Transcript Ensuring Generation Adequacy in a Competitive Electricity

Generation Adequacy through
Backstop Call Option Obligations
Shmuel S. Oren
University of California at Berkeley
Presented at CREG Workshop,
Bogotá, Colombia
July 25, 2006
The Promised Land
• Generation companies bear all the investment risk
and consumers (LSEs) bear all the price risk.
• Customers and suppliers are free to choose levels of
exposure to price risk through risk management and
contractual agreements.
• Forward markets and hedging instruments enable
parties to manage their risk exposure
• Competitive forces drive generation capacity,
technology mix and prices toward a long term
equilibrium that reflect supply and demand choices
for reliability and cost.
• Fixed costs of generation capacity at long run
equilibrium are exactly covered by inframarginal
costs and scarcity rents
July 2006
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2
Long Run Market Equilibrium in an
Energy – Only Market
Energy
Price
($/MWh)
Demand at 7:00 - 8:00 p.m.
Price at7:00-8:00 p.m.
Inframarginal Profits
Scarcity rent
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 1
GEN 2
Q1
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GEN 3
GEN 4
GEN 5
Q2
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Optimal
Capacity
MW
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Challenges to Energy Only Markets
• Steep supply function and uncertainties make scarcity
rents highly volatile and sensitive to market error in
determining the optimal capacity
• It is practically 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 abuse
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4
Challenges to Energy Only Markets
(Cont’d)
• Spot prices and scarcity rents are suppressed by
regulatory price caps, market mitigation practices,
deployment of operating reserves, and out of market
operator actions (e.g., reliability unit commitment) so
generators cannot recover their fixed costs.
• Who will pay for reserve capacity that is required to
assure supply reliability.
• 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
(free riders)
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5
Proposed Texas Energy Only Market
• Two level system wide offer cap HCAP=$3000/MWh LCAP=$500/MWh.
HCAP activated if total fixed cost recovery (FCR) by a generic peaker in a
one year window (fixed or moving) is <75K/MW while LCAP activated
when FCR reaches $150K/MW (Bang bang mechanism).
• Use of reserves is represented by a “proxi-generator” with a linear offer
curve starting at 30% of CAP and reaching 100% of CAP at 100MW.
(price reaches cap if 100MW of spin used)
• Aggressive program to stimulate demand response
• ISO publishes 10 year forecast and statement of opportunity.
• Offer price disclosure with short delays
• Emergency Load Response mechanism (ELR) – ISO can purchase up to
one year call options with strike price at HCAP from load resources to be
deployed only in lieu of involuntary curtailment and when price is at the
system wide cap.
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Classification of Capacity Mechanism
Energy only
markets
Reliance on economic incentives
Capacity payments
Operating reserve
pricing
Strategic reserves
procurement
Contracting
obligations
Capacity
obligations
Regulated
regional
monopoly
Explicit demand for generation capacity
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Properties of a Good Capacity
Mechanism
• Replicate investment incentives in functional energy only
market (forward contracting)
• Facilitate risk sharing between consumers and producers
• Provide intrinsic value to consumers in exchange for risk
sharing (not subsidy to generators)
• Incent new investment and enable direct participation by
new entrants
• Provide stable income to generators to reduce cost of
capital in exchange for windfall profit potential
• Provide reasonable opportunity to generators to recover
their fixed cost on a long run basis (address the “missing
money” problem)
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8
Desired Properties (cont’d)
• Incent performance and have meaningful penalties for
non-performance that reflects the damage.
