Download Efficiency and marginal cost pricing in dynamic competitive markets

What Can We Learn from the Collapse of
California Wholesale Electricity Market
In-Koo Cho1
Hyunsook Kim2
Sean P. Meyn3
1 Department
of Economics
University of Illinois
2 KIPF
3 Department
of Electric and Computer Engineering
University of Illinois
October 27, 2009
Origin
Indispensable
Not storable
Reliability of service is extremely important.
Northeast black out on August 14, 2003 cost more than $6B.
According to Richardson, [U.S. is] ”a superpower with a
third-world electricity grid”.
Affected Area of Black out on August 14, 2003
Figure: Area affected by the black out. [Source: Wikipedia]
Before
Figure: Area before the black out. [Source: Wikipedia]
After
Figure: Area after the black out. [Source: Wikipedia]
Origin, continued
Large market
PJM, serving 51M people in 13 states with annual billing
exceeding $20B.
CAISO, serving 27M Californians (excluding LA and some
other metropolitan area). 2nd largest in U.S. and 5th largest in
the world.
CAISO control area
Figure: PG&E, SCE and SDG&E serve 75% of the state. LA is controlled
by LADWP.
Major California Grid System
1
Figure 2.1: Map of Major California Transmission Lines
Schematic Drawing
NW2........
NW1
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NW3
SR2
HUMB
SF
SR3
NP15
PATH15
ZP26
PATH26
SP15
LA1
LA2
II1
LA3
II2
NV3
LA4
NV4
MX
LC3
AZ2
LC2
AZ3
LC1
AZ5
Origin, continued
Large capital investment
Generators
Transmission network
Large capital cost
High entry barrier
Origin, continued
Used to be
Vertically integrated monopolist
Tightly regulated
Rate is set to recover the cost
Close relationship between regulators and utilities
Wholesale Power Market
A bold attempt to reform a traditionally regulated industry
Competition among generators and utilities to achieve
Low price
Reliable service
Time Line
California Public Utility Commission (CPUC) Blue Book
[1994] spell out the key components of restructuring:
Retail competition
Transition cost recovery
Generation divestiture
CAISO and CalPX
CAISO and CalPX were founded in 1997 and 1998,
respectively.
CalPX administers market transactions.
CAISO ensures reliable management of transmission network.
Implementation
Traditional utilities were forced to sell off the generation
capacities to generators.
The utilities purchase the power, while generators supply
power competitively in the wholesale market CalPX.
Transmission lines are managed by Independent System
Operators (ISO) to ensure fair and reliable way of allocating
the capacity.
Implementation
Traditional utilities were forced to sell off the generation
capacities to generators.
The utilities purchase the power, while generators supply
power competitively in the wholesale market CalPX.
Transmission lines are managed by Independent System
Operators (ISO) to ensure fair and reliable way of allocating
the capacity.
Emulate a market where the utilities and the generators
compete each other.
Stack up the marginal production cost of different generators
to build a supply curve (nuclear, coal, gas turbine, and so on).
Find an intersection of the demand and the supply to clear the
market.
Supply and Demand
Price
Supply Curve
Trash ($30+)
Gas Turbine ($20-30)
Coal ($10-15)
Nuclear ($6)
O
Quantity
Supply and Demand
Price
High Priority Customers
Customers with interruptible services
Demand Curve
O
Quantity
Supply and Demand
Price
High Priority Customers
Customers with interruptible services
Supply Curve
Consumer Surplus
Equilibrium
Price
($20-30)
Gas Turbine ($20-30)
Producer Surplus
Coal ($10-15)
Nuclear ($6)
O
Demand Curve
Quantity
Equilibrium Quantity (< 45,000MW)
Important Details
Meeting the demand continuously is extremely important,
because the cost of black-out is large.
Although one can predict the demand for power fairly
accurately, there will be a forecasting error.
Maintain reserve capacity to meet the unexpected surge.
Real Example
Figure: Forecast and actual demand on Feb 18, 2007 posted at CAISO
Web page
Important Details, continued
The main constraint is that the generators need time to ramp
up (and down) to meet the demand.
Nuclear. Practically fixed.
Coal. 1 hour.
Gas turbine. 15-30 minutes.
Hydro. Shorter.
A schematic scheduling is
Nuclear provides the base load, under “must run” contract.
Coal provides the shoulder load.
Gas turbine and hydro provide the peak load.
Important Details, continued
Multiple rounds of markets to help generators set the dispatch
schedule.
Day ahead
Hour ahead
Real time (10-20 minutes)
Adjustment bids and rebate
Important Details, continued
Primary Services
Bulk energy
State-wide service
Ancillary Services
Needed for reliability
Localized service
Rules differ, as the composition of generating technologies
differ across the regions.
Different Phases
April 1998-May 2000.
