Electricity economics

An adaptation of the Norwegian hydropower

model to the Mexican mixed energy market
Edwin Castellanos Bordon

Thesis for the Master of Philosophy in Economics

University of Oslo

November 2016
Acknowledgments

This study is an acknowledgment to Norway, a country that has provided me with an outstanding
education at the University of Oslo, by contributing to the further development of the knowledge
gathered by its top-class researchers. Also, it is also a contribution to the development of my home
country, Mexico, which is a country that has provided everything that constitutes me as a person
and has given me countless opportunities to grow. This study is a depiction of my interests in the
energy development of the country and the accomplishment of environmental goals to achieve
sustainable growth in one of the most relevant sectors in Mexico in the present.

I am grateful to my supervisor Finn R. Førsund who provided the guidance I needed and motivated
me with his supporting spirit and interest in my work. Also, I recognize the importance of his work
to provide us economists the tools to understand the energy market, a sector that was mostly
reserved for the engineering field. It is because of his contributions and feedback that I was able
to successfully perform this study.

I am also very grateful to my family’s unconditional and consistent support during all my life. It
is because of the values that they transmitted to me that I have been able to pursue my goals. They
have given me invaluable advice and I am most proud of having them as my parents. I am very
thankful to my brother who has been by my side since I am able to remember as a family member
and as my friend.

I would also like to thank my friends for the hours that we worked together at the University and
for the fun moments during my studies.

Finally, I would like to thank Karen for believing in me and her encouragement during my whole
Master’s degree. It is because of you that I always hold a high spirit and that I keep on moving
forward. Thank you for the immeasurable love and support you always provide me and for making
me happy. I am honored to love you and most fortunate to say that you are my girlfriend and my
best friend at the same time.

I
Summary
This thesis studies the Mexican electricity market by adapting and applying the Norwegian
electricity model to the specific characteristics of the country. Mexico and Norway operate their
electricity system using a completely different mix of fuels to run their power plants and, as a
result, the economic interpretations may vary. Mexico is divided in eight different electrical
regions, with different prices and different technologies for power generation. The aim of this
study is to understand how the six regions that are interconnected interact with each other
according to their power generation and the prices in specific periods.

Geographic and climate conditions of the country play an important role on the interaction of the
electrical regions in Mexico. The northern regions are mostly dominated by dry ecosystems while
the south and center regions have prominent rainfall, forests and jungle. In turn, these conditions
determine the type of technologies used for power generation and create specific region to region
interactions. When comparing this scenario to Norway, a country that generates most of its power
through hydroelectric plants we find quite different patterns. The models rely on the basic
economic assumption of finding an equilibrium price at the intersection of the demand and supply
curves.

In order to study this interaction, the electricity models proposed by Finn Førsund are applied to
the specific characteristics of each region and interpreted in their own perspective. In order to find
qualitative information about the electrical regions in the country non-linear programming
methods are used in order to build realistic social planning problems and finding the corresponding
optimal solutions. The decision for optimal power generation in each region will depend on the
restrictions imposed in the system and the differences in prices. In essence, it will be optimal for a
region to generate and export electricity in high price periods while the opposite will happen during
low-price periods. The models may include thermal, hydro and intermittent energy according to
their participation in generation activities in each region.

However, when reservoir, trade and capacity constraints become binding prices are affected and
they influence the optimal generation of power in order to maximize the consumer and producer
surplus. Despite of the fact that the six relevant regions are interconnected, the size and shape of
the country make trade between some of them unfeasible as it is too expensive to transport

II
electricity through extended lengths due to the lack of high voltage direct current transmission
lines in Mexico. This thesis proposes bilateral trade models between the regions that engage in
trading activities taking into account the respective constraints that apply to their specific
circumstances. These models provide insight on when it is optimal to generate with each
technology, the effects of trade in prices and consumption and the correct management of water
reservoirs.

III
Table of Contents

1. Introduction-------------------------------------------------------------------------------------------------- 1
Electricity demand in Mexico------------------------------------------------------------------------------- 8
Hydropower in Mexico------------------------------------------------------------------------------------- 12
2. Background for the Energy Model--------------------------- ------------------------------------------ 14
Thermal Energy in Mexico--------------------------------------------------------------------------------- 15
Renewable Energy in Mexico------------------------------------------------------------------------------ 17
3. The Energy Model------------------------------------------------------------------------------------------ 18
4. The Mexican Hydropower Model------------------------------------------------------------------------ 22
Constraints in the Mexican Hydropower Model--------------------------------------------------------- 24
Optimal management of a hydropower system---------------------------------------------------------- 24
The output constraint---------------------------------------------------------------------------------------- 25
Flow-of-the-river and wind power generation------------------------------------------------------------ 28
5. Multiple Producers in Hydropower--------------------------------------------------------------------- 32
Coupled Hydropower---------------------------------------------------------------------------------------- 35
6. Mix of Thermal and Hydropower Generation--------------------------------------------------------- 37
The Complete Mexican Energy Mix---------------------------------------------------------------------- 40
Multiple Producers in a Mixed Energy Model----------------------------------------------------------- 43
7. Regional models with trade------------------------------------------------------------------------------- 47
Transmission General Model------------------------------------------------------------------------------- 51
8. Region-Specific Models for the Mexican System------------------------------------------------------ 53
Northwest-North Model------------------------------------------------------------------------------------- 54
North-Northwest Model------------------------------------------------------------------------------------- 56
Northwest-South Model------------------------------------------------------------------------------------- 56
North-South Model------------------------------------------------------------------------------------------ 58
Northeast-South Model-------------------------------------------------------------------------------------- 68
North-Northeast Model-------------------------------------------------------------------------------------- 59
South-Northwest Model------------------------------------------------------------------------------------- 61
South-North Model------------------------------------------------------------------------------------------ 63
South-Northeast Model------------------------------------------------------------------------------------- 64
South-Center Model----------------------------------------------------------------------------------------- 64
Center-South Model----------------------------------------------------------------------------------------- 67
South-Peninsular and Peninsular-South Models--------------------------------------------------------- 67
9. Qualitative Conclusions about the Mexican Region-Specific Models----------------------------- 69

IV
 Northwest Region-------------------------------------------------------------------------------------------- 69
North Region-------------------------------------------------------------------------------------------------- 70
Northeast Region--------------------------------------------------------------------------------------------- 70
South Region-------------------------------------------------------------------------------------------------- 71
Center Region------------------------------------------------------------------------------------------------- 72
Peninsular Region-------------------------------------------------------------------------------------------- 72
Environmental Policies in Mexico and their Impact on Prices----------------------------------------- 73
Pricing Policies and the Effects of Subsidies on Consumption----------------------------------------- 73
Management of the Mexican System---------------------------------------------------------------------- 74
10. Conclusions-------------------------------------------------------------------------------------------------- 75
References-------------------------------------------------------------------------------------------------------------- 78

V
© Edwin Castellanos Bordon

2016

Electricity Economics: An adaptation of the Norwegian hydropower model to the Mexican

Mixed Energy Market

Edwin Castellanos Bordon

http://www.duo.uio.no/

Printed at Reprosentralen, University of Oslo

VI
 1. Introduction

For many years, the Mexican energy sector was solely operated and managed by the State and its
authorities. In order to understand the current state of the electricity industry in Mexico, some
general information will be provided.

Energy generation started in Mexico in the late 19th century with the first generating plant built in
1879 in a city called Leon in Guanajuato. It was used by a textile company and this scheme was
also used by the mining industry, marginally providing electricity to the public sector and some
citizens. The hydroelectric history of Mexico starts in 1889 with the first plant built in Chihuahua
under the name Batopilas powering urban and commercial areas.

It was during the government of Porfirio Diaz that the electricity sector was deemed as a public
service and public lighting was placed in several main roads in Mexico City. International
companies such as The Mexican Light and Power Company of Canadian origin and The American
and Foreign Power Company started operating in the country along with The Electric Company
of Chapala in the west. By the start of the 20th century Mexico had an installed capacity of 31MW
and it was owned by private companies. Ten years later the sector grew to 50MW of installed
capacity and 80% of the electricity was generated by The Mexican Light and Power Company
through the first big hydroelectric project which was the Necaxa plant in Puebla.

It was not until December 2nd 1933 that generation and distribution were established as public
utility services. However, by 1937 Mexico’s population was of 18.3 million habitants but only 7
million had access to electricity and the three companies could barely cope with the demand.
Tariffs were high and blackouts were very frequent since these companies were focused on the
most profitable urban markets while rural areas were completely abandoned despite of the fact that
62% of the population lived in them. By then the total installed capacity in the country was of
629MW. In order to face this challenge, the federal government created the Federal Electricity
Commission (which will be named CFE), which is the public electricity company that is in charge
of most of the generation and all the distribution and transmission activities to date. The main
purpose of its creation was to organize and run a national system of generation, transmission and
distribution of electricity, based on technical and economic principles as a non-profit company to

1
obtain a minimum cost and the highest performance possible in order to address the general
interests (law published in the Diario Oficial de la Federacion on August 24th 1937).

It was then when the CFE started building generating plants and expand the transmission and
distribution lines. The first hydroelectric plant that was in charge of the CFE started its construction
1938 by building the canals, roads and highways to what eventually would become the
Ixtapantongo Hydroelectric System in the State of Mexico, later to be called the Miguel Aleman
Hydroelectric System. In only eight years CFE’s capacity increased from 64kW to over 45MW. It
was then when the foreign companies ceased to invest and CFE was forced to increase the installed
capacity and distribute power through these private companies. By 1960 the CFE owned about
54% of the available 2308MW of installed capacity, Mexican Light and Power Company 25%,
American and Foreign Power Company 12%, and the rest of the companies 9%.

Despite of the efforts to bring electricity to the Mexican population only 44% had access to it,
which is why President Adolfo Lopez Mateos decided to nationalize the electric industry in 1960.
It was then when the National Electric System was created expanding the supply reach and
accelerated industrialization. The State acquired the foreign goods and infrastructure which had
serious operational and labor deficiencies due to the lack of investment. From here on, installed
capacity increased considerably to almost 8GW in 1970 and 17GW by 1980 through important
public investment in those years. It is also important to note that during the first years of history
of the Mexican electric industry over 30 voltages for distribution, 7 for high tension and 50 and 60
hertz frequencies coexisted. It was because of that that distribution was an important challenge for
CFE and the national company managed to unify the economic and technical criteria to standardize
equipment and reduce costs.

As demand continued to grow, in 1991 the installed capacity grew to 26.8GW but more
importantly it was during the beginning of the 21st century that the coverage reached 94.7% with
36.4GW of installed capacity and 614,653 kilometers of transmission and distribution lines. Until
2005, CFE generated 99% of the total electricity in the country.

The company that was in charge of the electricity services in Mexico’s central area was Luz y
Fuerza del Centro (another company owned by the State), but since 2009 CFE has been in charge
to provide the service to the whole country when Luz y Fuerza del Centro was closed down by

2
President Felipe Calderon Hinojosa. By 2015 the total installed capacity for CFE was 41.9GW,
however, the independent producer sector has grown during the last decade importantly, reaching
an installed capacity of 12.9GW for a total of 54.8GW. Independent producers generate electricity
to sell it exclusively to CFE under a contract following the Law of the Public Service of Electric
Energy. If we add to this the recently built plants by privates, the total installed capacity in Mexico
is 68GW.

It is also important to consider the Energy Reform that passed through the congress in 2014. Before
the energy reform, there were limited opportunities for privates to generate electricity, being the
self-supply scheme the only viable possibility to make this projects happen. While electricity
generation was considered as a matter that was only to be addressed by the state, self-supply was
not considered under the scope of the Mexican constitution. However, paperwork and the operating
framework represented important challenges reducing the attractiveness of the market. Under the
self-supply scheme, it was necessary to find off-takers to sign long-term Power Purchase
Agreements, lasting usually over 20 years. Naturally, financial institutions required that these off-
takers were low risk companies, with AA or AAA credit grades, so the off-taker pool of companies
was rapidly depleted. Smaller companies had to deal with important struggles in order to
participate in these projects.

The Energy Reform’s objective is to create incentives to bring a higher quality service, with lower
costs and more environmentally friendly. For the first time in Mexico the generation and
distribution markets are open to free competition. Reporting of the electricity market has been
made official through the National Center of Energy Control (CENACE) since 2016. This was
done in order to avoid conflicts of interest since they could arise if CFE remained as the generator
and coordinator of the system. This will allow the development of renewable energy projects as
they need higher investments in transmission. However, transmission and distribution will remain
as natural monopolies and these activities are still reserved for the government. However, the
expansion plans of the transmission system will be responsibility of CENACE. The main purpose
of the Energy Reform for the electricity market is to allow private investors to invest in new
capacity. As a comparison to the Norwegian electricity market, demand in Mexico has grown
consistently and there are no signs of overinvestment. The case is, in fact, the opposite. The fast
grow in demand had become a challenge too difficult to overcome by the public sector.

3
On the other hand, the Law for the Exploitation of Renewable Energies and the Financing of the
Energy Transition (LAERFTE) has established ambitious plans for Mexico’s climate change
strategy. Published in 2008, the law states that Mexico has the goal having a limit on the use of
fossil fuels for electricity generation of 64% by 2024, 60% by 2035 and 50% by 2050. This
represents an important challenge because today, more than 75% of the electricity is generated
through fossil fuels and by 2027 the more pollutant fuels used for generation will be replaced with
natural gas. On the other hand, Mexico is committed to reduce greenhouse gas emissions by 30%
for 2020 and 50% by 2050 through the General Law of Climate Change (LGCC). This implies that
the renewable energy investments will depend entirely on the private sector. This is where the
importance of hydro comes into place and it is one of the main motivations of this project. While
the law is supporting the development of renewable energy projects, the hydroelectric sector has
not received a lot of attention during the last years. While CFE’s current hydro participation
represents around 16%, the private sector has focused mainly on developing wind and solar energy
projects. While the investment has been considerable, it is important to notice that solar and wind
power are intermittent energies, and to cover the increasing demand more base load supply will be
needed. It is safe to assume that there are two technologies that can contribute to the reduction of
greenhouse emissions and base load supply: hydro and nuclear power.

While nuclear power has received intense criticism around the world after the historical disasters
such as Chernobyl and Fukushima, hydropower is a viable option for Mexico due to the availability
of resources. However, the growth of the hydropower sector in Mexico has stagnated for some
years, despite being an industry with a mature technology that offers one of the lowest costs per
kWh produced in the sector in a competition with natural gas. The enormous natural gas reservoirs
found in the United States of America in the recent years and the construction of pipelines
transporting this fossil fuel to Mexico has significantly decreased the price from $10USD in 2008
to approximately $2.5USD per million BTUs. On the other hand, the current devaluation of the
Mexican peso that has impacted the exchange rate from $12.30 to $19.60 MXN per USD from
2013 to 2016 has definitely affected the demand for natural gas, giving new grounds for
hydroelectric and renewable energy competition.

To date, there is no formal economic analysis on the Mexican energy model and the political
pricing policy in Mexico allows different prices both regionally and between different user groups.

4
In Mexico’s electricity market there are seven different domestic tariffs and 36 industrial tariffs.
However, these tariffs are determined by the amount of subsidy that is given by the government,
rather than by the actual price of generation. In addition, the country’s electric system is divided
in ten different transmission regions but three of them are completely isolated from mainland
Mexico’s system and from each other: the Baja California (connected to the California system in
the United States), Baja California Sur and Mulege systems. However, tariffs differ in eight regions
and only six of them are part of the mainland system. Also, the environmental and climate change
policy has been implemented and was seriously enforced recently, which may not allow the
construction of profitable but environmentally hazardous projects anymore. Figure 1.1 shows the
transmission regions in Mexico:

Figure 1.1. Regions of the National Electric System (Transmission)

Source: CENACE, official operator of the transmission network as of 2015

The lack of a formal economic analysis of the Mexican electricity sector is the main motivation of
this study. As opposed to Norway, who restructured its electricity market in the 1991, the Mexican
Energy Reform was approved until 2014 and it is still too soon to determine the quantitative effects
of this new policy. However, the establishment of an open market will allow us to consider new

5
economic assumptions for qualitative analysis. However, the remarkable achievements of the
Norwegian market reform could be used as a baseline for the optimal development of the newly
restructured Mexican energy sector.

Electricity has come to play an increasingly important role in the development of modern
economies. Quoting from the book Hydropower Economics written by Finn Førsund:

“The nature of electricity is such that supply and demand must be in a continuous physical
equilibrium. The system breaks down into a relatively short time if demand exceeds supply and
vice versa. A system failure may lead to grave economic consequences if the blackout lasts too
long.” (Førsund, 2011, p. 6)

It is there where the importance of the analysis comes into play. The country used as a baseline to
develop the theory behind Hydropower Economics was Norway. This study will aim to give
qualitative analysis on the Mexican electricity market based on the main findings in these fields,
testing the adaptability of the model at the same time.

This thesis will be based on the finding published by Finn Førsund in his book Hydropower
Economics, in which he provides a qualitative economic analysis of how to use the stored water
in hydropower systems with fixed generating capacities. While the problem exists as a dynamic
problem, new energy projects take time to develop, even more than the time necessary to empty
multiyear reservoirs.

Thus, the dynamic problem can be solved through fixed generating capacities for a given set of
periods. These concepts and the theory involved will be adapted to the Mexican scenario, in which
there are several types of generating technologies, and five interconnected regions with different
prices. This scenario can be addressed by using the trade theory included in the previously
mentioned book. Instead of considering scenarios of trade between countries, they will be referred
to as regions but the methodology will be adapted as necessary. An important assumption that will
be needed for simplicity is that regions will trade only with bordering entities due to elevated costs
of transmission across large distances. This can be observed by comparing the territorial division
of the regional tariffs and the Interconnected National System in the following figures.

