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DESIGNING AND TESTING MARKET RULES 5.1 Design for Competiti e !ri"es
In economics, it is well said that the markets should be designed to produce competitive prices, but especially in electricity markets, competitive prices sometimes appear disconcertingly high. Opening wholesale electricity markets, in which energy is purchased for subsequent delivery to those who use it, has been accompanied by concerns that such markets fail to be competitive. The California electricity market meltdown in the summer of !""" brought with it numerous accusations of inadequate competition and analyses of the role that it may have played in creating price spikes and destabili#ing the market. $hile most designers remain loyal to the ideal of competitive prices, many decide to redefine them to be lower at times, and some believe that they are %ust not right. Competitive prices sometimes include a scarcity rent much greater than needed to cover the concurrent fi&ed cost payment. In a competitive unrestricted market, s"#r"it$ rent is the difference between the value to consumers of the most valuable '$h that cannot be supplied due to limited generation capacity (i.e., the marginal demand)side offer accepted* and the marginal cost of the most e&pensive '$h served. +carcity rents represent the market mechanism needed to signal resource shortages and provide incentives for new investment in resources. In a long)run equilibrium, if we allow generators to collect such scarcity rents by letting demand)side bids set the clearing prices in times of shortage, then the scarcity rents should be e&actly what are required to cover the amorti#ed fi&ed cost of the marginal generating unit. ,urthermore, if the technology mi& is optimal, i.e., least total cost, then the combination of scarcity rents and infr#m#rgin#% profits, which amount to the difference between the market clearing prices and the respective marginal costs, will e&actly cover the amorti#ed fi&ed cost of each generation technology in the capacity mi& in the long run. +carcity rents are necessary for suppliers to cover their fi&ed costs, which, can be thought of as a constant flow of cost equivalent to the cost of renting the power plant. In power markets the scarcity rents fluctuate dramatically and consequently, the competitive prices are too high sometimes and lower other times. ,ederal -lectricity .egulatory Commission (,-.C* proposed a p#$&#s&'i( auction design in the hopes of holding prices below their competitive level. The pay)as)bid rule is currently used in the -ngland and $ales spot market. +everal early proposals for the California -lectricity market also had this intent. In a pay)as)bid auction, prices paid to winning suppliers (those competitive suppliers selected to provide power supply in any given time period / along with the price and other terms of the power sale* are based on their actual bids, rather than the bid of the highest priced supplier selected to provide supply. ,or this reason, pay)as)bid auctions are also known as discriminatory auctions because they pay winners a different price tied to the specific prices offered in their bids. 'any schemes have been proposed to hold prices down to variable cost, and given sufficient regulatory authority they can be effective. Consequently it is important to understand that reducing price in the short run will increase it in the long run. This is not true if prices remain at or above the competitive level, but the competitive price pays higher and lower cost producers e&actly the same when they both are needed at the same time. ,-.C0s scheme was intended to hold baseload prices well below the competitive level. The -fficient)Competition .esult states that competitive price will, over the long run, induce the right investment in both baseload plants and peak load power plants.

5.1.1 !#$&#s&)i( !ri"ing in Conte*t to In(i#n E%e"tri"it$ M#r+et It is seen that there is some surplus generation capacity lying unutili#ed at some point of time but at the same time load shedding is being carried out by the utilities. +imilarly, there is captive generation capacity available with industrial users like steel industries, sugar industries, etc. which are lying un)utili#ed and could be harnessed to supply to the inter)+tate grid at the time of utter need to maintain grid security. There is, therefore, a need for a mechanism such as ,re-.en"$ S.pport An"i%%#r$ Ser i"es /,SAS0 to utili#e these un)despatched1 surplus capacities to enhance the power supply to the grid, when required, to maintain grid security. ,re-.en"$ S.pport An"i%%#r$ Ser i"es / ,+2+*, at present in the Indian conte&t, aims to stabili#e the grid frequency by ma&imi#ing unutili#ed generation and minimi#ing load shedding, under certain conditions, for ensuring grid safety and security. ,requency +upport 2ncillary +ervice would be the service offered through bids by a generating station or any other authori#ed entity on behalf of the generating station to make itself available for dispatch and get dispatched1 scheduled by the nodal agency to support the system frequency. The window for receiving bids in ,requency +upport 2ncillary +ervice market to be opened after closure and clearance of the day)ahead market (32'* in the power e&changes. The bids to be invited on a day ahead basis for which the window would be open for submitting bids considered for despatch ne&t day. The window for receiving bids in ,requency +upport 2ncillary +ervice market to be opened after closure and clearance of the day)ahead market (32'* in the power e&changes. The bids to be invited on a day ahead basis for which the window would be open for submitting bids considered for despatch ne&t day. The nodal agency would be responsible for preparing combined bid area)wise, time)block)wise stack of the bids received from all the power e&changes. The stack to be prepared on the principle of merit order of bids. The prices payable to the providers of ,+2+ would be based on the principle of pay) as)bid and the amount payable would be for the despatched quantum at the bid price of the participant.

