The Economics of Electricity Markets

Preface xv Nomenclature xvii PART I INTRODUCTION TO ECONOMIC CONCEPTS 1 1 Introduction to Micro-economics 3 1.1 Economic Objectives 3 1.2 Introduction to Constrained Optimisation 5 1.3 Demand and Consumers’ Surplus 6 1.3.1 The Short-Run Decision of the Customer 7 1.3.2 The Value or Utility Function 7 1.3.3 The Demand Curve for a Price-Taking Customer Facing a Simple Price 7 1.4 Supply and Producers’ Surplus 10 1.4.1 The Cost Function 11 1.4.2 The Supply Curve for a Price-Taking Firm Facing a Simple Price 11 1.5 Achieving Optimal Short-Run Outcomes Using Competitive Markets 14 1.5.1 The Short-Run Welfare Maximum 14 1.5.2 An Autonomous Market Process 15 1.6 Smart Markets 17 1.6.1 Smart Markets and Generic Constraints 17 1.6.2 A Smart Market Process 18 1.7 Longer-Run Decisions by Producers and Consumers 20 1.7.1 Investment in Productive Capacity 20 1.8 Monopoly 22 1.8.1 The Dominant Firm – Competitive Fringe Structure 24 1.8.2 Monopoly and Price Regulation 25 1.9 Oligopoly 26 1.9.1 Cournot Oligopoly 27 1.9.2 Repeated Games 27 1.10 Summary 28 Questions 29 Further Reading 30 PART II INTRODUCTION TO ELECTRICITY NETWORKS AND ELECTRICITY MARKETS 31 2 Introduction to Electric Power Systems 33 2.1 DC Circuit Concepts 33 2.1.1 Energy, Watts and Power 34 2.1.2 Losses 35 2.2 AC Circuit Concepts 36 2.3 Reactive Power 38 2.3.1 Mathematics of Reactive Power 40 2.3.2 Control of Reactive Power 42 2.3.3 Ohm’s Law on AC Circuits 43 2.3.4 Three-Phase Power 44 2.4 The Elements of an Electric Power System 45 2.5 Electricity Generation 46 2.5.1 The Key Characteristics of Electricity Generators 49 2.6 Electricity Transmission and Distribution Networks 52 2.6.1 Transmission Networks 54 2.6.2 Distribution Networks 57 2.6.3 Competition and Regulation 59 2.7 Physical Limits on Networks 60 2.7.1 Thermal Limits 61 2.7.2 Voltage Stability Limits 64 2.7.3 Dynamic and Transient Stability Limits 64 2.8 Electricity Consumption 66 2.9 Does it Make Sense to Distinguish Electricity Producers and Consumers? 67 2.9.1 The Service Provided by the Electric Power Industry 69 2.10 Summary 70 Questions 71 Further Reading 72 3 Electricity Industry Market Structure and Competition 73 3.1 Tasks Performed in an Efficient Electricity Industry 73 3.1.1 Short-Term Tasks 73 3.1.2 Risk-Management Tasks 75 3.1.3 Long-Term Tasks 75 3.2 Electricity Industry Reforms 76 3.2.1 Market-Orientated Reforms of the Late Twentieth Century 77 3.3 Approaches to Reform of the Electricity Industry 79 3.4 Other Key Roles in a Market-Orientated Electric Power System 81 3.5 An Overview of Liberalised Electricity Markets 82 3.6 An Overview of the Australian National Electricity Market 85 3.6.1 Assessment of the NEM 87 3.7 The Pros and Cons of Electricity Market Reform 88 3.8 Summary 89 Questions 90 Further Reading 90 PART III OPTIMAL DISPATCH: THE EFFICIENT USE OF GENERATION, CONSUMPTION AND NETWORK RESOURCES 91 4 Efficient Short-Term Operation of an Electricity Industry with no Network Constraints 93 4.1 The Cost of Generation 93 4.2 Simple Stylised Representation of a Generator 96 4.3 Optimal Dispatch of Generation with Inelastic Demand 97 4.3.1 Optimal Least Cost Dispatch of Generation Resources 98 4.3.2 Least Cost Dispatch for Generators with Constant Variable Cost 99 4.3.3 Example 101 4.4 Optimal Dispatch of Both Generation and Load Assets 102 4.5 Symmetry in the Treatment of Generation and Load 104 4.5.1 Symmetry Between Buyer-Owned Generators and Stand-Alone Generators 104 4.5.2 Symmetry Between Total Surplus Maximisation and Generation Cost Minimisation 105 4.6 The Benefit Function 105 4.7 Nonconvexities in Production: Minimum Operating Levels 106 4.8 Efficient Dispatch of Energy-Limited Resources 108 4.8.1 Example 109 4.9 Efficient Dispatch in the Presence of Ramp-Rate Constraints 110 4.9.1 Example 111 4.10 Startup Costs and the Unit-Commitment