6
 Figure 1.2. Regional tariff division map in Mexico.
Source: Comision Federal de Electricidad, official government electricity agency

The transmission system for electricity is what links the consumers to the generating plants. In
Mexico, the electricity delivered to customers has 110-120 volts and 60 Hertz. However,
transmission lines have different voltages according to the distances traveled by electricity. The
extension of the Mexican territory and its geographic composition cause significant energy losses
when electricity travels through long distances. In addition, Mexico does not have any direct
current high voltage transmission lines that allow the transmission of electricity at a lower cost and
with less energy losses. However, the infrastructure expansion program of the electricity sector
does consider using this technology in the future.

The Mexican Energy Reform established that CENACE is in charge of monitoring and operating
the electricity market as it was published in the Nation’s Official Journal (DOF). In the short run
CENACE will operate a Day Before Market which closes on day before to the Operation Day and
a Real-Time Market which closes before every Hour of Operation. It is planned to introduce an
Hour Before Market in the coming years to complement these two markets.

7
 Figure 1.3. Interconnected National System
Source: CENACE and Comision Federal de Electricidad, official government electricity agency

It is because of the reform that the equilibrium of the market can now be found in power, with an
operator that is independent of suppliers and consumers and controls the transmission network. As
the theory suggests, these conditions are sufficient for the assumptions of the economic model to
be valid. As a comparison, CENACE acts in the same way as Nord Pool in Scandinavia.

Electricity Demand in Mexico

Electricity demand data in Mexico has been publicly available since 2015 and it is usually
measured in weekly periods. Daily data per hour is available but as a new entity data series are not
yet officially published, though it is definitely possible to acquire and organize it. In Figure 1.4
and Figure 1.5 we can see the differences in hourly use of electricity in the North and South
regions, during summer and winter and during a weekday and a weekend.

8
Figure 1.4. Daily load curve for the Northern Regions
Source: SENER (Energy Secretariat) with data of CFE

Figure 1.5. Daily load curve for the Northern Regions

Source: SENER with data from CFE

9
The data is available for the year 2014 and it is compared to the maximum demand in the operation
area. In the Northern regions there is a noticeable difference between summer and winter, while in
the southern regions the demands overlap in several hours of the day. The use of air conditioning
increases demand in the north, while in the southern region the differences between summer and
winter are not so clear. The peak comes at night when all the lights in households are turned on as
well as TV sets in the southern region. On the other hand, in the north electricity consumption
remains high during the whole night and decreases during the morning, reflecting decreasing
temperatures at night. In warmer regions consumption in the summer remains high throughout the
day and it is somewhat stable during winter months. In the southern regions the differences
between lows and highs is more noticeable, having sharp peaks between 19 and 22 hours.

Despite of not having hard data on household demand of electricity by use, it can be easily
categorized. Due to Mexico’s climate, there is mostly no need for space heating. On the other hand,
air conditioning plays an important part of the country’s electricity consumption, especially in the
northern regions. In fact, the average temperature acts as an indicator to determine the proportion
of subsidies given by the government to consumers, i.e., the warmer the region, the higher the
subsidy for air conditioning activities. This is not the case in the central and southern regions. Also,
in general stoves and hot water appliances use liquefied or natural gas to operate, washing
machines are much more common than dryers and dishwashers. Thus, electricity is mostly used
for lighting, refrigerating, deep freezing, washing, TVs and PCs. Air conditioning increases
demand during the day in the Northern regions. The impact of air conditioning can be seen
comparing the central and southern regions to the northern ones; the increases on electricity
consumption in the former are much sharper compared to the stable demand of the latter regions.
As opposed to the Norwegian case, in Mexico electricity demand is higher in summer than in
winter. Also, demand increases in the summer due to water pumping for agricultural purposes.
This illustrates an opposite scenario as the one depicted by Førsund. Using weekly periods, which
are officially available, Figure 1.6 illustrates the demand evolution throughout the year.

10
 Figure 1.6. Weekly demand evolution in Mexico’s interconnected system
Source: CENACE

The lowest demand of the year has been recorded coincidentally on the first week of the year for
the last three consecutive years. The highest recorded demand was recorded during week 24 in
2014 (39,000MWh), during week 33 in 2015 and week 28 in 2016 as shown in Figure 1.6 by the
solid green, black and red lines. The area between the dotted green vertical lines show the period
of highest consumption during the year, while the red and blue dotted lines (not the horizontal red
dotted line) show the Reserve Operational Margin (ROM). The ROM shows the difference
between the total demand and the available capacity for power generation. With increases in
demand, we can see that during the 22nd week of 2016 this margin came at an all-time low of 6%.
For economists, it is natural to assume that as capacity becomes scarce, also electricity prices
naturally increase, thus demand is affected by price. We can see important differences between
summer and winter days and it may be attributable to the use of air conditioning during warm
weather seasons since this type of appliances are intensive users of electricity. Electricity

11
consumption increases by 80-90% in the northern regions in summer, while in the other regions
the increase is close to 20-30% compared to the first week of the year.

We know that the ROM was in quite a low level during the peak demand week of 2016. While
demand is growing, also increasing participation from the private sector due to the Energy Reform
will play an important role to satisfy the demand and increase the generating capacity, while
CENACE will have to work accordingly to increase transmission availability.

Hydropower in Mexico

Mexico has important potential in hydropower resources. However, the country is divided in half
with tropical weather and deserts; thus, most of the water is located in the center-southern region.
Mexico had over 12GW of hydropower installed capacity by 2014 and approximately 90% of the
reservoirs and plants are located in the center and southern regions. Despite of the advantages of
hydropower generation, in Mexico’s long term energy plans hydro will lose importance gradually,
unless interest is awoken in the private sector. Natural gas combined cycle plants will drive the
growth of the Mexican electricity sector as years go by.

Figure 1.7. Development of accumulated energy in reservoirs 2014-2015.

Source: SENER, Expansion of the National Transmission Grid Program 2016-2030.

12
Storage capacity in Mexico is significant but it depends strongly on the type of pluvial years: dry,
medium and humid years. Figure 1.7 shows the development of accumulated energy of reservoirs
in Mexico. The year 2014 started with 22,503 GWh of stored water and it declined until June, it
then increased due to the rainy season and grew since September (when the period to fill up
reservoirs starts) to 21,054GWh at the end of the year. However, 2015 was a dry year, reaching
minimum values of 10,960GWh in June and lowering the stored capacity to 18,091GWh, a 4,412
GWh reduction in comparison to the previous year. The total energy generation in 2014 was
31,222GWh and due to the lower inflows in 2015, production was reduced to 23,240GWh. It is
expected that hydropower generation will be lower in 2016 in comparison with the two previous
years due to low inflows. This behavior will be consistent with the economic theory that will be
used in this study. Figure 1.8 shows the behavior of stored energy in the Mexican reservoirs.

13
 2. Background for the energy model

“The key economic question in hydropower production is the time pattern of use of water in the
reservoir given each time period. With enough storage capacity the water used today can
alternatively be used tomorrow. The analysis of hydropower is therefore essentially a dynamic
one.” (Førsund, 2011, p.14)

The behavior of hydropower generation appeals to this assumption, taking into account the
opportunity cost of using water in different periods. Also, the costs of operating hydropower plants
are very low since there is no cost on inflows and labor costs are quite small when measured against
production. Investment costs are high, but they play no role in the optimal operation of plants
according to the water resources available. In order to address the problem of not including
investment in the model it is required to solve for the optimal management of stored water given
production capacity. In order to find qualitative information about the social planning problem
while optimizing power generation we will use nonlinear programming models using Kuhn-
Tucker conditions. The quantitative analysis and the use of stochastic dynamic programming tools
used in engineering for variables and methodology will not be addressed. Details on the variables
and methodology will be covered in the next sections.

Environmental concerns regarding hydropower in Mexico are important to consider. Hydropower

does not contribute to the generation of harmful regional greenhouse emissions such as sulfur
dioxide (SO2), nitrous oxide (NOx) or the global pollutant carbon dioxide (CO2). Nevertheless,
this type of energy does not only include environmental hazards but also political issues.
Concerning the environment, the use of water and the creation of reservoirs can alter the
microclimate and the ecosystems’ cycles in general. Artificially creating reservoirs involves
flooding entire areas that can importantly alter the ecosystem, potentially endangering species and
their habitats. The change in water flows may affect aquatic wildlife. As opposed to Norway, the
value of the use of natural waterfalls, lakes and rivers is not considered to be a major deterrence
for the creation of hydropower projects, but population displacement and relocation plays a key
role in their success.

Hydropower projects use large plots of land in order to build the reservoirs and the infrastructure
needed. Naturally, the amount of land required depends on the scale of the project. In Mexico,

14
large hydropower projects are developed and operated by CFE, and the state is fully responsible
for acquiring the land and mitigating the environmental hazards created. The private sector usually
participates with smaller projects which are, under Mexican standards, considered to be renewable
energy projects up to 50MW. Larger projects are not considered “renewable energy” projects
under the Mexican operating framework since they involve flooding considerable areas of an
ecosystem, alter the microclimate of a region and change water levels in water bodies that may
affect aquatic life. Also, large projects require aggressive capital investments, with examples like
the Chicoasen I that required an investment of over 800 million USD. The private sector in Mexico
has focused on developing hydropower projects with less than 50MW of capacity, and despite
being a sector that is not growing nearly as fast as the wind or solar industries, the potential to
build small hydro and mini hydro is 56GW. (Castellanos, et. al., Mexico Energy Review, 2014).

Thermal Energy in Mexico

The choice of technology used for power generation in Mexico is closely related to the price
evolution of different types of fuels. Mexico has promoted the construction of infrastructure to
satisfy the demand for natural gas in the coming years. Also, the discovery of large natural gas
reservoirs in the United States has pushed the price of natural gas to the lowest levels in the last
20 years due to the construction of pipelines across the border that has made imports easier.
However, the low prices of oil are not related to the regional behavior of natural gas in North
America. The future planning of the electric sector in Mexico has directed its efforts towards a
lower use of oil and its sub products in the next years while plans to increase the participation of
natural gas in order to reduce greenhouse emission. Coal, fuel oil and diesel use will be reduced
drastically by 2029 while, in addition to natural gas, geothermal steam and uranium’s participation
will increase.

Wind and solar power plants are expected to be developed by the private sector. CFE has also to
substitute older power plants for more efficient ones in order to take proper advantage of the
available resources, maintain a reliable MRO and reduce power failures. Thermal power capacity
accounted for over 72% of Mexico’s energy mix and for 75% of total power generation in 2014.
Compared to hydroelectric power generation the participation of thermal technologies is
importantly dominant, however, the participation of hydropower is not negligible. Figure 1.8
shows the participation of each energy source in Mexico’s electricity generation. The graph uses

15
data from CFE and the Energy Regulation Commission (CRE). The CRE is in charge of creating
and enforcing the optimal operating framework in the energy sector. This commission is
responsible for managing and issuing resource exploitation permits in every activity related to
energy. Also, it is responsible for planning long term strategy and design laws to promote the
efficient operation of the energy market, being also the enforcer of such laws.

Figure 1.8. Generation by source in Mexico

Source: National Energy Strategy, SENER with information from CFE and CRE

As opposed to hydropower, thermal power does have important operation costs, which mostly
depends on the amount and the price of the fuel used to operate the plants. This implies that the
production function will include costs that negatively affect energy generation. These variables
will be considered in the model in order to obtain precise first order conditions. However, often
thermal plants have lower investment costs but higher operating costs which affect the optimal
decision of generation technology. In the Mexican case not only this comes into play but also the
geographical availability of resources. While natural gas has been considered as the “cleanest”
fossil fuel, important greenhouse emissions originate from these technologies. On the other hand,
Mexico is still producing roughly 20% of its electricity through highly polluting technologies (coal
and fuel oil) raising environmental concerns.

16
Renewable energy in Mexico

Environmental concerns have become increasingly important on a global scale, promoting

investment in renewable energy sources as an effort to reduce greenhouse emissions and mitigate
climate change. Europe’s investment in renewables grew through the combined efforts of the
private sector and public policies, offering tax exemptions and the famous feed-in tariff schemes.
However, due to the economic recession in the European Union in 2009 public expenditure on
these schemes was drastically reduced. As a result, renewable power generation companies started
expanding to new and promising markets for growth. Mexico has been one of the countries that
started developing renewable energy projects benefiting of the European expertise. As a result,
investments in the renewable energy sector in Mexico started growing after 2008 through self-
supply schemes despite of the strong limitations of private participation in power generation,
especially in wind energy.

The Energy Reform allows more direct private participation in the Mexican energy market and
investments have intensified. Although the current participation of renewable energy in Mexico is
low, it is important to include this type of generation in the model as wind energy as it is the
technology that is expected to have a higher impact on Mexico’s future energy mix. It is expected
that wind power’s participation on total installed capacity will become approximately 13%.

17
 3. The energy model

In order to analyze de economics behind energy generation we need to establish baselines on the
methodology. As mentioned before, it is possible to use discrete time since capacity growth and
project development takes more than one year to start operating from any given year. The new
projects that contribute to capacity and production growth are negligible from one year to another
when taking into account the proportion they represent compared to the country’s total. The use of
discrete time makes it possible to use the previously mentioned non-linear programming tools.
Also, technical change of hydropower can be dismissed since it is an embodied technology.

The variables that will be considered in this study will be the amount in the reservoir, 𝑅𝑡 , net inflow
of water, 𝑤𝑡 , electricity production from regulated hydro, 𝑒𝑡𝐻 , unregulated river, 𝑒𝑡𝑅 , wind power,
𝑒𝑡𝑊 and thermal capacities, 𝑒𝑡𝑇ℎ , and release of water, 𝑟𝑡 , respectively just as described by Førsund.
Capitalized variables represent stock variables and lowercase variables stand for flow variables,
indexed t to refer to the time period. More variables will be introduced as the model is developed
and will be explained accordingly.

Starting with hydropower, the transformation of water into electricity depends on the release of
water and the gross head, which is the vertical height from the upper level of the dam to the outlet
of water from the turbines. However, in order to successfully measure the output of the plant it is
necessary to convert the cubic meters of water into power generation. For this, the fabrication
coefficient, (𝑎), will allow us to identify how many cubic meters of water are needed to generate
1KWh. The production function will have standard assumptions implying that production is
increasing in input and height. Assuming that the latter equation holds with equality the water
measured in cubic meters would exactly correspond to water measured in kWh.

𝑒𝑡𝐻 = 𝑓𝑡 (𝑟𝑡 , ℎ𝑡 ), 𝑓′𝑟𝑡 > 0, 𝑓′ℎ𝑡 > 0 (3.1)

1
𝑒𝑡𝐻 ≤ 𝑟 (3.2)
𝑎 𝑡

The objective of using non-linear programming is to optimize the management of current capacity;
therefore, capital costs are not included in the production function. In the case of the unregulated
river the water release should be replaced by the unregulated river flow in both equations. Another
important assumption regarding hydropower is the lack of presence of operational costs. At present

18
time the capacity is given and water is a renewable resource provided by nature. As opposed to
thermal power, water for power generation is not purchased as an input in any market. Maintenance
does not act as a variable cost but rather as a part of the capital expenditures of the project. On the
other hand, labor costs do not vary according to output; the same amount of employees is needed
to operate the plant in any production scenario. The only relevant cost for this analysis will be the
opportunity cost of water comparing between the costs and benefits of using water today or
tomorrow. In any other sense, we will assume that there are zero variable costs in the present.

Just as in the Norwegian case, the number of run-of-the-river facilities in Mexico is quite small
and the height of the waterfalls varies from dam to dam. Water management is a dynamic problem
since water is used to generate electricity reducing the amount of water in the reservoirs, but there
are also inflows that fill them up at the same time. Thus, the amount of water available has to be
constrained according to its use and renewal. Nevertheless, as opposed to what happens in a
northern country such as Norway, temperatures in Mexico are higher and the need to adapt the
Norwegian hydropower model for water evaporation is necessary. CONAGUA estimates that 72%
of the total precipitation evaporates; however, precipitation and evaporation happen throughout all
the year. The evaporation of water that is released for energy generation becomes irrelevant for
the reservoir (except in coupled hydro plants which will be covered in Appendix 5), thus, it has to
be calculated to find the total amount of losses that the reservoir incurs.

𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑊𝑡 − 𝑟𝑡 − 𝑣𝑡 , 𝑡 = 1, … , 𝑇 (3.3)
𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑟𝑡 , 𝑡 = 1, … , 𝑇 (3.4)

Equation (3.3) indicates that the amount of water at the end of period t is less or equal to the amount
of water in the previous period (which is equal to the reservoir content at the beginning of period
t) plus the water inflow minus the release of water minus the evaporation of water in period t and
the variable W stands for gross inflow. Strict inequality means that there is overflow. Equation
(3.4) shows that the variable 𝑤𝑡 stands for net inflow accounting for the losses generated by
evaporation at the end of period. Evaporation varies according to climate conditions and specific
conditions of the water reservoirs, such as depth, the amount of water in the reservoir, and the total
area that is exposed to sunlight.

19
 Figure 3.1. Groups of climates in Mexico
Source: INEGI (Instituto Nacional de Estadistica Geografia e Informatica) National Institute of
Statistics Geography and Informatics

The equation goes in line with the fact that the more water there is in the reservoir the less
proportional evaporation while it might be higher in absolute terms (Goor, et. al., 2010). Figure
3.1 shows a map of the temperature variations in the Mexican territory and we can see how
temperatures vary according to the different regions. Hydropower is mostly present in the southern
area of the country so an analysis of the average temperatures is relevant in order to show the
importance of the role of evaporation in energy generating models.

In Mexico climate is determined by several factors such as altitude over sea level, geographic
latitude, different ecosystems, and the existing distribution of water and land. Following the order
of the numeration in Figure 3.1 the warm humid climate covers 4.7% of the country and has an
average annual temperature between 22°C and 26°C with high precipitations between 2000 and
4000 millimeters per year. The warm sub-humid climate covers 23% of the Mexican territory and
has the same average temperatures as the warm humid region, but in certain areas the average
temperature goes well above 26°C. The yearly precipitation in these regions varies from 1000 and
2000 millimeters.

20
The dry regions in Mexico are mostly located in the center and northern areas of the country,
corresponding to 28.3% of the territory. The average temperatures vary between 22°C and 26°C
in some regions and in other regions it goes from 18°C and 22°C. The annual rainfall is between
300 and 600 millimeters. The regions with very dry climate have an average temperature between
18°C and 22°C and precipitation is extremely low, from 100 to 300 millimeters. These areas cover
20.8% of Mexico’s territory.

