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. 13) .............................................................................. 2
1.1.
What is Electricity?................................................................................................................ 2
1.2.
Measuring Power and Energy ................................................................................................ 3
1.3.
Pricing Generation Capacity .................................................................................................. 3
1.4.
Power Supply and Demand (Ch. 14) .................................................................................... 5
What to Deregulate? (Ch. 12)........................................................................................................ 7
2.1.
3.
4.
5.
Ancillary Services and the System Operator ......................................................................... 7
Electricity Economics 101.............................................................................................................. 9
3.1.
Demand, Supply, Surplus ...................................................................................................... 9
3.2.
Marginal costs in a Power Market (Ch. 16).......................................................................... 9
Reliability, Price Spikes, and Investment ..................................................................................... 12
4.1.
Reliability and Investment Policy ........................................................................................ 12
4.2.
Price Spikes Recover Fixed Costs ....................................................................................... 14
4.3.
Optimal price spikes for peakers.......................................................................................... 15
4.4.
Reliability and Generation ................................................................................................... 19
Market Power ............................................................................................................................... 30
5.1.
Defining Market Power........................................................................................................ 30
5.2.
Exercising Market Power..................................................................................................... 34
5.3.
Modelling Market Power ..................................................................................................... 36
5.4.
Designing to Reduce Market Power .................................................................................... 39
5.5.
Monitoring Market Power.................................................................................................... 41
1.
Pricing Power, Energy and Capacity (Ch. 13)
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
Unitskilowatts, hours, and dollarsfollow 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.
Measuring Power and Energy
Power ~ rate of flow of energy,
[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 (millidollar, 1/1000 $), to convert: 80 $/MWh = 80 mills/kWh
= 80$ cents/kWh.
1.3.
Pricing Generation Capacity
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 overnight), in $/kW
Load duration ~ percentage of running time of a plant
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:

FC ~ OC, converted to $/MWh ~ $/kWy
FC = f(cf), in $/MWh ~ $kWy
Figure 13.1 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 13.1 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 Energycost 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
Figure 13.2: Use of screening curves to select a generator
Table 13.2 Fixed and Variable Cost of Generation
Overnight
Fixed
Fuel C
Capacity Cost
Cost
Cost
Heat rate
Cost
$/kW*
$/MWh
$/MBtu
Btu/kWh
$/MWh
Advanced nuclear
1729
23.88
0.40
10,400
4.16
Coal
10212
14.10
1.25
9,419
11,77
Wind
919
13.85


Advanced combined cycle**
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: GuDProzess mit integrierter Kohlevergasung
1.4.
Power Supply and Demand (Ch. 14)
Loadduration curve: measures the number of hours per year the total load is at or above any given
level of demand
Base load
Midload
Peakload (peakers)
Figure 14.1: A loadduration curve
Screening Curves and Longrun Equilibrium
Figure 14.3: Using screening curves to find the optimal mix of technologies
2.
What to Deregulate? (Ch. 12)
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
freerider problem:
it is costly to maintain the system balance.
supply:
market for spinning reserve.
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 selfstart (when the system goes down)
The System Operator Service (SO)
Coordination of ancillary services, monopoly
Independent system operator (ISO): nonprofit, independent
Trans Co: forprofit 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?
Startup costs, noload costs
Two approaches:
Central Dispatch (nodal pricing, Pool), vs. decentralized unit commitment
(bilateral)
Some examples:
Pool Co:
Australia, Alberta, ExEngland
Nodal pricing:
PFM, NY ISO, New England ISO, BETTA
Bilateral:
England, Wales (NETA)
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
blackstart
supply
demand
(frequency)
capability
system operator
service
unit commitment
transmission congestion
bilateral
nodal, pool
TRs
management
risk management
electricity
transmission/distribution
retail supply
3.
Electricity Economics 101
3.1.
Demand, Supply, Surplus
Perfect Competition
Definitions
Agents act competitively, have wellbehaved 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).
WellBehaved Costs
Shortrun 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 15.2 Total surplus equals the area between the demand curve and the marginal cost curve.
3.2.
Marginal costs in a Power Market (Ch. 16)
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 16.2: Adding individual supply curves horizontally to find the market supply curve. If B is continuous, A + B is also.
Left and RightHand Marginal Costs
Problem:
The costs of producing one unit additional may be different from the
savings of production one unit less.
Figure 16.2 Right and lefthand marginal costs
Definitions:
Lefthand marginal cost (MCLH)
The savings from producing one less unit of output.
Righthand marginal cost (MCRH)
The cost of producing one more unit of output. When this is impossible, MCRH
equals infinity.
The marginalcost 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 marginalcost range,
MCR, contains the market price, P, whether or not that is the competitive price.
A Marginalcost Example
Four suppliers can each produce 100 MW but no more.
