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Generation Adequacy through Backstop Call Option Obligations Shmuel S. Oren University of California at Berkeley Presented at CREG Workshop, Bogotá, Colombia.

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Presentation on theme: "Generation Adequacy through Backstop Call Option Obligations Shmuel S. Oren University of California at Berkeley Presented at CREG Workshop, Bogotá, Colombia."— Presentation transcript:

1 Generation Adequacy through Backstop Call Option Obligations Shmuel S. Oren University of California at Berkeley Presented at CREG Workshop, Bogotá, Colombia July 25, 2006

2 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 2 The Promised Land Generation companies bear all the investment risk and consumers (LSEs) bear all the price risk. Customers and suppliers are free to choose levels of exposure to price risk through risk management and contractual agreements. Forward markets and hedging instruments enable parties to manage their risk exposure Competitive forces drive generation capacity, technology mix and prices toward a long term equilibrium that reflect supply and demand choices for reliability and cost. Fixed costs of generation capacity at long run equilibrium are exactly covered by inframarginal costs and scarcity rents

3 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 3 MW Energy Price ($/MWh) Price at7:00-8:00 p.m. Price at 9:00 - 10:00 a.m. Price at 2:00 - 3:00 a.m. GEN 1 Demand at 2:00 - 3:00 a.m. Q1Q2 Optimal Capacity GEN 2 GEN 3 GEN 4GEN 5 Demand at 7:00 - 8:00 p.m. Demand at 9:00 - 10:00 a.m. Scarcity rent Demand Response Inframarginal Profits Long Run Market Equilibrium in an Energy – Only Market

4 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 4 Challenges to Energy Only Markets Steep supply function and uncertainties make scarcity rents highly volatile and sensitive to market error in determining the optimal capacity It is practically impossible to differentiate legitimate scarcity rents from inflated prices due to exercise of market power. Demand response is limited by technological barriers and operational practices Very high scarcity rents even if they are legitimate are politically unacceptable (reason for price caps) Low levels of reserves foster collusive behavior and market power abuse

5 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 5 Challenges to Energy Only Markets (Cont’d) Spot prices and scarcity rents are suppressed by regulatory price caps, market mitigation practices, deployment of operating reserves, and out of market operator actions (e.g., reliability unit commitment) so generators cannot recover their fixed costs. Who will pay for reserve capacity that is required to assure supply reliability. Capacity shortages cannot be resolved overnight and while the entry occurs the persistent scarcity rents result in wealth transfers from consumers to producers. Exposures in the electricity supply chain are not properly allocated to insure voluntary, socially efficient risk management practices by the market participants (free riders)

6 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 6 Proposed Texas Energy Only Market Two level system wide offer cap HCAP=$3000/MWh LCAP=$500/MWh. HCAP activated if total fixed cost recovery (FCR) by a generic peaker in a one year window (fixed or moving) is <75K/MW while LCAP activated when FCR reaches $150K/MW (Bang bang mechanism). Use of reserves is represented by a “proxi-generator” with a linear offer curve starting at 30% of CAP and reaching 100% of CAP at 100MW. (price reaches cap if 100MW of spin used) Aggressive program to stimulate demand response ISO publishes 10 year forecast and statement of opportunity. Offer price disclosure with short delays Emergency Load Response mechanism (ELR) – ISO can purchase up to one year call options with strike price at HCAP from load resources to be deployed only in lieu of involuntary curtailment and when price is at the system wide cap.

7 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 7 Classification of Capacity Mechanism

8 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 8 Properties of a Good Capacity Mechanism Replicate investment incentives in functional energy only market (forward contracting) Facilitate risk sharing between consumers and producers Provide intrinsic value to consumers in exchange for risk sharing (not subsidy to generators) Incent new investment and enable direct participation by new entrants Provide stable income to generators to reduce cost of capital in exchange for windfall profit potential Provide reasonable opportunity to generators to recover their fixed cost on a long run basis (address the “missing money” problem)