Finally, the mild weather is divided in humid and sub-humid. The humid mild climate registers
average temperatures between 18°C and 22°C and has significant rainfall averaging 2000 to 4000
millimeters per year in 2.7% of the country. The mild sub-humid climate covers 20.5% of the
country and temperature can vary significantly. Some regions register temperatures from 10°C to
18°C (center), others from 18°C to 22°C (south), and in certain regions it can drop below 10°C
(north) with precipitation averaging from 600 to 1000 millimeters during the year.

This climate map of Mexico shows us that the southern region is mostly dominated by warm and
mild humid and sub-humid climates with mostly high average temperatures. This goes in line with
the proposed model taking into account the high average temperatures and the important
precipitation levels where hydropower is present.

In a practical case for Mexico, as energy demand and generation is usually measured in weeks.
The model allows to find qualitative information using horizons of 2 years as an example, but it
can be extended to all periods. This proposal is based on the fact that the reporting of Mexican
energy authorities follows this format.

In order to convert water flows to energy units we need to use the annual profile of inflows and
releases for the Mexican hydropower system as it is shown in Figure 1.7. In Norway inflows are
low in the winter weeks due to the low temperatures and the freezing of water. In Mexico, the
strong inflow season starts during the summer and finishing in December due to the rainy season.
In this period generation is slightly higher than during the winter and spring season. It follows to
clarify that since hydropower is mostly present in the southern region, air conditioning follows a
rather stable path during the year for intensive users such as hotels, restaurants and buildings. Most
homes do not have air conditioning and the ones that do, use it sparingly.

21
 4. The Mexican Hydropower Model

In order to make a more realistic model we have to introduce an upper reservoir constraint, deal
with the treats of overflow, and no emptying of the reservoir until the terminal period. For
simplicity, we will also assume that water is present in the first period. This is a quite realistic
assumption as the hydropower infrastructure is already present in the Mexican market and
reservoirs will have given amounts of water for the period chosen. The variations in the pattern of
inflow can be of up to ±25% between dry and humid seasons.

Figure 4.1. Annual Precipitation in Mexico

Source: CONAGUA (Consejo Nacional del Agua), National Water Council

22
Most of the hydropower plants are located in the southern region. As we can observe in Figure 4.1
the precipitation map is consistent with fact that reservoirs are located in the Center, South and
Peninsular region.

“In the case of all water being present in the first period, utilization of water within a horizon can
be regarded as a problem of managing a resource of finite amount, just like extraction of non-
renewable resources like oil.” (Førsund, 2011, p.21).

In order to have equality in the production function (3.1) it is necessary to assume that production
of electricity is efficient and that water is available in the first period. We also assume unlimited
transferability of water to the other periods given the available water in the first period. Creating
an example with water being available in the first period using the production function under these
assumptions gives us:

𝑇 𝑇

∑ 𝑟𝑡 = 𝑤1 ⇒ ∑ 𝑎𝑒𝑡𝐻 = 𝑤1 , (4.1)
𝑡=1 𝑡=1

Where W represents water measured in KWh and w represents the net inflow accounting for
evaporation. In this equation water is measured in cubic meters on the left hand sided, while
dividing water by the fabrication coefficient lets us have units in KWh, as proposed before in
equation (3.2).

In order to find the optimal energy generation standard economic assumptions, indicate that energy
consumption will be measured by utility functions as a standard social planning problem with no
discounting due to short cycles (T covers one seasonal cycle of one year). The horizon is somewhat
lower when comparing Norway having three to five years of multi-year reservoirs to Mexico with
multi-year reservoirs of two to three years. By standard assumptions and concavity properties of
the utility functions the marginal utility will be measured in monetary units and represents the
marginal willingness to pay and the social price of electricity as follows:

𝑈𝑡 (𝑒𝑡𝐻 ), 𝑈 ′ 𝑡 (𝑒𝑡𝐻 ) ≥ 0, 𝑈 ′ 𝑡 (𝑒𝑡𝐻 ) < 0, 𝑡 = 1, … , 𝑇 (4.2)

𝑈′𝑡 (𝑒𝑡𝐻 ) ≡ 𝑝𝑡 (𝑒𝑡𝐻 ) (4.3)

23
Despite of the growth of the Mexican energy demand and capacity, the variations observed in one
year cycles are quite low. In this analysis we will immediately introduce constraints into the social
planning problem, but the basic model can be reviewed in Appendix 1.

Constraints in the Mexican hydropower model

In order to properly explain the behavior of a hydropower model it is necessary to include other
restrictions in addition to the limit of water availability. The constraints vary according to the
length of the periods chosen and if single or multiple plant models are considered. It is necessary
to include storage, generation and emptying constraints. Storage constraints limit the maximal
reservoir capacity for energy generation while the generation constraint is directly related to the
maximum capacity in MW of power plants. In the basic model the result is that prices are equal in
all periods. However, in reality electricity prices change in short periods of time. Also, excess
emptying of the reservoirs may result in severe environmental damage damaging the flora and
fauna along the water bodies. Environmental concerns in Mexico due to water release are rather
constant since water flows are active during the year. Environmental concerns include the risk of
flooding, impact in fishing activities and microclimate changes that impact agricultural activities.
In order to calculate the amount of energy that can be produced we use the maximal capacity in
kW (or MW) in a period length of one hour to be measured in kWh (or MWh). In this analysis we
will only use energy as the relevant variable for the power and production constraints. Ramping
up and ramping down has also has to be considered in the model for shorter periods when release
changes.

In the Mexican electricity model it will be important to establish trade constraints in order to be
able to link the different regions and their interaction and will be addressed accordingly as the
models are developed. The losses due to temperature variations will not be considered as the effects
are negligible. Environmental constraints may reduce environmental problems; however, the most
aggressive phase comes from building the hydropower plant rather than from operations.

Optimal management of a hydro system

In this section we will specify the objective function for power producers using standard economic
assumptions to maximize producer and consumer surplus. The objective function will allow us to
maximize the social surplus under the consumer demand function and using a partial equilibrium

24
approach we can simplify the methodology as the demand equals the supply in equilibrium where
the consumer’s expenditures correspond to the producers’ profit. The demand function decreases
in price. In the case of hydropower, we previously mentioned that operation costs are quite low so
the objective function will be specified with zero operating costs as follows:

𝑇 𝑥𝑡

𝑂𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛: ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 (4.4)

𝑡=1 𝑧=0

As we are using the consumer surplus approach it is necessary to include a choke price that yields
zero demand. The reservoir constraint proposed for the reservoirs in this model can be specified
as in (3.4) but divided by the fabrication coefficient in order to convert from cubic meters to energy
units of kWh:

𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑟𝑡 = 𝑅𝑡−1 + 𝑤𝑡 − 𝑎𝑒𝑡𝐻 =>

𝑅𝑡 𝑅𝑡−1 𝑤𝑡
≤ + − 𝑒𝑡𝐻 𝑡 = 1, … , 𝑇 (4.5)
𝑎 𝑎 𝑎

This way every variable is expressed in terms of energy units. However, for notational convenience
we will not show the fabrication coefficient. We will introduce an upper reservoir constraint at the
same time that an output constraint on hydropower generation. A more detailed explanation of the
basic model, the optimal solutions, scarcity, and terminal periods can be found in Appendix 2. In
this case we will directly cover the complex hydropower model that will be applied for the Mexican
market.

The output constraints

As mentioned before Mexico has a total installed hydropower capacity of over 12GW but it
represents around 18% of the total installed capacity, the rest is mostly generated by thermal power
plants and a small participation of wind and nuclear energy. Also, the ROM hit a historic low this
year at 6%, thus, constraining hydro, thermal and wind power’s output will be relevant in the final
model. For now, the analysis will cover hydropower’s output constraint:

𝐻
𝑒𝑡𝐻 ≤ 𝑒 , 𝑡 = 1, … , 𝑇 (4.6)

25
 𝐻
Where 𝑒 stands for the upper limit for power generation. It has no time subscript since it is a
technical constraint. If the highest power demand is lower than the power generation capacity, then
we have sufficient power capacity. This highest peak in demand is the closest point to the left axis
in the load-duration curve.

𝐻
𝑥𝑡𝑚𝑎𝑥 < 𝑒 , 𝑡 = 1, … , 𝑇 (4.7)

We now insert the production constraint (4.6) into the social planning problem (4.4)

𝑇 𝑥𝑡

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜
𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 − 𝑣𝑡 (4.8)
𝑅𝑡 ≤ 𝑅
𝐻
𝑒𝑡𝐻 ≤ 𝑒
𝑅𝑡 , 𝑒𝑡𝐻 ≥ 0
𝐻
𝑇, 𝑤𝑡 , 𝑅0 , 𝑅, 𝑒 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑇 𝑓𝑟𝑒𝑒, 𝑡 = 1, … , 𝑇

Yielding the Lagrangian:

𝑇 𝑒𝑡𝐻 𝑇 𝑇

𝐿 = ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ 𝜆𝑡 (𝑅𝑡 − 𝑅𝑡−1 − 𝑤𝑡 + 𝑒𝑡𝐻 + 𝑣𝑡 ) − ∑ 𝛾𝑡 (𝑅𝑡 − 𝑅)

𝑡=1 𝑧=0 𝑡=1 𝑡=1
𝑇
𝐻
− ∑ 𝜌𝑡 (𝑒𝑡𝐻 − 𝑒 ) (4.9)
𝑡=1

The endogenous variables are 𝜆𝑡 , 𝛾𝑡 , 𝜌𝑡 (𝑡 = 1, … , 𝑇) and the first order conditions are:

𝜕𝐿
= 𝑝𝑡 (𝑒𝑡𝐻 ) − 𝜆𝑡 − 𝜌𝑡 ≤ 0 ( = 0 𝑓𝑜𝑟 𝑒𝑡𝐻 > 0)
𝜕𝑒𝑡𝐻

𝜕𝐿
= −𝜆𝑡 + 𝜆𝑡+1 − 𝛾𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 > 0)
𝜕𝑅𝑡
𝜆𝑡 ≥ (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 ) (4.10)
𝛾𝑡 ≥ (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅)
𝐻
𝜌𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝐻 < 𝑒 ), 𝑡 = 1, … , 𝑇

26
The production constraint reduces the maneuverability of the hydro system and if there is too much
inflow and not enough water can be processed then the threat of overflow becomes an issue. Also,
it makes the water value to be lower than the price according to the first condition since a lower
amount of water is used. This situation may also arise in peak load periods in which electricity
demand is very high and triggers the output constraint, using less water and raising prices. These
are the two reasons that make the production constraint binding. Now maneuverability depends on
a minimum number of periods 𝑡 0 to empty the reservoir and, the higher it is, the more limited
maneuverability. It can be described as follows:

𝐻
𝑡 0 = min 𝑡 𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝑡𝑒 ≥𝑅 (4.11)

However, there are situations in which inflows are greater than the generation capacity with no
maneuverability. The main objective is to avoid spilling water and maneuverability only happens
when production is greater than the inflows. If the case is the opposite, then there will be a lock-
in of water (meaning that water cannot be moved from the reservoir). The largest contribution for
power generation comes from thermal energy using fossil fuels and inflows rarely exceed
generation capacities. In this case, in periods with threats of overflow generation from thermal
power plants can be decreased without turning off the plants to avoid start-up costs and increase
hydropower’s participation. The constrained model can be explained by Figure 4.2 in which the
production constraint binds in the second period.

If the output constraint is binding in the second period then the energy production for period 1 is
covered at optimal prices, but not for period 2. To avoid water spilling then production has to be
transferred to period 1, but this will lower the price of electricity in the first period and raise it in
the second. The difference in prices will be the output constraint multiplier and the generation in
period one will be AB’’. If the output constraint is not binding, then the transfer of water will be
from B’. However, since the output constraint is binding the water transfer is lower, from B’’ to
C. The price increase is caused by the binding constraint and the increase of water use AB’’ in
period 1 leaving less water to be used in period 2.

27
 Figure 4.2. Bathtub diagram of hydropower with capacity constraint binding in period 2.
Source: Hydropower Economics, Førsund, 2005, p.53.

In the case of a locking-in of water, spill would be necessary to avoid overflow making the
reservoir constraint binding and implying a zero water value since the reservoir in the second
period cannot exceed its capacity, in other words, the extra water accumulated ends up in overflow
and cannot be used. Due to the production constraint and the changes in prices the social value of
electricity generation is lowered. The illustration provides an example of how this happens and an
explanation on why this price differences happen. In order to find the optimal solution, it is
important to understand how these variations affect the equilibrium between supply and demand.

Flow-of-the-river generation and wind power generation

The flow-of-the-river generation has a very low participation in total yearly production of
hydropower in Mexico. This type of energy uses water flows that cannot be stored and must be
used continuously to produce electricity. The main feature of this type of resources is that
generation cannot be controlled. Due to its minimal participation, generation through run-of-the-
river power plants may not have any relevant effect in the social prices. However, wind power
follows the same essence as it is an intermittent generation resource and power plants generate
only in its presence. For the Mexican case we will only add wind power in the social planning

28
problem but adding flow-of-the-river generation will become straightforward after discussing
wind power. The social planning problem becomes:

𝑇 𝑥𝑡

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

Subject to

𝑥𝑡 = 𝑒𝑡𝐻 + 𝑒𝑡𝑊
𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 − 𝑣𝑡
𝑅𝑡 ≤ 𝑅 (4.12)
𝑥𝑡 , 𝑒𝑡𝐻 , 𝑅𝑡 ≥ 0, 𝑡 = 1, … , 𝑇
𝑇, 𝑒𝑡𝑊 , 𝑅0 , 𝑅, 𝑤𝑡 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑇 𝑓𝑟𝑒𝑒

Where 𝑒𝑡𝑊 is the electricity produced by wind power in period t and since no storage is possible
then 𝑒𝑡𝑊 = 𝑔𝑡𝑊 . Costs for wind power plants are mostly absorbed by capital investments, there is
no market price for wind. Another new term is added, 𝑥𝑡 , and it stands for the energy balance in
the first constraint. The constraint holds with equality so it can be substituted directly.

𝐻 𝑊
𝑇 𝑒𝑡 +𝑒𝑡 𝑇 𝑇

𝐿= ∑ ∫ 𝑝𝑡 (𝑧) 𝑑𝑧 − ∑ 𝜆𝑡 (𝑅𝑡 − 𝑅𝑡−1 − 𝑤𝑡 + 𝑒𝑡𝐻 + 𝑣𝑡 ) − ∑ 𝛾𝑡 (𝑅𝑡 − 𝑅) (4.13)

𝑡=1 𝑧=0 𝑡=1 𝑡=1

The first order conditions are the same as for problem (4.10) and 𝑒𝑡𝐻 + 𝑒𝑡𝑊 is used as the argument
in the price function:

𝑝𝑡 (𝑒𝑡𝐻 + 𝑒𝑡𝑊 ) = 𝜆𝑡 , 𝑡 = 1, … 𝑇 (4.14)

In a bathtub diagram in Figure 4.3 the wind inflows and availability extend the walls of the graph
to the outside in case there is positive generation in both periods. Then the demand curve for the
first period is extended towards the new vertical axis for the first period and the curve for the
second period is anchored to the opposite wall. There are more generation possibilities due to wind
power and, as a result, the demand curves shift to a lower price. If the case is that wind power
generation is higher in the first period, then the amount of water transferred to the second period
has to be lower in order to keep water values equal. This translates into a higher consumption
increase in the first period than in the second since the demand curve is more elastic in period 1.

29
In other words, consumption increases more in the first period due to the elasticity of the demand
after a price decrease due to the contributions of wind power. It is important to mention that when
dealing with bathtub diagrams the subscripts 1 and 2 can be easily substituted by t and t + 1, being
able to analyze any period available.

Figure 4.3. Bathtub diagram adding wind power to hydropower generation.

Source: Adaptation from Hydropower Economics, Førsund, 2011, p. 60.

Adding uncontrollable river flows to the social planning problem is also straightforward as it is
added in the energy balance equation. It is not rare to have both types of unregulated power at the
same time and due to the increased instantaneous generation the demand curves are shifted further
down and the price decreases since power supply grows. If the production constraint is not binding,
windmills and unregulated river production may be the cause for price variations and also in
seasons when wind power production is so high that less electricity is generated from stored water.
As a general assumption for equilibrium we know that prices and quantities must have a
simultaneous solution. During this study the main focus has been obtaining the optimal prices and
in order to solve for quantities and obtain qualitative information the inverse function of the
optimal price to be calculated. According to the optimal solution obtained for the social planning
problem we find that the price is equal to the water value (shadow price) for all periods. Also
production is equal to the available reservoir level and the water inflows in a given period. A

30
backward induction approach to find the inverse function and determine optimal quantities is
available in Appendix 3, as well as the corresponding interpretations of the results.

31
 5. Multiple producers in hydropower

Mexico has approximately 180 hydropower generating plants but only around 25 are big scale
producers. The rest of them are either mini or micro hydropower plants with smaller reservoirs
and lower capacities. In order to start introducing multiple producers in our model we will start by
assuming that the plants operate independently, but that will change in a later section when a
transmission system is specified and region-specific analysis is done. By doing this we can still
assume that a plant can empty its reservoir in a specific period and maneuverability is still at its
maximum. In order to keep the current analysis, flow we will also add wind power to the energy
balance equation and maximize the social planning problem accordingly. There are many
windmills operating in Mexico, but the amount of energy produced is an exogenous variable. The
output constraint will also be introduced simultaneously in the social planning problem in order to
find the relevant qualitative interpretations for the multiple producer model. The same
methodology will be used as in equation (4.12) in order to determine the output constraint but the
subscript j is introduced to indicate independent plants.

