1 Resource Adequacy and Market Power Mitigation via Option Contracts Hung-po Chao and Robert Wilson EPRI and Stanford University Presentation at POWER Conference on Electricity Restructuring University of California Energy Institute March 19, 2004

2 Motivation FERC’s Standard Market Design delegates to state regulators: Resource Adequacy requirements –Ensure ample generation capacity –Encourage long-term contracting –Mitigate market power in spot markets

3 Primary Rationale for Long-Term Contracting State PUC can mandate transfer of transactions: –From spot market, where demand is inelastic and some suppliers have market power –To forward market, where supply is more elastic because longer time frame allows Investments in capacity expansion Entry by new firms: forward market is contestable Predicted benefits for utilities, state PUCs, ISO: –Reduce price volatility and sellers’ market power –Improve system reliability and security

4 Role of Option Contracts Compared to fixed-price fixed-quantity contracts, Options reduce utilities’ quantity risks –Prime example: California’s contracts in 2001 –But, of course, options increase risk-bearing by suppliers A portfolio of options with a spectrum of strike prices increases elasticity of net demand in spot markets –Demand net of options called at their strike prices is more elastic

5 Illustration of the Effect on Net Demand of Portfolio of Options with Spectrum of Strike Prices Price p Quantity q D(p)D*(p) S*(p) Net Supply S(p) Clearing price p* Quantity of Options Callable at Strike Prices > p Net Demand Effect of options is to tilt the net demand and supply curves - Fixed-price fixed-quantity contracts shift these curves Greater demand elasticity mitigates suppliers’ market power Net purchase in spot market

6 Using Options to Implement a Price Schedule Price p P(q’) P(q) q q’ S*(p) = Supply net of options D(p) D’(p) Load Level Quantities of options called when load levels are q and q’, where q < q’ Design the portfolio of options to implement a price schedule P(q) for net spot purchases when the load level is q - Allows the price cap to vary with the load level - Higher price allowed when higher load occurs

7 Some Implementation Aspects Options must be backed by physical resources of seller. Optioned quantity must be offered as standing bid at ISO. Physical obligation is necessary to: –Ensure resource adequacy and mitigate market power –Improve system reliability PUC can conduct periodic procurement auctions of option contracts, then allocate options among LSEs according to each LSE’s price- or load-duration curve, net of existing contracts. –Avoids free-rider problem among LSEs. LSEs can use option prices to set terms of retail service contracts. Or, use retail contracts to design option portfolio. (The paper addresses other implementation aspects)

8 Example of a Theoretical Model Supply Side: Firms are symmetric, market is contestable –Fixed cost of entry: number of firms is endogenous –Costs are (a) linear in capacity, (b) quadratic in energy per unit of capacity. Constant returns to scale. Demand Side: –Demand is linear in actual and expected spot prices. –A stochastic term (revealed in the spot market) shifts the load level. Forward Market for Options –Inelastic Demand: Quantity (at strike prices < p) =  p. –Supply: Since the firms are symmetric, each firm bids to supply the same fraction of demand at each strike price. Spot Market for Energy: Spot price equates net demand and net supply.

9 Results for an Example Costs: Demand: Parameters specified in text of paper (1) Optimal magnitude  of option demand in forward market if the number n of firms is fixed. (2) Resulting consumers’ surplus, depending on the fixed number n of firms  More firms  Fewer options, BUT  Optimal option portfolio  Few firms suffice !

10 Results for an Example (continued) (3) Consumers’ surplus resulting from each choice of the magnitude  of the option demand when the number n of firm is endogenous.

11 Results for an Example (continued) Case 1 No contract Case 2 Forward contract Case 3 Option portfolio Expected level of spot demand Expected level of demand with option coverage Quantity of forward contracts Expected spot price Producers' profit Consumers' surplus Total surplus