2004 IEEE International Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DWT2004) April 2004 Hong
Kong
Price capping for power purchase in electricity markets
Nu0 Xu', H.W. Ngan', Fushuan Wen3, A.K. David2
( 1 . Zhejiang University, Hangzhou 3 10027, China)
(2. The Hong Kong Polytechnic University, Hong Kong, China)
(3. The University of Hong Kong, Hong Kong, China)
Abstract - Alrhough reform of electric supply indusrry has
raken place worldwide for about two decades, vigorous price
variation in power markets remains one of the crucialproblems
ro be resolved. Transmission network operating in natural
monopoly environment requires stringenr regularion bur it
should also be fair ro allow rhe network company recover its
costs and have rational benefits. In this pape,: a purchase price
cap method is proposedfor achieving this objective. It includes
development o f a heurisfic approachfor serting up an adequate
price cap for generation companies with due consideration on
appropriare mgularory framework. The proposed approach
gives a promisirig theoretical backup for adopting the purchase
price cap as one of rhe measures to control the marketprices in
the Zhejiong provincial power market which is being operated
as a single buyer market model.
Index Terms price capping, Power Marker and Transmission
pricing.
1. lNTRODUCTlON
Reform of electricity supply industry has taken place
worldwide leading to changes mainly in the generation
and distribution operation but transmission network
operation still remains a nahual monopoly. Basically,
regulation is required to ensure rational pricing for
transmission services and to recover cost of investment
with reasonable profit arising from the business. The
transmission operators try to distance themselves from
the market risk, if possible, by linking retail electricity
prize with the MCP (market clearing price). However,
due to different social and political reasons, situation
arises in the contrary and, in the extreme case, retail
electricity prices in a single-buyer model is seen to he
fixed. It explains, from the economic point of views, how
market instability is caused by shifting the financial risk
from the consumers to the transmission operators. In a
proper regulatory regime, the financial risk that
transmission operators are facing must be removed or
reduced. Otherwise, they may confront serious financial
problem leading to bankruptcy in the extreme case, or
even economic, social, or political crisis, as typified by
the electricity market crisis in California [I].
In this respect, a lot of economists do not believe
that price capping is effective as it sends out a distorted
economic signal by which insufficient investment and
lost of supply and demand equilibrium will be resulted.
On the other hand, price capping is widely used in many
electricity markets worldwide as it helps reduce the
financial risk on the transmission operators and to limit
the exercising of market power by generation operators.
Although price capping is simple in principle, how to set
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it up rationally to provide correct price signals and to
achieve the objectives mentioned above is not easy.
Continuous research effort has been devoted on this topic
area. For instance, reference [3] proposed to set price cap
based on the value of lost load (VOLL), but the value of
VOLL is difficult to estimate. However, there is little
publication on area relating to theory of setting price cap
for the generation side in general.
Considering the above background review and the
present electricity market circumstances in China, the
scope of this paper is to investigate the problem for
deriving a method for setting an adequate price cap for
generation companies operating under a single-buyer
market model. In these electricity markets, the retail
electricity price is fixed and the demand elasticity is zero.
When the generation capacity is insufficient, the
generation companies are in fact operating in oligopoly
environments and they may exercise market power and
manipulate on electricity pricing. Thus, the transmission
company as the single-buyer may shoulder up serious
financial risk and hence they must he protected. With this
in mind and to further extend the objective to restrict
market power played by generation companies, the
regulatory organization would try to set up some sort of
price capping mechanism for the generation operators.
Assuming that the retail electricity pricing set up by
government or regulatory organization is rational, this
paper reports on rational price cap mechanism developed
for meeting different objectives such as the need of
break-even calculation and sustainable development of
transmission companies. Also, it helps provide correct
pricing signal for attracting investment and satisfying the
market equilibrium. By referring to actual historical data
of the market clearing price (MCP) and the traded
volume of electricity in each auction round for a studied
period such as the past one year, the probability
distribution function of the MCP can be identified and
represented as a function of the price cap. Then, adequate
price cap can he estimated based on the presumably
known average cost of transmission service and the retail
electricity prices, and some estimated parameters.
Finally, potential bidding behaviours of generation
companies in response to the change of the allowed
bidding price cap are briefly analysed and reported on
the paper.
2004 EEE lntemational Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong

2. COSTING FRAMEWORK

With the presumption that transmission networks are in

regulated operation, this paper outlines fundamental
processes for recovering running and capital costs of
transmission services based on the Zejiang's power
market model. It shows how price caps are applied for
mitigating market power and to achieve a balance
between the income and costing components in a
specified period of time as shown in Eq. (1):

EP (Pcq)+ C m = E, (1)

Where
Pcap : the price cap set for generation;
Ep (Pcap) : the per unit average transmission cost;
C,,, : the per,unit average operating cost;
E, : the per unit average transmission revenue.

2.1 Operating Cost

The operating cost of the transmission services

consists of various components such as cost of using the
power grid, the cost of ancillary and managing services,
and other financial costs. Seeing that these costing
components can be Fig. out beforehand and their
projected operating cost, C,,, can be regarded as a
known quantity in the subsequent contexts.

