Power Economics III: Security of Supply and Market Design, Reserve Power Markets

Supply Adequacy and Market Design

Learning Goals

• Define what security of supply is
• Understand how investments are made to achieve security of supply
• Reflect on electricity market designs that can guarantee investments

Security of Supply

There are many definitions. We will use this one:

Definition: Security of Supply

Security of Supply: Security of supply exists when electricity Reliability consumers are able to obtain electricity of defined quality when they need it, at cost- reflective and transparent prices

36/ 50

Security of Supply/Reliability

Reliability Definitions

Reliability Adequacy Security Investments

Adequacy The ability of the electric system to supply the energy demand at all times, considering scheduled and unscheduled outages of system elements.

Security The ability of the electric system to withstand sudden disturbances.

5/ 50

Refinancing of Fixed Costs and Investments

General Refinancing of Power Plants on the Market

• Bidding: short-term marginal costs of their power plants
• Refinancing of fixed costs and investment by more expensive power plants are price-setting sufficiently >contribution marginsoften
• Most expensive power plant cannot achieve a contribution margin

Load Marginal Costs Margi nal Costs 1 Contribution margin to cover fix costs Volume Load Contribution margin to cover fix costs Volume

Refinancing of Peak Load Power Plants

Options for Refinancing Peak Load Power Plants

• Peak-load power plants demand a higher price than their short-term input costs (markups), which they can impose on the market due to shortages . In some countries, laws against restraints of competition can make it difficult for operators of peak load power plants to bid with markups

Marginal Costs Load Contribution margin to cover fix costs Volume

Price Spikes for Peakers

Peak Prices and Contribution Margins

Peak prices: when demand sets the price, peaker power plants can earn contribution margins to cover fix costs and capex

Value of Loss Load (VoLL) Price /MWh Demand curves $1000 -1 $30 Supply curve $18 Demand curves QJ = 4 GW Qa = 8 GW

Excursion: Value of Lost Load - VOLL

Definition of VOLL

Definition Monetary indicator expressing the costs associated with an interruption of electricity supply.

• The VoLL is determined by an estimate of the cost supported by the consumer following a service interruption or by the payment that consumers pay or are willing to pay to avoid a shortage.
• In markets where consumers face price variation, VOLL is minimized.
• Currently electro-intensive reveal their VoLL when they disconnect – The problem comes from small consumers.
• Hard to estimate since it varies widely depending on customer class, business sector, duration of outage, and advanced warning of the outage: Eg. MISO (Midwest SO) estimates the VoLL at $730-$2510/MWh for residential, $15,000-$50,000/MWh for businesses, and $16,000- $78,000/MWh for large industrials.

Excursion: Value of Lost Load - VOLL

Your Value of Loss Load

What is your Value of Loss Load?

VoLL - Survey

Mentimeter Survey

Mentimeter: www.menti.com Code: 3339 2326

Price Spikes for Peakers - Example

Financing Peak Capacity Investment

A peak power plant with an annual capex of 100k€/MW should be financed via contribution margins earned in the hours when demand (VoLL) sets the electricity price of the market. How many VoLL-prices do we need to finance a new peak capacity investment? Assumption: p = VoLL = 1000 €/MWh Annual capex of investment: 100 k€/MW Cvar = 100 €/MWh

Price Spikes for Peakers - Example

Calculating Hours for Peak Capacity Investment

A peak power plant with an annual capex of 100k€/MW should be financed via contribution margins earned in the hours when demand (VoLL) sets the electricity price of the market. How many VoLL-prices do we need to finance a new peak capacity investment? Assumption: p = VoLL = 1000 €/MWh Annual capex of investment: 100 k€/MW Cvar = 100 €/MWh Capex Capex #hours = Margins p - Cvar 100.000€/MW = = 111 h (1000 - 100)€/MWh

Stocktaking of the Energy-only Market

Current State and Challenges

The electricity market in still functions today as an Energy-only Market in many countries

• reliable supply of customers since the beginning of liberalisation
• a capacity gap in the different electricity markets is foreseeable

The marginal cost market does not clarify the remuneration of the "last power plant"

• The last power plant in the merit order always earns only its input costs, but not its fixed costs; peak-load pricing recently occurred > see current price crises
• Missing-money problem? Renewable energies reduce the market prices but do not cause the missing-money problem
• The remuneration of peak-load power plants also without RES unclear
• RES dampen prices, the market is reacting to > decommissioning

Current Discussion about Market Design

Missing-Money-Problem

MC [€/MWh] demand p * Missing-Money = (p*3 - Pmax) · X3 Pma P2 Gas turbine CCGT Coal p1 Lignite coal i Nuclear X1 X2 X3 · Price caps to avoid market power abuse in oligopolistic markets · Missing contribution margins to cover fix or capital costs [MW] supply

Current Discussion about Market Design

Market Design Discussions and Price Caps

MC [€/MWh] supply demand p* Missing-Money = (p*3 - Pmax) · X3 Pma P2 țunine CCGT Coal p1 Lignite coal i Nuclear X1 X2 X3 . Price caps to avoid market power abuse in oligopolistic markets . Missing contribution margins to cover fix or capital costs · Market design discussions started already in the early 2000es (Oren 2000, Joskow and Tirole 2000) [MW]

How to Overcome Missing Investments?