5.1 Testing of M#r+et (esign

In a turbulent environment such as the restructuring of the 4.+. electric industry, new market designs are nearly always conceived and implemented without rigorous testing. In fact a complete absence of testing is common5 however, few designs are implemented without claims that they produce 6the correct incentives6 and 6efficient outcomes.6 4nfortunately, when such designs are tested against even the best)behaved hypothetical situations, they do not always live up to their claims. 2 moderately rigorous test would involve a laboratory simulation of the market design. $hile this is recommended, especially when gambling with sums that can run into the billions of dollars, a more modest course of testing is presented here. 7o design should be implemented without this minimal level of testing, which is called the 6bottom)line test6 because it tests the effect of a market design on the total cost of supply. It does not provide a cookbook procedure, but it provides a structure that is often missing, and it sets a minimum standard. The test procedure can be broken into three steps. 5.1.1 T2e )ottom&Line Test of M#r+et R.%es 1. 'odel the cost functions of the players in the market. !. Compute the minimum possible cost of serving the target load level. 3. Compute the cost increase of serving the load under proposed rules. If consumer response to price (demand elasticity* is important for the rules being tested, then the bottom)line test must be modified by e&amining the decrease in total surplus caused by the design instead of the increase in cost. ,ortunately, most market rules can be tested

adequately under the assumption of completely inelastic demand. Then consumer benefit is unaffected by market rules and drops out of the test procedure. 8ack of demand elasticity confers market power on suppliers, and most designs are not efficient in the presence of market power. The bottom)line test is only intended to test designs for competitive markets, so to counteract the effects of inelastic demand, suppliers should simply be assumed to behave competitively. Step 14 Mo(e%ing Costs #n( )enefits 9asic economics always assumes market participants will act to ma&imi#e their benefit net of costs, so cost and benefit functions must be specified to calculate the predicted behavior. To perform a 6bottom)line test,6 first determine what costs and benefits are relevant. In this case, the relevant costs are (:* the cost of generation including its dependence on location, and (!* the cost of wires. A useful economic model must include both. 'odeling elastic demand would complicate the computation of benefits and is not relevant to the benefits being claimed. The basic bottom)line test which focuses only on supply costs will be sufficient. The first test of a design should be as simple as possible, and the model needs at least one wire and two generation locations to evaluate the design. These are specified in the final sub)section which uses the details of the model to compute costs. Step 14 Comp.ting Minim.m Cost The bottom)line test requires computing the minimum cost of producing and delivering the power required to meet a fi&ed level of demand. In principle this can be done by trying all ways of producing the required output. ;enerally a little mathematics will simplify the process. ,or a particular specification of the test model, step ! always gives a simple answer that is %ust one number. 7o e&cuse should be accepted for a more comple& or less precise answer although it may be useful to test several variations of the. Step 34 Comp.ting Cost .n(er t2e !ropose( R.%es The behavior of suppliers must be considered when computing the effect of the rules on the total cost of delivered energy. +uppliers will react to market rules, and this reaction must be predicted. -conomics enters the test process at this point by dictating the assumption that suppliers will ma&imi#e their profits. This may not be true when a rule is first put in place, but with practice, suppliers should learn how to ad%ust their behavior to the rule and ma&imi#e their profit. The profit ma&imi#ing assumption is key to economics, and though not precisely true, is generally the best appro&imation available. E*#mp%e4 2ssume that there are two cities in the market, and they are connected by a transmission line as shown in ,igure <.:.