9 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 9 Desired Properties (cont’d) Incent performance and have meaningful penalties for non-performance that reflects the damage. Enable generators to opt out by increasing spot price potential income in exchange for risk taking Enable load to opt out (self-insure) by avoiding capacity payment in exchange for taking spot price or curtailment risk Not interfere with bilateral forward market and voluntary risk management practices Allow self-provision through bilateral contracts Mitigate credit problem Obligations imposed on LSEs should reflect customer base and account for load migration Easy sunset when market provides sufficient insurance through contracting and load response

10 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 10 Call Options as Price Insurance Strike Option ValueTime Spot Payback to LSEs holding option Definition: A call option is the right but not obligation to purchase one unit of power over the contract duration at an agreed upon strike price

11 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 11 Mechanics of Backstop Call Option Obligations Load serving entities (LSEs) required to hold at the beginning of each month hedges in the form of forward contracts and/or call options (with verifiable physical cover) totaling their share of the target capacity set by the regulator based on reliability consideration. Qualifying hedges must be at least three year forward- looking with forward or strike prices at or below a mandatory level set by the regulator Price cap should be raised to a level that reflects VOLL (e.g. $10,000) Mandatory strike price shall be high enough so as not to interfere with risk management activities but significantly below the energy price cap. (For example the energy price cap can be raised to $10,000/MW and the mandatory strike price set to $1000/MW).

12 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 12 Call Option Mechanics (cont’d) With a $1000 strike price consumers get the same price protection as under the current cap but will have to pay a fair market price for that protection Nonperforming capacity liable for difference between spot market price and strike price (liquidation damages) plus a penalty (only nonperforming generators are exposed to spot market price spikes). Obligation may be locational with LMP-based settlement so that option value (with same strike price) will be location dependent. Uncommitted capacity and firm load can sell energy at spot market prices above strike but no higher than the offer cap. (incentive for speculative entry, load response and uncommitted imports) Private contracts that meet the duration and strike price requirement will count toward the LSE hedging obligation.

13 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 13 Call Option Mechanics (cont’d) Hedging obligations can be met by a portfolio of supply contracts and curtailable loads (committed demand response). Call options may be, self provided, procured bilaterally or procured through a voluntary auction hosted by the ISO. Load can Opt out by offering a call option at the strike price covered by a curtailable service contract (interrupt when spot reaches strike) Deliverability can be assured by making call option obligations locational with physical cover. LMP based settlement with same strike price makes option prices location dependent. (like NY but without administrative prescription)

14 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 14 Call Option Value in a Price- Capped Energy Market Hours Energy Price $/MWh Cap Strike Annualized Call option value $/MW 8760 Price duration curve

15 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 15 Call Option Prices as Function of Generation Capacity Based on Opportunity Cost of Selling at Spot

16 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 16 Comparison to Demand Function Demand function Demand curve is set administratively ISO procures all available capacity and adjusts LSE obligation accordingly (discourages self-provision) Disincentive for self-provision No opt out for load Call Options Liquidation damage risk and opportunity to sell above strike for non committed units creates intrinsic market value for option. Generators selling option are liable for providing energy at reduced rates (strike) Option price is implied by opportunity cost of selling energy above strike (market based) and can be determined through an auction mechanisms Option obligations never exceed target capacity- available capacity in access of target assumes the risk of cost recovery through the unmitigated spot market

17 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 17 Caveats and Questions Deliverability and physical cover Pricing operating reserve use Market power in the energy market Market Power in the call options market What Happens if the spot energy market does not clear Central Procurement

18 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 18 Deliverability and Physical Cover In a perfect world liquidation damages based on locational prices (along with appropriate credit limits) should induce rational seller of options to invest at the appropriate location in order to cover their risk From an engineering perspective we want all the locational call options to be covered by deliverable physical capacity (preferably at the same location) As a compromise we can use physical cover with coarser granularity then the locational call option obligations (larger zones) allowing sellers some discretion in covering locational risk and making call options more competitive. Seller that bear the locational risk of the call option can cover their risk through a combination of generation investments and congestion hedges (FTRs) Given the physical cover requirement, locational risk may be sufficient to induce investment in the proper location.

