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Don’t Overemphasize Spot at the Expense of Forward and Real Time (Macro & Micro) Federal Energy Regulatory Commission February 26, 2002 Robert Blohm Investment Banker & Economist email: [email protected] TOTAL COST CURVES E V T A E N L U E TOTAL REVENUE LINEAR : AR = MR = MR = AR AC = T O R MC = TOTAL COST TOTAL REVENUE CURVES LINEAR : AC = MC NON-LINEAR NON-LINEAR AC : AVERAGE COST MC : MARGINAL COST AR : AVERAGE REVENUE MR : MARGINAL REVENUE : SLOPE : SLOPE QUANTITY SOLD QUANTITY SOLD OUTSIDE THE PERFECTLY COMPETITIVE TEXTBOOK WORLD OF STRAIGHT LINES , CURVES ARE NON-LINEAR . $ / UNIT PERFECT COMPETITION ONLY AT A HORIZONTAL SUPPLY AND DEMAND CURVE WHERE MARGINAL EQUALS AVERAGE MC: MARGINAL COST AC: AVERAGE COST AR: AVERAGE REVENUE MR: MARGINAL REVENUE p : PERFECTLY COMPETITIVE PRICE pc q : PERFECTLY COMPETITIVE QUANTITY pc : PERFECTLY COMPETITIVE SUPPLY AND DEMAND CURVE MC SUPPLY CURVE p AC p pc AR DEMAND CURVE VALUE CURVE MR q q pc QUANTITY IMPERFECT COMPETITORS PRODUCE THE PROFIT-MAXIMIZING QUANTITY AND PRICE OFF THE AVERAGE REVENUE CURVE IMPERFECT COMPETITION : ONCE THE (PERCEIVED) DEMAND CURVE SLOPES , AVERAGE AND MARGINAL REVENUE DIVERGE PERCEIVED AGGREGATE DEMAND CURVE STEEPENS AS THE INDUSTRY COMPRISES FEWER STRATEGIC PLAYERS. EACH PLAYER IS EFFECTIVELY A SMALL MONOPOLIST, LEAVING ONE-ANDTHE-SAME RESIDUAL PORTION OF DEMAND UNSERVED. $ / UNIT AR : AGGREGATE PERCEIVED AVERAGE REVENUE MR : AGGREGATE PERCEIVED MARGINAL REVENUE PERFECT COMPETITION : FLAT HORIZONTAL SUPPLY AND DEMAND CURVE $ / UNIT A QUINTOPOLY ACTUAL DEMAND CURVE 1/3 p p=c 1 q $ / UNIT Q PERCEIVED DEMAND CURVE AR c QUANTITY MR 5/6 q 1 2/3 A QUADROPOLY A TRIOPOLY 1/2 2/5 p p AR MR 4/5 q c 2/3 1 3/5 Q AR MR c 3/4 q 1 p AR p AR c ACTUAL AND PERCEIVED DEMAND CURVE MR 1 1/3 Q A MONOPOLY A DUOPOLY MR 2/3 q 1 1/2 Q c 1/2 1 q QUANTITY UNIT PRICE A MARKET'S OR AUCTION'S PRICE-DETERMINING MECHANISM AFFECTS PRICE SIGNALLING . IMPLICIT BILATERALIZATION OF POOLS . SINGLE (MP) PRICE POOL HIDES (AP) PRICE PATH . NET DEMAND-IMPATIENCE S : SUPPLY D : DEMAND Q : TOTAL QUANTITY BOUGHT / SOLD MP : MARGINAL PRICE AP : AVERAGE PRICE : TRANSACTED PRICES AP S VARIABLE-COST CURVE MP D VALUE CURVE QUANTITY & Q TIME SPLITTING THE DIFFERENCE WITH LESS PRICE-SENSITIVE BUYERS GIVES SELLERS A HIGHER (AVERAGE) PRICE . BILATERALIZATION MEANS MULTIPERIOD PRECOMMITMENT IN MULTIPLE FORWARD MARKETS : PRICE-PATH REVELATION MEANS SMOOTHER, MORE PREDICTABLE PRICE BEHAVIOR . UNIT PRICE O : OFFER-PRICE CURVE BID & OFFER CURVES B : BID-PRICE CURVE ARE S : SUPPLY CURVE NOT THE SAME AS D : DEMAND CURVE O THE VALUE / O VARIABLE-COST SUPPLY AND DEMAND CURVES . THE LESS PATIENT TRADE FIRST AS THE CURVES INTERSECT S ON THE PRICE PATH FROM LEFT TO RIGHT . VARIABLE-COST CURVE S BID & OFFER CURVES START FROM INVERTED POSITIONS IMPLICIT D VALUE CURVE B SEQUENCE OF TRADE FROM THE LEFT AS BID CURVE RISES & OFFER CURVE LOWERS . B Q D BILATERALIZATION OF POOLS RIGHTWARD SEQUENCE OF TRADE AS BID & OFFER CURVES APPROACH VALUE CURVE & VARIABLE-COST CURVE FROM THE LEFT UNIT PRICE O O S S B D B D O S B D QUANTITY & TIME UNIT PRICE A MARKET'S OR AUCTION'S PRICE-DETERMINING MECHANISM AFFECTS ALLOCATION OF SURPLUS . NET DEMAND-IMPATIENCE . SINGLE (MP) PRICE POOL REALLOCATES TO BUYERS THE EXTRA SURPLUS OTHERWISE GOING TO SELLERS MORE PRICE-SENSITIVE THAN BUYERS . : SURPLUS TO SELLERS IN A SINGLE (MP) PRICE POOL AP : EXTRA SURPLUS TO SELLERS IN A BILATERALIZED EXCHANGE AP : AVERAGE PRICE MP : MARGINAL PRICE S : SUPPLY D : DEMAND S VARIABLE COST CURVE MP D VALUE CURVE Q QUANTITY & TIME UNIT PRICE NET SUPPLY-IMPATIENCE . CALIFORNIA UTILITIES WANTED A PERMANENTLY MANDATORY POOL TO BE ABLE TO CAPTURE EXTRA SURPLUS , POST RETAIL ACCESS . WHEN THEY FAILED TO GET IT , THEY DIVESTED GENERATION TO BECOME NET DEMANDERS . : EXTRA SURPLUS TO BUYERS IN A BILATERALIZED EXCHANGE S : SUPPLY D : DEMAND MP : MARGINAL PRICE AP : AVERAGE PRICE S VARIABLE COST CURVE MP D VALUE CURVE AP Q QUANTITY & TIME UNIT PRICE NET DEMAND-IMPATIENCE . MARKET POWER OF SELLERS RELATIVE TO BUYERS . BILATERALIZATION MEANS SELLERS PRICE OFF THE MARKET'S AVERAGE (TRANSACTION) REVENUE CURVE . ONE-(MARGINAL-)PRICE POOLS