,igure <.: Step 14 ).i%(ing t2e Mo(e% #n( Comp.ting Costs. 2ssume for simplicity that generation can be located near either city, and the cost is= > :"1'$h ( `?<"1'$h appro&imately* for capacity

and >!"1'$h (`:@""1'$h appro&imately* for energy. 2ssume peak load on the system is :?,""" MW with :!,""" '$ located at city A and A""" '$ located at city 9. 2ssume the average hourly load is :",""" '$, assume that line capacity costs >A1'$h ( `?<"1'$h appro&imately*, and for reliability purposes assume the minimal line capacity is <"" M5. This is a sufficient model of the relevant costs. Step 14 ,in(ing t2e Minim.m Cost. 9ecause the above model assumes that generators cost the same at either location, the cheapest arrangement is to locate them where they are needed, that is :!,""" '$ of generation at A and A""" '$ of generation at 9. In this case, no power line is needed to facilitate trade. The total long)run cost of power in this model is found by summing three components as follows= :?,""" '$ & >:"1'$h B >:?","""1h for generation capacity C :",""" '$ & >!"1'$h B >!"","""1h for energy C <"" '$ & >A1'$h B >!,"""1h ) for line capacity for a total of >@?!,"""1h. This is the minimum total cost of serving the load. Step 34 ,in(ing Tot#% Cost .n(er t2e !ropose( R.%es 4nder the proposed transmission pricing rules, generators will pay different transmission charges depending on their location. In particular, if they were located in the minimal cost arrangement %ust described, the generators at A would have :/A, of their flow assigned to the line from A to 9 because by .ule :1A, of it goes to the !<D of load at 9. The generators located at 9 would have @1A, of their flow assigned to that line. (This second power flow is in the opposite direction and cancels the first, but this does not affect the charges.* 9ecause charges are proportional to flow, the generators at 9 are charged three times more than the generators at A. $henever a generator is retired at 9, it will be replaced with a generator at A because, counting transmission charges, A is the cheaper place to locate. The long)run consequence of this dynamic is that all new generators will locate at A and all e&pansion of e&isting generators will take place at A. In the long run, all generating plants will be located at A. Consequently a A ;$ transmission line will be built to supply 90s peak load. That is eight times bigger than the <"")'$ line required for reliability in the least)cost configuration. This increases the total cost of energy by the cost of the e&tra transmission line. An e&tra @<"" '$ of line costs an e&tra >:A,"""1h. This brings total cost under the proposed design to >@E?,"""1h.

5.3 M#r+et !o6er

'arket power is defined as the ability of a supplier to profitably raise prices above competitive levels and maintain those prices for a significant time period. In wholesale power markets, a player is said to have market power if it is pivotal5 which means that it is so large relative to the pool of other suppliers and to demand that, without it, supply would be physically less than demand and the market would not clear. The market power issue is of particular interest to policymakers and legislators as they consider electric power industry restructuring, because the e&ploitation of market power can significantly erode the consumer benefits that would be e&pected to result from the transition from regulated to competitive markets. 5.3.1 Design to Re(."e M#r+et !o6er /M#r+et !o6er Mitig#tion0 Competition is good public policy as it encourages efficiency and price transparency. $hile proper market design is important, the success of competitive electricity markets depends first and foremost on structural conditions that do not distort market outcomes. One of the important conditions is that structural market power must be eliminated or effectively mitigated. 'arket Fower in power markets can be effectively mitigated or reduced by the following techniques= a. ,orward contracts and obligation of suppliers.

b. 4ncertainty of demand which causes supply)curve bidding. c. 8ong)run consequences. d. 9etter market design ,or6#r( Contr#"ts #n( 7'%ig#tion of S.pp%iers4 -lectricity forward contracts represent the obligation to buy or sell a fi&ed amount of electricity at a pre)specified contract price, known as the forward price, at certain time in the future (called maturity or e&piration time*. In other words, electricity forwards are custom) tailored supply contracts between a buyer and a seller, where the buyer is obligated to take power and the seller is obligated to supply. The payoff of a forward contract promising to deliver one unit of electricity at price , at a future time T is= Fayoff of a ,orward Contract B ( S T F * (:* where ST is the electricity spot price at time T. 2lthough the payoff function (:* appears to be the same as for any financial forwards, electricity forwards differ from other financial and commodity forward contracts in that the underlying electricity is a different commodity at different times. The settlement price ST is usually calculated based on the average price of electricity over the delivery period at the maturity time T. Consider a forward contract for the on)peak electricity on day T. On)peak electricity refers to the electricity delivered over the daily peak)period, traditionally defined by the industry as "?="" ) !!="". The daily off)peak period is the remaining hours of the day. In this case, ST is obtained by averaging the :? hourly prices from "?="" to !!="" on day T. The best e&ample of the benefits of forward contracts is provided by the residual obligations of regulated utilities to serve their 6native load.6 Dem#n( Un"ert#int$ #n( S.pp%$&C.r e )i((ing4 2 second factor reducing market power below the level predicted by the Cournot model is that suppliers do not bid in the Cournot style. They do not simply bid quantities but instead bid supply curves. 6+upply)Curve 9idding,6 however, refers to more than %ust a formal bidding procedure in which a price is specified at a number of output levels. +upply)curve bids come in two types= the Cournot type, and the true supply)curve type. A Cournot bid curve will set price to marginal cost up to some Cournot quantity limit and then set price at the price cap beyond that.0 True supply)curve bidding differs from this prescription by setting price above marginal cost but below the price cap for some quantities. This is a qualitatively different strategy and is referred to as 6supply)curve bidding.6 It is important because the use of this bidding strategy reduces market power relative to the Cournot +trategy. 8ike Cournot competition, supply)curve competition is defined in terms of a game played between suppliers. In supply)curve equilibrium, %ust as in Cournot equilibrium, each supplier plays a strategy that is optimal given the other player0s strategy. This is the standard 7ash equilibrium concept.

