Market Architecture Robert Wilson Stanford University

2 New Markets in Basic Industries Privatization / Liberalization (worldwide) Deregulation / Restructuring(in U.S.) –Communications, Energy, Transport, Water Motives: Efficiency & Investment Arguments: Scale Contestability Markets get prices (incentives) right Light-handed regulation suffices Implementation requires Market Design

3 Elements of Market Design Inputs: Scarce resources. Outputs: Products, services. Instruments: Tradable rights and contracts. Markets: Physical forward and spot. Financial hedges. Prices: Bids. Allocation rules. Settlement rules. Efficiency: Gains in short-run. Investments long-run. Incentives: –Procedures invulnerable to gaming –Rules + Incentives Efficiency (2nd Best) –Mitigate or control market power

4 Wholesale Electricity Markets Energy: Long-forward. Day-ahead, Day-of. Real-time. –Markets: Bilateral. Exchange. Spot [ = Real-time] Transmission: Day-ahead. Real-time. –Managed by SO [ = System Operator] –Markets: Congestion pricing, or purchase counterflow Reserves: Capacity = Day-head. Energy = Real-time. –Markets: Auctions by SO. Real-time control by SO. Hedges: Energy (Futures, CFDs). Transmission. –Markets: Auctions by SO. Secondary markets.

5 Simplified Electricity Market Imports into Region A Exports from Region B Uncongested Energy Price Supply into A net of Demand in B Demand into A net of Supply in A Transmission Capacity B A Supply Incs in A || in B Supply Decs in B || in A Congested Price in A Congested Price in B Transmission: Uses A-Incs & B-Decs [ Transmission Charge = P(A) P(B) ] Spot Market: Uses all Incs & Decs P(A) P(B) Note: actual market has many zones or nodes

6 Design Issue #1 Centralized v Decentralized (Complete v Incentives) Centralized = consolidated markets SO optimizes everything: energy, trans., reserves Prices = shadow prices on constraints –Prices are right if model good & data accurate Decentralized = separated markets PX clears markets, SO conducts auctions Prices = clearing prices –Prices are right if markets are complete & perfectly competitive

7 Institutional Perspectives Centralized designs are based on –Relational contracting. SO = Traders agent. Organizational structure inherited from utilities. –Objectives = reliability, coordination, pricing. –Incentives = sanctions. Abuses are penalized. Decentralized designs are based on –Voluntary participation, bidding, availability. Few markets based on simple market clearing. –Objectives = efficiency, competition, min-SO. – Incentives = market prices for deviations.

8 Theoretical Perspectives This debate is like 1930s Lange-Lerner. Basic fact is primal-dual equivalence of quantity and price mediated mechanisms. Can incomplete and imperfect markets match optimization? –Requires good price discovery & repeat mkts. Is decentralization necessary to promote competition and strengthen incentives? –Centralized designs cannot provide sufficient incentives if pricing is constrained (Vickrey).

9 Examples of Incompleteness Simple contracts with retail customers –So demand highly stochastic (and no storage!) Energy: Forward markets clear each hour independently. No contingent contracts. Transmission: Scarce resources are not priced when large zones are used. Reserves: Capacity is priced imperfectly on relevant quality dimension -- response time. These are a few among many.

10 Example of Gaming Centralized: set price at each node. –Nodal Price = Energy Price + Injection Charge from [Demand = Supply] & [Trans. Capacity] Decentralized: 1 st clear DA energy market, 2 nd adjust energy in zones, 3 rd use incs/decs. –Gaming: bidder sells huge quantity day-ahead that the SO is forced to sell back at low-priced dec in the spot market. Enter at congested node! This is inevitable consequence of unpriced scarce resources (i.e., incomplete market).

11 Other Effects of Incompleteness Impaired Efficiency –Intertemporal effects are ignored. Startup costs, ramping constraints,… –Flexible resources & reserves are under-priced. Due to lack of contingent planning or contracts. –Entrants attracted to wrong locations. Due to unpriced transmission constraints. –Sequence of markets depends on rational expectations. Anticipate transmission charge. Impaired Competition –Each incompleteness invites gaming.

12 Remedies for Incompleteness Sequence of markets –Repeated trading of simple contracts (long-forward, day-ahead, hour-ahead, spot) approximates complete market. Transmission is similar if pricing is locational at nodes. Better price discovery –Iterative auction approximates Walrasian model but requires good activity rules. Example: use it or lose it options. Complex market-clearing procedures –Requires consolidated markets run by SO ?

13 Summary Can centralization work well? [complete] –Strengthen competition, or use incentive- compatible settlement rules (e.g., Vickrey). Can decentralization work well? [incentives] –It works - systems are operating successfully. Most are seen as promoting competition. –But to price efficiently and prevent gaming requires effectively complete markets. –Can this be done without consolidated market? Working hypothesis is ultimately yes - after many improvements to control gaming.

14 Design Issues #2, #3 (Addressed in text of paper) Design details of each market –Energy: bilateral contracting, or an exchange. –Transmission: Implementing nodal pricing in decentralized market Markets for hedges, firm transmission rights –Reserves: design of two-dimensional auctions (available capacity, contingent energy supply). Mitigation of market power –Divestiture. Contract cover. Supply auctions.

15 Comparisons with Other Industries Transport industries with similar issues but different solutions: –Gas pipelines –Rail networks –Telecommunication networks To what extent are solutions derived from: –Technical differences? Point-to-point transport –Ownership and control? Each network privately owned and managed, no SO!