Taking Stock: Review of Past Market-Related Research 2005 PSERC Retreat Cambridge, MD

Previous Analytical & Experimental Work at Cornell Preferred Market Clearing (LAO vs PAO) Demonstrate Exercise of Market Power Repeated Markets Load Pockets Self-Regulating Markets (with Active Demand) Forward Contracts -- a temporary fix. Forward Markets prior to construction -- a longer term solution

Previous Analytical & Experimental Work at Cornell (cont.) True Co-optimization (and Markets) Energy & Operating Reserves Energy & VARs (Including Load) Two-part Offers vs Lost Opportunity Cost (or both) The Impact of Transfers on Congestion, Cost, and Market Power Revenue Adequacy of “Efficient” Markets “Public Good” Aspects of Electricity Systems

Two-Sided Electricity Markets: Demand-Side Participation 3 Findings: 1. Markets Perform More Efficiently with Customer Participation, with Less Need for Regulation 2. Real Time Pricing Performs Better that Pre-announced Demand Response Programs in Most Cases 3. Customers Prefer DRP before Trying RTP, but Switch Their Preferences after Experiencing RTP

Capacity and Generator Implications of Two-Sided Markets 3 Findings: Max Line Flow under Markets May be 6-8% Smaller with Demand-Side Participation than under Regulation with FP. Max Generation Capacity May be 7.5% Smaller under Markets with RTP than under Regulation with FP. Line Flows under Markets May be More Predictable with Demand Response, and Approach Performance under Regulation.

Market Test Market Power in a Spot Market can be Transferred into Forward Contracts 4 The widespread belief that market power will automatically be mitigated if generators hold forward contracts is correct if current spot prices do not affect forward prices (unlikely) or if forward contracts are not renewed (unrealistic). Speculation in the spot market may increase when contracts are due for renewal because persistently high spot prices result in higher forward prices. In tests with 1) No contracts, 2) Permanent contracts, and 3) Renewable contracts (10 periods long), students earned the lowest profits with a PERMANENT contract and the highest profits with a RENEWABLE contract. Software agents were able to replicate the speculative behavior of the best students (i.e. with the highest earnings)

Forward Markets, Market Power and Capacity Investment 5 Findings: 1. Forward markets before investment decisions decrease spot market prices and enhance efficiency: Intuition: firms compete to gain “Stackelberg Leader” advantage. 2. Forward markets after investment decisions decrease capacity investments, increase price volatility and might decrease social welfare: Intuition: firms use capacity commitments to counteract price reducing effects of forward markets. 3. Forward (physical) contracts and futures (financial) contracts have the same effects.

Market Test Maintaining Reliability is Expensive 6 Maintaining acceptable levels of reliability requires having additional transmission and generation capacity available to meet load when relatively rare contingencies occur (e.g. some expensive generators are dispatched at the physical minimum levels to provide spinning reserves). In numerous test of markets for energy and reserves, students tended to withhold expensive capacity that was needed to meet reliability standards, particularly if reserves were only paid opportunity costs. Although maintaining reliability is a socially efficient decision, the LRMC of energy in a contingency can be extremely high, and typically, price caps in the USA are too low to cover the capital costs of the expensive generators needed to ensure that the supply system is reliable.

PARTICIPATION BY LOADS IN REACTIVE POWER MARKETS Several approaches have been proposed to allow buyers to participate in reactive power markets or a related voltage market: A) Hogan long ago demonstrated the theoretical need for reactive power markets to provide incentives for reactive power generation and load management by buyers. B) Kim and Outhred have argued that customer participation can be implemented through a market for voltage which takes into account customer values for voltage. We have shown in the paper cited below that voltage is a public good. Public good markets are vastly more difficult to implement than private good markets (but not impossible). We have shown that efficiency requires nodal reactive power pricing and that reactive power is a private good. 6 “Public Goods and Electric Power: A New Look at the Role of Markets” David Toomey, William Schulze, Richard Schuler, Robert Thomas , James Thorp

Market Test Wheeling Affects BOTH the Engineering and Economic Characteristics of the Market 7 Wheeling real energy through a network may increase flows sufficiently to reach voltage and thermal limits on transmission lines. This type of congestion increases market power for some generators (and could be a major impediment for others). Congested systems are easier to exploit because the market is spatially fragmented. Students were able exploit the market power created by transfers and raise spot prices, and the effects of transfers were locationally specific. Even though the quantity of real energy flowing though the network stayed the same for a number of periods in the experiments, the flows on individual lines were quite erratic. Identifying accounting pathways for physical bilateral contracts defies the laws of physics and is highly misleading in a deregulated market.

Market Analysis LICAP Auctions are an Expensive Way to (maybe) ensure Generation Adequacy 8 Current financial incentives in the spot market are insufficient to maintain generation adequacy and higher price spikes are not politically acceptable. Increasing payments to generators in Locational Installed Capacity (LICAP) auctions is more expensive and less reliable than using Power Purchase Agreements (PPA) for new capacity. The eligibility for and treatment of PPA should be an explicit part of the rules for a “deregulated” market. An analytical framework has been developed to determine an optimum portfolio of call options between generators and load serving entities. In this market, generators are paid a high risk premium that is consistent with observed forward prices in New York City.

FINANCIAL INCENTIVES FOR MAINTAINING GENERATION ADEQUACY 8 Three approaches have been proposed to maintain generation adequacy to reliably meet demand: The Vertically Integrated Regulated Utility Uncapped Real-Time Prices in Markets (Australian Approach) Capped Market Prices with a Subsidy for Generators (ICAP) We have shown in the paper cited below that, even in a “perfect market” with generators paid real-time (uncapped) prices for real and reactive power (and these prices fall in the many $1000s of dollar range in failure states), generator’s revenues fail to cover costs. This problem is obviously exacerbated by capping prices. So, there is a major need to find a non-distorting way to subsidize generation. “Public Goods and Electric Power: A New Look at the Role of Markets” David Toomey, William Schulze, Richard Schuler, Robert Thomas , James Thorp

PUBLIC GOODS AND REVENUE ADEQUACY 9 We have shown that uncapped real-time uniform prices for real power, reactive power, and transmission will not collectively generate sufficient revenue to provide for the efficient provision of the public goods in the system (reliability, voltage, and frequency). The missing revenue can only be efficiently obtained by extracting some of the consumer surplus through reliability differentiated service for buyers. The average consumer has values for real power on the order of $10,000 per MW-hr, but the cost is on the order of $100 per MW-hr (this situation is called the diamond-water paradox in economics). It is this difference between value and cost that creates the demand for extremely reliable service. Clearly, some buyers will pay more for more reliable service. “Public Goods and Electric Power: A New Look at the Role of Markets” David Toomey, William Schulze, Richard Schuler, Robert Thomas , James Thorp

Market Analysis Reliability is Dependent on the Design and Capacity of the Transmission System 9 It is inappropriate to use a specified reserve margin as the proxy for reliability in a deregulated market. Although generation adequacy is necessary for reliability, it is not sufficient because there is no longer enough excess transmission capacity. The primary role of transmission in an AC network is to maintain the reliability of supply. Decisions about transmission adequacy cannot be decentralized because reliability is primarily a public good. The pipeline analogy for paying transmission owners is appropriate for a DC intertie but not for an AC network. The AC transmission system should be fully regulated using performance-based rates of return that penalize unscheduled outages. Revenues collected by an ISO from nodal price differences should be pooled and used as a partial payment for system reliability and transmission.