The energy balance equation will now be:

𝑁 𝐿

𝑥𝑡 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 , 𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑡 = 1, … , 𝑇 (5.1)

𝑗=1 𝑙=1

And the social planning problem will be:

𝑇 𝑥𝑡

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

Subject to

𝑁 𝐿

𝑥𝑡 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊
𝑗=1 𝑙=1

𝑅𝑗𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 (5.2)

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗 ≥ 0
𝑅𝑗𝑡 , 𝑥𝑡 , 𝑒𝑗𝑡𝐻 , 𝑒𝑙𝑡𝑊 ≥ 0

32
 𝐻
𝑇, 𝑤𝑗𝑡 , 𝑒𝑙𝑡𝑊 , 𝑒𝑗 , 𝑅𝑗0 , 𝑅𝑗 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒, 𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑡 = 1, … , 𝑇

Since electricity is a homogeneous good, the generation is just summed and there is a single
aggregated demand function for an identical good produced. To solve for the first order conditions,
we build the following Lagrangian:

∑𝑁 𝐻 𝐿 𝑊
𝑗=1 𝑒𝑗𝑡 +∑𝑙=1 𝑒𝑙𝑡
𝑇 𝑇 𝑁 𝑇 𝑁

𝐿=∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ ∑ 𝜆𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 ) − ∑ ∑ 𝛾𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗 )

𝑡=1 𝑧=0 𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑁
𝐻
− ∑ ∑ 𝜌𝑗𝑡 (𝑒𝑗𝑡𝐻 − 𝑒𝑗 ) (5.3)
𝑡=1 𝑗=1

The first-order conditions are:

𝑁 𝐿
𝜕𝐿
= 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝑗=1 𝑙=1

𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (5.4)
𝜕𝑅𝑗𝑡
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁

Just as in the previous cases we assume that electricity is always consumed and it has a positive
price and the water value becomes zero if there is overflow according to the complementary
slackness condition, but optimal management avoids overflow. In this case the stations differ in
reservoir capacity and output capacity.

If the output constraint is not binding, then the price has to be equal to each plant’s water values if
they have positive production and the other plants having positive production in the same period
will also have the same price for electricity.

The reservoir constraint measures a marginal increase in the consumer and producer surplus for a
marginal increase in the reservoir accounting for evaporation in each plant (assuming that climate
conditions are the same and the plants are located in the same region). This constraint will not be
binding in the periods following scarcity periods but will become relevant after threats of overflow.
33
This implies a higher production after overflow periods since water spilling needs to be avoided
until the water value is again equal to the price. For this to happen it must exist a price difference
in the water values in the overflow period and the following one. This way the second condition
in (5.4) tells us that these reservoir constraints are only valid for the plants that have an upper
reservoir constraint that is binding. However, at an aggregated level we can only find solutions for
the aggregated production but not the individual plants. Due to non-satiation the plants continue
to produce electricity up to the last period and all water is used up in the last period. The price
changes at the aggregate level occur when there is no possibility to transfer enough water to other
periods and more water is used in the period in question, increasing generation and decreasing
prices.

Next, we assume that the output constraint is binding and it can be the case that the individual
water values may not be the same across plants at optimum. Now the water value becomes plant
specific as some of the plants in the social problem may have binding output constraints and the
maneuverability of water is further reduced. There are three different scenarios for binding output
constraints taking into account two consecutive prices:

i) 𝑝𝑡 > 𝑝𝑡+1
ii) 𝑝𝑡 = 𝑝𝑡+1
iii) 𝑝𝑡 < 𝑝𝑡+1

The output constraint reduces the value of the objective function since less water can be processed
and more is kept in the reservoir. This reduces the water value since the plants can process less
water than optimal in the case of higher availability and high demand. In the first case the price is
higher in the first period compared to the second period. Comparing this situation to the
unconstrained case then the water value of the current period will be equal to value in the next
period. If there is no constraint, then more water will be processed in the current period to reduce
the price up to the level in which they become equal in both periods. It follows that for the water
value to be lower in t than in t + 1 then the price in t + 1 has to be lower. Due to the binding output
constraint water cannot be processed in the current period but in it can be in the next one.

On the second case, the price in the current period is equal to the price in the next period. It follows
that the water value is equal in both of them regardless of a binding output constraint. There is no

34
increase in the objective function for the system through price changes. Therefore, more electricity
can be obtained from plants that are unconstrained.

The third case describes a situation in which the price in the current period is lower than in the
next period. In this case more water would optimally be transferred to the next period and a binding
constraint in period t would not allow for a price increase in period t + 1 and by assumption the
reservoir constraint would not be binding in this period. The water value cannot be increased. Also,
as demand increases more water is needed and the constraints of the constraints may become
binding. It is interesting to note that water values may remain the same but prices change due to
more binding constraints. For the Mexican scenario the constraints would become binding in an
unusual situation of high demand during summer days, however, the MRO historic lowest is at 6%
in week 22 of 2016, when demand starts to rise due to rising summer temperatures and the rainy
season has recently started. While some output constraints may become binding for specific
individual plants to prevent overflow or to cover high demand periods, it might not be the case of
a total straining of the system where constraints bind simultaneously. Also, the higher availability
of thermal power can compensate for these peaks in demand.

In multi-year reservoirs production constraints may be the cause to stop accumulation sooner to
allow maximum generation in high-price periods if the periods do not last enough to empty the
full reservoir. Maneuverability is only possible for periods when production can exceed the inflows
in order to create enough space to store inflows and avoid spilling. If the model allows for perfect
maneuverability of water, Hveding’s conjecture establishes that plants can be considered as a
single aggregate plant and reservoirs can be seen as a single aggregate reservoir. At optimum, all
plants should be emptied at the same time. However, in reality it will be quite unlikely for this to
happen. In order to further understand the maneuverability of water in a multi-plant model and the
optimal management of energy generation Appendix 4 offers a detailed explanation of Hveding’s
conjecture.

Coupled Hydropower

In hydropower systems it is common to have plants that operate in the same river system. The
water released in one hydropower plant is then stored and used by another hydropower plant
downstream. While the reasoning is quite straightforward and it is briefly explained in Appendix

35
5 and more details can be found in the book Hydropower Economics by Finn Førsund. In order to
maintain a higher level of simplicity for the analysis of the Mexican electricity market further
ahead the applied models to specific regions will not include coupled hydropower constraints.
Coupled hydropower can be added to the region-specific models if desired to provide further
insight of the market’s behavior. Environmental constraints on water release become increasingly
relevant in coupled systems since it is necessary to maintain water flows and levels at a certain
rate to avoid damaging the ecosystem and aquatic life. The possible environmental restrictions are
also covered in Appendix 5 to complement coupled hydropower. While all of these constraints can
be added straightforwardly to the models the equations become very large and may not be practical
for pedagogical purposes.

36
 6. Mix of Thermal and Hydropower Generators

So far we have covered mostly what can be applied to the Norwegian electricity market with
mostly all power being generated with hydropower. On the other hand, Mexico is a perfect
example of a mixed energy model in which thermal, hydro and renewable energies participate in
the total electricity generation in the country. In Mexico 75% of the power is generated using fossil
fuels with an important participation of hydro and growing wind power participation. The
operation of thermal plants is a static problem as opposed to the dynamic nature of hydropower.

A special characteristic of the thermal power technology is that the technology and its scale vastly
change the fixed and variable costs. The variable costs of thermal energy come from the type of
fuels that they use to generate electricity. Technology can be chosen to have lower investment
costs and higher variable costs or vice versa. The former is optimal for peak periods while the
latter is optimal to use as base load. This interaction becomes highly relevant when a mix with
hydro is involved. Taking into account the existence of different electric regions that operate
specific mixes of technology different types of interaction between them will occur when
describing the social planning problem.

The types of fuels used for thermal plants include coal, oil, gas, wood, and even uranium can be
considered to define the energy sources available. All of these inputs have a price in the market
and the variable costs may not be negligible as opposed to wind or hydropower. These costs will
be included in the social planning problem in order to properly maximize the consumer and
producer’s surplus. However, generation through fossil fuels contribute for widespread
environmental problems. Global and local pollutants include sulfur, nitrous oxide, suspended
particles and most importantly carbon dioxide. Many countries have committed to reduce their
emissions due to the latent danger of global warming and its effects on our lifestyles and
ecosystems. The “cleanest” fossil fuel to be burned is natural gas while coal and oil burning has
more adverse effects on the environment so replacing dirtier technologies for cleaner ones has
become a rising trend through many countries and can be considered investments on abatement.
In addition, emissions originated by nuclear power are mostly non-existent but nuclear waste
management is a long-term problem created by this technology. Despite the bad reputation of
nuclear power due to the accidents that have been experienced in Chernobyl and Fukishima, the
probability of this happening is quite low.

37
The basic short-run production function for thermal energy and its emissions have the following
properties:

𝜕𝑓𝑖𝑡 𝜕𝑓𝑖𝑡
𝑒𝑖𝑡𝑇ℎ = 𝑓𝑖𝑡 (𝐸𝑖𝑠,𝑡 , 𝐿𝑖𝑡 ), > 0, ≥ 0, 𝑖 = 1, … , 𝑀, 𝑠 = 1, … , 𝑆
𝜕𝐸𝑖𝑠,𝑡 𝜕𝐿𝑖𝑡
𝜕𝑔𝑖𝑝,𝑡 𝜕𝑔𝑖𝑝,𝑡
𝑧𝑖𝑝,𝑡 = 𝑔𝑖𝑝,𝑡 (𝐸𝑖𝑠,𝑡 , 𝐿𝑖𝑡 ), > 0, ≤ 0, 𝑝 = 1, … , 𝑃 (6.1)
𝜕𝐸𝑖𝑠,𝑡 𝜕𝐿𝑖𝑡

Where 𝑒𝑖𝑡𝑇ℎ is the thermal energy generated by the plant i using 𝐸𝑖𝑠,𝑡 and 𝐿𝑖𝑡 as the fuel and labor
vectors respectively. 𝑧𝑖𝑝,𝑡 is the emission vector. Nevertheless, the labor vector may have no
influence if the related labor has no effect in output but rather supervises the operation processes.
Capital is included in the functional form. Technology change is also included in the production
function.

Minimizing cost functions for electricity generation is needed considering the fuel prices and the
labor costs in the short run while respecting an imposed emission cap. The cost function will have
standard assumptions for convex functions and will describe the price path of fuels in the short
run. The cost functions will then be a function of electricity production and will be increasing:

𝑇ℎ
𝑐𝑖𝑡 = 𝑐𝑖 (𝑒𝑖𝑡𝑇ℎ ), 𝑐′𝑖 > 0, 𝑐′′𝑖 > 0, 𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 , 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇 (6.2)

However, operations of the plants frequently cease when the utilization rate drops below 40%. The
plants are designed to have the lowest costs at maximum production, and following a convex curve
the costs below a utilization rate of 40% are too high. Further ahead shutdown and starting costs
will be introduced. The operation costs also vary according to the demand type for which the plant
is generating. For base energy the cost is the cheapest, followed by shoulder and, finally peak
energy. The interpretation is straightforward as for increasing demand levels the costs of
generating rise in turn. As demand for fuels rise the price might rise too and shifts the cost curve
upwards. It is also possible to include the emission cap and express it as an increasing function of
energy production. It is mathematically consistent to then minimize the total cost of generation to
reach the maximum output by:

min ∑ 𝑐𝑖 (𝑒𝑖𝑡𝑇ℎ )
𝑖=1

38
Subject to

∑ 𝑒𝑖𝑡𝑇ℎ ≥ 𝑒𝑡𝑇ℎ
𝑖=1
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (6.3)
𝑀

∑ 𝑧𝑖𝑡 ≤ 𝑧𝑡
𝑖=1

𝑒𝑖𝑡𝑇ℎ , 𝑧𝑖𝑡 ≥ 0
𝑇ℎ
𝑒𝑡𝑇ℎ , 𝑒𝑖 , 𝑧𝑡 𝑔𝑖𝑣𝑒𝑛, 𝑖 = 1, … , 𝑀 𝑡 = 1, … , 𝑇

Where by simplifying the multi-output model by Frisch (1965) we substitute the pollutant as a
function of generation:

𝑧𝑖𝑡 = 𝑔𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ ), 𝑔′𝑖𝑡 > 0, 𝑖 = 1, … , 𝑀 (6.4)

Finding the following Lagrangian:

𝑀 𝑀 𝑀 𝑀
𝑇ℎ
𝐿= − ∑ 𝑐𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝑣 (− ∑ 𝑒𝑖𝑡𝑇ℎ + 𝑒𝑡𝑇ℎ ) − ∑ 𝜃𝑖 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑡 ) − 𝜇(∑ 𝑔𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ ) − 𝑧𝑡 ) (6.5)
𝑖=1 𝑖=1 𝑖=1 𝑖=1

Adapted to be compared to a maximization problem to find the first order conditions:

𝜕𝐿
= −𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) + 𝑣 − 𝜃𝑖 − 𝜇𝑔′ 𝑖𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝑀

𝑣 ≥ 0 (= 0 𝑓𝑜𝑟 ∑ 𝑒𝑖𝑡𝑇ℎ > 𝑒𝑖𝑇ℎ (6.6)

𝑖=1
𝑇ℎ
𝜃𝑖 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 )
𝑀

𝜇 ≥0 (= 0 𝑓𝑜𝑟 ∑ 𝑔𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ ) < 𝑧𝑡 )

𝑖=1

The objective function is concave and the constraints are convex in the social planning problem
and a plant will not be used if the total production shadow price is lower than its marginal cost.
The capacity constraint is zero since the plant i is not used and the marginal costs will remain equal
with non-binding constraints. However, if the production constraint increases then the costs also
increase. The equilibrium is found where the costs of the fully used and partially used plants are

39
equal while accounting for costs of the environmental constraints. This way the plants with the
highest costs will produce below their maximum capacity while more efficient plants will be fully
utilized. The environmental constraints are becoming increasingly important in Mexico, with
ambitious goals to reduce emissions in the following years. The further in the future we analyze
the Mexican case, the stricter the environmental policies and the higher the costs of emissions.
This goes in line with the model and the lower participation of thermal power will be triggered by
environmental policies rather than by increasing fuel costs, then for partially and fully used plants
the optimum is found at:

𝑇ℎ
𝑐 ′ 𝑖′ (𝑒𝑖 ) + 𝜃𝑖′ + 𝜇𝑔′𝑖′ 𝑡 = 𝑐 ′ 𝑖′′ (𝑒𝑖𝑇ℎ
′ 𝑡 ) + 𝜇𝑔′𝑖 ′′ 𝑡 = 𝑣 (6.7)

The complete Mexican energy mix

Now that we have covered the theory behind the relevant technologies to be considered in the
Mexican energy mix for electricity production the total model can be developed. We still assume
that electricity is a homogenous good no matter the technology used to produce it. The energy
balance equation will now include the three types of electricity and the relevant constraints for
each of them. The social planning problem will now include the costs incurred by the use of fossil
fuels and the objective is to maximize de producer and consumer surplus. In order to make the
model more realistic the reservoir constraint will be introduced directly in the optimization
problem. For simplicity we will not cover the aggregated model in this section.

𝑇 𝑥𝑡

max ∑ [ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − 𝑐(𝑒𝑡𝑇ℎ )]

𝑡=1 𝑧=0

Subject to

𝑥𝑡 = 𝑒𝑡𝐻 + 𝑒𝑡𝑊 + 𝑒𝑡𝑇ℎ

𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻
𝑅𝑡 ≤ 𝑅 (6.8)
𝑇ℎ
𝑒𝑡𝑇ℎ ≤ 𝑒
𝑥𝑡 , 𝑒𝑡𝐻 , 𝑅𝑡 , 𝑒𝑡𝑇ℎ ≥ 0, 𝑡 = 1, … , 𝑇
𝑇ℎ
𝑇, 𝑒𝑡𝑊 , 𝑅0 , 𝑅, 𝑤𝑡 , 𝑒 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑇 𝑓𝑟𝑒𝑒

40
The Lagrangian function for the social problem is

𝑇 𝑒𝑡𝐻 +𝑒𝑡𝑊 +𝑒𝑡𝑇ℎ 𝑇 𝑇

𝑇ℎ
𝐿 = ∑[ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − 𝑐(𝑒𝑡𝑇ℎ )] − ∑ 𝜃𝑡 (𝑒𝑡𝑇ℎ − 𝑒 ) − ∑ 𝜆𝑡 (𝑅𝑡 − 𝑅𝑡−1 − 𝑤𝑡 + 𝑒𝑡𝐻 )
𝑡=1 𝑧=0 𝑡=1 𝑡=1

− ∑ 𝛾𝑡 (𝑅𝑡 − 𝑅) (6.9)
𝑡=1

The necessary first-order conditions we find for this Lagrangian are:

𝜕𝐿
= 𝑝𝑡 (𝑒𝑡𝐻 + 𝑒𝑡𝑊 + 𝑒𝑡𝑇ℎ ) − 𝜆𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝐻 > 0)
𝜕𝑒𝑡𝐻
𝜕𝐿
= 𝑝𝑡 (𝑒𝑡𝐻 + 𝑒𝑡𝑊 + 𝑒𝑡𝑇ℎ ) − 𝑐 ′ (𝑒𝑡𝑇ℎ ) − 𝜃𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝑇ℎ > 0)
𝜕𝑒𝑡𝑇ℎ
𝜕𝐿
= −𝜆𝑡 + 𝜆𝑡+1 − 𝛾𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 > 0) (6.10)
𝜕𝑅𝑡
𝜆𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 )
𝛾𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅)
𝑇ℎ
𝜃𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝑇ℎ < 𝑒 ) , 𝑡 = 1, … , 𝑇

We assume that electricity generation is positive in all periods so either hydro or thermal or both
are needed since wind power cannot offer base load production. Thermal will not be used when:

𝑐 ′ (0) > 0 (6.11)

And due to the complementary slackness condition 𝜃𝑡 = 0. Then combining the first and second
condition, hydropower will not be used when

𝑝𝑡 (𝑥𝑡 ) = 𝑐 ′ (𝑒𝑡𝑇ℎ ) + 𝜃𝑡 ≤ 𝜆 (6.12)

If the social price is lower than the water value, then the water will be stored to be used in a higher
price period. In this case hydro will be used only in case in which thermal and wind power capacity
is not enough to cover the demand. According to the distribution of hydropower in Mexico there
will be some regions in which hydropower will only be used in one period, which is the period
with the highest price. This will happen especially in the northern and center regions where the
share of hydropower is quite small and can be used to cover peak demand.

