier Concentration:

The two key requirements for competition are high demand elasticity and low supplier concentration.
Compared with other industries, the power industry has reasonably low supplier concentration in most
regions, but it is desperately short of demand elasticity. Although supplier concentration is reasonable,
market power could be reduced still further by reducing concentration, and in many cases this would
harm inefficiency very little. While it is extremely difficult to divest large suppliers of generation,
mergers should be carefully mentioned.
What keeps prices down:
Power markets lack demand elasticity but have other features that work naturally to limit market
power:
Forward contracts and obligations of suppliers
Uncertainty of demand which causes supply curve bidding
Long-run consequences.
Forward contracts and obligations of suppliers
Example of the benefits of forward contracts is provided by the residual obligations of regulated
utilities to serve their native load.
In newly restructured power markets, it is not uncommon for utilities to be required or to choose to
divest generation.
39

## This typically leaves them in the position of being net buyers.

It is as if they had sold more than 100% of their potential output in long-term forward contracts.
Example: A utility had a 2000 MW load obligation and 1000 MW of generating capacity. With that
excess of load it would probably sell none of its power and would be forced to purchase to 1000 MW
in the market. Some of that would be purchased in the spot market. Because it is only a buyer it will
always want a low price and will have no incentive to exercise monopoly power. Being more than
100% forward contracted takes away all monopoly power and gives the supplier an incentive to
depress the price by exercising Monopsony power.

## Market Power Reduced On Peak

Price/MW
Price when no suppliers have

## Price when 4 out of

5 suppliers

Long-term obligations: one reason market power is more of a problem during peak hours

## Supply Curve Bidding

Finding residual demand for suppliers other than S1. Stoft (2002), p.352.

40

When one supplier bids a supply curve instead of a fixed quantity, it reduces the market power of the
other suppliers (residual demand). The reduced slope of the residual demand curve relative to the
original demand curve indicates that it is much more price sensitive (elastic) than the true demand
curve. It may be possible for a market designer to take advantage of supply-curve biddings by
requiring bidders to submit a single price schedule for the entire day. This schedule should be used for
the day ahead market, the hourly market, and the RT market.

## Market Power and Forward Contracts

When a supplier has sold forward a quantity of its output, that sale will affect its future exercise of
market power in the spot market. If the supplier does not anticipate that todays energy price will
affect tomorrows price of forward contracts, or if the forwards are all very long term so there will be
no repeat sales for a long time, the profit function can be written as
SR(q)= P(Q)(q-qF)+pFqF-c(q)
Where pF is the forward price, q is the suppliers output, and qF is the quantity of power sold forward
which may be greater than its output. From here, proceed as with a normal Cournot supplier to find
dSR (q )
dP(Q)
dc(q)
= P (Q)
=0
(q qF )
dq
dq
dq
1+

(q qF ) Q dP MC (q )
=
Q
P dq
P

ss

1
MC
=
1
e
P

## Market Power and Forward Contracts

ss
LX =

Spot share plays the same role in the determination of LX as market share s played previously. IF all
load is under forward contract, then the sum of over al suppliers is zero instead of one. Also note that
because can be negative, the Lerner index of the corresponding Cournot competitor will be negative.
This indicates that it will overproduce, causing its marginal cost to rise above the market price. These
producer are net buyers , and they exercises market power in order to push the price down.

5.5.

## Monitoring Market Power

The trick to market monitoring is to ignore vague definitions and rigorously apply the economic
definition of market power.

41

Checking for the exercise of market power and for inefficiency.
Discovering inappropriate market rules.
Suggesting improvements to market rules.
Checking for and penalizing those who violate rules
Re-pricing market transactions deemed not to be just and reasonable.
Penalizing those who exercise market power.
Market Monitoring Fallacies:
Some Market Power is needed and beneficial:
Because competitive price cannot cover fixed costs, or perhaps because it cannot cover startup costs,
market power is needed to keep a sufficient number of generators in business.
Market Power cannot be proven:
Because high prices can be caused by scarcity or by opportunity costs, it is not possible to prove that
they have in fact been caused by market power. In addition, no market-power determination can be
made without waiting a year to see if profits are higher than normal.
Result:

If a supplier would profit (in expectation) from the sale of an additional unit,
assuming the market price would not change and th3 supplier chooses not to
sell, it has exercised market power.

## Proving Market Power:

It is necessary to show that the supplier profit from withholding. There are three
approaches to proving profitability:

Accounting

Statistics

42