Definitions

Energy-only Market

• Power plant operators are only remunerated for delivering energy, (if they actually produce electricity and sell it on the market) The maintenance of the power plant and the resulting fixed costs must be recovered contribution margins

Capacity Remuneration Mechanisms

• In addition to the energy-only market, power plants are awarded additional revenues via additional mechanisms for keeping their capacity in the market/system.
• "Capacity markets" are one option how to do this.

Centralized Approach via Capacity Market

Capacity Market Structure

Capacity provision Capacity payment Capacity market Levy of capacity payments Electricity supply Capacity providers (supply, storage, flexible demand) Retailers End consumers End consumer electricity price Electricity supply Wholesale electricity price Electricity supply Wholesale electricity price Wholesale electricity market (EOM)

Energy-only Market vs. Capacity Remuneration Mechanisms

Arguments for the Energy-only Market (EOM)

Collection of arguments for the "Energy-only market (EOM)":

• The EOM has so far efficiently balanced supply and demand
• The EOM allows the European integration of the electricity markets
• Expected shortages are reflected in rising prices on the futures markets

Advantages of EOM

• Opportunities and risks of investments remain with the investors, not the public sector
• different flexibility options equally encouraged
• Market design relatively simple and transparent

Disadvantages of EOM

• The level of performance of the EOM does not have to be in line with the politically expected level.

Energy-only Markt vs. Capacity Remuneration Mechanisms

Arguments for a Capacity Remuneration Mechanism

Arguments for a Capacity Remunaration Mechanism:

• EOM does not provide sufficient incentives for new investments
• Investors do not want to cover the price risk
• Investors do not invest in new capacities/keep old ones in the market >required power plant capacities are missing to cover (peak) demand >Public authorities define the level of security and purchase it
• via central capacity market (auctions)
• or via decentralised obligation on energy suppliers

Capacity Remuneration Systems - Overview I

Types of Capacity Remuneration Systems

low 1 Simple capacity subsidy Complexity 2 Index- based capacity payment medium 3 Strategic Reserve Description · Direct investment subsidy for new construction · Demand conditions possibly specified (e.g. type of plant, operator) · Direct payment for equipment provision based on a shortage index · Criteria: Availability, existing capacity, seasonal factors · Some x% of the generation capacity is taken out of the market and reserved for critical periods (spike prices) · Remuneration for this part of the capacity in the system Declaration · Mechanism is often linked to other policy objectives (e.g. environmental objectives) · System used in Spain and Ireland · Objective: To ensure the availability of existing plants in case of high demand · Model established in Germany and Sweden/Finland, to ensure peak load • Model refers to generation plants that might be mothballed and demand side management

Capacity Remuneration Systems - Overview 2

Advanced Capacity Remuneration Systems

Description medium 4 Capacity Tender · Premium for the provision of new plants to compensate for missing contribution margins (missing money) · Tendering via auction procedure · Trading options on power plant capacities against option premium · Realisation of option in case market price > strike price 6 high Capacity market · Fully developed capacity market with target capacities defined by central planner • Bidding process for secure generation and load management against capacity constraints Declaration · Proposed as part of the debate in Germany in 2014 · Applied in many countries with growing demand · Model launched in Brazil, Columbia Complexity Realiability Options 5 · Enables hedging against price spikes in the market · Processes introduced in the USA (PJM, NE-NO) · In USA secondary market tur Guarantee of long-term flexibility

Energy-Only Market and Strategic Reserve

Strategic Reserve Mechanism

Stand-by cost 1 Including levy of strategic reserve cost Strategic reserve Activation cost Central regulatory body Electricity supply Fee for strategic reserve cost Capacity providers (supply, storage, flexible demand) Electricit y supply Retailers End consumers End consumer electricity price1 Electricit y supply Wholesale electricity price Electricity supply Wholesale electricity price Wholesale electricity market (EOM)

Pros and Cons of Different CRM Types

Advantages and Disadvantages of CRMs

1 Simple capacity subsidy 2 Index- based capacity payment 3 Strategic Reserve Advantages · High transparency · Simple implementation · Possible national implementation · Regional focus possible · Economically efficient by including existing plants · Flexible to design/adapt · Small market intervention Disadvantages · Effectiveness not guaranteed · Disturbance of the profitability of existing plants · Strong market intervention · Index formation not transparent · Compensation is difficult to determine · Strong market intervention · Can be used to avoid peak prices > Possibility of market intervention · Danger of underused capacities