41
If the reservoir constraint is not binding hydro and thermal will be used constantly in all periods
when the social price is equal to the water value and equal to the marginal cost of thermal
generation plus the shadow price of the capacity constraint:

𝑝𝑡 (𝑥𝑡 ) = 𝜆 = 𝑐 ′ (𝑒𝑡𝑇ℎ ) + 𝜃𝑡 (6.13)

However due to the reservoir constraint in (6.10) the thermal capacity may vary between periods.
This is relevant in periods with a threat of overflow since higher water releases will lower the
social price and thermal power will be then used for higher price periods to cover the peak-load.
Also, the presence of wind power may cause fluctuations in the price due to its intermittency, but
most of the wind power plants are located in the southern region, with hydro playing the major
role in generation. A bathtub diagram can be used to show a possible situation in a mixed energy
model.

In this graph AD represents the total capacity with inflows from AC and CD with a storage capacity
at BC. In our example wind power is also participating in electricity generation. More power is
available so the hydropower and thermal power demand curves are pushed down since the prices
lower due to increased supply. Thermal power will be produced for higher price periods as in AA’
and DD’ and more thermal will be generated in higher price periods. The price change comes from
a binding reservoir constraint and water is still being stored for the higher price period. Since
thermal power is not fully utilized then the water value is equal to the marginal thermal costs. From
the price difference, thermal power is used as base load in the first period and as peak load in the
second period. We choose hydro as base load in the second due to a higher water value. These
situations will arise when studying the specific cases for the electric regions in Mexico and will
vary accordingly to the participation of thermal and hydro in each of them. This bathtub diagram
can be easily modified to aid the explanation of the dynamics in the model.

42
 Figure 6.1. Bathtub diagram for mixed power with binding reservoir constraint.
Source: Hydropower Economics, Finn Førsund, 2011, p. 120.

Multiple producers in a mixed energy model

Now we will create an aggregated model for multiple producers in hydro and thermal power
keeping the production and reservoir constraints. In this model we will determine that each specific
plant will have the characteristics to become either base or peak load. The planning problem can
be described as follows:

𝑇 𝑥𝑡 𝑀

max ∑ [ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )]

𝑡=1 𝑧=0 𝑖=1

Subject to

𝑁 𝐿 𝑀

𝑥𝑡 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + ∑ 𝑒𝑖𝑡𝑇ℎ

𝑗=1 𝑙=1 𝑖=1

𝑅𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (6.14)

43
 𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗

𝑥𝑡 , 𝑒𝑖𝑡𝐻 , 𝑅𝑗𝑡 , 𝑒𝑖𝑡𝑇ℎ ≥ 0,

𝑇ℎ
𝑇, 𝑒𝑙𝑡𝑊 , 𝑅𝑗0 , 𝑅𝑗 , 𝑤𝑗𝑡 , 𝑒 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒
𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑡 = 1, … , 𝑇

The first constraint represents the energy balance in an aggregated model for hydro, thermal, and
wind power generation plants. The rest of the will have the same interpretation as before but we
are now interested in the relationship and optimal management of both hydro and thermal power
for multiple producers. Also, we will still assume that the time period chosen is short enough to
see changes in technology and will only focus on price changes for optimal generation. The
Lagrangian for the social problem in (6.14) now becomes:

∑𝑁 𝐻 𝐿 𝑊 𝑀 𝑇ℎ
𝑗=1 𝑒𝑗𝑡 + ∑𝑙=1 𝑒𝑙𝑡 +∑𝑖=1 𝑒𝑖𝑡
𝑇 𝑀 𝑇 𝑁

𝐿=∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) − ∑ ∑ 𝜆𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 + 𝑣𝑗𝑡 )

𝑡=1 𝑧=0 𝑖=1 𝑡=1 𝑗=1
[ ]
𝑇 𝑁 𝑇 𝑁 𝑇 𝑀
𝐻 𝑇ℎ
− ∑ ∑ 𝛾𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗 ) − ∑ ∑ 𝜌𝑗𝑡 ( 𝑒𝑗𝑡𝐻 − 𝑒𝑗 ) − ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑖 ) (6.15)
𝑡=1 𝑗=1 𝑡=1 𝑗=1 𝑡=1 𝑖=1

The first-order conditions are:

𝑁 𝐿 𝑀
𝜕𝐿
= 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + ∑ 𝑒𝑖𝑡𝑇ℎ ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝑗=1 𝑙=1 𝑖=1

𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (6.16)
𝜕𝑅𝑗𝑡
𝑁 𝐿 𝑀
𝜕𝐿
= 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + ∑ 𝑒𝑖𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝑗=1 𝑙=1 𝑖=1

𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ),
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ) , 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

44
The prices vary since water values become plant specific due to the reservoir dynamics and the
interaction with wind and thermal power plants and the demand. Thermal plants would now run
when the social price is:

𝑁 𝐿 𝑀

𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + ∑ 𝑒𝑖𝑡𝑇ℎ ) ≤ 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ), 𝑡 = 1, … 𝑇 (6.17)

𝑗=1 𝑙=1 𝑖=1

The production of thermal power is not directly related to the reservoir levels of the individual
plants but the energy produced by them affects the price and, thus, production indirectly. As the
social problem now includes individual plants the variation between prices will be large but the
tendency is to have higher prices in peak periods compared to base load hours. For the partially
used plants the capacity constraint is not binding so the social price has to be equal to the marginal
cost of partially used plants and fully utilized plants accounting for the capacity constraint. Strictly
speaking base-load plants have to be operating at all times either fulfilling the full or partial
capacity constraint. Base load plants are run at all times, but peak load plants will run in peak load
periods under the same conditions as in base load periods. Then combining the first order
conditions for base-load production then the shadow price of water and the capacity constraint
should equal marginal cost with the respective thermal capacity constraint which must add up to
the social price:

𝑁 𝐿 𝑀
𝑇ℎ
𝜆𝑗𝑡 + 𝜌𝑗𝑡 = 𝑐 ′
𝑖 (𝑒𝑖𝑡 ) + 𝜃𝑖𝑡 = 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + ∑ 𝑒𝑖𝑡𝑇ℎ ) 𝑓𝑜𝑟 𝑏𝑎𝑠𝑒𝑙𝑜𝑎𝑑 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 (6.18)
𝑗=1 𝑙=1 𝑖=1

Using this definition and the characteristics of hydropower (which have no variable costs) we can
determine that hydropower plants with smaller reservoirs and larger inflows will produce in more
periods than plants with larger reservoirs due to the fact that they can store less water for higher
period prices. Then hydropower plants will not be used if the water value is higher than the current
price. In Mexico larger hydropower plants are located in the southern regions, so this condition
will become relevant in their analysis.

Thermal power plants have costs associated with them being turned off to a cold state and start-up
costs to bring them to production mode. This is called being in a spinning state and most of the
costs originate from burning fossil fuels. However, these costs are associated with individual plants

45
but they may not be as important when dealing with the aggregate supply. Since the study of the
Mexican market considers the different systems at an aggregate level, these costs will not be
studied in large detail. The cost function for thermal energy considering 3 periods would be:

𝑐𝑖𝑡 = 𝑐𝑖 (𝑒𝑖𝑡𝑇ℎ ) = 𝑎𝑖 + 𝑏𝑖 𝑒𝑖𝑡𝑇ℎ , 𝑖, 𝑡 = 1, . . ,3, (6.19)

Where 𝑎𝑖 is the start-up cost of plant i when it is tuned off in a period and is started up in later
periods assuming technical feasibility to do so. The profitability of knowing when to keep a
thermal plant spinning or closing it down are seen more in detail by Førsund, 2011.

46
 7. Regional models with trade

It is very realistic to include trade in electricity generation. This comes particularly relevant due to
the important differences in generation and technologies used in the electric regions in Mexico.
Also in order to specify the flows the transmission system will have to be specified. To begin on
the trade modeling only one interconnector will be assumed. Trade was present in Mexico well
before the recently published Energy Reform, but international trade may become a growing sector
in the coming years.

In order to introduce trade in our model money has to be a variable to consider. The value of the
export variable will be either positive or negative which in turn will represent exports and imports
respectively. The imports or exports will be added or subtracted from the demand curve and utility
can be separated in electricity and money. The simpler model is described by Førsund but the
aggregate model will be covered and later the transmission constraint will be introduced.

Thus the energy balance involving export and imports would become:

𝑁 𝐿

𝑥𝑡𝐻 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
− 𝑒𝐻,𝑡 , 𝑡 = 1, … , 𝑇 (7.1)
𝑗=1 𝑙=1
𝑀

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ − 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
+ 𝑒𝐻,𝑡
𝑖=1

Where 𝑒𝑡𝑋𝐼 is net trade and it is positive for export and negative for import. There can only be
export or import or it can be zero. The trade constraint will be directly introduced to the model.
The social planning problem will now be:

𝑇 𝑥𝑡𝐻 𝑥𝑡𝑇ℎ 𝑀

max ∑ [ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )]

𝑡=1 𝑧=0 𝑧=0 𝑖=1

Subject to

𝑁 𝐿

𝑥𝑡𝐻 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
− 𝑒𝐻,𝑡
𝑗=1 𝑙=1

47
 𝑀

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ − 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
+ 𝑒𝐻,𝑡
𝑖=1

𝑅𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (7.2)
𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗
𝑋𝐼 𝑋𝐼 𝑋𝐼 𝑋𝐼
𝑒𝐻,𝑡 ≤𝑒 , 𝑒𝑇ℎ,𝑡 ≤𝑒
𝑥𝑡𝐻 , 𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝐻 , 𝑅𝑗𝑡 , 𝑒𝑖𝑡𝑇ℎ , 𝑒𝐻,𝑡
𝑋𝐼 𝑋𝐼
, 𝑒𝑇ℎ,𝑡 ≥ 0,
𝑇ℎ
𝑇, 𝑒𝑙𝑡𝑊 , 𝑅𝑗0 , 𝑅𝑗 , 𝑤𝑗𝑡 , 𝑒 , 𝑒𝑡𝑋𝐼 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒
𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼 𝑋𝐼
Where 𝑒𝐻,𝑡 and 𝑒𝑇ℎ,𝑡 are the net trade of hydro and thermal respectively, being export if positive
and import if negative. The Lagrangian for the social problem substituting for the energy balance
equation will be:

∑𝑁 𝐻 𝐿 𝑊 𝑋𝐼 𝑋𝐼
𝑗=1 𝑒𝑗𝑡 + ∑𝑙=1 𝑒𝑙𝑡 +𝑒𝑇ℎ,𝑡 −𝑒𝐻,𝑡 ∑𝑀 𝑇ℎ 𝑋𝐼 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 −𝑒𝑇ℎ,𝑡 +𝑒𝐻,𝑡
𝑇 𝑀

𝐿=∑ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )

𝑡=1 𝑧=0 𝑧=0 𝑖=1
[ ]
𝑇 𝑁 𝑇 𝑁 𝑇 𝑁
𝐻
− ∑ ∑ 𝜆𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 ) − ∑ ∑ 𝛾𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗 ) − ∑ ∑ 𝜌𝑗𝑡 ( 𝑒𝑗𝑡𝐻 − 𝑒𝑗 )
𝑡=1 𝑗=1 𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑀 𝑇
𝑇ℎ 𝑋𝐼
− ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑖 ) 𝑋𝐼
− ∑ 𝛼𝐻,𝑡 (𝑒𝐻.𝑡 −𝑒 )
𝑡=1 𝑖=1 𝑡=1
𝑇
𝑋𝐼 𝑋𝐼
− ∑ 𝛼 𝑇ℎ,𝑡 (𝑒𝑇ℎ,𝑡 −𝑒 ) (7.3)
𝑡=1

Where 𝛼𝐻,𝑡 and 𝛼𝑇ℎ,𝑡 are the shadow prices on the trade constraint. The first order conditions
will now be:

𝜕𝐿
= 𝑝𝑡𝐻 (𝑥𝑡𝐻 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 𝑡 + 𝑝𝑡 (𝑥𝑡 ) − 𝛼𝐻,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 > 0)
𝜕𝑒𝐻,𝑡

48
 𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (7.4)
𝜕𝑅𝑗𝑡
𝜕𝐿
= 𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = 𝑝𝑡 𝑡 − 𝑝𝑡 (𝑥𝑡 ) − 𝛼 𝑇ℎ,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)
𝜕𝑒𝑇ℎ,𝑡
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 − 𝑣𝑗𝑡 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ),
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ) ,
𝑋𝐼 𝑋𝐼
𝛼𝐻,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 <𝑒 )
𝑋𝐼 𝑋𝐼
𝛼 𝑇ℎ,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 < 𝑒 ), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

In this social planning problem, we find time-specific and plant-specific water values as shown in
the first condition. Here we are also taking into account the motion of the reservoirs’ shadow prices
and if hydropower and thermal power are generated their respective condition holds with equality.
Then also if hydropower and thermal power is exported then their respective conditions hold with
equality and it must be in line with their export conditions to hold with equality. In addition, social
prices in the countries must be in equilibrium as long as the constraints are not binding due to the
complementary slackness conditions. Now the prices between thermal and hydro may be different
and, due to the reservoir constraint the hydro price would be higher. It is then important to consider
that it may be optimal to export thermal power in order to transfer production to hydro in high
price periods. But in the case that the export constraint on thermal power is not binding then from
the complementary slackness and the thermal exports conditions prices have to be zero. Wind is
included in the hydropower social price as it behaves as run-of-the-river power and a higher supply
may push hydropower prices down.

If the capacity constraint on thermal is not binding, then the price is equal to its marginal cost and
if the hydropower capacity constraint is not binding the social price will be equal to the shadow
value. The importance of the capacity constraints is that they will play a role in the optimal
production for exports and home consumption, with a difference of their respective multiplier. If
the trade constraints are binding then there may exist different prices between countries or regions,

49
e.g. if the export constraint is binding then more energy will have to be used in the home country
in order to avoid spilling and then the social price will be lower. The opposite will happen if the
country is import constrained. An example of a bathtub diagram for trade in Figure 6.1 is presented
for two periods. Hydro is located in the middle with thermal extensions on each side. The hydro
floor goes from AD with available water AC and CD in period 1 and 2 respectively. BC is the
storage capacity that can be transferred to period 2. The autarky solution for hydro is represented
by the dotted lines. The reservoir constraint creates a price difference and difference in water
values too. The country specific prices are represented by the horizontal dotted lines and they are
equal for both periods in autarky.

If the countries open up for trade, then the hydro wall will shift to the left and the thermal wall for
period will shift to the right to make room for imports. The thermal price is lower than hydro in
period 1 in autarky while it is higher in period 2. The equilibrium price with trade becomes slightly
lower than in autarky but the water use changes importantly since a full reservoir is transferred to
the second period. It is important to consider also the generation constraint on hydropower which
in turn would lower the amount of water transferred to the second period if it becomes binding.
With a maximal amount now saved for the second period and exports to thermal will be done
expressed by DD’. The difference between the prices in the two periods is depicted by the shadow
price on the reservoir constraint and the price in the second period does not decrease enough to
generate more thermal energy. The shadow price on thermal is decreased and thermal usage may
be transferred to future periods. On the other hand, hydro has now a higher social price compared
to the autarky price, less water is used at home due to export and less electricity will be consumed.
However, in period 1 the situation is the opposite and Thermal gets a deficit in trade while Hydro
experiences a surplus since the equilibrium price is higher when hydro exports compared to when
it imports. The situation for Thermal power is the opposite. If the transmission constraints become
binding for Thermal, then a lower consumption and lower import will happen and the price on
thermal will increase in period 2. Hydro will export less due to the transmission constraint reducing
the surplus and lowering the social price. Consumption will be increased and the exports from
thermal will be reduced while hydro will consume more water in both periods.

50
 Figure 7.1. Hydro and Thermal power trade with binding constraints.
Source: Hydropower Economics, Førsund, 2011, p. 157.

The transmission general model

The existence of a network may not directly affect the dynamics of a hydropower system but it
may influence the quantitative solutions for thermal generation. If a transmission system is made
explicit we have to address the fact that electricity is lost in the network due to heat creation, losing
2-3% in high-voltage transmission in national and regional grids and 5-15% in low-voltage
networks. The relevant losses to consider in the analysis of the Mexican electricity market will be
the high-voltage losses since the study focuses on the specific situations for each region and their
interaction with other regions. The physical laws governing the transmission networks will not be
covered in this study but the aim is to find the most cost-efficient way to establish a transmission
node of generation and a consumption node. Several generators can be within a node and different
type of consumers too. The location of hydropower plants is determined by the availability of
resources but that is not the case with thermal power plants. If hydropower is involved the overlap
of consumption and generation nodes may not be too big, but it may become a possible situation
if thermal power generation plants are located within the same node as the consumers.

However, modeling the specific situation of each of the Mexican electric regions has become
increasingly complex. Introducing transmission into the model may increase the complexity to

51
such level that in order to obtain the corresponding accurate qualitative conclusions out of it may
be a field for further study. Nevertheless, a brief explanation of the general transmission model
will be included in Appendix 6 in order to understand how generation and consumption link in
order to avoid disregarding its importance.

52
 8. Region specific models for the Mexican system

After analyzing the possibilities in a mixed electricity model with thermal and hydro plus
intermittent energy represented by wind and the respective constraints that play a role in the social
price formation we can now extrapolate the model to the specific situations in the Mexican
electricity system. So far the information regarding the Mexican electricity system shows us that
the country is divided by different electric regions, where they are interconnected and electricity
flows from one region to another. Trade is present in the model and due to geographical positioning
trade is mostly viable for a region with 1 or more regions at a time. However, to maintain the
current path of the study we will focus on bilateral trading models with the corresponding
interpretation of the results of each model. The northern regions mostly generate power through
thermal resources while the southern regions have a strong participation of hydropower in their
systems. Each system will be addressed individually and a region-specific model will be provided
for each one of them. The regions to consider will be the Northwest, North, Northeast, Center,
South, and Peninsular regions. The Baja California and Baja California Sur systems are completely
isolated from the National Electric System and are almost entirely run by thermal power. On the
other hand, the Baja California Sur system has no trade and the Baja California system barely
trades electricity with the United States despite of being part of the same grid. It is then safe to
assume that a pure thermal model will apply in these to special cases and do not provide additional
information for the price formation in mainland Mexico. There are plans to interconnect these
regions in the future as demand and infrastructure grows but that issue may be addressed in further
studies after the proposed expansion of the grid is fulfilled.

