Capacity mechanisms as means for energy supply security (Mechanism design and regulatory policy...

Norwegian University of Life SciencesØstfold University College 1

Capacity mechanisms as means

for energy supply security

Igor Pipkin

Mechanism design and regulatory policy issues

Agenda

• Introduction

• Energy vs capacity

• Security of electricity supply

• Missing money/markets

• Capacity mechanisms

• Design essentials

• Well-designed capacity mechanism

Norwegian University of Life Sciences 2

Introduction

• Capacity mechanism, capacity market, capacity payment,

capacity remuneration scheme

–The difference?

• To stimulate investment in new capacity, maintenance of

the existing capacity and to have this capacity available

during the periods of scarcity

• Experience from many countries/markets

• Additional set of rules

• There is still no consensus on the nature of these rules

for capacity mechanismsNorwegian University of Life Sciences 3

Deregulation, restructuring

and regulations

“The objective of regulation is to prevent (or conversely

produce) inefficient (efficient) outcomes in different places

and timescales that might (might not) otherwise occur.”


• Regulatory policy issues:

- What is the problem?

- Why cannot the existing market fix it?

- The solution

- Market power

- The role of interconnectors

Energy vs capacity

• High Nordic hydro reservoirs

• 81% full (69% median 1990-2012)

• Surplus of 22.7 TWh (15 days of

peak consumption in Nord Pool)

• Cold weather

• Technical issues in Sweden

• Russia – Finland


Day-ahead market price(last 30 days)



Regulating prices(last 30 days)

Urgent market messages


Strategic reserve schemes

• Some capacity is available in addition to the ancillary service

capacities contracted by the Transmission System Operators

(TSOs)

• Strategic reserve is established to remain available in scarcity

situations

• The required reserve is determined and tendered by the TSO

• The selected generator is withheld from the spot market

• The cost for maintaining strategic reserve is collected through

grid charges or balancing market charges

• The crucial issue is the price at which the market is cleared

whenever strategic reserve is activatedNorwegian University of Life SciencesGore, 2015 11

What would the price be

without peak load reserve?


Renewables (RES) - volatility

• Wind 30% - 30% - 20%

• Poor wind forecasts

• Need of Flexibility is the need for some

units to follow the net load variability

• Reserves is the need for some units to

follow the net load forecast errors

Norwegian University of Life SciencesNørgård, Giebel, Holttinen, Søder and Petterteig, 2004 13

GW

wind generation Germany (per hour)

Stranded assets

• Gas vs Coal

• Lower utilization rate for

conventional power plants

• Uneconomic generation

assets mothballed

(temporary idled or shut

down) or permanently

retired ahead of their

planned decommissioning

date

Norwegian University of Life SciencesCaldecott and McDaniels, 2014 14

Cancelled and postponed EU projects

SRMC lignite, hard coal and natural gas

Flexibility constraints

Nuclear Hard Coal Lignite Gas Pump

Storage

Start-up Time

“cold”

~ 40 H ~ 6 H ~ 10 H < 2 H ~ 0.1 H

Start-up Time

“warm”

~ 40 H ~ 3 H ~ 6 H ~ 1.5 H ~ 0.1 H

Load Gradient of

“nominal Output”

~ 5%/m ~ 2%/m ~ 2%/m ~ 4%/m ~ 40%/m

Min. Shutdown

Time

- - - - ~ 10 H

Min. Load 50% 40% 40% <50% ~ 15%


Flexibility vs RESInternational Energy Agency

• 45% RES + same reliability criteria

• Less baseload capacity

• Increase flexibility


Investment needs as share of

installed capacity

Norwegian University of Life SciencesTHEMA, 2014 17

Uncertainty vs risk

• Uncertainty about future system design

• The resulting political and regulatory uncertainties, too,

may deter new investments


• The right time?

• The right place?

• The right

technologies?

• The right price for

new capacity?

Uncertainty vs risk

• Uncertainty about future system design

• The resulting political and regulatory uncertainties, too,

may deter new investments


• The right time?

• The right place?

• The right

technologies?

• The right price for

new capacity?

