December 4, 2000© 2000 Fernando L. Alvarado1 Reliability concepts and market power Fernando L. Alvarado Professor, The University of Wisconsin Invited Seminar at the U. S. Department of Energy December 4, 2000

December 4, 2000© 2000 Fernando L. Alvarado2 Outline Reliability basics overview Some market power issues

December 4, 2000© 2000 Fernando L. Alvarado3 Basics overview (assumptions) Exactly two technologies –Each technology has a known price No market power Inelastic demand Reliability event occurs when demand exceeds supply

December 4, 2000© 2000 Fernando L. Alvarado4 Quantity (power) Price Demand (inelastic) Available supply Clearing price Maximum available power Deterministic Demand and Supply, low demand case

December 4, 2000© 2000 Fernando L. Alvarado5 Quantity (power) Price Demand (inelastic) Available supply Clearing price Maximum available power Deterministic Demand and Supply, high demand case

December 4, 2000© 2000 Fernando L. Alvarado6 Probabilistic Demand, high demand case Outage probability Probability of low prices

December 4, 2000© 2000 Fernando L. Alvarado7 The piece-wise nature of the supply curve Generator 1Generator 2 Generator 3Generator 4 Generator 5 Generator 6

December 4, 2000© 2000 Fernando L. Alvarado8 The effect of a generator outage Outaged generator Old supply limit New supply limit

December 4, 2000© 2000 Fernando L. Alvarado9 Effect of demand uncertainty and generator outage n-1 secure insecure Probability p2 Outage probability is p1*p2 Probability p1

December 4, 2000© 2000 Fernando L. Alvarado10 System B System A Generator 1AGenerator 2A Generator 3AGenerator 4A Generator 5AGenerator 6A Generator 1BGenerator 2B Generator 3B Generator 4BGenerator 5B High price n-1 insecure Low price Secure

December 4, 2000© 2000 Fernando L. Alvarado11 System B System A High price n-1 secure Low price n-1 secure

December 4, 2000© 2000 Fernando L. Alvarado12 System B System A Low price n-1 secure Flow

December 4, 2000© 2000 Fernando L. Alvarado13 Temptation: construct a composite supply curve + Low price n-1 secure unnecessary

December 4, 2000© 2000 Fernando L. Alvarado14 Flow Normal conditions System B System A Low price n-1 insecure Low price n-1 secure Situation with line transmission limits Max flow Outaged generator Unable to clear

December 4, 2000© 2000 Fernando L. Alvarado15 System B System A Flow Max flow Use of distributed reserves Low price n-1 secure

December 4, 2000© 2000 Fernando L. Alvarado16 Features of the example Only two areas (one flowgate) Radial Demand is inelastic Time delays are not an issue Generators have no startup/shutdown costs or restrictions or minimum power levels

December 4, 2000© 2000 Fernando L. Alvarado17 Observations Demand elasticity is important Locational aspects of reserves matter –LMP for reserves Ramping rates matter In deregulated markets only units explicitly committed to reserves are available –In regulated markets and in PJM all units are Reliability requires that we increase supply –Standby charges tend to reduce supply (Tim Mount)

December 4, 2000© 2000 Fernando L. Alvarado18 Reality Many flowgates Networked sysyem Demand can be elastic Time delays important Generators have fixed costs and restrictions Load is uncertain Transmission outages exacerbate problems If one firm dominates a technology, market power occurs (next) If one firm dominates a location, market power results

December 4, 2000© 2000 Fernando L. Alvarado19 Market Power? The ability to raise prices significantly above the efficient economic equilibrium Disclaimer: the slides that follow are not really a market power study but rather they represent a simplified illustration of how higher prices could result as a result of market concentration.

December 4, 2000© 2000 Fernando L. Alvarado20 Market Power: Assumptions There are exactly two technologies –Each technology has a fixed marginal price –  availability of the expensive technology –Limited availability of the cheap technology –Cheap technology has fixed costs to recover Demand is inelastic –First deterministic, then probabilistic All suppliers but a schedule all their cheap power Supplier a owns P MW in n  1 equal-sized generators –Supplier a can “withhold” one or more generators –Bidding above marginal cost is not allowed, withholding is

December 4, 2000© 2000 Fernando L. Alvarado21 The piece-wise nature of the supply curve revisited Other suppliers Supplier a generator 1 Demand Clearing price If generators bid marginal price, the generators surplus is zero Supplier a generator 2

December 4, 2000© 2000 Fernando L. Alvarado22 Red generator decides to withhold one generator Withheld generator Clearing price Surplus for red supplier Red supplier now has large surplus Of course blue supplier has even LARGER surplus! Surplus for blue supplier

December 4, 2000© 2000 Fernando L. Alvarado23 If margins are increased Clearing price Now it is not possible for red supplier to withhold and gain Raising prices would require collusion Question: and how are the expensive technology units supposed to recover their fixed costs if they always clear at their marginal cost? Answer: you may end up with less capacity than you thought