In order to study the specific characteristics of each region the technologies used and the regions
to which they are interconnected will be specified. If a region is interconnected to more than one
region alternative models will be presented according to the specific interaction between them.
The in this section is to use the theory presented to find optimums of the social planning problem
adapting it to each region and qualitative information will be deduced from the results of the model.

53
Northwest-North model

The northwest region is home to an important proportion of the deserts in the country. The climate
is dry and hydroelectric resources are scarce. In total, hydropower stands for approximately 6% of
the total energy generation in the region. This figure has been decreasing as the years go by since
there are no water resources that can be exploited in the sense of reservoirs, but we can consider
intermittent energy. As the demand of the region grows, hydropower is expected to become
decreasingly significant to power generation in the area. However, combining geothermal energy
and the run-of-the-river hydro intermittent energy does play a role in generation. Thus, hydropower
and the management of water may not be sufficiently significant to create price changes and affect
the optimal solutions. The Northwest region is connected to the North and Southern tariff region.

The model for the Northwest region considering a multi-plant scheme and trade with the North
region would become:

𝑇 𝑥𝑡𝑇ℎ 𝑀

max ∑ [ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑡𝑋𝐼 ]

𝑧=0 𝑧=0 𝑖=1

Subject to

𝑀 𝐿

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ + ∑ 𝑒𝑙𝑡𝐼 − 𝑒𝑇ℎ,𝑡

𝑋𝐼

𝑖=1 𝑙=1
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (8.1)
𝑋𝐼 𝑋𝐼 𝑋𝐼
−𝑒 𝑇ℎ ≤ 𝑒𝑇ℎ,𝑡 ≤ 𝑒 𝑇ℎ
𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝑇ℎ ≥ 0, 𝑋𝐼
𝑒𝑇ℎ,𝑡 𝑢𝑛𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 𝑠𝑖𝑔𝑛
𝑋𝐼 𝑇ℎ
𝑇, 𝑒𝑙𝑡𝐼 , 𝑒 𝑇ℎ , 𝑒𝑖 𝑔𝑖𝑣𝑒𝑛
𝑙 = 1, … , 𝐿, 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼
Where 𝑒𝑇ℎ,𝑡 is the net trade of thermal energy, being export if positive and import if negative. Also
𝑒𝑙𝑡𝐼 stands for intermittent energy generation in the system. The Lagrangian for the social problem
substituting for the energy balance equation will be:

54
 ∑𝑀 𝑇ℎ 𝐿 𝐼 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 +∑𝑙=1 𝑒𝑙𝑡 −𝑒𝑇ℎ,𝑡
𝑇 𝑀 𝑇 𝑀
𝑋𝐼
𝐿 = ∑[ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑡𝑋𝐼 ] − ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒 𝑇ℎ )
𝑧=0 𝑧=0 𝑖=1 𝑡=1 𝑖=1

𝑇 𝑇
𝑋𝐼 𝑋𝐼 𝑋𝐼 𝑋𝐼
− ∑ 𝛼𝑡 (𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ ) − ∑ 𝛽𝑡 (−𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ ) (8.2)
𝑡=1 𝑡=1

Where 𝛼𝑡 and 𝛽𝑡 are the shadow prices on the trade constraint. The first order conditions will be:
𝜕𝐿
= 𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝜕𝐿 𝑇ℎ 𝑇ℎ 𝑋𝐼 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 (𝑥𝑡 ) + 𝑝𝑡 − 𝛼𝑡 + 𝛽𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)
𝜕𝑒𝑇ℎ,𝑡
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ), (8.3)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛼𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 > 0)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛽𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 − 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 < 0), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

In this system there is no hydropower with reservoirs but it runs on thermal and a certain
percentage of intermittent energy taking run-of-the-river and geothermal energy. On the other hand
trade only includes thermal energy since the presence of hydropower goes down to 1% or less in
the northern region and intermittent energy is not meaningful either. The optimal generation is
defined by:

𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) = 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) + 𝜃𝑖𝑡 (8.4)

The first condition tells us that the price is equal to the marginal cost of generating thermal energy
if the capacity constraint is not binding. If the capacity constraint is binding the price will increase
due to a lower supply of electricity. At the same time the production of intermittent energy will
push the price further down. Considering the nature of the trade constraints only one of them can
be binding at a time. By combining the first and second conditions we find that there are two
possibilities for trade:

𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) + 𝜃𝑖𝑡 = 𝑝𝑡𝑋𝐼 − 𝛼𝑡

𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) + 𝜃𝑖𝑡 = 𝑝𝑡𝑋𝐼 + 𝛽𝑡 (8.5)

55
Interpreting these results, we find that it is quite realistic to have differences in prices of electricity
between regions, especially when different technologies are involved. The import price on
electricity will be equal to the social price in the North region. Taking into account equation (8.5)
we observe that in case that the export constraint is binding it will be optimal to export when home
prices are lower and to import when higher. This goes in line with intermittent energy increasing
the supply and pushing prices down; the oversupply generated by intermittent energy can be
compensated by exporting thermal to the North region pushing the price up again. However, if the
marginal cost of producing thermal power plus the shadow price on the constraint is higher than
the price of import due to a non-satiated demand imports will be made in order to increase
consumption by increasing supply and pushing prices down. It will be optimal to consume the
electricity produced with the lower marginal cost. In this model the costs of energy production will
depend mostly on the prices of fuels; the North region is the region with the highest coal
participation of them all. Then it is possible that on demand increases in a specific region more
costly fuels and less efficient plants would cover the excess demand in autarky but trade allows
replacing their generation with more efficient and possibly cleaner fuels.

North-Northwest Model

The model in this case is almost identical to the Northwest-North model. The only difference
becomes the absence of intermittent energy in the region. Hydropower accounts for less than 1%
of total generation and there are no significant intermittent generators either. The model has a pure
thermal power system and the social planning problem would be exactly the same as in (8.1) but
the social price would no longer be pushed down by intermittent energy generation. The
interpretation of the model remains the same, but with no alterations in the social price. The
Lagrangian and the first order conditions only change by eliminating intermittent energy from the
energy balance equation, where the social price is expressed as a function of the energy balance.

Northwest-South Model

The next case to be considered is the model for the Northwest region and its involvement in trade
with the South region. The South region does have an important participation of hydropower and
intermittent energy so the model will include the possibility to import hydropower to the northern
region. The social planning problem becomes:

56
 𝑇 𝑥𝑡𝑇ℎ 𝑥𝑡𝐻 𝑀

max ∑ [ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑇ℎ,𝑡

𝑋𝐼
]
𝑡=1 𝑧=0 𝑧=0 𝑖=1

Subject to

𝑀 𝐿

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ + ∑ 𝑒𝑙𝑡𝐼 − 𝑒𝑇ℎ,𝑡

𝑋𝐼

𝑖=1 𝑙=1
𝑋𝐼
𝑥𝑡𝐻 = 𝑒𝐻,𝑡
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (8.6)
𝑋𝐼 𝑋𝐼 𝑋𝐼
−𝑒 𝑇ℎ ≤ 𝑒𝑇ℎ,𝑡 ≤ 𝑒 𝑇ℎ
𝑋𝐼 𝑋𝐼
𝑒𝐻,𝑡 ≤ 𝑒𝐻
𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝑇ℎ , 𝑒𝐻,𝑡
𝑋𝐼
≥ 0, 𝑋𝐼
𝑒𝑇ℎ,𝑡 𝑢𝑛𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 𝑠𝑖𝑔𝑛
𝑋𝐼 𝑇ℎ 𝑋𝐼
𝑇, 𝑒𝑙𝑡𝐼 , 𝑒 𝑇ℎ , 𝑒𝑖 , 𝑒𝐻 , 𝑔𝑖𝑣𝑒𝑛
𝑙 = 1, … , 𝐿, 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼
Where 𝑒𝐻,𝑡 is the import of hydro energy. It is positive or equal to zero because hydropower can
only be imported or be equal to zero. Also 𝑒𝑙𝑡𝐼 stands for intermittent energy generation in the
system. The Lagrangian for the social problem substituting for the energy balance equation (8.7)
will be:

∑𝑀 𝑇ℎ 𝐿 𝐼 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 +∑𝑙=1 𝑒𝑙𝑡 −𝑒𝑇ℎ,𝑡
𝑋𝐼
𝑒𝐻,𝑡
𝑇 𝑀

𝐿 = ∑[ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑇ℎ,𝑡

𝑋𝐼
]
𝑡=1 𝑧=0 𝑧=0 𝑖=1

𝑇 𝑀 𝑇 𝑇
𝑋𝐼 𝑋𝐼 𝑋𝐼
− − ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒 𝑇ℎ ) − 𝑋𝐼
∑ 𝛼𝑡 (𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ ) − 𝑋𝐼
∑ 𝛽𝑡𝑇ℎ (−𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ )
𝑡=1 𝑖=1 𝑡=1 𝑡=1
𝑇
𝑋𝐼 𝑋𝐼
− ∑ 𝛽𝑡𝐻 (−𝑒𝐻,𝑡 − 𝑒𝐻 ) (8.7)
𝑡=1

Where 𝛼𝑡 and 𝛽𝑡 are the shadow prices on the trade constraint. The first order conditions will
now be:
𝜕𝐿 𝑇ℎ 𝑇ℎ ′ 𝑇ℎ 𝑇ℎ 𝜕𝐿 𝑇ℎ 𝑇ℎ 𝑋𝐼 𝑇ℎ
𝑇ℎ = 𝑝𝑡 (𝑥𝑡 ) − 𝑐 𝑖 (𝑒𝑖𝑡 ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡 > 0) 𝜕𝑒 𝑋𝐼 = −𝑝𝑡 (𝑥𝑡 ) + 𝑝𝑡 − 𝛼𝑡 + 𝛽𝑡
𝜕𝑒𝑖𝑡 𝑇ℎ,𝑡
𝑋𝐼
≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)

57
 𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝐻 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 𝑡 + 𝛽𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 > 0)
𝜕𝑒𝐻,𝑡
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ), (8.8)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛼𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 > 0)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛽𝑡𝑇ℎ ≥ 0 (= 0 𝑓𝑜𝑟 − 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 < 0)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛽𝑡𝐻 ≥ 0 (= 0 𝑓𝑜𝑟 − 𝑒𝐻,𝑡 < 𝑒𝐻 ), (𝑒𝐻,𝑡 < 0), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

The first condition tells us the same information as in the Northwest-North model where the social
price for thermal energy is equal to the marginal cost and the shadow price on the restriction on
capacity as in the equation (8.4). There is still export and import of thermal energy in the region
but now the third condition indicates that the price on hydro will be equal to the shadow price on
imports in case they are positive. If the social price of imported hydropower is lower than the home
price of thermal energy, hydropower will be imported until the prices between thermal power and
hydropower become equal. However, the amount of hydropower that can be imported is limited
and will be determined by 𝛽𝑡𝐻 . On the other hand, the remaining imports can be done for thermal
power if the social price is lower in the South compared to the price in the Northwest region. The
price differences between periods may be caused by the amount of intermittent energy produced
by the run-of-the-river and geothermal power plants in the Northwest, but more importantly by the
price changes caused by the fluctuating water value in the South region where hydropower is
importantly present. If the water value in the South region is higher in a specific period, power
would be generated and exported, e.g., if the water value is low in another period the Northwest
region may export electricity to the South region in the amount 𝛼𝑡 .

North-South Model

The similarities with the Northwest-South model remain, but the same principle applies to the
social problem proposed in equation (8.6). The intermittent energy that causes price fluctuations
disappears, but the differences in inflow and binding reservoir and capacity constraints in the south
may cause prices to vary, creating periods in which importing or exporting is optimal. The energy
balance equation in the north model will not have intermittent energy participation but the rest of
the constraints and shadow prices remain the same. The only variation will be the social price
which does not include renewable energy generation. On the other hand, the changing water values

58
due to the reservoir and production constraint in the southern region will cause the water values to
change, exporting while high and importing while low, obviously accounting for the constraints
on trade.

Northeast-South Model

The Northeast region has the same characteristics as the North region and the social planning
problem will be defined in the same way. Thus, the interaction with the southern region will also
be the same. The energy balance equation will consist only of thermal energy generation and trade
with the southern region of thermal power and imports of hydropower from the southern region
when the water value is higher. On the other hand, thermal exports will take place when the water
value is lower than the marginal cost of electricity generation in the North region. The first order
conditions and the interpretations remain the same as in the North-South model.

North-Northeast Model

The North-Northeast model is a purely thermal situation. Hydro resources are very scarce and
renewable energy is not relevant to the total energy generation. The production is so low that the
effects on the social price would be undetectable. The North and Northeast regions are very dry
regions and compared to the other regions in the country is where coal has still an important
participation on electricity generation. However, most of the electricity is generated by natural gas
and combined cycle plants. Nevertheless, in the North the use of coal for thermal generation may
create price differences with the Northeast region that relies mostly on natural gas resources. The
social planning problem can be defined:

𝑇 𝑥𝑡𝑇ℎ 𝑀

max ∑ [ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑡𝑋𝐼 ]

𝑡=1 𝑧=0 𝑖=1

Subject to

𝑀
𝑇ℎ
𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ − 𝑒𝑇ℎ,𝑡
𝑋𝐼
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (8.9)
𝑖=1
𝑋𝐼 𝑋𝐼 𝑋𝐼
−𝑒 𝑇ℎ ≤ 𝑒𝑇ℎ,𝑡 ≤ 𝑒 𝑇ℎ
𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝑇ℎ ≥ 0, 𝑋𝐼
𝑒𝑇ℎ,𝑡 𝑢𝑛𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑒𝑑 𝑠𝑖𝑔𝑛

59
 𝑋𝐼 𝑇ℎ
𝑇, 𝑒 𝑇ℎ , 𝑒𝑖 𝑔𝑖𝑣𝑒𝑛
𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼
Where 𝑒𝑇ℎ,𝑡 is the net trade of thermal energy, being export if positive and import if negative. The
Lagrangian for the social problem substituting for the energy balance equation will be:

∑𝑀 𝑇ℎ 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 −𝑒𝑇ℎ,𝑡
𝑇 𝑀 𝑇 𝑀
𝑇ℎ
𝐿 = ∑[ ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) + 𝑝𝑡𝑋𝐼 𝑒𝑡𝑋𝐼 ] − ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑖 )
𝑡=1 𝑧=0 𝑖=1 𝑡=1 𝑖=1

𝑇 𝑇
𝑋𝐼 𝑋𝐼 𝑋𝐼 𝑋𝐼
− ∑ 𝛼𝑡 (𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ ) − ∑ 𝛽𝑡 (−𝑒𝑇ℎ,𝑡 − 𝑒 𝑇ℎ ) (8.10)
𝑡=1 𝑡=1

Where 𝛼𝑡 and 𝛽𝑡 are the shadow prices on the trade constraint. The first order conditions will
now be:
𝜕𝐿 𝜕𝐿
= 𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 (𝑥𝑡 ) + 𝑝𝑡 − 𝛼𝑡 + 𝛽𝑡
𝜕𝑒𝑖𝑡𝑇ℎ 𝜕𝑒𝑇ℎ,𝑡
𝑋𝐼
≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ), (8.11)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛼𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 > 0)
𝑋𝐼 𝑋𝐼 𝑋𝐼
𝛽𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 − 𝑒𝑇ℎ,𝑡 < 𝑒 𝑇ℎ ), (𝑒𝑇ℎ,𝑡 < 0), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

In this scenario the thermal electricity social price equals the marginal cost of production plus the
shadow price on the capacity constraint. On the other hand, only one of the import or export
constraints can be binding due to the existence of a pure thermal power system. This means that
trade between regions will depend purely on the marginal costs of production. Since the North and
Northeast regions have very similar geographic and natural resource conditions, cost efficiency
will play a major role in determining the trade between them. It is safe to say that the Northeast
region has less costly and less pollutant fuels due to the availability of pipelines that connect the
United States and Mexico (used mostly for natural gas imports) and the technology used in the
plants. Coahuila, a state located in the North region of Mexico, is the main coal mining region in
the country. Thus, price variations may occur despite of having the same structure in the social
planning problem. When demand rises in the North region, more costly and more pollutant fuels
are used. An environmental constraint may be very relevant in this case to cap greenhouse

60
emissions. In the case that an environmental constraint is binding, production in the North region
may be reduced, pushing prices up due to non-satiated demand and imports to cover the missing
thermal power may be required.