2.2 Selling Price

In the Zhijiang's power market model, transmission

operator charges different kinds of customers like
industrial, commercial or residential sectors with
different rates set by the commission but retail prices are
expected to be kept unchanged for a specified period, say,
one year. Also, it is difficult to project the market share
of each category of customers due to the changing mix of
customer portfolio from time to time. A practical method 1
is hence required for determining the average revenue
per unit of electricity sold. In the paper, it is proposed to 0.e / I
determine the percentage of share of each category of 0. 6
I
customers by assuming that they are stochastic variable
with normal distributions about their mean value. 0. 4 /. :I
/ I
For customer i, we can then denote for the following
derivation:
qr : the percentage share of customers,
pj : the mean of q;,
: the standard distribution of qi,
0,
Hence, the probability density function can be obtained
as in Eq. 2 3. APPLICATIONS
Operation of the Zhejiang electricity generation
market began on I", Jan. 2000. Power company of the
By performing simple analysis on their historical data, Zhejiang province acts as the single buyer. There are
the probability distribution of percentage share of each upper limit (Price cap) and lower limit (zero) for bids for
category of customers can be obtained and by which, the generation companies. This section will describe the
probability distributions and their corresponding retail application of the methods hereinbefore based on the

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2004 IEEE International Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong

actual data of the operation of this market in 2001. R(P,=R&-&,p, and f(P,) has no value at these two
According to the traded volume of electricity and the points. Thus, the expectation of the stochastic variable
MCP in each auction around (half an hour) in 2001, the P, in the year is:
curve of probability distribution of MCP can be obtained
as in Fig. 1.

Based on the characteristic of the curve illustrated Substituting Rcop= k(Cap- 4 )+ R,

in Fig. 1, it can be linearised piecewise. Then a new
curve can be constructed as shown in Fig. 2. It shows the (From k = R, - Rs ) into (6), the E(P,) is:
ratio of the traded volume of electricity to all traded
volume in 2001 is RL,Q and bap respectively and
egp - P,

their corresponding MCPs are less than PL,P, and Pcav

By expressing MCP as continuous variables, the
With different price contracts model allowable in the
following function can be obtained.
Zhejiang electricity market, the transmission company
settles with generation companies in each auction round
according to Eq. 8.
4' = QiiP, + Q,!-;(PCi- P,) (8)
where, 4' is the real cost of electricity purchased from
generation company i at auction round t, Qii is real
electricity volume that generation company i sells at
auction round t, Q;i is the contract electricity volume
of generation company i at auction round t, Pci is the
contract price of generation company i. Thus, the average
cost per unit electricity purchased of transmission
comnanv is

9 p, 4
fL 0<p,<p,; (4) where T is the total number of auction rounds in one year
F(Q=jM(p,-P,)+RL, p, 5p. <e; if there are 48 auction rounds in each day; T
f: -e =365x48=17520 and N is the total number of
generation companies which take part in the electricity
market; Qp(n,o,lis the total traded electricity volume,
p."P- T 11

Then the probability density function f(P,) of the stochastic

variable P, is:
N

P, < 0; e,!-= CQii.

i=l
0 < P, < P'; Hence, it is not difficulty to solve, that

By writing QL as a constant with value less then

a =-
Q;
1, it implies that the ratio of total contracted electricity to
Corresponding to the upper and lower bid limits, the total traded electricity is constant in each auction round.
probability distribution curve has two points where P,=O
or P,=P,,. P, should be regarded as a disperse variable
instead of a continuous variable at the points where P,=0 Hence,
2 '=I
QiP,
= aE(P,). In fact, a varies in a
or P,=P,,. The probability is RL when P,=O, and the QgPd,
probability is l-Pcap when P,=P,.,, i.e. R(P,=O)=R',

