1. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Economic Laboratory Experiments - A Valuable Complement to the VT Bastian Henze Tilburg University & CentER GRI North-West Workshop Brussels, February 26 th 2009

2. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Overview  Economic Laboratory Experiments: An Introduction  Economic Laboratory Experiments: An Economist’s Wind-tunnel  The Experiment for the GRI NW

3. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Economic Laboratory Experiments: An Introduction

4. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Core-features of Experiments  Real human beings (the “subjects”) are put into a controlled laboratory environment  The subjects (inter-)act according to a set of rules (“institutions”) specified by the experimenter  Subjects are paid in real currency, their payment is performance-dependent

5. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N In the Laboratory  Subjects are seated in separate compartments  Subjects make entries on a computer screen  Software computes outcomes based on subjects’ entries  Inputs and outcomes are stored for later analysis Data

6. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N General Benefits (I)  The environment can be adapted to either mirror the essential features of a real- or hypothetical surrounding  The controlled environment allows for comparisons with theoretical benchmarks (such as e.g. surplus, price volatility)  The possibility to adapt interaction rules allows for  Comparison of policy proposals  Evaluation of policy proposals prior to their implementation

7. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N General Benefits (II)  Performance-based payment induces the subjects to act in the way they deem optimal in order to maximize their payoff given the environment and the interaction rules  Using human subjects permits the detection of opportunities for strategic behavior in the environment / Interaction rule combination  Can neither be achieved with (business) simulations nor workshops!  Experiments can be conducted at comparatively low costs

8. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Benefits for the Task at Hand  Every single benefit mentioned applies to the task at hand and complements alternative methods such as computer simulations!  The scope for experiments is thus to  Compare the effect of different (and possibly “new”) regulatory schemes on both transmission pricing in the short run as well as on incentives to invest into new capacity in the long run  Assess both the performance of these regulatory schemes and their robustness towards changes in the environment

9. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Economic Laboratory Experiments: An Economist’s Wind-tunnel

10. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N What are Wind-tunnels used for?  Test the validity of a proposed design prior to its introduction  Improve and hone a design  Benefit: Avoid unpleasant surprises  Would you buy a car which “should theoretically” drive?

11. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Experiments are Wind-tunnels  Economic experiments have a long and successful record as wind-tunnels for policy proposals  Trading rules for electricity wholesale markets  Computer-based allocation mechanisms for gas  Allocation of airport landing slots  Allocation of communication time with space- probes (NASA)  …

12. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Wind-tunnel in Action…  November 2000: Proposal to change the pricing regime for wholesale-electricity in California from a Uniform Price Auction (UPA) to a Discriminatory Price Auction (DPA)  April 2001: Implementation of a DPA for electricity wholesale markets in GB.  Is the proposal / was the actual policy change sound?  Experiments provide (would have provided) insights ex-ante  Rassenti, Smith and Wilson 2003 conducted these

13. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Environment  Three Node Network  Five generators are distributed over the three nodes, each of them has a generation portfolio with different cost levels  The generators repeatedly face cyclical demand for electricity (off-peak, shoulder, peak)  Reallocation of generation assets allows the introduction of unilateral price-setting power for some of the generators (hence two different conditions: “no market power” and “market power”)

14. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Interaction Rules  Uniform Price Auction (UPA)  Generators submit asking-price schedules, these are aggregated and a uniform price for electricity at each node is calculated  Discriminatory Price Auction (DPA)  Generators submit asking-price schedules and every accepted schedule is paid exactly the price asked. Hence, there is no uniform price for electricity at each node.

15. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Findings  UPA and no market power: Almost 100% of attainable surplus realized  Ceteris paribus, a change from UPA to DPA raises prices in off-peak and shoulder periods  Efficiency drops considerably under DPA as all generators submit significantly higher price schedules  Introducing DPA has about the same effect as introducing market power by reallocation of generation assets  Prices are less volatile under DPA

16. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Experiment for the GRI NW

17. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Aim and General Properties  The experiment aims to assess and compare the absolute and relative performance of different regulatory systems with regard to  Overall efficiency  Incentives for the TSO to invest  Two “Cases” of regulation are compared  One Baseline Case  One Innovative Case

18. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Common Environment  1 TSO  4 Shippers  1 Interconnector Line with limited capacity  TSO can expand capacity on the line via investments, and can do so at any point in time  Demand grows, but not linearly and there is demand uncertainty on the TSO’s side  Shippers can choose to have a part of their capacity demand in “long term contracts” (  higher payoff, but a fine is incurred if they fail to acquire the specified capacity)

19. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N The Baseline Case  The sole market place is a short term market for the capacity on the interconnector  TSO must offer all physically available capacity in the market  Allocation of capacity via Uniform Price Auction  Successful shippers pay lowest accepted bid  Regulatory Constraint: TSO must not – for each allocated capacity unit – receive more than her long term marginal costs of investments (plus markup)

20. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Innovative Case (1)  Unregulated short term capacity market  However, the TSO must still offer all available capacity  Additional Periodic Market for Long Term Financial Transportation Rights (LTFTR)  LTFTR are issued by the TSO  LTFTR entitle their holder to a share of the revenue generated in short term capacity market  LTFTR insure their holders (shippers) as well as the TSO against price volatility in that market

21. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Innovative Case (2)  Regulation of the LTFTR market  Same regulation as for the short term capacity market in the Baseline Treatment  TSO can however opt to issue more rights than capacity currently available  For all capacity installed between two LTFTR markets, TSO receives additional LTFTR which entitle her to (unregulated) revenue from the short term capacity market which is not allocated to previously issued LTFTR  For the next LTFTR market, these “incremental” LTFTR have to be auctioned to the shippers as well

22. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Innovative Case (3)  So the TSO has two income streams which she can influence by installing additional capacity  Regulated revenues from sales of LTFTR in the periodic LTFTR auctions  (Temporarily) unregulated profits generated by the addition of capacity between two subsequent LTFTR markets  The introduction of LTFTR generates a stable income stream for the TSO and also insures shippers from price volatility in the short run

23. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Timeline & Interaction with VT  Presentation of initial results is targeted for the May-workshop  Progress and interaction with the VT is monitored by a team consisting of  Bas Barten (GTS)  Adam Cooper (EFET)  Erik Rakhou (NMa)

24. F A C U L T Y O F E C O N O M I C S A N D B U S I N E S S A D M I N I S T R A T I O N Thank you very much!