Decision 113 4.11 Summary 115 Questions 116 Further Reading 117 5 Achieving Efficient Use of Generation and Load Resources using a Market Mechanism in an Industry with no Network Constraints 119 5.1 Decentralisation, Competition and Market Mechanisms 119 5.2 Achieving Optimal Dispatch Through Competitive Bidding 121 5.3 Variation in Wholesale Market Design 123 5.3.1 Compulsory Gross Pool or Net Pool? 124 5.3.2 Single Price or Pay-as-Bid? 125 5.4 Day-Ahead Versus Real-Time Markets 126 5.4.1 Improving the Quality of Short-Term Price Forecasts 127 5.4.2 Reducing the Exercise of Market Power 129 5.5 Price Controls and Rationing 129 5.5.1 Inadequate Metering and Involuntary Load Shedding 131 5.6 Time-Varying Demand, the Load-Duration Curve and the Price-Duration Curve 133 5.7 Summary 135 Questions 137 Further Reading 137 6 Representing Network Constraints 139 6.1 Representing Networks Mathematically 139 6.2 Net Injections, Power Flows and the DC Load Flow Model 141 6.2.1 The DC Load Flow Model 144 6.3 The Matrix of Power Transfer Distribution Factors 145 6.3.1 Converting between Reference Nodes 146 6.4 Distribution Factors for Radial Networks 146 6.5 Constraint Equations and the Set of Feasible Injections 147 6.6 Summary 151 Questions 152 7 Efficient Dispatch of Generation and Consumption Resources in the Presence of Network Congestion 153 7.1 Optimal Dispatch with Network Constraints 153 7.1.1 Achieving Optimal Dispatch Using a Smart Market 155 7.2 Optimal Dispatch in a Radial Network 156 7.3 Optimal Dispatch in a Two-Node Network 157 7.4 Optimal Dispatch in a Three-Node Meshed Network 159 7.5 Optimal Dispatch in a Four-Node Network 161 7.6 Properties of Nodal Prices with a Single Binding Constraint 162 7.7 How Many Independent Nodal Prices Exist? 163 7.8 The Merchandising Surplus, Settlement Residues and the Congestion Rents 163 7.8.1 Merchandising Surplus and Congestion Rents 163 7.8.2 Settlement Residues 164 7.8.3 Merchandising Surplus in a Three-Node Network 165 7.9 Network Losses 166 7.9.1 Losses, Settlement Residues and Merchandising Surplus 167 7.9.2 Losses and Optimal Dispatch 168 7.10 Summary 169 Questions 170 Further Reading 170 8 Efficient Network Operation 171 8.1 Efficient Operation of DC Interconnectors 171 8.1.1 Entrepreneurial DC Network Operation 173 8.2 Optimal Network Switching 173 8.2.1 Network Switching and Network Contingencies 174 8.2.2 A Worked Example 174 8.2.3 Entrepreneurial Network Switching? 176 8.3 Summary 177 Questions 178 Further Reading 178 PART IV EFFICIENT INVESTMENT IN GENERATION AND CONSUMPTION ASSETS 179 9 Efficient Investment in Generation and Consumption Assets 181 9.1 The Optimal Generation Investment Problem 181 9.2 The Optimal Level of Generation Capacity with Downward Sloping Demand 183 9.2.1 The Case of Inelastic Demand 185 9.3 The Optimal Mix of Generation Capacity with Downward Sloping Demand 186 9.4 The Optimal Mix of Generation with Inelastic Demand 189 9.5 Screening Curve Analysis 191 9.5.1 Using Screening Curves to Assess the Impact of Increased Renewable Penetration 192 9.5.2 Generation Investment in the Presence of Network Constraints 193 9.6 Buyer-Side Investment 193 9.7 Summary 195 Questions 196 Further Reading 197 10 Market-Based Investment in Electricity Generation 199 10.1 Decentralised Generation Investment Decisions 199 10.2 Can We Trust Competitive Markets to Deliver an Efficient Level of Investment in Generation? 