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Ensuring Generation Adequacy Through Hedging Obligations Shmuel Oren University of California at Berkeley NSF/EPRI Workshop on Economics, Electric Power.

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Presentation on theme: "Ensuring Generation Adequacy Through Hedging Obligations Shmuel Oren University of California at Berkeley NSF/EPRI Workshop on Economics, Electric Power."— Presentation transcript:

1 Ensuring Generation Adequacy Through Hedging Obligations Shmuel Oren University of California at Berkeley NSF/EPRI Workshop on Economics, Electric Power and Adaptive Systems Washington DC, March 28-29,2002

2 Shmuel Oren – March 28-29, 2002 What is Reliability zNERC (North American Electric Reliability Council) defines reliability as: “the degree to which the performance of the elements of the electrical system results in power being delivered to consumers within accepted standards and in the amount desired” zReliability encompasses two concepts: ySecurity: “the ability of the system to withstand sudden disturbances.” This aspect concerns short-term operations and is addressed by ancillary services which include:Voltage support, Congestion relief, Regulation (AGC) capacity, Spinning reserves, Nonspinning reserves, Replacement reserves. y Adequacy: “the ability of the system to supply the aggregate electric power and energy requirements of the consumers at all times”. This aspect concerns planning and investment and is addressed by Planning reserves, Installed capacity, Operable capacity or Available capacity.

3 Shmuel Oren – March 28-29, 2002 Planning Reserves and Reliability zPlentiful reserve capacity makes it easier to achieve security but is not necessary zSecurity can be achieved even with limited reserves by curtailing load or by raising prices sufficiently to induce demand response and investment. zGeneration adequacy is required to insure supply at a reasonable price zIn a competitive market “obligation to serve” is “obligation to serve at a price” z“Reliability” is not a product and has no meaning unless it is defined in terms of a price ceiling on secure energy supply zGeneration adequacy can be interpreted as price insurance which in theory is a private good. Given proper technology, market participant should decide how much of the good they want and at what price, based on their risk management preferences.

4 Shmuel Oren – March 28-29, 2002 zInadequate supply leads to high prices which attract investment zExcess capacity will drive competitive prices to marginal cost zGenerators on the margin and reserve capacity will not cover their fixed costs. zExit through early retirement of capacity will drive prices up during peak demand leading to demand response and scarcity rents zWhen capacity is optimal scarcity rents exactly covers fixed costs zCapacity deficiency will drive scarcity rents above equilibrium levels resulting in excess profits which will attract new investment. zForward markets will form that enable consumers to lock in prices and avoid price volatility and to investor to hedge their investment risk by securing long term supply contracts Achieving generation adequacy in an ideal market

5 Shmuel Oren – March 28-29, 2002 MW Energy Price ($/MWh) 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. Q1Q2Optimal Capacity GEN 2 GEN 3 GEN 4 GEN 5 Demand at 7:00 - 8:00 p.m. Demand at 9:00 - 10:00 a.m. Energy Market With Excess Capacity GEN 6 Operating level Price at7:00-8:00 p.m

6 Shmuel Oren – March 28-29, 2002 Energy Market With Optimal Capacity 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. Q1Q2Optimal Capacity GEN 2 GEN 3 GEN 4 GEN 5 Demand at 7:00 - 8:00 p.m. Demand at 9:00 - 10:00 a.m. Price at7:00-8:00 p.m. with Capacity payment Scarcity rent Demand Response

7 Shmuel Oren – March 28-29, 2002 Energy price volatility zPrice volatility is an inherent aspect of electricity due to its nonstorability and the steep supply curve. WSCC Generation Resource Stack Electricity On-peak Spot Prices

8 Shmuel Oren – March 28-29, 2002 Key questions zCan we rely on the “market” to provide investment incentives for adequate planning reserves? zWhat mechanism will provide an income stream that can sustain reserve generation capacity? zWill capital markets operate efficiently to sustain an adequate amount of generation investment? zIs an unrestricted energy market in which scarcity rents feed new investment politically feasible? zWhat mechanism should be used (if any) to restrain market power and transfer of wealth between producers and consumers while investment catches up with scarcity? zWhat should be the risk management obligation of an LSE