Stable and low prices ($20-$37/MW)
Price ceiling ($100-$150/MW) for retail price was not binding.
June 2000-January 2001.
High price ($147-$265), occasionally hitting $750
Low reserve capacity (Below 1.5%) triggers rolling black-outs
PG&E declared bankruptcy, as it cannot pay for the wholesale
power.
January 2001.
Collapse of CalPX
Signs of Market Dysfunction(?)
Extreme price volatility in the ancillary service market as early
as 1998
Shortage of power at key junctures
Large profit accrued by generators and fuel suppliers
Extremely high retail price
Price Volatility
Illinois, July 1998
APX Power NL, July 2006
Previous Week
Price (Euro/MWh) Volume MWh
Current Week (7/27)
Purchase Price $/MWh
5000
Previous week
4000
3000
2000
1000
0
Mon
Tues
Weds
Thurs
Fri
4000
3000
2000
1000
800
600
400
200
0
Sat
Sun
70
250
60
200
50
150
30
20
50
10
0
Thurs
Fri
Sat
Sun
Mon
Tues
Weds
Forecast Prices
40
100
Weds
Tues
Wed
Thus
Fri
Ontario, November 2005
PX prices $/MWh
Forecast Demand
California, July 2000
Spinning reserve prices
Mon
Demand in MW
Last Updated 11:00 AM Predispatch 1975.11
Dispatch 19683.5
21000
18000
15000
2000
1500
1000
500
0
Last Updated 11:00 AM Predispatch 72.79 Dispatch 90.82
Hourly Ontario Energy Price $/MWh
3
6
9
12 15 18 21
Tues
3
6
9
12 15 18 21
Weds
Figure: Price dynamics in four different markets
3
6
9
12 15 18 21 Time
Thurs
Cause
Supply
Drought in the winter of 2000 reduced the supply of hydro
power in Pacific Northwest
No significant generation capacity was built in the preceding
10 years in California
Transmission capacity was not improved.
Demand
The economy of California has expanded throughout 90’s.
Especially, the demand from the area around Silicon Valley
increased, causing congestion from south to north.
Cause, continued...
Manipulation
Generators could have manipulated the dispatch schedule.
Natural gas price may have been manipulated.
Enron traders openly discussed manipulating California’s power
market during profanity-laced telephone conversations in which they
merrily gloated about ripping off “those poor grandmothers” during
the state’s energy crunch in 2000-01, according to transcripts of the
calls.
The calls were obtained from the government and transcribed by a
public utility district near Seattle that wants Enron to forfeit
millions of dollars in ill-gotten gains over the energy trading scandal.
[AP by Kristen Hays (06/03/04)]
Cause, continued...
Design
Compared to PJM, California design is more decentralized.
The market could be fragile against the exogenous shock and
manipulation (such as capacity withdrawal).
Price cap at the retail level, but no such cap at the wholesale
level, caused the utilities and CalPX to declare bankruptcy.
Economic theory predicts...
1
If the demand and the supply are stable, so is the market price.
2
Without market power, the market price must be close to the
marginal production cost of power, which is around $30-50.
3
If the market is competitive,then both consumers and
generators gain something out of the market.
Supply and Demand, again
Price
Supply Curve
Consumer Surplus
Equilibrium
Price
Producer Surplus
Demand Curve
O
Equilibrium Quantity
Quantity
Therefore,...
If the market price is bouncing between 0 and the price cap,
then something is wrong with the market.
In particular, the gap between the market price and the
production cost is an evidence of the market power.
Consumer rip-off strengthens the evidence of the market
power.
If we design the market properly, then the market price should
be hovering around the marginal production cost.
Economic theory predicts...?
The prediction is valid if
the energy market is static, or
the energy market is not subject to any friction.
Economic theory predicts...?
The prediction is valid if
the energy market is static, or
the energy market is not subject to any friction.
The power market is operating 24/7, and is subject to the
ramping constraint.
Economic theory predicts...?
The prediction is valid if
the energy market is static, or
the energy market is not subject to any friction.
The power market is operating 24/7, and is subject to the
ramping constraint.
But, if the supply side friction is not too severe, then it should
be valid?
Economic theory predicts...?
The prediction is valid if
the energy market is static, or
the energy market is not subject to any friction.
The power market is operating 24/7, and is subject to the
ramping constraint.
But, if the supply side friction is not too severe, then it should
be valid?
No.
Economic theory says...
Even if the supply side friction is small, the market outcome is
very different from what we expect. In particular,
the price is extremely volatile, fluctuating between 0 and the
ceiling, without any tendency to converge to the marginal
production cost, and
the supplier can accrue all the gains from trading, leaving
nothing to the consumers.
All these bad things can happen even if the market is free from
any strategic manipulation, and even if the market is efficient.
