1

Resource Adequacy and Market Power Mitigation

via Option Contracts

Hung-po Chao and Robert Wilson

EPRI and Stanford University

Presentation at

POWER Conference on Electricity Restructuring

University of California Energy Institute

March 19, 2004

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Motivation

• FERC’s Standard Market Design delegates to state regulators:

• Resource Adequacy requirements

–Ensure ample generation capacity

–Encourage long-term contracting

–Mitigate market power in spot markets

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Primary Rationale for Long-Term Contracting

• State PUC can mandate transfer of transactions:

– From spot market, where demand is inelasticand some suppliers have market power

– To forward market, where supply is more elastic because longer time frame allows• Investments in capacity expansion

• Entry by new firms: forward market is contestable

• Predicted benefits for utilities, state PUCs, ISO:

– Reduce price volatility and sellers’ market power

– Improve system reliability and security

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Role of Option Contracts

• Compared to fixed-price fixed-quantity contracts,Options reduce utilities’ quantity risks– Prime example: California’s contracts in 2001

– But, of course, options increase risk-bearing by suppliers

• A portfolio of options with a spectrum of strike prices increases elasticity of net demand in spot markets– Demand net of options called at their strike prices

is more elastic

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Illustration of the Effect on Net Demand of Portfolio of Options with Spectrum of Strike Prices

Price p

Quantity q

D(p)D*(p)

S*(p) Net SupplyS(p)

Clearing price p*

        

 

 

Quantity of Options Callable at Strike Prices > p

Net Demand

• Effect of options is to tilt the net demand and supply curves - Fixed-price fixed-quantity contracts shift these curves

• Greater demand elasticity mitigates suppliers’ market power

Net purchase in spot market

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Using Options to Implement a Price Schedule

Price p

P(q’)P(q)

q q’

S*(p) = Supply net of options

D(p)

D’(p)

Load Level 

        

 

Quantities of options called when load levels are q and q’ , where q < q’

• Design the portfolio of options to implement a price schedule P(q) for net spot purchases when the load level is q

- Allows the price cap to vary with the load level - Higher price allowed when higher load occurs

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Some Implementation Aspects

• Options must be backed by physical resources of seller.Optioned quantity must be offered as standing bid at ISO.Physical obligation is necessary to:

– Ensure resource adequacy and mitigate market power

– Improve system reliability

• PUC can conduct periodic procurement auctions of option contracts, then allocate options among LSEs according to each LSE’s price- or load-duration curve, net of existing contracts.

– Avoids free-rider problem among LSEs.

• LSEs can use option prices to set terms of retail service contracts. Or, use retail contracts to design option portfolio.

(The paper addresses other implementation aspects)

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Example of a Theoretical Model

• Supply Side: Firms are symmetric, market is contestable– Fixed cost of entry: number of firms is endogenous– Costs are (a) linear in capacity, (b) quadratic in energy per

unit of capacity. Constant returns to scale.

• Demand Side:– Demand is linear in actual and expected spot prices.– A stochastic term (revealed in the spot market) shifts the

load level.

• Forward Market for Options– Inelastic Demand: Quantity (at strike prices < p) = p.– Supply: Since the firms are symmetric, each firm bids to

supply the same fraction of demand at each strike price.

• Spot Market for Energy: Spot price equates net demand and net supply.

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Results for an Example2( , ) /(2 )C x y h k y c x y

( , , ) ( )D p p a b p p p Costs:Demand:

Parameters specifiedin text of paper

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

0 2 4 6 8 10

Number of firms, n

Op

tim

al o

pti

on

po

rtfo

lio

req

uir

emen

t,

 

(1) Optimal magnitude of option demand in forward marketif the number n of firms is fixed.

(2) Resulting consumers’ surplus, depending on the fixed number n of firms

More firms Fewer options, BUT Optimal option portfolio Few firms suffice !

999.27

999.28

999.29

999.3

999.31

999.32

999.33

999.34

999.35

999.36

0 2 4 6 8 10

Number of firms, nC

on

su

me

rs' s

urp

lus

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Results for an Example (continued)

(3) Consumers’ surplus resulting from each choice of the magnitude of the option demand when the number n of firm is endogenous.

999.26

999.27

999.28

999.29

999.3

999.31

999.32

999.33

0 0.5 1 1.5 2 2.5 3

Option portfolio requirement, (MWh^2/$)

Co

nsu

mer

s' s

urp

lus

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Results for an Example (continued)

Case 1No contract

Case 2 Forward contract

Case 3 Option portfolio

Expected level of spot demand

0.998742 0.999864 0.999997

Expected level of demand with option coverage

0 0 0.969344

Quantity of forward contracts0 0.046047 0

Expected spot price 125.82 13.58 0.33

Producers' profit 251 0 0

Consumers' surplus 749 973 999

Total surplus 999.19 972.85 999.35