9 Shmuel Oren – March 28-29, 2002 What's missing in the theoretical market paradigm? zTheory does not account for reserve capacity that is required on the “bench” to ensure system reliability. When resources are only paid for produced energy such reserve capacity will not collect sufficient revenues to cover its fixed costs and will exit the market zSteep supply function and uncertainties make scarcity rent highly volatile and sensitive to market error in determining the optimal capacity zIt is impossible to differentiate legitimate scarcity rents from inflated prices due to exercise of market power. zDemand response is limited by technological barriers and operational practices zVery high scarcity rents even if they are legitimate are politically unacceptable (reason for price caps) zLow levels of reserves foster collusive behavior and market power yEven suppliers with low market share can become pivotal suppliers. yHigh prices are sticky zCapacity shortages cannot be resolved overnight and while the entry occurs the persistent scarcity rents result in wealth transfers from consumers to producers. zExposures in the electricity supply chain are not properly allocated to insure voluntary, socially efficient risk management practices by the market participants

10 Shmuel Oren – March 28-29, 2002 Alternative Approaches to Ensuring Generation Adequacy zCapacity payments (old UK system, Argentina, Spain) yGenerators receive capacity payments based on availability, technology, VOLL, LOLP to incentivize investment and availability. zShortcomings: yPayoff to incumbents but does not reassure investors yResults in over investment and too low energy prices that reinforce the need for capacity payments ySuppresses demand side response since scarcity rents are covered by capacity payments

11 Shmuel Oren – March 28-29, 2002 Alternative Approaches to Ensuring Generation Adequacy (cont’d) zICAP obligation (PJM, New York, New England) yCentral agency (ISO or Regulator) specifies requirements for planning reserves based on traditional planning tools. yLoad serving entities have to meet a monthly prorata ICAP obligation yICAP markets allow supplier to trade reserves and efficiently reallocate the reserves requirements. zShortcomings: yCapacity product is too short term to affect planning yCapacity product does not obligate the seller to be available for energy production or to provide energy at some price yCapacity prices do not reflect the value of producing energy yShort-term supply and demand for ICAP are inelastic so there is either excess (zero price) or shortage (infinite price)

12 Shmuel Oren – March 28-29, 2002 Alternative Approaches to Ensuring Generation Adequacy (cont’d) zACAP obligation (Proposed in California) yISO specifies requirements for available capacity obligation yLoad serving entities have to meet a monthly ACAP obligation that is based on their forecasted next month peak load plus a fixed percentage yACAP obligation can be met through a portfolio of generation resources an physical load management yResources counted toward ACAP obligation are subject to ISO verification at the beginning of each month and must be scheduled or offered into the ISO operated markets. zShortcomings: yBased on the outdated “obligation to serve” paradigm were capacity is a product and reliability is a service attribute. yIn a market paradigm, capacity is an option to produce energy and reliability is the availability of supply at a reasonable price. yWithout an explicit strike price a capacity product does not protect customers from price spikes and therefore does not provide reliability

13 Shmuel Oren – March 28-29, 2002 Alternative Approaches to Ensuring Generation Adequacy (cont’d) zTwo year RPRS obligation (Reliant proposal) yWorks like another ancillary service product yISO procures two year options on RPRS capacity based on forecasted need of replacement reserves yQSEs assigned obligation based on daily load and charged RPRS clearing price for their obligation yProviders required to offer contracted capacity as replacement reserves at contract strike price and offer balancing energy at MCPE. yContract duration adequate to affect planning zShortcomings: yCost of option not covered by QSE payment. Must be uplifted or allocated in proportion to annual RPRS payment. yPuts ISO in the position of buying forward and selling spot yInconsistent with decentralized markets and MIN ISO philosophy

14 Shmuel Oren – March 28-29, 2002 Alternative Approaches to Ensuring Generation Adequacy (cont’d) zHedging obligation (strawman) yload serving entities (LSEs) are required to hold at the beginning of each month verifiable hedges in the form of forward contracts and/or call options totaling 115% of their next month forecasted peak load. yQualifying hedges must have at least two years duration with no less than one year remaining life. Strike prices of call option should be at or below a maximum level set by the regulator (the strike price should be substantially below the price cap, e.g. 200$/MWh) yHedging obligations can be met by a portfolio of contracts with generators and curtailable load contracts (physical cover). yGenerator risk (and consequently the cost of options) may be reduced by indexing the strike price to fuel cost or by using “spark spread” call options (spark spread=electricity price - heat rate adjusted gas price) yCall options that are exercised must be able to generate the promised power or be liable for the price cap applied to the undelivered quantity. ySelf-insurance covered by a financial security may be allowed on a limited basis If allowed, security should cover the difference between the price cap and the regulated strike price for an X month worth of the uncovered hedging obligation. yACAP can be viewed as special case were the strike price equals to the price cap and physical exercise capability is enforced