MASK PRICE SIGNALLING OF MARKET POWER ; SO, UNDER THE MYTH OF PERFECTLY-COMPETITIVE POOL PRICING , THEY MAY ENCOURAGE SELLERS TO REDUCE QUANTITY . S : SUPPLY D : DEMAND AR : AVERAGE REVENUE MR : MARGINAL REVENUE MR : MARGINAL REVENUE AFTER SUPPLY REDUCTION AR p REDUCED SUPPLY CURVE IF SINGLE-(VARIABLE-COST-)PRICED POOL MR S MR VARIABLE COST CURVE D VALUE CURVE Q REDUCED QUANTITY IF SINGLE-(VARIABLECOST-)PRICED POOL QUANTITY & TIME Table 1 The physical energy price is the average price of the purchase portfolio. The financial concept of "term structure" is closely linked to a "purchase portfolio", which is a strongly physical concept. bought at t-n consumed at ... t-3 t-2 t-1 t-n . ... . ... t-3 . ... . t-2 . ... . . t-1 . ... . . . t . ... . . . Column t-n: termstructure of purchases made at time t - n t . Row t: (pre)purchase portfolio for consumption done at time t 2 Measures can hurt forward markets • Operation of spot market by a system operator – Officially designed/operated spot market risks being made the mandatory market for regulated supply by State regulators • Lack of physical transmission rights – Hoarding of physical transmission rights is outdone by a properly designed real-time market • Financial rights can be hoarded too, and at much less cost – Financial derivatives are always more expensive than the real thing A spot market is not a real-time market for reliability • It can be an economic optimization market • The real time-market is the true end-point of the forward market price path. • Real time transactions cannot be done moment-by-moment deterministically – Time is too short • Real time performance and value must be measured probabilistically – Classical physics versus quantum mechanics • Joint indeterminacy of position and momentum • Joint indeterminacy of time and reliability-pricing – reliability pricing as a time average Tiered real-time market • NERC’s Control Performance Standard – targets error performance of Balancing Authorities relative to system/frequency error performance – individual error is assessed based on whether it hurts or helps the system/frequency Approximate CPS1 p : ProbabilityOn average over the past year: e : Annual standard MW, or p + deviation of DF ( ) Target 2 2 : e = e + m DF RMS m D F : Year's Mean of D F DF :1-minute average of Frequency error Bi < 0:Control area i's bias -e B-i <0:Bias for other than i B < 0: System bias ( ) - - 10 B i D F : DT-i ,CPS 2 = 16.5 e10 å-i B-i B "No inadvertent allowed in the direction of Frequency error when +e DF ³ e " -50 50 DF = ± 10 Bi e 2 16 .5e 10 å -i B-i B DF +(mHz) 10 B i D F Control area i's maximum allowed 1-minute average total tie-line flow (including response) in the direction of the frequency error: : æ e ö DTi = -10 Bi ç e - DF ÷ è DF ø One-year target probability density of 1-minute averages of frequency error, adjusted for deviation of the mean from 0 Tiered real-time market (cont.d) • Market made it necessary to price Balancing Authorities’ inadvertent – because they have have commercial interest – must be done in a way compatible with tariffed pricing of unscheduled energy of exclusively commercial entities Tiered real-time market (cont.d) • Market made it necessary to price Balancing Authorities inadvertent (cont.d) – 3 components of inadvertent valuation • Market value of the energy • Transmission loading component • Frequency control contribution (FCC) – value of unscheduled is not just energy: it is also quickness of response » primary (response) and secondary (regulation/AGC, and (operating & replacement/load-following reserves) » primary is faster and more valuable than secondary – value is the unscheduled energy’s good or bad contribution to the frequency deviation relative to system/frequency error performance » compatible with CPS1 Balancing Authorityi 's Frequency Control Contribution i,h is the slope of the regression line through points relating DF h toI i sampled at different hoursh + DF h = i, h Ii - DF h Dual pricing of unscheduled energy Ambiguity along the diagonal Revenue/Expense Unscheduled part 0 energy part U 0 sold bought good bad peU + p peU - p - peU + p - peU - p receive pay Primary Response Stabilizes