Pricing and Gaming in a Simple electricity Market Queen’s University Regulatory Economics Class Guest Lecture March 24, 2015

David Brown Senior Advisor, Regulatory Policy 2

3Overview Deregulation in Electricity –Potentially competitive sectors –Regulated natural monopoly sectors –Motives for restructuring Concept of congestion in general A simple electricity grid Pricing, shadow prices, LMP Ontario’s uniform pricing Congestion side payments and gaming

Structure of the Electricity Sector 4 Dispatchable loads Demand bids

Deregulation in electricity Potentially competitive sectors Natural monopoly regulated sectors Motives for electricity deregulation: Official story –Transfer investment risk to private sector –Greater price and cost transparency –Benefits of competition Motives for electricity deregulation: Real story –Political lobbying by industrial loads 5

6 Congestion Generally Economic Activity takes place via infrastructure networks. Examples are: road systems, telephony, gas pipelines, electric grid, the banking system, air travel system. Some networks are “hard” like the grid, gas pipelines, road system. Some are “soft” like common languages e.g.., English, common software packages e.g., Microsoft Windows. Mostly networks are in the background when we think of the activity that uses them – we take them for granted. Congestion: reaching the capacity of the network to transmit what ever it transmits.

7 Gardiner and Lakeshore

Two regions trading 8 P S1 D1 S2 D2 Region 1Region 2Aggregate S1: P = QS2: P = Q D1: P = 30 – 0.5QD2: P = 30 – 0.25Q

Two regions trading Pre-tradeRegion 1Region 2Aggregate Price /3 Quantity /351 2/3 Exports -- Imports -- Trade Price 21 Quantity Supplied Quantity Demanded Exports 14- Imports -14 Trade with congestion Price 19 1/422 1/6 Quantity Supplied 28 1/224 1/352 5/6 Quantity Demanded 21 1/231 1/352 5/6 Exports 7- Imports -7 9

Congestion generally When the infrastructure is uncongested production is at its highest and there are no “congestion costs”. The quantity is produced at its lowest possible cost. When trade is restricted (to 7 units in the example) or not possible there is a re-dispatch of production from lower cost to higher cost producers. The total produced is lower. There is a price difference between the two regions. Starting from the no trade / no infrastructure position a social decision must be made as to how much capacity to build. 10

Congestion generally This decision has that “one size must fit all” characteristic of many public goods. Thus the decision will tend to be made in the political arena. Who will oppose larger capacity and who will support it? 11

Congestion generally These types of issues arise frequently in regulatory economics There is at least one very big example of a congestion story happening right now in North America with big implications for Canada What is it? 12

A Three Node Electricity Grid 13 Figure 1 A Three Node Grid NW NE S

A Three Node Electricity Grid 14 Figure 2 Dispatch with no constraints 26 2/3 MW NW NE G2 = $30 G1 = $20 Injection = /3 MW 26 2/3 MW S Load = 80

A Three Node Electricity Grid 15 Figure 3 Injections at both nodes 33 1/ = 23 1/3 MW NW NE G2 = $30 G1 = $20 Injection = 30 Injection = / = 76 2/3 MW 33 1/ = 53 1/3 MW S Load = 130

A Three-Node Electricity Grid In figure 3 in the text the market price would be $30 given a demand of 130 MW. Generator 2 at the NW node would be earning rents as its costs are $20 / MW while it receives the price of $30. 16

Shadow Prices 17 Figure 4 Shadow Prices P = / = 23 1/3 MW P = 30 NW NE G2 = $30 G1 = $20 Injection = 30 Injection = / = 76 2/3 MW 33 1/ = 53 1/3 MW S Load = 130 P = 30

Shadow Prices The Shadow Price The Shadow Price at a node is the marginal cost of serving another MW of load at that node. In a system with no transmission constraints or line losses each node could be served by the generator that is at the margin in the merit order. Thus the shadow price at all nodes would be that generator’s offer price. If transmission constraints are present then generation will have to be re- dispatched around the constraint – the merit order will have to be departed from. This will result in locational differences in shadow prices. 18

Transmission constraints Thermal Limit: exceed this limit and the line might melt Security Limit: exceed this limit and the line would not be able to handle the extra surge that might occur under some other contingency. This type of limit will be more restrictive than a thermal limit. 19

Grid with a Constraint Figure 4 in Word doc. Figure 5: Redispatch around the constraint is necessary to avoid violating the constraint. For every 2 MW injected at NE, only need to reduce injection at NW by 1 MW. 20

A Three-Node Electricity grid What will the shadow prices be with a corrected dispatch? In figure 6, with locational marginal pricing, there are rents being earned but not by the generators. 21

Ontario’s uniform price system Although the intention at market opening in 2002 was to move to an LMP system, it never sat well with the Ontario government. Also, it would have meant higher prices for consumers in southern Ontario – many of whom are politically influential. 22

Uniform Price System It is actually referred to as the two-schedule, uniform price system Market Schedule ignores congestion constraints – pretends we can operate as in Figure 2 here. Dispatch schedule includes constraints – sets quantities for the generator but the price is set by market schedule. With load = 80, price = $20. But what about G2 whose costs are $30? 23

Congestion Payments G2 must be given a “constrained on” payment – pay the owner the profits he loses by not being able to actually carry out the market schedule: G2’s market schedule is 0 output therefore 0 profit. G2’s dispatch schedule is 10 MW. With MCP set at $20 in market schedule G2 loses $100. Congestion payment is the operating profit he would make in market schedule minus the operating profit he makes in dispatch schedule 24

Uniform prices and two schedules: Congestion side payments Congestion payment = Operating Profit (Market Schedule) – Operating Profit (Dispatch Schedule) Operating profit in the market schedule is defined as: 1) Operating profit(MS) = (MCP – Offer price) * Market Quantity = (20 – 30) * 0 = 0 Similarly operating profit in the dispatch schedule is defined as: 2) Operating profit(DS) = (MCP – Offer price) * Dispatch Quantity = (20 – 30) * 10 = -$100 Congestion payment = 1 – 2 = ) = $100. More Generally Congestion payment = (MCP – Offer price) (Market Quantity – Dispatch Quantity) 25

Congestion Payment to G1 This payment is harder to understand Because of congestion G1 can only produce 70 MW, not 80. Pay G1 the difference between his market schedule profit and his dispatch schedule profit. With Load = 80, MCP = 20 G1 gets no payment. However if load was up at 130, then MCP = $30, and G1 will get a congestion payment. (Fig 7 in doc.) 26

Gaming of Congestion Payments A big problem in this market is that generators can influence the size of the congestion payments they receive: Congestion payment = (MCP – Offer price) (MQ – DQ) If you are constrained on MQ < DQ. What can you do to increase the size of the payment? If you are constrained off MQ > DQ. Same question… 27