201 10.2.1 Episodes of High Prices as an Essential Part of an Energy-Only Market 201 10.2.2 The ‘Missing Money’ Problem 202 10.2.3 Energy-Only Markets and the Investment Boom–Bust Cycle 203 10.3 Price Caps, Reserve Margins and Capacity Payments 203 10.3.1 Reserve Requirements 204 10.3.2 Capacity Markets 205 10.4 Time-Averaging of Network Charges and Generation Investment 206 10.5 Summary 207 Questions 207 PART V HANDLING CONTINGENCIES: EFFICIENT DISPATCH IN THE VERY SHORT RUN 209 11 Efficient Operation of the Power System in the Very Short-Run 211 11.1 Introduction to Contingencies 211 11.2 Efficient Handling of Contingencies 212 11.3 Preventive and Corrective Actions 213 11.4 Satisfactory and Secure Operating States 215 11.5 Optimal Dispatch in the Very Short Run 216 11.6 Operating the Power System Ex Ante as though Certain Contingencies have Already Happened 218 11.7 Examples of Optimal Short-Run Dispatch 219 11.7.1 A Second Example, Ignoring Network Constraints 221 11.7.2 A Further Example with Network Constraints 222 11.8 Optimal Short-Run Dispatch Using a Competitive Market 223 11.8.1 A Simple Example 224 11.8.2 Optimal Short-Run Dispatch through Prices 227 11.8.3 Investment Incentives 228 11.9 Summary 229 Questions 230 Further Reading 230 12 Frequency-Based Dispatch of Balancing Services 231 12.1 The Intradispatch Interval Dispatch Mechanism 231 12.2 Frequency-Based Dispatch of Balancing Services 232 12.3 Implications of Ignoring Network Constraints when Handling Contingencies 233 12.3.1 The Feasible Set of Injections with a Frequency-Based IDIDM 235 12.4 Procurement of Frequency-Based Balancing Services 238 12.4.1 The Volume of Frequency Control Balancing Services Required 238 12.4.2 Procurement of Balancing Services 239 12.4.3 Allocating the Costs of Balancing Services 240 12.5 Summary 241 Questions 242 Further Reading 242 PART VI MANAGING RISK 243 13 Managing Intertemporal Price Risks 245 13.1 Introduction to Forward Markets and Standard Hedge Contracts 245 13.1.1 Instruments for Managing Risk: Swaps, Caps, Collars and Floors 246 13.1.2 Swaps 246 13.1.3 Caps 247 13.1.4 Floors 248 13.1.5 Collars (and Related Instruments) 249 13.2 The Construction of a Perfect Hedge: The Theory 249 13.2.1 The Design of a Perfect Hedge 250 13.3 The Construction of a Perfect Hedge: Specific Cases 252 13.3.1 Hedging by a Generator with no Cost Uncertainty 252 13.3.2 Hedging Cost-Shifting Risks 254 13.4 Hedging by Customers 256 13.4.1 Hedging by a Customer with a Constant Utility Function 257 13.4.2 Hedging Utility-Shifting Risks 258 13.5 The Role of the Trader 259 13.5.1 Risks Facing Individual Traders 261 13.6 Intertemporal Hedging and Generation Investment 263 13.7 Summary 264 Questions 265 14 Managing Interlocational Price Risk 267 14.1 The Role of the Merchandising Surplus in Facilitating Interlocational Hedging 267 14.1.1 Packaging the Merchandising Surplus in a Way that Facilitates Hedging 269 14.2 Interlocational Transmission Rights: CapFTRs 269 14.3 Interlocational Transmission Rights: Fixed-Volume FTRs 271 14.3.1 Revenue Adequacy 271 14.3.2 Are Fixed-Volume FTRs a Useful Hedging Instrument? 273 14.4 Interlocational Hedging and Transmission Investment 273 14.4.1 Infinitesimal Investment in Network Capacity 274 14.4.2 Lumpy Investment in Network Capacity 274 14.5 Summary 276 Questions 277 Further Reading 277 PART VII MARKET POWER 279 15 Market Power in Electricity Markets 281 15.1 An Introduction to Market Power in Electricity Markets 281 15.1.1 Definition of Market Power 281 15.1.2 Market Power in Electricity Markets 282 15.2 How Do Generators Exercise Market Power? Theory 284 15.2.1 The Price–Volume Trade-Off 284 15.2.2 The Profit-Maximising Choice of Rate of Production for a Generator with Market Power 286 15.2.3 The Profit-Maximising Offer Curve 287 15.3 How do Generators Exercise Market Power? Practice 289 15.3.1 Economic and Physical Withholding 289 15.3.2 Pricing Up and the Marginal Generator 291 15.4 The Incentive to Exercise Market Power: The Importance of the Residual Demand Curve 292 15.4.1 The Shape of the Residual Demand Curve 293 15.4.2 The Importance of Peak Versus Off-Peak for the Exercise of Market Power 293 15.4.3 Other Influences on the Shape of the Residual Demand Curve 295 15.5 The Incentive to Exercise Market Power: The Impact of the Hedge Position of a Generator 295 15.5.1 Short-Term Versus Long-Term Hedge Products and the Exercise of Market Power 297 15.5.2 Hedge Contracts and Market Power 297 15.6 The Exercise of Market Power by Loads and Vertical Integration 298 15.6.1 Vertical Integration 299 15.7 Is the Exercise of Market Power Necessary to Stimulate Generation Investment? 