• Enable generators to opt out by increasing spot price
potential income in exchange for risk taking
• Enable load to opt out (self-insure) by avoiding capacity
payment in exchange for taking spot price or curtailment
risk
• Not interfere with bilateral forward market and voluntary
risk management practices
• Allow self-provision through bilateral contracts
• Mitigate credit problem
• Obligations imposed on LSEs should reflect customer
base and account for load migration
• Easy sunset when market provides sufficient insurance
through contracting and load response
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Call Options as Price Insurance
Definition: A call option is the right but not obligation to
purchase one unit of power over the contract duration at
an agreed upon strike price
Spot
Spot
Payback to LSEs
holding option
Strike
Option Value
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Time
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Mechanics of Backstop Call Option
Obligations
• Load serving entities (LSEs) required to hold at the beginning of
each month hedges in the form of forward contracts and/or call
options (with verifiable physical cover) totaling their share of the
target capacity set by the regulator based on reliability
consideration.
• Qualifying hedges must be at least three year forward- looking
with forward or strike prices at or below a mandatory level set
by the regulator
• Price cap should be raised to a level that reflects VOLL (e.g.
$10,000)
• Mandatory strike price shall be high enough so as not to
interfere with risk management activities but significantly below
the energy price cap. (For example the energy price cap can be
raised to $10,000/MW and the mandatory strike price set to
$1000/MW).
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Call Option Mechanics (cont’d)
• With a $1000 strike price consumers get the same price
protection as under the current cap but will have to pay a
fair market price for that protection
• Nonperforming capacity liable for difference between spot
market price and strike price (liquidation damages) plus a
penalty (only nonperforming generators are exposed to
spot market price spikes).
• Obligation may be locational with LMP-based settlement so
that option value (with same strike price) will be location
dependent.
• Uncommitted capacity and firm load can sell energy at spot
market prices above strike but no higher than the offer cap.
(incentive for speculative entry, load response and
uncommitted imports)
• Private contracts that meet the duration and strike price
requirement will count toward the LSE hedging obligation.
July 2006
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Call Option Mechanics (cont’d)
• Hedging obligations can be met by a portfolio of
supply contracts and curtailable loads (committed
demand response).
• Call options may be, self provided, procured
bilaterally or procured through a voluntary auction
hosted by the ISO.
• Load can Opt out by offering a call option at the
strike price covered by a curtailable service contract
(interrupt when spot reaches strike)
• Deliverability can be assured by making call option
obligations locational with physical cover. LMP
based settlement with same strike price makes
option prices location dependent. (like NY but
without administrative prescription)
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Call Option Value in a PriceCapped Energy Market
Energy Price $/MWh
Cap
Strike
Annualized
Call option value
$/MW
Price duration curve
8760
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Hours
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Call Option Prices as Function of
Generation Capacity Based on
Opportunity Cost of Selling at Spot
Energy Price
Annualized Call Option
Value
Call Option Price
Per Hour
Capa
ci
Strike
ty
Cap
Cap -Strike
P*
8760
Price Duration Curve
Q*
Hours
Capacity
Implied Demand Curve for Capacity
At optimal capacity Q* the call option price
P* = Average Hourly {CT fixed cost – CT energy profit with price capped at Strike}
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Comparison to Demand Function
Demand function
• Demand curve is set administratively
• ISO procures all available capacity and adjusts LSE
obligation accordingly (discourages self-provision)
• Disincentive for self-provision
• No opt out for load
Call Options
• Liquidation damage risk and opportunity to sell above strike
for non committed units creates intrinsic market value for
option.
• Generators selling option are liable for providing energy at
reduced rates (strike)
• Option price is implied by opportunity cost of selling energy
above strike (market based) and can be determined through
an auction mechanisms
• Option obligations never exceed target capacity- available
capacity in access of target assumes the risk of cost
recovery through the unmitigated spot market
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Caveats and Questions
•
•
•
•
•
Deliverability and physical cover
Pricing operating reserve use
Market power in the energy market
Market Power in the call options market
What Happens if the spot energy
market does not clear
• Central Procurement
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Operating Reserves Pricing
• Co-optimization of
energy and reserves +
a “reserve penalty”
that gradually raises
the offer curve to the
cap as function of
reserve depletion.