Risk is present when future events occur with

measurable probability

Uncertainty is present when the likelihood of

future events is indefinite or incalculable

(Knight, 1921)

Regulations


“The objective of regulation is to prevent (or conversely

produce) inefficient (efficient) outcomes in different places

and timescales that might (might not) otherwise occur.”

• The CO2 Market (European Emission Allowances)

• Feed-in tariff (Germany +++)

• EL-certificates (Sweden and Norway)

Examples of regulatory

mechanisms Norway/ Sweden Germany

The goal Clean energy Clean energy

26.4 TWh

(10% of consumption)

The product kWh RES kWh RES

Contract time terms 2012-2035 (1%-18%-1%) 20 years

Incentive/Penalization I < E(P) + P(El-cert) I < FiT**

The counterparties

Buyer consumers consumers

Seller new RES new RES

Purchase mechanism auction subsidy by technology

WinnersCO2 CO2

Lower electricity price Lower electricity price

Loosers Lower utilization rate for existing

power plants

Lower utilization for

conventional power plants


The Security-of-Supply (SoS)

Problem

• Modern society depends critically on electricity

• Social, economic and political dimensions

• Avoid emergency situations and ensure quality

• Physical supply of electricity is the result of a complex

and interlinked set of actions, some of which are

performed many years in advance

• Examples: Technologies/infrastructure, fuel supply, hydro

reservoirs, maintenance schedule, grid, start-up for

operation when needed, and operating reserve margins


The four dimensions of SoS

• Security

(Operation)

• Firmness

(Planning)

• Adequacy

(Expansion)

• Strategic

(Strategic

Expansion)


The ability of the electrical system to support

unexpected disturbances such as electrical

short circuits, unexpected loss of components of

the system, or sudden disconnection.

The ability of facilities already installed to

respond to actual requirements and meet

the existing demand efficiently.

The existence of enough available generation

and network capacity, either installed or

expected to be installed, to efficiently meet

demand in the long term.

Energy policy, diversifying fuel supply and the

generation technology mix, environmental

concerns, etc.

Short-term

Short &

med-term

Long-term

Very long-

term

What is expected from the market?

• Intervention vs. leaving the market to its own devices

• Which is the best alternative at each dimension?

• In which dimension do regulators to a large extent trust

in market agents and mechanisms?


Regulatory Intervention No Intervention

Strategic Adequacy Firmness Security

Short & very-long/long term

• Balancing and Ancillary Services Markets

• The situation after the markets have closed (gate closure)

in which a TSO acts to ensure that demand is equal to

supply, in and near real time.

• The market cannot internalize very long-term or out-the-

sector objectives (externalities)

• Decommissioning of the nuclear power plants

• Renewable revolution (20/20/20)

• National subsidies (coal, gas)

• Introduction of capacity mechanisms


Firmness and adequacyTransition towards decarbonisation while securing electricity supply

• Flexibility (ramp-up)

• Can be controlled/managed

• Energy constrained

• Demand response/smart grid

• Electricity storage/pump station

• Carbon capture and storage

• Environment/renewables


Climate &

Environment

Firmness &

Adequacy

Affordability

Competitiveness

The market solves the problem if…

• Perfectly competitive market, where all agents have

perfect information

• The short-term spot price always reflects demand-side

marginal utility

• Risk neutrality (i.e. no risk aversion) of all the system

agents

• Convex production cost function (no start-up costs)

• Neither economies of scale nor lumpy investments


Missing money problem

• Perfect energy-only

market

• 2 technologies

• Base and peak

• Load reduction

price at value of lost

load (VOLL)

Norwegian University of Life SciencesGore 2014, Joskow and Tirole 2004, Joskow 2008 28

• Price-cap to mitigate

market power

• Missing money:

(VOLL-Price cap)*T1

Security of supply vs price of

blackouts

• Price will always clear the

market in a competitive market

• Duration of blackouts depends

on the generation capacity built

to avoid them

Norwegian University of Life SciencesCramton, Ockenfels, Stoft 2013 29

• The incentive to build generation to avoid blackouts

depends on the price being paid during blackouts

• No competitive price during blackouts

• Scarcity Network collapse Market collapse

• Consumers are not willing to pay a price during the collapse

Pricing blackouts


Duration of

blackouts

hours/year

Value of

Lost Load

(VOLL)

$/MWh

Annual

cost of

blackouts

$

Rental cost of

reliable

capacity

(RCC) $/MW

5 20 000 100 000 80 000

Build up to the point where the duration of

blackouts falls to 4 hours per year, i.e. where

the marginal cost of capacity equals

the marginal reduction in the cost of lost load

Market for blackouts

• Too high a price cap results in too much capacity

• Example: the marginal price-elastic consumer sets the

price in case of scarcity/blackout, not the VOLL of non-

elastic consumers

• Relevant to determining the value of reliability for the

majority of customers?