South-Northwest model

Now we will study the models from the perspective of the South region, where hydropower has an
important participation in energy generation and it is the only region that interacts actively with
all the others. In this case the water values will be explicitly calculated and the behavior of the
electricity market. It is important to consider the bilateral trade models from the perspective of
each region since the generation is different in each of them and the effects on trade affects them
differently. Now we can define the South-Northwest social planning problem as the following:

𝑇 𝑥𝑡𝐻 𝑥𝑡𝑇ℎ 𝑀

max ∑ [ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )]

𝑡=1 𝑧=0 𝑧=0 𝑖=1

Subject to

𝑁 𝐿

𝑥𝑡𝐻 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
− 𝑒𝐻,𝑡
𝑗=1 𝑙=1
𝑀

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ − 𝑒𝑇ℎ,𝑡

𝑋𝐼

𝑖=1

𝑅𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (8.12)
𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗
𝑋𝐼 𝑋𝐼 𝑋𝐼 𝑋𝐼
𝑒𝐻,𝑡 ≤𝑒 , 𝑒𝑇ℎ,𝑡 ≤𝑒
𝑥𝑡𝐻 , 𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝐻 , 𝑅𝑗𝑡 , 𝑒𝑖𝑡𝑇ℎ , 𝑒𝐻,𝑡
𝑋𝐼 𝑋𝐼
, 𝑒𝑇ℎ,𝑡 ≥ 0,
𝑇ℎ
𝑇, 𝑒𝑙𝑡𝑊 , 𝑅𝑗0 , 𝑅𝑗 , 𝑤𝑗𝑡 , 𝑒 , 𝑒𝑡𝑋𝐼 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒
𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼 𝑋𝐼
Where 𝑒𝐻,𝑡 and 𝑒𝑇ℎ,𝑡 are the net trade of hydro and thermal respectively, being export if positive
and import if negative. However, the North region has no hydropower to export to the South region

61
 𝑋𝐼
so it will be safe to assume that the value of 𝑒𝐻,𝑡 will only appear as exports. The Lagrangian for
the social problem substituting for the energy balance equation will be:

∑𝑁 𝐻 𝐿 𝑊 𝑋𝐼 𝑋𝐼
𝑗=1 𝑒𝑗𝑡 + ∑𝑙=1 𝑒𝑙𝑡 +𝑒𝑇ℎ,𝑡 −𝑒𝐻,𝑡 ∑𝑀 𝑇ℎ 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 −𝑒𝑇ℎ,𝑡
𝑇 𝑀 𝑇 𝑁

𝐿=∑ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ ) − ∑ ∑ 𝜆𝑗𝑡 ( 𝑅𝑗𝑡

𝑡=1 𝑧=0 𝑧=0 𝑖=1 𝑡=1 𝑗=1
[ ]
𝑇 𝑁 𝑇 𝑁
𝐻
− 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 ) − ∑ ∑ 𝛾𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗 ) − ∑ ∑ 𝜌𝑗𝑡 ( 𝑒𝑗𝑡𝐻 − 𝑒𝑗 )
𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑀 𝑇
𝑇ℎ 𝑋𝐼
− ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑖 ) 𝑋𝐼
− ∑ 𝛼𝐻,𝑡 (−𝑒𝐻.𝑡 −𝑒 )
𝑡=1 𝑖=1 𝑡=1
𝑇
𝑋𝐼 𝑋𝐼
− ∑ 𝛼 𝑇ℎ,𝑡 (𝑒𝑇ℎ,𝑡 −𝑒 ) (8.13)
𝑡=1

Where 𝛼𝐻,𝑡 and 𝛼𝑇ℎ,𝑡 are the shadow prices on the trade constraint. The first order conditions
will now be:

𝜕𝐿
= 𝑝𝑡𝐻 (𝑥𝑡𝐻 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 𝑡 + 𝛼𝐻,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 > 0)
𝜕𝑒𝐻,𝑡
𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (8.14)
𝜕𝑅𝑗𝑡
𝜕𝐿
= 𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = 𝑝𝑡 𝑡 − 𝑝𝑡 (𝑥𝑡 ) − 𝛼 𝑇ℎ,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)
𝜕𝑒𝑇ℎ,𝑡
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ),
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ) ,
𝑋𝐼 𝑋𝐼
𝛼𝐻,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 <𝑒 )
𝑋𝐼 𝑋𝐼
𝛼 𝑇ℎ,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 < 𝑒 ), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

62
The water values will be plant and time specific and evaporation is taken into account in the first
condition. The south region also has an important amount of wind energy generation which is
included in the energy balance equation. The second condition indicates that the price on exported
hydropower will be equal to the shadow value on the trade constraint. The third condition tells us
that the shadow price on water is equal to the water value in the next period minus the shadow
price on the reservoir constraint. If there is trade of thermal energy, then the constraint will be
binding and if hydropower is exported then the export constraint will also be. The social prices in
the regions will be in equilibrium according to the complementary slackness conditions.

Wind and renewable energy increases the supply and pushes the social price down in both regions.
The capacity constraints play a role in the optimal production for exports and consumption
considering the shadow prices on the constraints. This means that if the trade constraints are
binding then more electricity will be consumed at the home country and to avoid spilling water the
price is pushed further down. If the import constraint is binding, then less energy will be available
and due to a non-satiated demand the price will be pushed up. Different prices may exist between
regions and it will be optimal to export in the periods when the price and the water value are higher.
Thermal energy will be imported in lower price periods. It is also important to consider the
hydropower capacity constraint which allows less water to be transferred to the high price period,
forcing more consumption in the lower price period and less power will be produced in the high
price period, but as the price becomes higher then there is a surplus in hydro exports. If the thermal
power constraint is binding, the price will increase and more exports will be made, while hydro
will export less.

South-North Model

The South-North model has only one difference from the South-Northwest model. The social
problem is designed in the same way but the price is not pushed down by renewable energy in the
North region. Hydropower will be produced in higher price periods and exported to the North
region. However, the first order conditions stay the same but demand will not vary due to
renewable energy production. In the same way water values are plant and time specific. Water can
be saved to higher price periods and import thermal power to cover the demand for electricity at
the home country. However, if the trade constraints are binding then less amount of energy can be
imported and more hydropower will be used to satiate demand. The similar effect will happen if

63
the water reservoir constraint is binding and less water can be transferred to the high price period,
more hydropower will be produced in order to avoid spilling and the price will be reduced. On the
other hand, if the thermal power constraint is binding the price will increase and more thermal
exports will be made. If the hydropower constraint becomes binding the price will become higher
and surplus in exports will occur. It is important to point out that the North region has an important
participation of coal in power generation. If environmental constraints become binding the thermal
power generation would be limited and the price would rise when demand rises. Then imports
from the southern region would increase to cover the demand.

South-Northeast Model

The South-Northeast model depicts the interaction between the mixed energy South region and the
purely thermal region of the Northeast. The characteristics of the social planning problem are the
same as the South-North model. The first order conditions are to be interpreted in the same way
and the respective constraints also remain the same. However, the Northeast region uses less
polluting fuels compared to the North region, so it is less likely that environmental constraints on
emissions will become binding. The optimal periods to generate hydropower will be in high price
periods while as much water as the reservoir constraint allows will be saved in low price periods.
The demand will be covered through thermal imports from the Northeast region taking into
account the transmission constraints.

South-Center Model

The Center region generates power through thermal and hydro. The model will become an
interaction between two mixed energy regions where water values will become important to
determine production and trade. However, renewable energy does not play an important role in the
Center region’s generation so intermittent energy will not have any effects on the price. The social
problem then becomes:

𝑇 𝑥𝑡𝐻 𝑥𝑡𝑇ℎ 𝑀

max ∑ [ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )]

𝑡=1 𝑧=0 𝑧=0 𝑖=1

64
Subject to

𝑁 𝐿

𝑥𝑡𝐻 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 + 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
− 𝑒𝐻,𝑡
𝑗=1 𝑙=1
𝑀

𝑥𝑡𝑇ℎ = ∑ 𝑒𝑖𝑡𝑇ℎ − 𝑒𝑇ℎ,𝑡

𝑋𝐼 𝑋𝐼
+ 𝑒𝐻,𝑡
𝑖=1

𝑅𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝑇ℎ
𝑒𝑖𝑡𝑇ℎ ≤ 𝑒𝑖 (8.15)
𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗
𝑋𝐼 𝑋𝐼 𝑋𝐼 𝑋𝐼
𝑒𝐻,𝑡 ≤𝑒 , 𝑒𝑇ℎ,𝑡 ≤𝑒
𝑥𝑡𝐻 , 𝑥𝑡𝑇ℎ , 𝑒𝑖𝑡𝐻 , 𝑅𝑗𝑡 , 𝑒𝑖𝑡𝑇ℎ , 𝑒𝐻,𝑡
𝑋𝐼 𝑋𝐼
, 𝑒𝑇ℎ,𝑡 ≥ 0,
𝑇ℎ
𝑇, 𝑒𝑙𝑡𝑊 , 𝑅𝑗0 , 𝑅𝑗 , 𝑤𝑗𝑡 , 𝑒 , 𝑒𝑡𝑋𝐼 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒
𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑖 = 1, … , 𝑀, 𝑡 = 1, … , 𝑇

𝑋𝐼 𝑋𝐼
Where 𝑒𝐻,𝑡 and 𝑒𝑇ℎ,𝑡 are the net trade of hydro and thermal respectively, being export if positive
and import if negative. The Lagrangian for the social problem substituting for the energy balance
equation will be:

𝑥𝑡𝐻 = ∑𝑁 𝐻 𝐿 𝑊 𝑋𝐼 𝑋𝐼
𝑗=1 𝑒𝑗𝑡 + ∑𝑙=1 𝑒𝑙𝑡 +𝑒𝑇ℎ,𝑡 −𝑒𝐻,𝑡 𝑥𝑡𝑇ℎ =∑𝑀 𝑇ℎ 𝑋𝐼 𝑋𝐼
𝑖=1 𝑒𝑖𝑡 −𝑒𝑇ℎ,𝑡 +𝑒𝐻,𝑡
𝑇 𝑀

𝐿=∑ ∫ 𝑝𝑡𝐻 (𝑧)𝑑𝑧 + ∫ 𝑝𝑡𝑇ℎ (𝑧)𝑑𝑧 − ∑ 𝑐(𝑒𝑖𝑡𝑇ℎ )

𝑡=1 𝑧=0 𝑧=0 𝑖=1
[ ]
𝑇 𝑁 𝑇 𝑁 𝑇 𝑁
𝐻
− ∑ ∑ 𝜆𝑗𝑡 (𝑅𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 ) − ∑ ∑ 𝛾𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗 ) − ∑ ∑ 𝜌𝑗𝑡 (𝑒𝑗𝑡𝐻 − 𝑒𝑗 )
𝑡=1 𝑗=1 𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑀 𝑇
𝑇ℎ 𝑋𝐼
− ∑ ∑ 𝜃𝑖𝑡 (𝑒𝑖𝑡𝑇ℎ − 𝑒𝑖 ) 𝑋𝐼
− ∑ 𝛼𝐻,𝑡 (𝑒𝐻.𝑡 −𝑒 )
𝑡=1 𝑖=1 𝑡=1
𝑇
𝑋𝐼 𝑋𝐼
− ∑ 𝛼 𝑇ℎ,𝑡 (𝑒𝑇ℎ,𝑡 −𝑒 ) (8.16)
𝑡=1

Where 𝛼𝐻,𝑡 and 𝛼 𝑇ℎ,𝑡 are the shadow prices on the trade constraint. The first order conditions will
now be:

65
 𝜕𝐿
= 𝑝𝑡𝐻 (𝑥𝑡𝐻 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = −𝑝𝑡 𝑡 + 𝑝𝑡 (𝑥𝑡 ) − 𝛼𝐻,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 > 0)
𝜕𝑒𝐻,𝑡
𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (8.17)
𝜕𝑅𝑗𝑡
𝜕𝐿
= 𝑝𝑡𝑇ℎ (𝑥𝑡𝑇ℎ ) − 𝑐 ′ 𝑖 (𝑒𝑖𝑡𝑇ℎ ) − 𝜃𝑖𝑡 ≤ 0 (= 0 for 𝑒𝑖𝑡𝑇ℎ > 0)
𝜕𝑒𝑖𝑡𝑇ℎ
𝜕𝐿 𝐻 (𝑥 𝐻 ) 𝑇ℎ 𝑇ℎ 𝑋𝐼
𝑋𝐼 = 𝑝𝑡 𝑡 − 𝑝𝑡 (𝑥𝑡 ) − 𝛼 𝑇ℎ,𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑇ℎ,𝑡 > 0)
𝜕𝑒𝑇ℎ,𝑡
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 − 𝑣𝑗𝑡 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ),
𝑇ℎ
𝜃𝑖𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑖𝑡𝑇ℎ < 𝑒𝑖 ) ,
𝑋𝐼 𝑋𝐼
𝛼𝐻,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 <𝑒 )
𝑋𝐼 𝑋𝐼
𝛼 𝑇ℎ,𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝐻,𝑡 < 𝑒 ), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁, 𝑀 = 1, … , 𝑀

The first condition tells us that the price of hydropower will be equal to the water value accounting
for evaporation minus the value of the evaporation of the water transferred to the following period
and the shadow value of the capacity constraint. The condition becomes binding when hydropower
is being generated in the period. The price on hydropower will be equal to the price of thermal
energy minus the trade shadow price on hydropower trade. If the trade constraint is not binding,
then the prices between countries will be equal as the common equilibrium price. The third
condition tells us that the water value in period t is equal to the water value of the following period
minus the shadow price of the reservoir constraint that could limit water transferability, both
periods having evaporation taken into account. Also, the price of thermal power will be equal to
the marginal cost of thermal production minus the shadow price of the capacity constraint. Finally,
the last condition tells us that the trade price of thermal power will be equal to the price of
hydropower minus the shadow price on thermal trade.

The complementary slackness conditions tell us that the constraints will be binding in the case
where the variables reach the upper limit. If the trade constraints are not binding, then the price on
hydro will equal the price of thermal in equilibrium, which is also equal to the marginal cost of

66
production and the water value. If the production and reservoir constraints become binding there
will be price differences between periods. Then water will be saved for the higher price period and
imports will cover the excess demand. In the high price periods exports will take place. In both
cases it is important to take into account the trade constraints. If the trade constraints become
binding when importing the price rises as a result and more water is used to cover the demand.
The opposite case will happen if the constraint becomes binding when exporting pushing the price
down. If both constraints are binding, then there will be different prices between countries. Also,
the generation of intermittent energy that include both wind and run-of-the-river will push the price
down in the home country, contributing to the price differences between regions in addition to the
effect of water values.

Center-South Model

The interaction between these regions from the perspective of the Center region will be very
similar to the South-Center model. The technology used to generate electricity in both regions is
the same, so the design of the social planning problem will remain the same. The only difference
is that the center region has no significant intermittent energy generation, so there will be no extra
supply of electricity that pushes the price down in the region. The first order conditions will be the
same as in the previous model and their interpretation remains the same. Also, the constraints will
bind under the same circumstances as before. Water will be transferred from low price periods to
be used in higher price periods in order to optimize production. Energy will be imported during
low price periods from the South region. The differences in water values are an important aspect
of the trade behavior. The prices also increase if the import constraint becomes binding due to low
supply of electricity. In the same way prices will decrease upon binding export constraints.

South-Peninsular and Peninsular-South Models

The Peninsular region generates electricity mostly through hydropower and thermal energy but
there are some wind farms in the region. In this case the model in the South and Peninsular region
will have the same design and the same variables. This model will behave as two mixed energy
markets with intermittent energy generation. Both will have capacity, reservoir and trade
constraints. The social planning problem will be defined as in the South-Center model and will be
interpreted accordingly. As both regions have the exact same generation models there will be no

67
difference between their perspectives. Both regions have intermittent energy, including wind
power and run-of-the-river plants that will push the price down when there is generation. The water
values between countries may differ from one period to another which will motivate trade between
them. Each region will as much water as possible until the reservoir constraint becomes binding
in order to use it in higher price periods to produce and export as far as the constraints allow it. If
the constraint on water becomes binding, then water will need to be used in order to avoid spilling
in the low price period and this will lower the social price of electricity. If the trade constraint on
imports become binding the supply in the home region is limited and the price is pushed up. On
the other hand, if the export constraint is binding the energy will be used for home consumption
in the value of the shadow price and the social price will be lowered. In the case that the constraints
are not binding then the home price and the foreign social price will be equal in equilibrium. In
the mixed model the differences between thermal and hydropower can be equalized by transferring
thermal production to hydro by exporting thermal energy.

68
 9. Qualitative Conclusions about the Mexican Region-Specific Models

The region-specific models were adapted according to their own characteristics and their power
generation schemes. In general, Mexico’s electricity system interacts according to the price
changes in power generation which are mostly motivated by the availability of water resources in
the Central, South, and Peninsular regions and the price of fossil fuels in the Northwest, North,
Northeast regions. On the other hand, the Central region accounts for the highest population
density and demand in the country, so it is expected that it will generally act as an importing region
since there is not enough capacity to cover the demand. However, trade constraints will play an
important role in the interaction of these regions in Mexico since the transmission lines do not
allow the market to engage in endless trade. In this section the results of these models will be
interpreted in order to provide a better understanding of the Mexican electricity market and
describe the behavior of each region according to the variability of the production prices.

Northwest Region

Price variability of electricity production in the Northern region will mostly depend on the
availability of natural gas for thermal power plants. Shortages due to high demand periods or the
congestion of the pipelines may increase the price of the generation fuel. Since the model shows
us that the price of thermal energy equals the marginal cost of production, as the costs of natural
gas increase, so does the social price on electricity. In this situation, the region will act as an
importer of electricity, either from the North or the South region. The choice of the trade partner
will depend on the availability of natural gas in the North region and the marginal cost of power
generation and the water value of the South region. For instance, if the marginal cost of thermal
power generation in the North is lower than the social price in the South, it will be preferable to
import thermal power from the North. However, if the trade constraint becomes binding for the
Northern region the remaining imports will be done at a higher price using hydro or thermal power
from the South. As a result, the social price will increase and consumption will decrease in the
Northwest, reducing the total surplus.

On the other hand, if the price is lower in the Northwest compared to its neighbors, exports will
take place. The Northwest will export electricity as long as the marginal cost of production in the
North is higher than the price of the exports. This is likely to happen in high demand periods in

69
the North when coal becomes an important source of energy. It will be optimal to replace coal
generation with cheaper electricity coming from the Northwest. Exports to the South will take
place when the water value in the South is low and it is optimal to replace hydropower for thermal
power coming from the Northwest. Also, the intermittent energy that is generated can be used for
home consumption allowing to increase exports to the neighboring partners as long as the trade
constraints allow it.

North Region

In the North region the prices of generation will also depend on the availability of the resources
but peaks in the demand become more important due to the high proportion of power plants that
use coal as fuel. In high demand periods the North will decide from which of the three neighboring
regions it will import electricity from. However, two of those regions are thermal power producers
implying that the transmission constraints on thermal power will be at a higher level. It is less
likely to experience congestion from thermal imports compared to the hydropower imports from
the southern region. In order to determine the optimal import quantities from thermal and hydro in
the North it is necessary to compare the home marginal cost of production with the costs in each
of the potential trade partners, choosing the cheapest energy supply first and move to the next
when the transmission constraint becomes binding. However, it will also depend on the specific
situation in the other regions to determine whether they choose to import or export electricity. It is
also possible that the North imports electricity from the Northeast and exports to the Northwest
and vice versa.

