CO 2 Charges: How can we assess the impact on electricity prices? Dr Anthony Downward, Prof. Andy Philpott, Electricity Power Optimization Centre, University of Auckland, New Zealand. EPOC Winter Workshop 2012, University of Auckland

Overview Background New Zealand Emissions Trading Scheme New Zealand Electricity Market NZEM historic prices Initial analysis assuming perfect competition SDDP Model Results Discussion of Assumptions Imperfect Competition model Impact of Transmission Fixed-point hydro mark-up Cournot Game Results Conclusions 2

Background – NZ ETS Emissions Profile Electricity Production (2010) (~20% of emissions) Transport Fuels (2010) (~40% of emissions) Agriculture (2015) (~10% of emissions) Industrial Processes (2010) (~10% of emissions) Waste (2013) Forestry (2008) Emissions Trading Scheme It is aimed to be an all fuels all industries scheme. Agriculture will not be included until There is a price cap of $25 / t CO 2 until the end of Until 2013 there is a 1 for 2 surrender rate. At the end of 2011 a review of the NZETS was completed which proposes increasing the price cap by $5 / t CO 2 each year from

Background – NZ ETS 4

Background – NZEM Electricity Market Structure New Zealand operates a real-time nodal pool market with vertically- integrated gentailers. There are five main generation companies, three of which are currently entirely state owned, although they operate as independent companies. Generation dominated by hydro, however, the peak load must be met by thermal generation and there is always a risk of a drought. Electricity Pricing Offers are submitted to the pool every half-hour and are cleared against demand. Offers do not have to reflect marginal cost. Electricity prices are computed at a nodal level, based on the marginal offer/bid for electricity. 5

Background – EAF Carbon Leakage The carbon intensive industries may head offshore to countries without carbon taxes. This can have two effects: the country loses jobs and export earnings, and global emissions can rise. Electricity Price Mark-up One of the main concerns is the impact that a carbon charge will have on electricity prices. Quantifying the increase in prices in a hydro dominated market is difficult, since the hydro opportunity costs increase as a result of the carbon charge. Emissions Allocation Factor In order to avoid compromising the competitiveness of New Zealand firms, it was decided to compensate certain trade-exposed industries. To do this, the electricity price mark-up must be computed. 6

Background – Electricity Prices 7

Is there a price impact? Examine bidding behaviour Construct a regression model for electricity prices Assume a competitive market and analyse the prices resulting with and without carbon charges. If you assume imperfect competition, you could construct a Cournot or Supply Function model and examine the equilibrium prices under different carbon charges. 8

Initial Analysis In 2008, Dr. Tom Halliburton was contracted by the Ministry for the Environment to estimate the mark-up in electricity prices due to a charge on CO 2 emissions. This analysis was performed using SDDP, which assumes a risk- neutral central planner will manage the hydro reservoirs so as to minimize the total system cost (including costs of outages). This model was run over a 23 year time-horizon ( ) for different carbon costs. The model was very comprehensive, using an investment model (GEM) to predict the installed capacity of various technologies in the future. 9

Initial Analysis 10

Based on the initial analysis, an EAF of 0.52 t CO 2 / MWh was put in place from July 2010; with the condition that it be reviewed by the end of The use of a perfectly competitive model was very contentious, at the time, since the a report for the Commerce Commission had recently stated that market power was being exercised (and there have been other recent examples). The Major Electricity Uses Group contracted Prof. Andy Philpott to examine the how the prices might change in a market with imperfect competition. Initial EAF 11

Imperfect Competition 12

Cournot – Dispatch Problem 13 We now present the dispatch problem, associated with a Cournot game over a network. where: A is a node-arc incidence matrix defining the topology of the network; L is a matrix containing loop-flow data, to ensure the flow complies with Kirchhoff's laws.

Cournot – Welfare 14 We compute welfare in the following way: p Total Generation (Q) Generation

Cournot – Nash Equilibrium 15 At a Nash equilibrium, each generator solves the following problem: The above problem is not necessarily convex. This makes it difficult to prove any general results governing how the equilibrium may change after the introduction of a carbon charge.

Cournot – Single Node 16 If we are dealing with a single-node network, or unlimited capacity network, it can be shown that increasing the cost of emissions is guaranteed to lead to equilibrium prices which are non-decreasing and non-increasing levels of emissions. However, the increase in price depends on a number of factors, such as which generators are marginal and the level of price elasticity in the market. Question: Does this result hold when line capacities are introduced?

Cournot – Two Node 17 PlantMarginal Cost (c)Emissions (γ) Coal$40 / MWh1.0 T / MWh Gas$50 / MWh0.4 T / MWh Downward A. The Energy Journal, 31(4):159–166 (2010)

Cournot – Two Node The coal plant is situated at node 1, and the gas plant is at node 2. The two nodes are joined by a transmission line with a capacity of 125 MW. The demand curves at each node at shown below. 12 Coal d 1 = 400 – 3.2p 1 | f | ≤ 125 d 2 = 500 –2.0p 2 Gas MC = 40 + αMC = α

Cournot – Two Node Without a charge on carbon, the gas plant is more expensive to run than the coal plant. Furthermore the demand at node 2 is larger than at node 1. These factors mean that the gas generator has incentive to withhold generation and congest the line towards node 2, at equilibrium.