Frequency Secondary Response Restores Frequency Hz 60 59.925 15 Seconds Inadvertent Interchange and Primary and Secondary Response Very simplified Balancing Authority A Balancing Authority B 100 100 Numbers in Mw Load 75 25 50 50 Generation Inadvertent of 25 75 Primary response of 50 in load reduction, 25 each in A and B 75 75 50 25 50 Outage of 50 in Balancing Authority B 100 75 100 25 50 50 Secondary response of 50 Replacement by 50 from Balancing Authority A 50 Tiered real-time market (cont.d) • FCC does not target frequency • Balancing Authorities must settle their FCC monthly – Since inadvertents sum to zero by definition, Balancing Authorities always clear • Balancing Authorities must also comply with CPS frequency targeting, acting as agents subject to NERC penalty – NERC CPS penalty will prompt Balancing Authorities to trade their CPS rights the way DOE pollution penalties prompted market for pollution rights. • To meet their monthly CPS scores, Balancing Authorities will trade their frequency control contributions as an alternative to buying options on frequency support Tiered real-time market (cont.d) • FCC is open and scalable to a market below Balancing Authorities – Balancing Authorities can apply FCC to their constituent entities to incent entities’ self-provision and good performance, thereby minimizing the Balancing Authority’s own local intervention. • Three tiered market for frequency control – NERC, Balancing Authorities, local entities. • Frequency is a public good requiring an authority like NERC to drive the frequency-control markets by the threat of penalty. – This meets both a reliability and a markets objective Producing unscheduled energy versus producing frequency support (under contract): Frequency support Secondary Producing without (option) contract j' Affects producer Producing under (option) contract 's ij ' j' Not affects producer 's ij ' because "scheduled"; so, settled Entitlement to payment for j Improves buyer reversing some system Primary because j' part reversed & settled with Affects producerj _ Entitlement to payment for part of some entityj _ 'sij 's ij _ 's ij _ Not affects buyerj j ij prepays part of 'sij ; rather j_ to 4 market operations Entities j may be indifferent, but BAsi Paying out your ij to anotheri * j,' For increasing his By settling Paying anotheri *j ' , ij (or i* ) i* , By buying- ij i* of his , ij _ or ij ' ij or ij to reduce your j, _ For increasing _ primary by - ij - ij of his , j_ are not indifferent, between his ij ' (or i* By increasing his scheduled ) secondary by - ij _ ij' No option contract Option contract No option contract Option contract Operation 1: Operation 2: Operation 3: Operation 1: Operation 4: Settlement payout of Buy primary support Trading Settlement Buy secondary support ij ij ij ij payout of ij Ancillary services markets • Ancillary services markets need to be developed as robust options markets – The option price is driven by volatility which is another way to capture/express Frequency Control Contribution Possible portfolio of options Price should arbitrage buyer's avoided cost with supplier's opportunity cost p supply: demand: price: q in order of size of unscheduled Puts on generation Calls on generation Calls on loads In a complete options market for frequency response the optimal scheduling point minimizes the cost of unscheduled B + C Period Overscheduling A C M w Optimally Scheduling B D Underscheduling Order of size of unscheduled A Overscheduled due to overscheduling Unscheduled B C Overscheduled + Underscheduled due to optimally scheduling D Underscheduled due to underscheduling MinValue ( B + C ) Min[Value( A), Value( D )] Conclusion • True price revelation requires specifying spot markets less in order to leave room for the forward and real-time markets to mature • FERC should not – over-specify spot markets on the phony pretext that those markets are delivering on their misnamed promise of real-time transactions and reliability, – nor prompt thereby the migration of transactions from physical forward markets where they belong. • Forward markets are in desperate need of liquidity development – Spot-opiented merchant generators are capital short