Ensuring Generation Adequacy Through Hedging Obligations

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. What is Reliability • NERC (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” • Reliability encompasses two concepts: • Security: “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. • 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. Shmuel Oren – March 28-29, 2002

3. Planning Reserves and Reliability • Plentiful reserve capacity makes it easier to achieve security but is not necessary • Security can be achieved even with limited reserves by curtailing load or by raising prices sufficiently to induce demand response and investment. • Generation adequacy is required to insure supply at a reasonable price • In a competitive market “obligation to serve” is “obligation to serve at a price” • “Reliability” is not a product and has no meaning unless it is defined in terms of a price ceiling on secure energy supply • Generation 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. Shmuel Oren – March 28-29, 2002

4. Achieving generation adequacy in an ideal market • Inadequate supply leads to high prices which attract investment • Excess capacity will drive competitive prices to marginal cost • Generators on the margin and reserve capacity will not cover their fixed costs. • Exit through early retirement of capacity will drive prices up during peak demand leading to demand response and scarcity rents • When capacity is optimal scarcity rents exactly covers fixed costs • Capacity deficiency will drive scarcity rents above equilibrium levels resulting in excess profits which will attract new investment. • Forward 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 Shmuel Oren – March 28-29, 2002

5. Energy Market With Excess Capacity Energy Price ($/MWh) Demand at 7:00 - 8:00 p.m. Price at7:00-8:00 p.m Demand at 9:00 - 10:00 a.m. Price at 9:00 - 10:00 a.m. Demand at 2:00 - 3:00 a.m. Price at 2:00 - 3:00 a.m. GEN 5 GEN 6 GEN 4 GEN 1 GEN 2 GEN 3 Q1 Q2 Optimal Capacity Operating level MW Shmuel Oren – March 28-29, 2002

6. Energy Price ($/MWh) Demand at 7:00 - 8:00 p.m. Price at7:00-8:00 p.m. Scarcity rent Price at7:00-8:00 p.m. with Capacity payment Demand Response Demand at 9:00 - 10:00 a.m. Price at 9:00 - 10:00 a.m. Demand at 2:00 - 3:00 a.m. Price at 2:00 - 3:00 a.m. GEN 5 GEN 4 GEN 1 GEN 2 GEN 3 Q1 Q2 Optimal Capacity MW Energy Market With Optimal Capacity Shmuel Oren – March 28-29, 2002

7. Energy price volatility • Price 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 Shmuel Oren – March 28-29, 2002

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

9. What's missing in the theoretical market paradigm? • Theory 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 • Steep supply function and uncertainties make scarcity rent highly volatile and sensitive to market error in determining the optimal capacity • It is 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 • Even suppliers with low market share can become pivotal suppliers. • High prices are sticky • 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 Shmuel Oren – March 28-29, 2002

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

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

12. Alternative Approaches to Ensuring Generation Adequacy (cont’d) • ACAP obligation (Proposed in California) • ISO specifies requirements for available capacity obligation • Load serving entities have to meet a monthly ACAP obligation that is based on their forecasted next month peak load plus a fixed percentage • ACAP obligation can be met through a portfolio of generation resources an physical load management • Resources 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. • Shortcomings: • Based on the outdated “obligation to serve” paradigm were capacity is a product and reliability is a service attribute. • In a market paradigm, capacity is an option to produce energy and reliability is the availability of supply at a reasonable price. • Without an explicit strike price a capacity product does not protect customers from price spikes and therefore does not provide reliability Shmuel Oren – March 28-29, 2002

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

14. Alternative Approaches to Ensuring Generation Adequacy (cont’d) • Hedging obligation (strawman) • load 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. • Qualifying 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) • Hedging obligations can be met by a portfolio of contracts with generators and curtailable load contracts (physical cover). • Generator 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) • Call options that are exercised must be able to generate the promised power or be liable for the price cap applied to the undelivered quantity. • Self-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. • ACAP can be viewed as special case were the strike price equals to the price cap and physical exercise capability is enforced Shmuel Oren – March 28-29, 2002

15. Key aspects of hedging obligations • Emphasis on mitigating price volatility rather than on “steel in the ground” which is only one of the possible market responses. • 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 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. • LSE obligations revised monthly to reflect changes in customer base • Secondary 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) Shmuel Oren – March 28-29, 2002

16. Summary • Generation adequacy should be viewed and treated as a financial risk management issue rather than a reliability issue. • The 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” • Imposing hedging requirements on LSEs is a market friendly way of ensuring generation adequacy • While 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. Shmuel Oren – March 28-29, 2002

17. Power Economics at UC Berkeley • Econ./Bus Ad./(UCEI): • Bornstein, Bushnell, Spiller, Wolfram • Emphasis on empirical IO, market power analysis, environmental issues, political economy • EECS: • Wu, Variya • Emphasis on market design/operations, communications, control • IEOR • Shmuel Oren • Emphasis on market design, planning, scheduling, risk management, auctions Shmuel Oren – March 28-29, 2002

18. 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 Shmuel Oren – March 28-29, 2002

19. Typical coursework • Major in IEOR • 3-4 courses in optimization (LP,NLP, IP, Networks,Combinatorial, DP,) • 2-3 course in stochastic modeling and optimization (Markov processes, queuing, SDP) • Minor or equivalent in Econ • Micro • Game theory • Mechanism design • Econometrics • Industrial organization • Minor or equivalent in Finance • Corporate finance • Derivatives • Dynamic asset pricing Shmuel Oren – March 28-29, 2002

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