December 4, 2000© 2000 Fernando L. Alvarado24 If demand is uncertain The expected surplus gain is: p*(  2 -  1 )*P 1 Probability p that withholding will result in surplus 22 P1P1 price  1 Quantity (power) Price Since  1 is cheap unit’s marginal cost, there is no expected surplus loss

December 4, 2000© 2000 Fernando L. Alvarado25 Additional observations If the margin to the “knee” is P m, any supplier with a total ownership above P m may profit from withholding –If more than one supplier meets this conditions, chances are that someone will withhold

December 4, 2000© 2000 Fernando L. Alvarado26 For two generators, surplus is P*(  2 -  1 )/2 for demand above this level Effect of “granularity” With only one generator, it is impossible to withhold and benefit P Surplus is P*(  2 -  1 ) for demand above this level

December 4, 2000© 2000 Fernando L. Alvarado27 Effect of “granularity,” three generator case Surplus is P*(  2 -  1 )/3 for demand above this level Surplus is 2P*(  2 -  1 )/3 for demand above this level

December 4, 2000© 2000 Fernando L. Alvarado28 Effect of “granularity” Surplus With n=1, there is no surplus Surplus with n=2 Surplus with n=3 Surplus with n=4 Surplus with n  Demand level

December 4, 2000© 2000 Fernando L. Alvarado29 Observations and assumptions For “worst case” effect, assume n=  Assume withholding will occur –Withholding “softens” the supply curve High cost periods needed for fixed cost recovery Demand is probabilistic Suggestion: market power occurs if expected surplus exceeds fixed cost recovery –This is also a signal for system expansion This means that in the absence of uncertainty, expansion will occur when expected profits exceed long run marginal costs

December 4, 2000© 2000 Fernando L. Alvarado30 Effect of number of suppliers on supply curve One supplier 2 suppliers 3 suppliers 10 suppliers Demand Price

December 4, 2000© 2000 Fernando L. Alvarado31 Price Demand Period during which fixed cost recovery can take place Effect of demand uncertainty on fixed cost recovery Withholding increases the period during which surplus accrues but reduces the amount that accrues

December 4, 2000© 2000 Fernando L. Alvarado32 Price Demand Period during which fixed cost recovery can take place The effect of demand uncertainty on fixed cost recovery

December 4, 2000© 2000 Fernando L. Alvarado33 Numerical studies Demand is 60/70/80/90/95% of “knee”  for demand varies from 0 to 20% Demand probability distribution is normal Supplier has  equal size units available There are 3/6/10/15/  suppliers We illustrate the fixed costs that can be recovered for each of the case combinations above according to our earlier withholding assumptions

December 4, 2000© 2000 Fernando L. Alvarado34 80% Variance of demand (per unit) Fixed cost recovery without market power (  suppliers) Thousands per year per MW 90% 95% 99% Demand level as a percentage of available capacity

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year)  suppliers, demand level as a parameter 60% 70% 80% 90% 95% Even for high demand levels, some demand variance is essential for cost recovery

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year) 15 suppliers, demand level as a parameter 60% 70% 80% 90% 95% For high enough demand levels cost recovery is possible even without demand variance

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year) 10 suppliers, demand level as a parameter 60% 70% 80% 90% 95% For high demand levels demand variance can become irrelevant

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year) 6 suppliers, demand level as a parameter 60% 70% 80% 90% 95% For low demand levels it is very difficult to recover fixed costs

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year) 4 suppliers, demand level as a parameter 60% 70% 80% 90% 95% For high demand levels, high variance can even be slightly detrimental to profits

December 4, 2000© 2000 Fernando L. Alvarado Demand Variance (percent) Fixed cost recovery (thousands per MW-year) 3 suppliers, demand level as a parameter 60% 70% 80% 90% 95% With three or less suppliers, it becomes feasible at high variances to recover fixed costs by withholding at low demand

December 4, 2000© 2000 Fernando L. Alvarado41 4 suppliers 3 suppliers At low demand and low variance it is impossible to recover fixed costs

December 4, 2000© 2000 Fernando L. Alvarado42 At higher demand with 3 suppliers it is possible to recover costs at low variance

December 4, 2000© 2000 Fernando L. Alvarado43 As demand increases, withholding becomes profitable even when there are many suppliers

December 4, 2000© 2000 Fernando L. Alvarado44 Only in the case of infinite suppliers is it impossible to recover costs

December 4, 2000© 2000 Fernando L. Alvarado45 Comments on numeric results The number of suppliers has a strong influence on cost recovery –Below a certain number of suppliers, cost recovery by withholding becomes easier There are demand threshold levels beyond which there is a jump in the ability to recover costs All studies assume that supplier can adjust level of withholding after learning the demand –Lower returns when this is not true, study underway Demand variance has a strong influence on ability to recover costs, sometimes with a threshold level

December 4, 2000© 2000 Fernando L. Alvarado46 Final remarks Two-technology suppliers can lead to higher than marginal prices as the knee of the supply curve is approached Larger number of suppliers reduces this effect Market power studies should consider fixed cost recovery issues We did not even look at congestion or voltage problems!