1. 1 RELIABILITY AND COMPETITIVE ELECTRICITY MARKETS POWER Research Conference UC Berkeley March 19, 2004 Paul Joskow MIT, CEEPR, CMI and Jean Tirole IDEI, GREMAQ, CERAS,MIT http://web.mit.edu/pjoskow/www/

2. 2 INTRODUCTION capacity obligations placed on LSEs, Despite all the talk about "deregulation“ procurement obligations placed on ISOs, OpRes, and other ancillary service requirements, protocols for non-price rationing and management of system emergencies, Lack of understanding between economists (focused on market design), engineers (focused on reliability rules). wholesale price caps, etc.

3. 3 Benchmark Proposition: Competitive wholesale and retail markets “work” (second-best) despite Our Research Program’s Structure: Examine implications of relaxing each of the five key assumptions in two papers: presence of price-insensitive consumers, rationing but only under five sets of key assumptions. This paper: Wholesale markets with price caps, capacity obligations, ISO procurement, and network collapses. Companion paper: Retail competition with load profiling, partially price sensitive consumers and zonal rationing. http://web.mit.edu/pjoskow/www/

4. 4 BASIC ELECTRICITY SYSTEM MODEL Uncertain demand indexed by contingent states i Price insensitive consumers on traditional meters who can be offered two-part tariffs Price sensitive consumers who see real time prices and are not rationed administratively Price insensitive customers may be rationed in state i with a fraction  i served Supply side characterized by a continuum of investment opportunities indexed by marginal cost of production c. I(c) denotes the investment costs of a plant with marginal production costs c. I′(c) < 0. u i (c) utilization rate of type c. Straightforward to introduce uncertainty on the supply side (e.g. probability of forced outage)

5. 5 THE BENCHMARK MODEL Continuum of states of nature Consumers: Price-insensitive: Demand: if no rationing expected consumption: gross surplus: Price-sensitive : Demand: if no rationing expected consumption: gross surplus:

6. 6 Producers: constant returns to scale: I (c) = investment cost for plant producing 1MW at MC c. Social optimum:

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8. 8 Benchmark Decentralization proposition

9. 9 Five key assumptions (e) Consumers are homogeneous up to a scaling factor. More complex consumer heterogeneity may lead to adverse selection and competitive screening

10. 10 WHOLESALE PRICE DISTORTIONS; WHOLESALE PRICE CAPS AND CAPACITY OBLIGATIONS (As is well known) wholesale price caps may be a response to market power or the outcome of regulatory opportunism, may lead to under-investment in peaking generation. Capacity obligations: LSE must forward contract with generators to make their capacity available to ISO during peak demand periods. Model reflects assumption that price cap is below the competitive market price in some (high) demand states (e.g. p i = VOLL i < $1000/Mwh)

11. 11 With up to three states of nature, combination of price cap and capacity obligation (and associated capacity price) can address market power, investment, and end-use consumer price incentives provided that: All generating capacity eligible to meet LSE capacity obligations and receive capacity payments not just peaking capacity, all consumers, including price-sensitive ones, count for determining capacity obligations and capacity prices are passed through to retail consumers, forward market for capacity is competitive With more than three states of nature, regulatory tradeoff between alleviating market power and providing proper investment incentives unless there is market power in only one state of nature.

12. 12 ISO PROCUREMENT Northeastern ISOs debating whether ISOs should acquire peaking capacity and interruptible demand – ISO dispatching protocols? – How much should the ISO purchase? – Recovery through uplift? We consider impacts of ISO behavior – out-of-merit dispatching (Patton et. al. 2004) – with purchase of no more than optimal amount of peaking capacity – with purchase of more than optimal amount of peaking capacity – with different types of uplift recovery rules These ISO behaviors distort investment decisions, may crowd out significant amounts of private investment, and may lead to the ISO buying a lot more capacity than it may plan initially in order to balance supply and demand Better get ISO goals and incentives right

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14. 14 NETWORK SUPPORT SERVICES AND BLACKOUTS Contrast: collapse: available generation rendered useless. rolling blackout: available generation very valuable (actually, value = VOLL), Simple model of OpRes: States of nature Inelastic demand Unit value v (v = VOLL). Programmed demand : load shedding. Capacity K: investment cost I K. Marginal cost of energy : c. Availability factor cumulative distribution function (could be state contingent). Reserves: (cost: )

15. 15 Timing: ●● ●● Long term choice of capacity K Load D i in state i realized Choice of - dispatched load d i < D i - reserves r i d i - (1+r i )d i < K ready to be dispatched Availability λ i realized: - If λ i (1+r i )d i < d i, d i satisfied -If λ i (1+r i )d i > d i, system collapses

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18. 18 Socially optimal policy: P i = MC i P i = VOLL i Price jump P i = VOLL i

19. 19 Implementation Regulation of OpRes purchases (public good) Off-peak: competitive price (MC). Load shedding region: price = VOLL. Reserve reduction region: price = VOLL Difficult (knife edge) region: small change in reserve requirement moves price to MC or VOLL.