• This implements a
scarcity pricing
mechanism that raises
the unmitigated spot
prices to the cap when
X MW of reserves are
deployed
July 2006
CAP
Price
Energy
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With
Reserves
Demand
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Market Power in Energy
• Since most generation capacity will be under call
option contracts there will be little incentive for that
capacity to exercise market power.
• Uncontracted capacity may exercise market power
but that will not affect consumers who are protected
by the strike price.
• Only nonperforming generators are exposed to
market power in the energy market so liquidation
damages can be expected to be CAP – STRIKE per
MW shortfall which provides a strong incentive for
performance and reinsurance by generators ( e.g. in
a hydro dominated systems hydro plants selling call
options will have an incentive to buy insurance
against drought from thermal plants.)
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Market Power in Call Options
• Long term call options enable
contestability from new entrants
• Competitive procurement (through
auction)
• Demand function
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Shape of Demand Function
Price
This part is realized
As expected profits from
energy market
(generators rather than
consumers take the risk)
Quantity
Target Capacity
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What if the Energy Spot Market
Does Not Clear?
• Scarcity pricing mechanisms will automatically raise spot
price to the offer cap
• If load is within the limits of the call options obligation
then consumers are not affected (only nonperforming
generators are exposed)
• If load exceeds call option obligations then the balance is
made up through use of operating reserves, load
interruption and dispatch of uncontracted capacity.
• The cost of covering the shortage even at very high
prices will only increase cost to customer slightly since
most of the load will be covered by the call options
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The Time Step Misalignment
Dilemma
• LSEs want hedging obligations to be
short term (load varies, no long term
contracts with customers, credit
requirements)
• Generators want call options to be long
term (can take it to the bank as
collateral for investment loans)
• How do we bridge the gap?
July 2006
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Central Procurement
– Works like an ancillary service product
– ISO conducts an annual central auction for annual three
year (or longer) forward call options on energy with a
specified strike price
– Procured quantity is based on forecasted load and
reserves requirements which may be zonal
– Option offered must be covered by existing capacity,
three year forward interruptible contracts or bilateral
contract with min three year duration and price at or
below strike price.
– LSEs holding long term contracts and curtailable load
contracts with appropriate duration and price can self
provide by offering call options against these contracts
into the auction.
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Central Procurement (cont’d)
– LSE obligation (and share of cost) determined Monthly
based forecasted monthly peak load.
– Cost of options allocated on a per MWh basis and over time
based on monthly LOLP calculation.
– Payment to sellers and allocation of cost to LSEs at
performance time (ISO passes payment through).
– For LSEs who self-provided their full obligation option
revenues offset costs.
– Providers of options required to offer contracted capacity at
contract strike price and offer any additional balancing
energy (beyond contracted capacity) at market clearing
prices.
– Failure to perform entails financial liability for the difference
between market price and strike price times the amount of
undelivered energy (liquidation damages) plus penalty.
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Procurement Auction
Aggregate supply curve
Price
starting price P0
excess supply
Round 1
P1
Round 2
P2
Round 3
P3
Round 4
P4
P5
Round 5
P6
clearing price
Quantity
Target Capacity
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Summary
• Self provision option enables smooth transition to
voluntary insurances. As the market matures individual
hedging obligation may be relaxed if the market as a
whole proves to be properly hedged.
• 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 consumers (represented by 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.
• Unlike forward contracts, call options do not have a “take”
obligation so the LSE can be required to hedge a larger
quantity than expected peak demand.
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July 2006
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Summary (cont’d)
• LSE obligations can be revised monthly to reflect
changes in customer base.
• Call option obligation functions as mandatory
insurance where capacity product is linked to energy
production capability and deliverability.
• Market price of option is driven by opportunity cost of
selling energy above strike price and it will decline
naturally with increased generation capacity (no need
for administrative demand curve and procurement
does not need to extend beyond target capacity)
• Self-provision through prudent risk management
practices by LSEs and demand response will lead to
natural sunset of the regulatory obligation.
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Ultimately, demand response and risk
management practices will evolve to the point
where the Promised Land can be reached.
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