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

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 mechanisms

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 activated
Norwegian 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 RES
International 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
Winners
CO2 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 adequacy
Transition 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
1616
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 price

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.

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)

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

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