15 Shmuel Oren – March 28-29, 2002 Key aspects of hedging obligations zEmphasis on mitigating price volatility rather than on “steel in the ground” which is only one of the possible market responses. zMultiple means of meeting hedging obligation ensures balance between investment, demand response and risk management zHedging products are long term to facilitate new investment response by transferring risk from the investor to the LSE. zEnables 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. zLSE obligations revised monthly to reflect changes in customer base zSecondary market for call options will enable LSE to adjust their holdings. Prices will fluctuate according to market conditions. (e.g. daily fluctuation of long term treasury bond prices)

16 Shmuel Oren – March 28-29, 2002 Summary zGeneration adequacy should be viewed and treated as a financial risk management issue rather than a reliability issue. zThe ultimate goal of long term reserves policies in a competitive electricity market is to mitigate price volatility through alternative means and not just to promote “steel in the ground” zImposing hedging requirements on LSEs is a market friendly way of ensuring generation adequacy zWhile price caps and reliability standards should be subject to regional jurisdictions (RTO, FERC, NERC) hedging requirements imposed on LSEs should be regulated at the state level.

17 Shmuel Oren – March 28-29, 2002 Power Economics at UC Berkeley zEcon./Bus Ad./(UCEI): yBornstein, Bushnell, Spiller, Wolfram yEmphasis on empirical IO, market power analysis, environmental issues, political economy zEECS: yWu, Variya yEmphasis on market design/operations, communications, control zIEOR yShmuel Oren yEmphasis on market design, planning, scheduling, risk management, auctions

18 Shmuel Oren – March 28-29, 2002 Power Systems Theses (at least one comm. member from Econ, Bus Ad and/or EECS) Joseph Doucet "Differential Pricing of Electricity Through Interruption Insurance", 1988 Todd Strauss, "Interruptible Electricity Tariffs with Early Notification", 1992 Alva Svoboda "Simulation of Dispatchable Demand-side Management in Electric Power System Operation Planning", 1992 Eric Friedman "Topics in Coordination and Decentralization", 1993 James Bushnell, "Multi-Dimensional Revelation in Auctions for Electric Power Supply", 1993 Chung-Li Tseng, "On Power System Generation Unit Commitment Problems", 1996 Wedad Elmaghraby "Multi-unit Auctions for Electric Power with Nonconvex Costs", 1998 Shijie Deng "Financial Methods in Deregulated Electricity Markets", 1999 Ami Beth Craft "Market Structure and Capacity Expansion in an Unbundled Electric Power Industry" (Stanford MSE Dept.), 1999 Rajnish Kamat, “Market Mechanisms in Deregulated Electricity Markets”, 2001 Afzal Siddiqi “Equilibrium Analysis of Spot and Forward Markets for Energy and Reserves” 2002

19 Shmuel Oren – March 28-29, 2002 Typical coursework zMajor in IEOR y3-4 courses in optimization (LP,NLP, IP, Networks,Combinatorial, DP,) y2-3 course in stochastic modeling and optimization (Markov processes, queuing, SDP) zMinor or equivalent in Econ yMicro yGame theory yMechanism design yEconometrics yIndustrial organization zMinor or equivalent in Finance yCorporate finance yDerivatives yDynamic asset pricing

20 Shmuel Oren – March 28-29, 2002 Key Points zEconomic work requires economic thinking. Engineering students doing economics work should learn to focus on process analysis rather than the problem/answer paradigm. zEncourage students to acquire broad training and exposure to other disciplines. zDo not reinvent the wheel. Encourage students to search the literature in other disciplines and build on it. zEncourage students to publish their work in the appropriate disciplinary journals. Avoid the “cottage industry” syndrome.

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