Cournot – Two Node 20 Once a charge on carbon ( α = 26) has been applied, the situation changes. Now the gas plant is cheaper to run than the coal, due to the coal plant’s higher emissions. This leads to a different equilibrium outcome. At equilibrium, the line is not constrained and the generators compete as in a single node situation.

Cournot – Two Node 21 We will now consider the impact that this carbon charge has had on generation, prices, welfare and emissions. Nodal Prices α = 0α = 26 Node 1$102.03$99.83 Node 2$118.75$99.83 Generation α = 0α = 26 Coal Gas Welfare α = 0α = 26 Consumer18,07123,566 Producer21,76614,032 Carbon α = 0α = 26 Emissions253.5 t257.9 t Revenue$0$6,705

Cournot Example Summary 22 Electricity Price Mark Up The previous example shows that in a market with transmission there are complicated interactions that mean the equilibrium prices do not vary smoothly with CO 2 charges. In the example, we saw prices drop as a result of the CO 2 charge (corresponding to a negative EAF). We could have constructed a similar example where the CO 2 charge causes congestion, leading to a price increase much larger than the increase in marginal costs. In fact, depending on the shape of the residual demand curves, and the capacities of generators, the possible equilibrium mark-ups can vary widely.

In this Cournot model, we use the following fuel prices: The plants that we model are as follows: Cournot Game for New Zealand 23 Genesis Contact

Approximating Hydro Offers 24

Computing the mark up 25 Electricity Price Mark Up It is simple to compute the change in cost for a thermal generator for a given carbon tax. However, understanding how the hydro generators react to a carbon charge is much more complicated. In a competitive setting, hydro generators’ water-value functions incorporate: the costs of marginal thermal generators, and shortage costs. We approximate this relationship by marking up historical hydro offer stacks by the expected change in price. This has feedback effect on the equilibrium prices, and so a fixed point must be found.

Hydro Mark up 26

Hydro Mark up 27

Price Mark up 28

Methodology 29

Methodology 30

Computing the mark up 31 Computing the Fixed Point In the simplest case, when there is only one period type, we wish to find the mark up, K, such that: K = E(K), where E(K) is the average equilibrium electricity price mark up given a hydro mark up K. However, a single value of K is not enough, since there is a lot of variation in electricity market states: over short horizons we must consider the types of periods (p): peak, shoulder, off peak, and over longer timescales: hydro availability (i): wet, dry, uncertain, normal.

Fixed Point 32 Price Mark up

Effect of Hydrology 33

Calibration 34

Computing the mark up 35 Computing the Fixed Point To account for this variation we must extend the notation. Let E(K i,i,p) be the equilibrium price mark up due to carbon charges for market state i in period type p, with hydro mark up K i. Then we compute the hydro mark up to be K j = Σ ip (r ijp * E(K i,i,p)), where r ijp is the probability that a extra unit of water in state j will be used in state i, and period p. Solving the above system, we compute a fixed point, K.

Cournot Game 36 We model the game as Cournot; the firms in the market own multiple plants, each with constant marginal costs. A quantity, q, is injected for each plant. The profit function for firm i is: where c j is the marginal cost of the generator, which changes depending on the carbon charge. We computed the equilibrium for 300 different periods. (25 periods for each of the hydrology states, and time of day).

Results 37 Electricity price mark up in 25 normal, offpeak period, K=0

Results 38 Electricity price mark up in 25 dry, shoulder periods, K=0

Results 39 Average Mark-ups due to carbon charge with no hydro mark up Converged EEF m values Off PeakShoulderPeak Wet Normal Uncertain Dry Off PeakShoulderPeak Wet Normal Uncertain Dry0.85

Results 40 Based on these individual EAF m values, we compute an overall EAF m of 0.65 t CO 2 / MWh. If we perform a sensitivity analysis around relative frequency of wet to normal years, we compute EAF m values between 0.61 and 0.69 t CO 2 / MWh. These figures are slightly higher than the 0.52 t CO 2 / MWh computed using SDDP, which assumed a competitive market. There is currently a consultation document on the governments’ ETS website proposing increasing the EAF to or t CO 2 / MWh.

Conclusions Emission allocations to industry are a significant expense to the government (and hence the taxpayer), and they therefore need to reflect the true additional costs that industry faces. An assumption of a perfectly competitive market provides neither an upper- or lower-bound on the electricity price increases due to carbon charges. Imperfect competition is much more difficult to model and the presence of hydro generation means provides that such models need to include the hydro generators’ anticipation of the thermal price increase. Our methodology provides a framework whereby we can compute such a mark up under imperfect competition. 41