Price Sample Path
Prices
250
200
Normalized demand
Reserve
150
100
50
0
Mon
Tue
Wed
Thu
Fri
Sat
Sun
I am not saying
I am not saying
There was no market manipulation by suppliers of power and
fuel.
I am not saying
There was no market manipulation by suppliers of power and
fuel. There is an ample empirical evidence, not to mention the
phone and e-mail records of Enron traders.
I am not saying
There was no market manipulation by suppliers of power and
fuel. There is an ample empirical evidence, not to mention the
phone and e-mail records of Enron traders.
Volatility is an acceptable outcome as long as the market
outcome is efficient.
I am not saying
There was no market manipulation by suppliers of power and
fuel. There is an ample empirical evidence, not to mention the
phone and e-mail records of Enron traders.
Volatility is an acceptable outcome as long as the market
outcome is efficient. No risk averse consumer wants to have
volatile utility bills, not to mention a large bill.
I am not saying
There was no market manipulation by suppliers of power and
fuel. There is an ample empirical evidence, not to mention the
phone and e-mail records of Enron traders.
Volatility is an acceptable outcome as long as the market
outcome is efficient. No risk averse consumer wants to have
volatile utility bills, not to mention a large bill.
Distribution of welfare is something we can ignore in designing
a market, as long as the market outcome is efficient.
I am not saying
There was no market manipulation by suppliers of power and
fuel. There is an ample empirical evidence, not to mention the
phone and e-mail records of Enron traders.
Volatility is an acceptable outcome as long as the market
outcome is efficient. No risk averse consumer wants to have
volatile utility bills, not to mention a large bill.
Distribution of welfare is something we can ignore in designing
a market, as long as the market outcome is efficient.
Electricity is a necessity, that is quite insensitive to the price
changes. High retail price has a large impact to overall
economy.
I am saying
It might be impossible to design an efficient market that
achieves efficiency of allocation and stability of market price.
Extreme volatility of price is not an evidence of market
dysfunction. An attempt to fix it by imposing price cap may
result in more harm than benefit.
Even if the consumers are being ripped off, we need other
evidences to prove the presence of non-competitive behavior
such as e-mail exchange among traders of natural gas.
If a stable price of power is a policy goal, we should look for
an alternative trading mechanism to the wholesale market
such as a bilateral long term contract.
I am saying, continued
Because the demand for power is very insensitive to price
changes, the long run stability of price can be achieved only
by providing ample reserve capacity rather than generation
capacity per se.
Increasing reserve capacity can be achieved through increasing
generating capacity, increasing transmission capacity but also
through conserving energy use. For example, we need to
re-evaluate the cost and the benefit of installing smart meters.
A Bit of Theory
Imagine a market where the demand is increasing and
decreasing rapidly.
The demand and the supply curves are overlaid, and the
intersections are moving around.
Graphs
Price
Supply Curve
Consumer Surplus
Equilibrium
Price
Producer Surplus
Demand Curve
O
Equilibrium Quantity
Quantity
Graphs
Price
Consumer Surplus
Supply Curve
Producer Surplus
Demand Curve
O
Quantity
Graphs
Price
Supply Curve
Consumer Surplus
Equilibrium
Price
Producer Surplus
Demand Curve
O
Equilibrium Quantity
Quantity
Graphs
Price
Supply Curve
Consumer Surplus
Producer Surplus
Demand Curve
O
Quantity
What is wrong with this picture?
Price
Supply Curve
Consumer Surplus
Equilibrium
Price
Producer Surplus
Demand Curve
O
Equilibrium Quantity
Quantity
What is wrong with this picture?
Price
Consumer Surplus
Supply Curve
Producer Surplus
Demand Curve
O
Quantity
Answer
The supply cannot catch up with the demand, because of the
ramping constraint.
The excess demand forces the price increase all the way to the
ceiling.
We will see extremely high price and no consumer surplus.
Yet, there is no market power.
Correct Figures Should Be ...
Price
Supply Curve
Consumer Surplus
Equilibrium
Price
Producer Surplus
Demand Curve
O
Equilibrium Quantity
Quantity
Correct Figures Should Be ...
Price
Supply Curve
Producer Surplus
Demand Curve
O
Quantity
Less Obvious
Price
Supply Curve
Consumer Surplus
Producer Surplus
Demand Curve
O
Quantity
Less Obvious, continued
Even with excess supply, the generator would not dump the
boiling water, because the demand will increase with a
positive probability.
The price go down to the floor, as a result.
Even less obvious is that in the end, the generator will extract
all the gain from trading.
Friction, not the market power, is the basis for the large profit.
Epilogue
Long term contract vs. spot market
Market uncertainty may lead to policy uncertainty.
Policy uncertainty may discourage investment to
infrastructure.
New way of diagnosing the market power.