Infrastructure and Project

Finance
Price formation in power markets
 The Main Risks Assumed in Markets

• Price risk
• Quantity risk
• Fuel price risk
• Availability risk

• Implication for project finance?

2
Electricity System
 Technical specifics of electricity
• “No storage”
Market has to clear fully at all times
• Electricity takes the path of least resistance
Electrons do not respond to prices
• Electricity “travels at light speed”
Market needs to clear instantaneously
• Interactions in transmission
– Actions by any generator or customer affect others (e.g.
congestion)
– Need for “ancillary services (incl. fast response, reactive
power) that support the existence of the market (system
stability)

4
https://www.youtube.com/watch?v=UTM2Ck6XWHg
 Functional Requirements
• Eliminating imbalances (supply and demand)

• Congestion management (transmission)

• Elicit Investment

• Check market power abuse

• Ancillary services (system stability, “reliability”)

6
 Key elements of any power market

• Forward markets

• Balancing markets

• Dispatch

7
Forward Market
in case of overloading, demand and supplies doesnt match, suppliers will ask buyer to auction their booking

Balancing market
Dispatch
 Vertically integrated monopoly

generation wholesaling
Competitive market includes: generation and wholesale

high voltage
transmission System operation
monopolistic market includes transmission, distribution
and system operation

Low voltage
distribution retailing
competitive

kwh $

customer 11
 Retail competition

wholesale

12
MO: Market operator; SA: Settlement administrator; ISO: Independent System Operator
 Merit Order Dispatch
marginal cost of each power plants
Source: W. Hogan (2004)
generators are bidding their price which relates to the capacity they can provide.
generators will try to bid a price close to system price. if its too high they wont get dispatched
because there will be someone cheaper, and if they bid cheaper you're bidding at loss thus it
gives incentive for the bidder to near the system price
 Price formation

• When there is excess capacity for given demand,

system marginal cost sets price

• When there is excess demand at maximum

capacity willingness to pay sets price (with elastic
demand)

• “Scarcity rent” and investment

 Auction Approaches
• Pay as bid (incentives like first‐price auction)

• Pay price that equilibrates demand and supply

to all bidders (incentives like second‐price
auction) – “system marginal cost”

• Incentives to bid ”truthfully”

 Balancing (Spot) Market

• The nature of bids

– Demand schedules
– Supply schedules

• Optimization program calculates resulting

prices for generators and consumers
 Euphemia
Pan‐European Hybrid Electricity Market Integration Algorithm
 Forward Market
• Why a forward market? hedge, speculate,arbitrage

• Day‐ahead market when system operator

schedules units
• The relationship between spot and forward
markets
– Pricing
– Fulfillment of obligations
Hedging through long-term contracts

The relation of short and long-term contracts:

• Complements, not substitutes
• Spot price as basis for contracts
20
 Exercise
A generator and a distribution company have
concluded a forward contract for delivery of 1
million kwh units of power at a price of 4
cents/kwh. On the day of dispatch the generator
can only produce 0.9 million kwh, while the
distribution company needs 1.1 million kwh. The
spot price in the balancing market is 5 cents/kwh.
Describe what the commercial transactions of the
generator and the distribution companies look
like. Assume that settlement occurs under
contracts for difference. What does settlement
look like?
 Market Power

• How can generators exercise market power?

– Pivotal bidder at peak time

– Capacity withholding
 Exercise of Market Power
Price $/kwh

A 6
5

4
3
2
1

Quantity (MW) 23
 Withholding Capacity

• Necessary repairs…

• Buyers unable to pay

• Exercise of market power

 Measures to curb market power
• Making markets work better
– Demand response
– Entry of new generators
– Long‐term contracts
• Regulatory measures
– Price caps = reservation prices
– Profit control = regulation
– Bidding restrictions
THE CALIFORNIA CRISIS
California
 The California story
• The smartest guys in the room – not just ENRON
• Basic system feature
– Wholesale market
– Fixed retail prices (no pass through of wholesale
prices)
– No long‐term hedging contracts
• Drought: 300 MW short on 50,000 MW capacity
• Response:
– Reregulate
– Raise retail tariffs by 40%

29
Disaster strikes
AVERAGE PRICES THAT UTILITIES PAID FOR
ELECTRICITY IN THE CALIFORNIA POWER
EXCHANGE'S DAY‐AHEAD AUCTIONS, APRIL
1998 THROUGH DECEMBER 2000
 (In)elastic Demand
Price $/kwh

4 5
3
1 2

Quantity (MW) 31
 California

• Prohibition of long‐term contracts

• What if CfDs had been concluded?