Each supplier has constant marginal cost (MC) up to this limit.
10
Marginal costs and demand are as shown in the figure.
If demand is given by D1,
1.
The competitive price is $60/MWh.
2.
Any higher price indicates market power.
3.
If the market is competitive, no supplier has MC < $60/MWh.
If demand is given by D2 and the suppliers are price takers,
1.
The market price (P) will be $100/MWh.
2.
No generator will have a marginal cost of less than $100/MWh.
3.
No market power is exercised at this price.
4.
P is greater than the cost of the last unit produced ($60/MWh).
In both case the marginalcost 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.
11
4.
Reliability, Price Spikes, and Investment
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 21.1: 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
solution: planned loadshedding, VOLLpricing (valueoflostload)
12
Fallacy 24.1
The Market Will Provide Adequate Reliability
Contemporary markets, with their demandside flaws and negligible demand
elasticity, would grossly under invest in generation without regulatory price
setting.
b)
Low demand elasticity
D2
S
D1
P2
P1
Q1
Q2
Equilibrium PQ will be found
Temporarily very high price levels are possible (price spikes)
Price spikes suffice to recover fixed costs, generate investment
The profit function and reliability policies
Result
Energy and Capacity Prices Together Induce Investment
Investment responds to expected shortrun profits, which are determined by
energy prices and (if there is an installedcapacity requirement) by capacity
prices. Regulatory policies determining these prices nee joint consideration.
13
A Profit function plots expected profit as a function of the ICap level
high ICap: low profits.
low ICap: higher profits
optimal ICap: profits correspond to fixed costs of a peaker, ~ $6/MWh
An installed capacity requirement produces a very different profit function:
4.2.
ICap below the required level fixed profit (capacity payment)
ICap above the required level profits of 0
equilibrium value of ICap, Ke.
Price Spikes Recover Fixed Costs
Fallacy 22.1
MarginalCost 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 22.1: Continuous marginal costs and a nearly flat (elastic) demand curve for one supplier.
Revenue R=P x Q
Shortrun profit ~ scarcity rent ~ producer surplus ~ inframarginal rent:
Scarcity rent = R Total variable costs.
14
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 Longrun, Supplier Recover Their Fixed Costs
In a longrun 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 shortrun
profits.
Restatement for Supply Curves with Vertical Segments
In a longrun 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 fixedcost fallacy: longrun 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: baseload and peakers
Table 22.1: Costs of Available Technologies
Technology
Fixes Cost per MWh
Variable Cost per MWh
Peaker
$6
$30
Base
$12
$18
Figure 22.2: Two technology screening curves showing capacity factors for which each technology is optimal.
15
Demand side:
Fluctuating demand: 4000 MW8000 MW
Figure 22.3: Supply and demand for the twotechnology model.
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 baseload capacity and 2000 MW should be peak capacity. this
last conclusion is determined by reading the screening curves to find that the tradeoff point is at a
duration of 0.5 and then reading the loadduration 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 averagecost 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
16
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 22.4: The loadduration curve flattened by high prices when load is limited.
The aggregate price spike
Individual price spikes are conveniently summarized by the priceduration 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 priceduration curve
above the average variable cost of the most expensivetorun, but still
investmentworthy, peakload generator.
The PriceSpike Revenue (Rspike)
The area of the price spike is the pricespike revenue. It is the average hourly
scarcity rent that would be earned by the most expensive investworthy peaker
during the year in question. It can be measured in $/MWh.
17
Figure 22.5: The aggregate price spike of a typical priceduration curve.
The Competitive Solution
Recall the result according to which in the longrun, supplies (have to) cover their fixed costs. Thus,
scarcity rents have to equal fixed costs.
Figure 22.6: The loadduration curve flattened by high prices when load is limited.
Result
LongRun Equilibrium Conditions for Two Technologies
In the longrun, peakers and base load plants must cover their fixed costs from
shortrun profits (inframarginal or scarcity rents). This implies two equilibrium
conditions:
FC peak = Rspike
FCbase = FC peak + (VC peak VCbase ) xD * pea ker
In our example:
$60 = $970 DPS and $12 = $6 + $(30 18) D * pea ker
DPS = 0,62%
D * pea ker = 0,5
baseload capacity: 6 GW
peaker capacity: 1975 MW
18
The Weak FixedCost Fallacy
Fallacy:
Lon MarginalCost Pricing Causes a Capacity Shortage
If generators are paid marginalcost prices, they will cover their fixed costs only
as the result of a serious and socially detrimental shortfall in generation
capacity.
Result:
MarginalCost Prices Induce the Optimal Mix of Technologies
Shortrun 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, nonspinning reserve)
Adequacy vs. Security
Operating reserves are required to maintain system security by handling shortterm 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
adequacy are distinct concepts, they are closely linked. A system with adequate capacity can maintain
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.