VOLL

Pcap

PROVIDE THE AMOUNT OF CAPACITY THAT

OPTIMIZES THE DURATION OF

BLACKOUTS

Alternatives to deal with

Security of Supply

• Do nothing: the so-called “energy-only markets”

• Do something:

- Price mechanisms (capacity payment)

- Quantity mechanisms (strategic reserves, capacity

markets, capacity obligation, reliability options)

Norwegian University of Life SciencesCramton, Ockenfels, Stoft 2013; Bratlle 2014 33

“Energy-only market”

• Raise the price caps

• Require prices to rise automatically to the price cap when the

System Operator (SO) take “out of market” actions to deal

with scarcity

• Increase real time demand response – active component of

the price formation and compete directly with supply

• Refine/increase the number of operating reserve products –

5/10 min ramp-up instead of “must run” scheduling and out-

of-market bilateral arrangements

• Consider reliability rules/criteria and reserve margins

Norwegian University of Life SciencesJoskow, 2008 34

Strategic reserve

Do something: the regulator buys (or orders the demand to buy)

- A product defined to fulfil the regulator’s objective

• Energy, capacity, financial option, etc.

• Duration, lag period, etc.

- Defining the counterparties

• Demand: all demand or just a part of it

• Generation: all generation, just new entrants, just one

technology

- Defining the bidding curve

• Fixed price, fixed quantity, elastic price-quantity curve

- By means of one or various purchasing process

• Auction (centralized or not) or bilateral


Price

• Firm (available) supply

• Regulator defines

Pblackouts and Pcap

• Pblackouts ≈ VOLL

• Second-best outcome

• Second-best, “optimal”

amount of capacity

• Ultimately depends on

the quality of the

regulator’s estimate of

VОLL

Norwegian University of Life SciencesCramton, Ockenfels, Stoft 2013, Stoft 2002 Joskow 2007 36

Quantity

• Average available capacity

• Regulator calculates C*

• Regulator sets Pcap

• Auction to supply capacity

and clears at Pblackouts*

• Pblackouts* - Pcap to

generators that sold

capacity during scarcity

hours on top of energy-

market payment of Pcap

Capacity Payments Capacity Markets

Capacity obligations

Price

• Poor definition of the

reliability product

• Weak economic incentive

to be available when

needed

• No guarantee that any

desired investment target

will be achieved


Quantity

• Poor definition of the

reliability product

• The must-offer requirement

was ineffective, as

unavailability could be

masked by high-priced bids

• Extreme short-term price

volatility depending on

reserve margin

• Elastic demand & delivery

date

Capacity Payments Capacity Markets

Price vs quantity based -

essentially the same

• Duration of blackouts = RCC/VOLL

• Duration of blackouts ≈ f(installed capacity)

• Customers consuming electricity must pay for the bundle

of capacity (proxy for supply reliability) and energy

• Artificial product => artificial demand


Is not a choice between a market approach and regulated approach

• Depends on other factors such as risk, market power,

and the coordination of investments in capacity

• Other important issues: penalties, capacity ratio, RES,

interconnection capacity, risk of volatile fuel prices?

Can these mechanisms

provide long-term adequacy?