300 15.8 The Consequences of the Exercise of Market Power 301 15.8.1 Short-Run Efficiency Impacts of Market Power 301 15.8.2 Longer-Run Efficiency Impacts of Market Power 302 15.8.3 A Worked Example 302 15.9 Summary 304 Questions 306 Further Reading 306 16 Market Power and Network Congestion 307 16.1 The Exercise of Market Power by a Single Generator in a Radial Network 307 16.1.1 The Exercise of Market Power by a Single Generator in a Radial Network: The Theory 308 16.2 The Exercise of Market Power by a Single Generator in a Meshed Network 311 16.3 The Exercise of Market Power by a Portfolio of Generators 313 16.4 The Effect of Transmission Rights on Market Power 314 16.5 Summary 315 Questions 315 Further Reading 315 17 Detecting, Modelling and Mitigating Market Power 317 17.1 Approaches to Assessing Market Power 317 17.2 Detecting the Exercise of Market Power Through the Examination of Market Outcomes in the Past 318 17.2.1 Quantity-Withdrawal Studies 319 17.2.2 Price–Cost Margin Studies 321 17.3 Simple Indicators of Market Power 322 17.3.1 Market-Share-Based Measures and the HHI 322 17.3.2 The PSI and RSI Indicators 324 17.3.3 Variants of the PSI and RSI Indicators 326 17.3.4 Measuring the Elasticity of Residual Demand 328 17.4 Modelling of Market Power 330 17.4.1 Modelling of Market Power in Practice 331 17.4.2 Linearisation 332 17.5 Policies to Reduce Market Power 332 17.6 Summary 333 Questions 334 Further Reading 334 PART VIII NETWORK REGULATION AND INVESTMENT 335 18 Efficient Investment in Network Assets 337 18.1 Efficient AC Network Investment 337 18.2 Financial Implications of Network Investment 338 18.2.1 The Two-Node Graphical Representation 339 18.2.2 Financial Indicators of the Benefit of Network Expansion 341 18.3 Efficient Investment in a Radial Network 342 18.4 Efficient Investment in a Two-Node Network 344 18.4.1 Example 345 18.5 Coordination of Generation and Network Investment in Practice 348 18.6 Summary 350 Questions 351 Further Reading 351 PART IX CONTEMPORARY ISSUES 353 19 Regional Pricing and Its Problems 355 19.1 An Introduction to Regional Pricing 355 19.2 Regional Pricing Without Constrained-on and Constrained-off Payments 357 19.2.1 Short-Run Effects of Regional Pricing in a Simple Network 360 19.2.2 Effects of Regional Pricing on the Balance Sheet of the System Operator 361 19.2.3 Long-Run Effects of Regional Pricing on Investment 363 19.3 Regional Pricing with Constrained-on and Constrained-off Payments 364 19.4 Nodal Pricing for Generators/Regional Pricing for Consumers 367 19.4.1 Side Deals and Net Metering 367 19.5 Summary 369 Questions 370 Further Reading 370 20 The Smart Grid and Efficient Pricing of Distribution Networks 371 20.1 Efficient Pricing of Distribution Networks 371 20.1.1 The Smart Grid and Distribution Pricing 373 20.2 Decentralisation of the Dispatch Task 374 20.2.1 Decentralisation in Theory 374 20.3 Retail Tariff Structures and the Incentive to Misrepresent Local Production and Consumption 377 20.3.1 Incentives for Net Metering and the Effective Price 378 20.4 Incentives for Investment in Controllable Embedded Generation 380 20.4.1 Incentives for Investment in Intermittent Solar PV Embedded Generation 384 20.4.2 Retail Tariff Structures and the Death Spiral 385 20.4.3 An Illustration of the Death Spiral 386 20.5 Retail Tariff Structures 388 20.5.1 Retail Tariff Debates 389 20.6 Declining Demand for Network Services and Increasing Returns to Scale 390 20.7 Summary 393 Questions 395 References 397 Index 399