19 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 19 Operating Reserves Pricing Co-optimization of energy and reserves + a “reserve penalty” that gradually raises the offer curve to the cap as function of reserve depletion. This implements a scarcity pricing mechanism that raises the unmitigated spot prices to the cap when X MW of reserves are deployed EnergyWith Reserves Demand CAP Price

20 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 20 Market Power in Energy Since most generation capacity will be under call option contracts there will be little incentive for that capacity to exercise market power. Uncontracted capacity may exercise market power but that will not affect consumers who are protected by the strike price. Only nonperforming generators are exposed to market power in the energy market so liquidation damages can be expected to be CAP – STRIKE per MW shortfall which provides a strong incentive for performance and reinsurance by generators ( e.g. in a hydro dominated systems hydro plants selling call options will have an incentive to buy insurance against drought from thermal plants.)

21 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 21 Market Power in Call Options Long term call options enable contestability from new entrants Competitive procurement (through auction) Demand function

22 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 22 Shape of Demand Function Price Quantity Target Capacity This part is realized As expected profits from energy market (generators rather than consumers take the risk)

23 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 23 What if the Energy Spot Market Does Not Clear? Scarcity pricing mechanisms will automatically raise spot price to the offer cap If load is within the limits of the call options obligation then consumers are not affected (only nonperforming generators are exposed) If load exceeds call option obligations then the balance is made up through use of operating reserves, load interruption and dispatch of uncontracted capacity. The cost of covering the shortage even at very high prices will only increase cost to customer slightly since most of the load will be covered by the call options

24 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 24 The Time Step Misalignment Dilemma LSEs want hedging obligations to be short term (load varies, no long term contracts with customers, credit requirements) Generators want call options to be long term (can take it to the bank as collateral for investment loans) How do we bridge the gap?

25 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 25 Central Procurement –Works like an ancillary service product –ISO conducts an annual central auction for annual three year (or longer) forward call options on energy with a specified strike price –Procured quantity is based on forecasted load and reserves requirements which may be zonal –Option offered must be covered by existing capacity, three year forward interruptible contracts or bilateral contract with min three year duration and price at or below strike price. –LSEs holding long term contracts and curtailable load contracts with appropriate duration and price can self provide by offering call options against these contracts into the auction.

26 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 26 Central Procurement (cont’d) –LSE obligation (and share of cost) determined Monthly based forecasted monthly peak load. –Cost of options allocated on a per MWh basis and over time based on monthly LOLP calculation. –Payment to sellers and allocation of cost to LSEs at performance time (ISO passes payment through). –For LSEs who self-provided their full obligation option revenues offset costs. –Providers of options required to offer contracted capacity at contract strike price and offer any additional balancing energy (beyond contracted capacity) at market clearing prices. –Failure to perform entails financial liability for the difference between market price and strike price times the amount of undelivered energy (liquidation damages) plus penalty.

27 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 27 Procurement Auction Price P0 P1 P2 P3 Quantity Round 5 Round 4 starting price clearing price Aggregate supply curve P4 P5 P6 Round 3 Round 2 Round 1 excess supply Target Capacity

28 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 28 Summary Self provision option enables smooth transition to voluntary insurances. As the market matures individual hedging obligation may be relaxed if the market as a whole proves to be properly hedged. Multiple means of meeting hedging obligation ensures balance between investment, demand response and risk management Hedging products are long term to facilitate new investment response by transferring risk from the investor to consumers (represented by the LSE) Enables reserve generation capacity to secure a stable income stream for fixed cost recovery in exchange for a tangible obligation to produce energy at a reasonable price when needed. Unlike forward contracts, call options do not have a “take” obligation so the LSE can be required to hedge a larger quantity than expected peak demand.

29 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 29 Summary (cont’d) LSE obligations can be revised monthly to reflect changes in customer base. Call option obligation functions as mandatory insurance where capacity product is linked to energy production capability and deliverability. Market price of option is driven by opportunity cost of selling energy above strike price and it will decline naturally with increased generation capacity (no need for administrative demand curve and procurement does not need to extend beyond target capacity) Self-provision through prudent risk management practices by LSEs and demand response will lead to natural sunset of the regulatory obligation.

30 July 2006All Rights Reserved to: Shmuel Oren, UC Berkeley 30 Ultimately, demand response and risk management practices will evolve to the point where the Promised Land can be reached.


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