5.8 Co.rnot Mo(e%

In a perfectly competitive market, the market price is a parameter over which firms have no control and each firm should increase its production up to the point where its marginal cost is equal to the market price. $hen competition is not perfect, each firm must consider how the quantity it produces might affect the quantity it sells. Imperfect competition can be modeled using either a Cournot 'odel, in which firms decide how much they produce or a 9ertrand model, in which firms decide at what price they sell their production. Consider the case of a 3uopoly, in which only two firms compete to sell a given good in a market. If both firms must decide simultaneously how much to produce, each of them will estimate the e&pected production of the other. 8et us assume that firm : estimates that the

e production of firm ! will be equal to y ! . ,irm : then sets its production at a level y: that ma&imi#es its e&pected profit. e ma& ( y: + y ! * y: c( y: * (:* y

where ( y: + y ! * represents the market price that would result from the e&pected total output

( y: + y ! * . The optimal production of firm : thus depends on its estimate of the production of
firm !. $e can e&press this relation directly in the form of a reaction function=

y: = f: ( y ! *
(!* +ince firm ! follows a similar process to optimi#e its production, we also have

y ! = f ! ( y: *
(@* 2t first, the estimates that each firm makes of the production of their competitor may be incorrect or inaccurate. Gowever, as they observe the market and gather more information, they revise their estimates and ad%ust their production accordingly. 4ltimately, their productions reach the Cournot -quilibrium=
y: = f : ( y ! * y ! = f ! ( y: *


Once this equilibrium is reached, neither firm would find it profitable to change its output. 8et us now consider the case in which there are n firms competing in the market. The total industry output is
Y = y: +.............. + y n

(<* ,irm, like all the other firms, seeks to ma&imi#e its profit=

ma& { y i (Y * c( y i *}

(?* where the market price (Y * is a function of the total industry output. This ma&imum is achieved when
d { yi (Y * c( y i *} = " dy i

(E* or

(Y * + y i

d (Y * dc( y i * = dy i dy i
Y 1Y

(I* ,actoring out on the left)hand side and multiplying the second term by

, we get

y Y d (Y * dc( y i * (Y *: + i = dy i Y dy i ( y * (J* The right hand side of equation (J* is equal to the marginal cost of production of firm i. If we define the market share of firm i as and use the definition of elasticity, then equation (J* can be written as

(Y * :

si (Y *

dc( y i * = dy i

(:"* This e&pression suggests that when the market share of firm is not negligible, it ma&imi#es its profit by setting its production at a level where its marginal cost is less than the market price. It is interesting to note that one firmKs ability to e&ert market power benefits all the firms in the market because it raises the price at which price)taking firms sell their products. 2ctions aimed at reducing market power therefore have to be initiated by regulatory authorities representing the interests of the customers.

Review Questions for University Exams

:. -&plain in detail the design for competitive prices in liberali#ed electricity market. !. $hat do you understand by scarcity rent and inframarginal profitsL @. $hy pay)as)bid auction design is better than the scarcity rent mechanism in electricity marketL A. -&plain Fay)as)9id Fricing in Conte&t to Indian -lectricity 'arket. <. $hy market designs in restructured power system or liberali#ed electricity market are testedL -&plain in detail the testing of market designs in competitive electricity market. ?. -&plain with proper illustrations the 9ottom)8ine Test of 'arket .ules for testing the market designs in liberali#ed electricity market. E. $hat do you understand by market powerL -&plain in detail how market power is mitigated in competitive electricity marketL I. -&plain in detail the design to reduce market power in electricity marketL J. Gow market power is e&ercised or controlled in competitive electricity marketL :". 3efine supply)bidding curve. Gow it can be used to reduce market powerL ::. In competitive electricity market, suppliers bid supply curves instead of bidding quantities. -&plain whyL :!. $hy supply curve bids increases competition in power marketL