 Market power
• Market power is exercised by withholding
capacity

• When withholding is observed is it an

expression of market power?
TRANSMISSION
Flow in power networks
 Locational
Prices
• Zonal Prices
• Nodal prices
– Congestion
– Transmission
losses
Source: W. Hogan (2004)
Einar Aas, Nordpool, Germany and Nasdaq
INVESTMENT
 Energy‐only Market
• Revenue to cover operating and investment
costs is obtained only through the price for
energy expressed e.g. in $/MWH

• The level of investment in capacity is

determined by the market (the decision is
decentralized to firms)
Source: W. Hogan (2004)
 Demand
• Lack of real time metering and billing
– At best consumers (“load”) react to prices with a
lag
• Lack of real time control
– If there were contracts for limited quantities of
electricity, they could not easily be enforced,
because it is cumbersome and costly to switch
particular users off
• Result: Demand is fairly inelastic
Price $/kwh Merit order dispatch
load

Quantity (MW) 43
 (In)elastic Demand
Price $/kwh

VOLL

4 5
3
1 2

Quantity (MW) 44
 Implications of Inelastic Demand
• At times demand and supply curves may not
intersect
• At those times rationing (“load shedding”) is
needed to match demand and supply
• By the same token, no “equilibrium” price
emerges from the interplay of demand‐ and
supply‐side bidding – “price is infinite”
• System operators need to set a price that is
paid to generators at those times
 Setting the price during times of
rationing (load shedding)
• Using opportunity cost (“value of lost load” –
VOLL) or willingness to pay

• “Normal” retail price of power: 10 cents/KWh

or $ 100/MWh

• VOLL estimates
– $1000 – 50,000 (high margin of uncertainty)
gas turbines has lower cost under low hours of operation. and at the crossover point with fossil
fuel switch usage
 Investment Incentives
• Simple example with two types of plants:
Technology FC/MWh VC/MWh
Peaker $6 $30
Baseload $12 $18

• Demand 4 GW or 8 GW with equal probability;

linear duration curve

• Demand inelastic till price reaches $1,000/MWh;

then perfectly elastic
 Screening curve
• When does cost of peaker equal cost of
baseload? (Cf = Capacity factor or duration of
load) cost of capital ada dalam fixed cost

– 6 + Cf * 30 = 12 + Cf * 18 
6+0.5*30= 21 <-- long run marginal cost
– Cf * 12 = 6 and Cf = 0.5
• Up to a capacity factor of 0.5 the peaking plant
should run, the rest should be supplied by the
base load plant
• Hence baseload plants needs to have capacity of
6000 MW (4000 used at all times plus 2000 half
of the time)
 The Peaking Plant

• What should be its size?

• Hint: How does the peaking plant cover its

investment costs?
 Long run marginal cost
• Fixed costs are variable
– Fixed cost (annuity) plus variable cost
• Where is profit (return on investment)?

• Terminology: Levelized costs, LRMC, feed‐in

tariff

• What shape the LRMC curve in a power

market?
CAPACITY MARKET
 Capacity market
• Regulators determine capacity demand

• Capacity is procured through an auction

• The auction revenue supplements revenue

from energy‐only market
 Rationales for Capacity Markets

• Energy‐only market does not fully function

(politics, market power)

• Energy and capacity markets together reduce

investor risk and market power
 Regulatory Intervention
• As long as the “demand side flaws” require
occasional load‐shedding the regulator needs
to set a price cap

• Alternatively she can set the quantity to invest

• Both decisions are of a similar nature. Why?

 Basics of Capacity Market
• Load‐serving entity (LSE) – utility, distribution
company, retailers…

• LSEs have to buy a certain level of capacity or

face a penalty

• They buy an option to deliver (availability) as

under PPA (penalty incentivizes generator to
be available)
 Bidding for option contracts
• Bid on capacity/availability charge
– Bidders need to estimate expected dispatch and
likely prices at time of dispatch
– In single‐buyer systems: price equals energy
charge of PPA (“avoided cost”)
– In competitive markets price needs to be
estimated by bidders
 Price caps, demand and supply
• Price caps can be lowered from VOLL, by going
for “Operating Reserve Pricing” (price cap
kicks in when some threshold level of reserves
is breached) or for capacity markets
• More regulatory fiat can thus lower investor
risk and incentives to abuse market power
• These approaches do not help making
demand more elastic or eliciting emergency
power
A long time ago in a country far, far
away…

• Chile introduces
competition in generation
in 1982
• The rest of the world does
not notice
 The basic market design in Chile
(formerly also Argentina)
• Generators submit marginal cost semi‐
annually
• System operator may audit the cost data
• Merit order dispatch on the basis of marginal
costs
• Capacity payments to cover investment costs
Are ancillary services public goods?
• Who has incentive to pay for system operation,
market operation and central trade enforcement
services etc.?

• Who has incentive to pay for frequency and

voltage stability? E.g. free rider problem in use of
reactive power

• Why would anyone invest in “safety devices” that

prevent system collapse?
INTERMITTENT ENERGY IN A
MARKET
California residual load with renewables
The “Duck Curve”
Residual load duration ‐ Germany
 Energy‐only Market

• How should intermittent energy forms be

treated?
configure the peak hour of production (high wind power generation),
What will happen to price duration?

the price will be shorter yet higher

 Capacity Market
excess capacity in renewable energy is left out because it is only occur on certain time (when the wind blows/sun shine)tot

• Is there excess capacity if total installed

capacity (incl. solar and wind) exceeds 100%
of peak demand?

• How should intermittent energy forms be

treated in a capacity market?
the benefit of introducing intermittern energy to the controllable energy is only to save variable cost of controlable energy
market.how to incentive renewable is to make them survive on the system price
 Intermittent Energy
• Benchmark case: peak is not reduced by intermittent
energy

• Benefit is avoided cost

• That means variable cost of competitors

• That means intermittent energy needs to be viable

based on energy prices in a capacity market and
neither need nor should receive capacity payments