• The lack of incentive for generators to be running in

times of stress (when the system needs them the most)

• Generators can profitably withhold output during periods

of scarcity and stress in order to create larger price

spikes

• Price volatility in short-term capacity markets is caused

by the fact that both the demand curve and the supply

curve are very inelastic

• Entry and the threat of entry is an (the only) antidote to

the exercising of market power by existing generators

Norwegian University of Life SciencesBidwell, 2005 39

The devil is in the details

Reliability options

• Physical capacity bundled with a financial option to

supply energy at spot prices above a strike price

• Hedges load from high spot prices

• Reduces supplier risk

• Spot price during the periods of scarcity can be as

volatile as is required for short-run economic efficiency

• Market power that would emerge in times of scarcity in

the spot market is reduced without damaging the

dispatch incentives on the generation side

Norwegian University of Life SciencesOren, 2005 40

Safe Passage to the Promised Land


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Price

10

strikeP

capP

16

10

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VoLL

Regulator

defines

strike price

Regulator

defines

price cap

Reliability options

• Payoff to consumers

• Option value as a

function of capacity

• Downward sloping,

supported by the

opportunity cost of

generators who can sell

their uncommitted

energy at the spot price


Capacity mechanisms and

cross-border effects

Norwegian University of Life SciencesMeyer, Gore, Brunekreeft, Viljainen, 2014 43

• Price effects

• Capacity effects – attract new investments in the region with

capacity mechanism

• Welfare effects – “free-riding”/welfare loss, “export” the

missing money problem to the energy-only market

• Infrastructure investment – prospects for cross-border trade

may appear less promising

Capacity mechanisms are a

European issue

• EC (2013) - Given the increasing integration of electricity

markets and systems across borders it is now increasingly

difficult to address the issue of generation adequacy on a

purely national basis

A purely national introduction of a capacity mechanism:

• Is expensive because capacity available abroad is not used

• Does not guarantee per se definite security of supply as the

markets are connected to one another

• Is contrary to the idea of a European internal market


What does the regulator seek?

• A major objective: secure the electricity supply

- Attract capacity

- Guarantee efficient resource management

• Hedge the consumers’ risk

- Stabilize prices

• Mitigate entry barriers

- Open the market to new entrants

- Some products may help mitigating market power

Norwegian University of Life SciencesBatlle, 2014 45

What do generators want?• Hedge their risk

• If the short-term signal is not optimal – additional source

of income may be needed

The product

• Capacity (MWs):

– Physical (installed)

– Firm (available in scarcity situations)

– Flexible, fast start-stop, cycling capability, ramping

capability (Short Term Operating Reserve)

• An energy contract:

– Physical (obligation to produce)

– Financial (guarantees a price)

– Physical + Financial (obligation to produce at a certain

price)


• Contract time terms:

–Entry

–Market power

• Penalization:

– In case of non-compliance

– The larger the penalty, the more reliable generation

will be, but also more expensive (risk premium)

• Guarantees:

– The physical unit can serve as a guarantee

The product


The counterparties

• Buyers: all demand or just a segment?

• Sellers: all technologies/new

investments or all units?

• Interconnectors: Buyers/Sellers?

Norwegian University of Life SciencesBratlle 2014, Keay-Bright (RAP) 2013 48

Purchase mechanism• Bilateral vs. Auction

centralized or not

• Bidding curve: price/quantity

Well-designed capacity

mechanism• Predictable and stable regulatory setting

• Effective market rules that support the efficient medium

and short-term operation of existing resources

• Coordinated, efficient investment, reduced investment

risk, and improved operation during periods of scarcity

• Should be procured several years in advance to enable

new entrants to participate and investments to be made

• Allow participation from neighbouring countries/regions

• Capacity market that allows projects to compete before

the investments are sunk, and thereby be reflected in the

capacity priceNorwegian University of Life Sciences 49

Well-designed capacity

mechanism• Downward sloping demand curve for the capacity product

• Clear and simple definition of capacity product consistent

with the market’s objective: capacity is the ability to supply

energy and reserves during a reserve shortage

• Strong performance incentives should come from supply

obligation during shortages – “no exceptions”

• Resources are rewarded based on their ability to reduce

shortages during scarcity conditions

• Those that provide more than their share are rewarded; those

that provide less than their share are penalized

• Technology neutral; compete to supply capacity on an equal

basis, i.e. one recognizes the different contributions each

resource makes to the reliability objective. Norwegian University of Life Sciences 50

Conclusions

• The market would ideally provide firm and adequate

supply

• Missing money/adequacy problem

• Some sort of intervention is needed


God is in the detail(attention paid to small things has big rewards)

Thank you

Capacity mechanisms as means for energy supply security (Mechanism design and regulatory policy...

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