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2004 IEEE International Conference on Electric Utility Deregulation, Resmctnring and Power Technologies (DRPT2004) April 2004 Hong Kong
very small range normally. It changes only when the load
is too low and the minimum output of units has to be
satisfied. If a more accurate approach is required, the
curve shown in Fig. I can be constructed based on the
data of contracted electricity volume and MCP in each
auction round. With that, I=' can be determined
Q,,,",",,
as a function of the Pcap In that circumstance, U' is
constant and
E, 1 = (1 - a)E(P, ) + E,,,,,,, (10)
By substituting (IO), (7) and (3) into (I), P,, can be
determined by Eq.11.
where
It has to be pointed out at this stage that the above
approach produces approximate results as it employs the
ex post approach for setting the price cap for generation
company in the following period. However, some
adjustment can always he made by extrapolation on the
historical data. For example, k can be obtained from the
historical data and regarded as an external parameter; Ps,
Rs, Pr and RL can be adjusted according to projected
circumstances of future electricity market. The following
section will outline the different rationale of adjustment.
4. ADJUSTMENT OF PARAMETERS
As discussed, the probability distribution curve of
Pm(MCP) can be constructed based on historical data.
According to this curve, the equation described the
relation between the cost per unit electricity purchased
and P,,, is found and hence P,,, can be determined. In
effect, Fig. 1 and Fig. 2 are the distribution curves kom
which the price cap can be determined. In the Zhejiang
electricity market, different price contract models are
employed. For the generation companies, their first
objective is to meet the contracted electricity
commitment so as to allow them to recover their sunk
costs in most cases. In normal circumstances, a small
change of price cap will not affect the bid action of
generation companies, i.e. the P,, h,Pr, and RL will not
changed obviously though they can be adjusted slightly
according to the following rationale.
In view of that the bid price of generation
companies concentrates between PL and P, and the
variable costs of generation companies locate between P,
and P,, PL and Ps can be adjusted slightly according to
the historical data and the change of variable costs of the
generation units. In order to avoid the start-stop cost, the
generation companies will bid zero to ensure the
generation units operates continuously at minimum
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output of which the MCP can be regarded as zero. Since
RL is the ratio of the traded electricity volume to the total
traded electricity volume in the whole year when MCP
equates to zero, RL can be estimated according to the
forecasted load curve.
When the price reaches P,, most probably the
generation companies complete their contracted
electricity volume. They expect that the surplus
generation capacities can be sold at higher price. The
electricity volume traded at the price helow P, in one
year can be estimated by multiplying the total contracted
electricity volume by a coefficient with value less than
one (for example 0.95). Hence R, can be estimated by
dividing the estimated electricity volume traded at the
price less than P, by the total traded electricity volume.
5. REACTION TO PRICE CAP
Generally speaking, the price cap and generation bid
price interact with each other. When the regulatory
organization adjusts the price cap, the generation
companies will adjust their bid price so as to maximize
their profit. They will react strategically but hardly is
there a simple theoretical solution. In fact, the parameter
k in section 3 may be helpful to give a clue for analysing
the generation response.
if If the ratio of the electricity traded at price cap
to the total traded electricity in one year will not
change when the price cap changes, then the
Kw can be determined based on the historical
data. Substituting KaPinto equation( 1l), P, can
he obtained.
ii) If the traded electricity at price cap is a function
of the adequacy of generation capacity, k,, can
be estimated based on the forecasted load and
the generation capacity available, then P,, can
be solved through (1 1).
iii) As shown in Fig. 2, when the price cap is
lowered and other conditions remain unchanged,
the traded electricity at new price cap will
increase and vice versa. In other word, h(Pca,)
remains unchanged when its price cap changes.
If P,, R,, PL and RL remain unchanged, E(P,.) is
equal to the area of three trapezoids ( BCDE,
BC,D,E and BCzDzE) in figure 2 viz,
(BE+ClD?)D?E = (BE+CD)DE =
(BE+CIDI)D,E
-RI + 1 - Rc,+,)(<ap -4) = se,, 0
Hence, RcOp= 2 - R, - sco,
1
D -- D
cap 1 s
Substituting this expression of into equation (6),
E(€),' can be determined as:
2004 IEEE International Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong

It can be noted that E(P,) will not change when P,,
changes.
Under this situation, if the price cap is set in such a
way that it cannot allow the transmission company to
break-even, viz. the primary Ep(Pcap)cannot satisfy
equation (I), then even the price cap is adjusted, the
operation status of transmission company will not change.
It is then required to consider other method, such as
improving the retail price of electricity. If the regulatory
organization want to increase the transmission company
revenue to let the transmission company break-even
through the method of decreasing the price cap, the
relationship of (BE+ C2D2)DIE < (BE+CD) DE must be
satisfied according to the analysis above and Fig. 2. If
the new decreased price cap is and the ratio of the
electricity volume traded at this price to the total
electricity volume is 1- Rlop,then
7. REFERENCES
I Fusbuan Wen, A.K. David. Lessons from Electricity
Market Failure in Califomia. Automation of Electric
Power Systems, 2001,25(5): 1-5
2 Fushuan Wen, F.F. Wu, Yixin Ni. Generation
Capacity Adequacy in the Deregulated Electricity
Market Environment. Automation of Electric Power
Systems, 2002,26(19): 16-22
3 S . Stoft. Power System Economics: Designing
Markets for Electricity. New York: Wiley-IEEE
Press, 2002

Namely, only when the slope of the BC2 is more than

kkin,the revenue of the transmission company may be
increased in order to break even.

6. CONCLUSION

In this paper, methods for setting price cap for

generation companies are developed for application in
the well-known single-buyer model with retail electricity
prices fixed. In the regulatory regime, the heuristic
method of setting price cap is introduced by employing
the ex post approach based on actual historical data. It
serves to make the transmission company break even.
Through the average cost of transmission service, the
retail electricity prices, the probability distribution curve
of MCP, and the adjustment of parameters, the price cap
can be determined. The potential bidding behaviours of
generation companies in response to the change of the
allowed bidding price cap are briefly analysed for several
special situations. Rationale for the price cap
determination has been outlined.

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