19
Two kinds of reserves:
Operating reserve
Planning reserve
security:
adequacy:
to withstand sudden disturbances (short
to supply the aggregate electrical demand
run reliability) optimally determined
at all times, accounting for outages
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).
Adequacy
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)
A Simplified Model of Reliability
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
generation adequacy = fundamental determinant of reliability
K [MW]:
installed generation capacity
g [MW]
generation outages
L [MW]
normal load (economic demand)
Lg [MW]:
augmented load = L+g
Operating reserves:
OR K g L = K  Lg
It is assumed that excess interruptions are not correlated with the level of operating reserves
Load shed (lost load): load can exceed supply lost load (LL) and served load:
LL = max (LgK , 0) = max (OR, 0)
20
the greater K, the smaller LL
increasing K: cost of LL , but cost of serving load
cost tradeoff: determines optimal K
Figure 23.1 The Simple Model of Reliability
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
load, Lg, exceeds installed capacity, K. Augmented load includes economic
demand, L, and generation of service, g. Systematic refers to losses that are
correlated with LgK.
When the peak of Lg is above K, this causes load shedding [MW].
DLS: duration of load shedding ( ~ typical value of 0.03%, 1 day in 10 years)
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
Cost NOT serving load: VLL (Value of Lost Load, VOLL)
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 23.1:
Optimal Duration of Load Shedding Is DLS * = PC peak / VLL
In a power system that satisfies Assumption 23.1, 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 23.2: An augmentedloadduration curve.
ValueofLostLoadPricing
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.
Valuing Lost Load
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 23.3. Even with these restrictions, the result provides a
basis for a more realistic analysis and explains why paying more than VLL, as suggested by nopricecap 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 minimumcost
reliability.
Deriving VOLL from the Demand Curve
ATTENTION!
Average VOLL vs. marginal VOLL
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 demandside flaw powermarket 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 shortrun demand curve is
unobservable. If consumers were charged realtime 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 25.1). 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
scaledback version of the complete market demand curve. As an example, Figure 25.1 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 13.2, 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 longrun 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 23.1
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 22.2 gives the longrun 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 25.1: 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 23.3, 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
average MWh of load that is shed
VH
average consumer surplus of power consumption
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:
$ 500 and $ 20,000/MWh
supplier S:
2,000 MW
AVCS:
$ 50/MWh
p*:
$ 100/MWh
short run profit with full output: = $(10050)/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:
= $(50050)/MWh*100 MW = $ 45,000/h less than half of profit at
full output
b)
price cap is $ 20,000/MWh:
= $(20,00050)/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 loadshedding durations may be calculated using Equation 25.1.
Table 25.1: 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 loadduration curve. The
steeper that curve, the greater the error in the installed capacity level and thus the greater the resulting
inefficiency. PJMs loadduration 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 25.1.
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 25.2 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 overbuild than to underbuild 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)
Pcap is used to design an optimal pricing policy
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 longrun equilibrium condition (1) for two technologies (result 22.2, 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).
See footnote 4. at Stoft, p. 167.
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 PriceQuantity Outcome
The basic strategy of withholding and the pricequantity 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,
An effect on price and quantity, and
An impact on market participants.
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)
Deadweight Welfare Loss (inefficiency resulting from monopoly power)
31
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 deadweight loss caused by the exercise of monopoly power.
Stoft (2002), p.333.
32
Market Power without quantity distortion
Constant Output WithholdingStoft (2002), p.324.
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 DemandSide Flaws
Demandside 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
demandside flaws can be ignored in the analysis of monopoly power.
33
Monopoly Power in a Power Auction  negative market power
Stoft (2002), p.324.
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
Exercising Market Power
Market Power should be looked for only in the realtime 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
An inframarginal exercise of market power. Stoft (2002), p.332.
Equilibrium installed capacity with market power. Stoft (2002), p. 334.
LongRun and ShortRun Market Power
Exercising market power by financial or physical withholding is a shortrun 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 DirectorateGeneral 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.
Ginicoefficient
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 PriceCost 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= (PMC)/P=1/e= (dQ/dP)(P/Q).
The monopolist withholds output causing a pricecost markup (relative markup) equal to the reciprocal
of the demand elasticity. This is simply the result of profit maximization.
37
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,
where s=q/Q (market share)
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 shareweighted 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 marketpower 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.
Designing to Reduce Market Power
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
Longrun 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 longterm 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
load obligations
Price when 4 out of
Probability distribution of load
5 suppliers
Loads in
Longterm 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 supplycurve 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)(qqF)+pFqFc(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
Market Monitoring Tasks
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
Repricing 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 marketpower 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:
The rationality assumption
Accounting
Statistics
42