RISK & CAPACITY INVESTMENT INCENTIVES IN ELECTRICITY MARKETS Peter Jackson Department Of Management University Of Canterbury

Outline  My research topic/motivation  Investment  Optimal Plant Mix  Hydro/Strategic concerns  Contracts/Portfolios  Market Structure/Solutions

My research…..  Evaluate the impact of investor risk on investment decisions  Explicitly deal with impact of  Hydro risk  Strategic behaviour  Deterrence  Outcomes, Solutions  Investment/Entry  Pricing/Efficiency  Market structure  Is not finished (hardly started!!!)

Motivation - Do electricity markets deliver appropriate security?  Security concerns were to the fore with central planners  Central planning proved uneconomic, and often over- investment resulted  Electricity markets have been created in an effort to capture economic efficiency  But private investors won’t invest unless it is economically justified  Private investors face different risks and are investing into a spot market that is susceptible to strategic behaviour

Investment and Prices – Why Invest?  Generation plant can be valued (equivalently) as a call option  Option value is dependent on pricing  Could discount or model risk more explicitly

Basic Screening Curve Analysis  Optimal Plant Mix  Risk Free  Not Strategic  Some energy limited plant  With shortage costs, fixed costs are recovered in equilibrium

Investment & Risk  My research focus is……  Hydro risk  Strategic risk  But there are significant other risks for investors  Reliability  Regulatory/Political  Demand growth  Input prices  Technological/Resource  Transmission*  To a greater or lesser extent all plant faces risks but peaking plant is most vulnerable.

Energy Limited Hydro  Energy must be/should be used  Inflow quantities determine total energy available  Reservoir size and plant rating determines flexibility  Inflow sequences are also important  Peaking plant may never operate for its true purpose.  Being in the optimal plant mix is not the same as being in the dispatch.

Energy Limited Hydro  Notional revaluation of fuel and capital cost based on energy available  All plant is impacted but peaking plant is worst off

Peaking Plant – Cautious Entry  Given hydro variability, how much peaking plant is required?  Apart from other issues the investor need to know inflow distribution.  What is really important is the PDC, and this can vary for a variety of reasons eg hydro inflows  But what if PDC is a result of gaming? (And gaming and hydro inflows are probably related)  What is the true underlying PDC? It may be impossible to estimate, especially for an entrant

The Impact Of Risk On Adequacy

Peaking Plant Investment  Price and quantity risk from a variety of sources  Natural  Strategic  Hydro generation makes forecasting particularly difficult  Not suitable for many standard forms of contract  Finance difficult to obtain given risks  So how do we get any peaking plant built at all?

Wider considerations….  Standalone entry very difficult  But firms have multiple generation plants, and contracts in place = lower risk  The impact on the portfolio of assets and obligations is more relevant than the performance of the individual asset  Spot market gaming may increase returns above SRMC and incentivise investment  Strategic firms will not want to settle contract shortfalls with competitors  Deterrence  Market structure may (or may not) help

NZ - Market Structure  LP Clearance  Market design goals  Allocative efficiency  Productive efficiency  Dynamic efficiency  NZ Market  S.O.E’s & Private investors  Energy only market  Vertical Integration  Hydro influence  Few Large customers Wolak Report, 2009

Potential Solutions  Tolerate gaming  Two part markets  Capacity ticket systems  Current proposals from taskforce

Contracts and Risk I  Consider increasing risk on generators who are unable to cover contractual obligations

Contracts & Risk II  Increasing cost of over contracting improves adequacy but this analysis assumes contracts are exogenous  What if contracts are endogenous? Equilibirum contract prices will be higher for higher risk  Customers will get more security (but pay for it)  What is the relative performance of other solutions?  Market power (18% - Wolak)  Capacity payments (25% - Initial market study)  Evaluation required

Future Work required  Energy limited plant  “MW limited”  Dynamic analysis  Plant retirement  Demand growth  Investment  Strategic interactions  Spot market  Cautious Entry  Deterrence  Complementarity Formulations  Evaluate remedies