Northeast Region

The situation in the Northeast region will be very similar to the one experienced in the Northwest.
However, the absence of renewable energy generation may limit the possibility to export thermal
power to the North and to the South. The same principle of marginal cost and water value
comparisons apply. In practice, it is common to observe that when the water value in the South
region is low, the three regions in the north export electricity at the same time to the South. The
model becomes consistent with the data by expressing the important similarities of the thermal
dominated northern regions. On the other hand, it is also common to observe that when the water
value in south is high and supply increases, the three northern regions import electricity.

70
Nevertheless, the trade pattern between the Northwest, North, and Northeast will depend on the
comparison of the marginal cost of production at an aggregate level.

South Region

The South region is the only region that is interconnected to all of the others. This region interacts
with every type of model including thermal only; thermal and intermittent energy; thermal, hydro
and intermittent energy; and thermal and hydro only. This becomes interesting because the South
region is the only one that has dominant hydropower generation in the country. Variations in the
social price of electricity and the water value will determine the trade patterns with all of its
neighbors. Fortunately, the model covers a mixed energy system with multiple producers and it
allow us to understand more easily the behavior of the region’s production, imports, and exports.
Water values become plant-specific which in turn affect the decisions of either exporting or
importing to different regions.

Starting with hydropower generation, it is optimal to use water in the periods in which the water
value is the highest. However, due to the output constraints it is not realistic to use all water in the
period with the highest price. In turn, the South region generates more hydropower and increases
exports in lower price periods in order to avoid spilling water. However, if the transmission
constraints become binding, more water will be used for home consumption and the social price
is pushed further down. On the other hand, the thermal capacity of the region is not able to cover
the electricity demand and the transmission constraints become binding on imports, so less water
can be stored and it has to be used for home consumption. The intermittent energy in this region
mostly consists of over 2GW of installed capacity coming from the wind turbines located in
Oaxaca.

A special case in the Mexican system is the interaction between the South and Center regions. As
mentioned before, the Center region does not have enough capacity to satiate the demand
becoming a consistent importer of electricity from the South. The transmission constraints become
binding due to the high amount of exports to the Center region increasing the price of electricity.

While trade with the northern regions has been explained, the interaction with the Peninsular
region requires the use of two mixed energy systems. Trade between these two regions can be
easily explained with Figure 7.1. In each of them as much water as possible will be saved for

71
higher price periods. The water values are specific to each region and their value will determine
the optimal quantities of electricity to be traded between them. We have to bear in mind that even
if the South region is importing electricity from the thermal regions in the North, it may still be
optimal to export electricity if the water value in the South is higher than the one in the Peninsular
region and thermal energy generation is not able to cover the demand.

Center Region

This region has the highest population density and important industrial activity. Thus, the demand
of the region is so high that the installed capacity is not enough to satiate it. In autarky, electricity
prices would increase importantly and production activities in the economy would face very high
costs of operation, especially energy-intensive activities. This situation is not optimal for growth
and makes imports crucial for the economic development of the Center region. In order to push
prices down, the region imports approximately 30-35% of the total demand of electricity.
However, this is the region in which transmission constraints become binding due to congestion.
It naturally follows that the price of electricity in this region is the highest in the country. Also,
output constraints are usually binding and many plants are run at full capacity. It is in complex
situations like this one when optimizing the use of resources and maximizing a social planner’s
problem becomes highly relevant.

Peninsular Region

The peninsular region has also a mix of hydro, thermal and intermittent energy like the South
region. The water values in this region will determine when to export or import, as well as the
optimal quantities to be generated and traded. Reservoir and capacity constraints in the Peninsular
region become binding if water is fully saved for the highest price period so in order to avoid
spilling more water is used for home consumption and prices are lowered. Also, depending on the
water values and the marginal costs of generation in the South, the decision on either trading hydro
or thermal power is made. It is possible that even at high marginal costs of thermal power
generation it is optimal to export thermal power in order to save water for higher price periods.
This happens in the situations in which the social price of electricity is high in the South region
due to scarcity. For this region Figure 7.1 also depicts a good example on how the electricity
market behaves.

72
Environmental policies in Mexico and their impact on prices

Mexico has committed to reduce emissions importantly for the coming years. However, the
country’s power generation industry is strongly dominated by fossil fuel generation and there is
still an important amount of power plants that use highly polluting fuels to operate. In future
periods, the model will face new environmental constraints due to the policies for environmental
protection that will limit the amount of power that can be generated with thermal plants. This
would result in an increase of prices of electricity due to scarcity. In this case, the South region
will export important amounts of electricity to the northern regions in order to reach the established
environmental goals for 2030 and 2050. If this issue is not addressed correctly, the social surplus
will decrease due to inefficiencies in the market, creating dead weight losses due to the
government’s intervention in the economy by restricting supply. It is likely to happen if the
capacity constraints become binding in the South and transmission constraints bind in the northern
regions. Also, thermal power generation in the Center region would become limited and the strain
on the transmission system is already considerable. Despite of the lack of attention, the
hydropower sector has the potential to contribute to maximize the social surplus in the Mexican
electricity market while fulfilling the environmental commitments that have been established.

Pricing policies and the effect of subsidies on consumption

Electricity consumption in Mexico has consistently been subsidized by the government according
to the use and the average temperature in the region. The higher the temperature, the higher the
subsidy on electricity. Taking the proposed model into account, subsidizing electricity would push
prices down in specific regions that experience high temperatures. The northern regions experience
high average temperatures during the year and they receive the highest subsidy on electricity
consumption, straining generation due to increases in the demand. On the contrary, the Center
region is located in a mountainous area with high altitudes, forests and, consequently, lower
temperatures. The high demand, the insufficient installed capacity, and the fact of receiving a lower
subsidy on electricity are the reasons for which the social price of electricity in the Center region
are the highest in the country. According to the model, it follows that the Center is in a constant
state of scarcity and imports electricity continuously. The subsidies in the South and Peninsular
regions are not as high as in the northern ones, but by pushing the consumption prices down
capacity constraints are more easily reached. Part of the producer surplus is transferred to

73
consumers, but there are inefficiencies in the market that generate losses due to governmental
intervention.

Management of the Mexican System

The energy model developed for Mexico in this study allows us to understand the behavior of the
electricity sector in this country. We have analyzed the effects of different constraints,
environmental and pricing policies through the interpretation of the optimal solutions and the
variation of prices. In order to fulfill the environmental commitments, to optimize the use of the
available resources, and to keep up with the growing demand in Mexico the interaction within the
electricity system needs to be optimized. While investment in renewable energy contribute
importantly to fulfill environmental goals, hydropower is also a viable source of energy that can
be used to achieve them. In order to successfully optimize the management of an electricity system
engineering and economics have to act as complements. The construction and optimal operation
of power plants is covered by engineering, but the understanding of the social effects and the role
of power generation in the development of a country can be provided by economics. The Mexican
case is no exception. Considering the differences in the regions mentioned in this study and the
results obtained, the system is able to maximize the social surplus in the social planning problem
through the interaction of the regions. Demand should be covered considering the effects of trade
and constraints on prices, efficiency and on the optimal management of the system. Water should
be used as much as possible in high price periods, e.g., during the summer months when demand
reaches its peak. The strain on the South region is considerable taking into account that it acts as a
constant provider of electricity to the Center region. A direct interconnection between the Center
and the Northeast region would further optimize power generation considering that they are
bordering regions. Also, it would provide new benefits on trading, increasing efficiency and
significantly reduce the pressure of the South system.

74
 10. Conclusions

We have studied the different cases and possibilities of interaction between energy markets within
Mexico. It is important to become familiar with the differences between the generation models
that interact within the country in order to better understand the market and the different
circumstances in which they are involved with trade. According to the data collected by the
recently created organism called CENACE, which plays a very similar role as Nordpool in the
Scandinavian countries, it is common that the southern region imports energy from the northern
countries whenever the water value is low and exports to the three regions simultaneously
whenever the water value is high. We have gone through the advantages of using non-linear
programming and Kuhn – Tucker conditions as the main tool to analyze the behavior of optimal
generation under realistic circumstances such as generation, reservoir and trade constraints. The
main purpose was to detect and understand the main drivers of price changes in the different
electric regions in Mexico and how they would interact with their neighbors.

The first part of this study consists of an overview of the Mexican electricity market and the key
technologies each region uses for power generation. In section 2, the study goes through the key
indicators of each of the generating technologies and the main drivers for demand in the country.
Background information is given in section 3 in order to start using the modeling tools proposed
by Finn Førsund, starting from the design of the social planning problem and the respective
constraints in section 4. This section provides the non-linear programming methods that allow us
to find qualitative information about optimal generation and how the prices and production behave
in order to maximize the social surplus of power generation. The assumptions of full certainty and
knowledge about inflows are in place and the model is based on optimal management of reservoirs
taking into account evaporation and reservoir constraints.

In Section 5 multiple producers are introduced into the model, which adapts much better to the
real situation of the Mexican market, where the water values vary among plants and periods.
Bathtub illustrations are used in order to better visualize the behavior and effect of the proposed
constraints to the model. Section 6 introduces the mixed model with hydro, thermal and
intermittent energy as key participants in power generation. The optimal use of each technology is

75
addressed in this section, which is very relevant for the Mexican scenario as hydropower has an
important participation in the Center, South and Peninsular regions. However, the Northwest,
North and Northeast region are mostly dominated by fossil fuel generation. This section discusses
the main causes for price changes and the importance of the constraints is explained by interpreting
their shadow prices. Many of the possibilities are explained and analysis was provided for each
possible circumstance. Whenever regions face restricted production capacity or the reservoir limit
is reached. The restrictions on water maneuverability force the region to use more hydropower to
avoid spilling reducing the price. Thermal capacity constraints also come into play so the optimal
mix is determined through the marginal cost of producing energy and the shadow price on the
capacity constraint. Hydropower will not be used in the case that the water value is higher than the
marginal cost of thermal generation and, on the contrary, thermal power will not be used when the
water value is lower than the marginal cost at zero production. In a multiple plant model, where
the water value varies from plant to plant, the same principle applies individually for each plant.

In section 7 trade is covered as part of the interaction between regions and constraints on the
amount of power that can be imported and exported are put in place. Also, the previously stated
constraints also play a role in the trading behavior and home consumption of electricity. The trade
constraint leads to price variability and reduces the profitability of trade. The water values
determine the use of hydropower in the home region and affect the amount of generation at the
optimum. The remaining demand can be covered through imports, or if the social price is higher
in the period, exports can be made to increase profits of generation. It also covers the introduction
of a transmission network and the effects of how water is used in the region and its effect on prices.
However, proper modeling of the transmission network requires introducing engineering and
electricity concepts. This task becomes increasingly challenge and its contribution to the
understanding of the Mexican energy model may not be as relevant. Nevertheless, understanding
how the losses and congestions in the network affect the optimal generation gives us insight on
how the power generation market works in reality.

Section 8 summarizes the background and the modeling systems covered in the previous section,
customized for every region in bilateral trading models. It is important to cover the models from
the perspective of each region as a home country since the model changes according to their
specific circumstances. The Northwest, North and Northeast regions are arid regions with mostly

76
no presence of hydropower reservoirs and powered mostly by thermal power. On the other hand,
the Center, South and Peninsular regions have important presence of hydro and thermal power.
Each region was treated independently and related to its neighboring regions in the models. Since
some of them are interconnected with several regions at the same time, it is safe to conclude that
similarities in the models were found, especially when comparing the northern regions (mostly
thermal) to the south regions (mixed energy). The social planning problem, as well as the necessary
first order conditions and the interpretations followed the same pattern in various cases. They key
decisions for the social planner in the northern regions include the import and export patterns with
the thermal and hydro neighbors according to the social price, importing when the price is low and
exporting in high price periods. The southern regions will also take into account the water values
and the social prices to make decision on exports and imports as well as production. Reservoir and
production constraints play an important role in the price path and may affect home consumption.
Section 9 describes the qualitative information obtained from each region according to the
interpretation of the models proposed. Also the effects on prices and trade behavior is studied as
well as the effects of two key policies concerning power generation in Mexico.

These models are an attempt to understand the interaction of the electric regions Mexico. The
complexity of the Mexican market should be understood in economic terms as it has become
increasingly important after the Energy Reform published in 2014 that opened the market to the
private sector formally. As the time goes by and the installed capacity increases the privates’
participation will become more relevant. The qualitative information obtained from these models
provides insight of the interaction of the relevant players in a fully-fledged competitive electricity
market in Mexico. While there is still room for further study and possible improvements, this first
attempt should provide a useful understanding of the Mexican electricity sector.

77
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Wolfgang, O et. al. (2009): “Hydro reservoir handling in Norway before and after deregulation”,
Energy 34 (10), 1642-1651.

80
Appendix 1:

While demand might grow importantly in the long run, using one year cycles in our analysis allows
us to successfully make qualitative conclusions and observing the sensitivity of demand for
electricity in relation to price by defining the social optimization problem by

max
𝐻
∑ 𝑈𝑡 (𝑒𝑡𝐻 )
𝑒𝑡
𝑡=1

Subject to

∑ 𝑒𝑡𝐻 ≤ 𝑊 , 𝑒𝑡𝐻 ≥ 0, 𝑡 = 1, … , 𝑇 (1.1𝑎)

𝑡=1

It follows from previous statements that W is given at the beginning of the first period and T is
given as a seasonal cycle. We also assume for now that there is no transfer of water to period T +
1. The introduction of water transfer with lower and upper constraints on reservoirs will be covered
later. In order to understand the full complexity of the Mexican electricity model it is reasonable
to start with more basic representations adding new variables and constraints along the way. In
order to find solutions for the social planning problem it is needed to create Lagrangian functions
and obtain the first-order conditions (Sydsaeter et. al. 1999, 2005) assuming that a unique solution
exists.

The Lagrangian for equation (1.1a) is:

𝑇 𝑇

𝐿= ∑ 𝑈𝑡 (𝑒𝑡𝐻 ) − 𝜆 (∑ 𝑒𝑡𝐻 − 𝑊 ), (1.2𝑎)

𝑡=1 𝑡=1

Where 𝜆 is the Lagrangian parameter. The necessary fist-order conditions for this problem are:

𝜕𝐿
= 𝑈 ′ 𝑡 (𝑒𝑡𝐻 ) − 𝜆 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝐻 > 0), 𝑡 = 1, … , 𝑇 (1.3𝑎)
𝜕𝑒𝑡𝐻

81
 𝑇

𝜆 ≥ 0 (= 0 𝑓𝑜𝑟 ∑ 𝑒𝑡𝐻 < 𝑊 )

𝑡=1

The endogenous variables are 𝑒𝑡𝐻 , 𝜆 (𝑡 = 1, … , 𝑇), and exogenous variables are W, T. In this case
there will be T endogenous variables and T equations. The Lagrangian parameter 𝜆 represents the
shadow price on the resource constraint and from the Kuhn – Tucker conditions we can interpret
that it is equal to the marginal utility of electricity consumption depicting an interior solution when
𝑒𝑡𝐻 > 0. This means that the shadow price represents the increase in the sum of utilities over all
periods when there is a marginal increase in the stored water W; the shadow price shows the
changes in the objective function when there are changes in the proposed constraint. This equality
holds for every period and non-satiation is assumed so the marginal utility of consumption of
electricity is always positive:

𝑈 ′ 𝑡 (𝑒𝑡𝐻 ) = 𝜆 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡 = 1, … , 𝑇 (1.4𝑎)

Equation (1.4a) represents the Hotelling’s rule for the price of water in our model. We also
assumed perfect transferability so if prices are different, transferring to periods with higher prices
increases welfare until prices become equal. The bathtub diagram applied to electricity economics
by Finn Førsund is a very useful tool to illustrate the solution in two periods.

In Figure 1.1a the total available electrical energy is represented by the horizontal axis and the two
marginal willingness to pay functions are measured by the vertical axes for period 1 and period 2.
In Mexico consumption is higher during the summer than during winter but the marginal utility in
the summer should not be higher than in the winter at optimum. In this case all available water is
used only for electricity production. The optimal solution is represented by the crossing points of
the marginal utilities of electricity production for both periods.

This diagram will become increasingly useful for our analysis of the Mexican electricity market
as the model becomes more complete.

82
 Figure 1.1a. Bathtub diagram for the optimal allocation of electricity between two periods.
Source: Hydropower Economics, Finn Førsund, 2011, p. 25.

Appendix 2:

In the social planning problem an upper reservoir constraint will be added and the lower constraint
will be normalized to zero so it will not be explicitly expressed in the constraint:

𝑇 𝑒𝑡𝐻

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜
𝑅𝑡 ≤ 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 (2.1𝑎)
𝑅𝑡 ≤ 𝑅
𝑅𝑡 , 𝑒𝑡𝐻 ≥ 0, 𝑡 = 1, … , 𝑇
𝑇, 𝑤𝑡 , 𝑅0 , 𝑅 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑇 𝑓𝑟𝑒𝑒

Water has no scrap value in this model and there is full maneuverability of the reservoirs letting
the amount at the last period is free. The Lagrangian for the social planning problem with its
respective Kuhn – Tucker conditions is:

83
 𝑇 𝑒𝑡𝐻 𝑇 𝑇

𝐿 = ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ 𝜆𝑡 (𝑅𝑡 − 𝑅𝑡−1 − 𝑤𝑡 + 𝑒𝑡𝐻 ) − ∑ 𝛾𝑡 (𝑅𝑡 − 𝑅) (2.2𝑎)

𝑡=1 𝑧=0 𝑡=1 𝑡=1

𝑒𝑡𝐻 , 𝑅𝑡 , 𝜆𝑡 , 𝛾𝑡 (𝑡 = 1, … , 𝑇) are the endogenous variables and the first order conditions are:

𝜕𝐿
= 𝑝𝑡 (𝑒𝑡𝐻 ) − 𝜆𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑡𝐻 > 0)
𝜕𝑒𝑡𝐻
𝜕𝐿
= −𝜆𝑡 + 𝜆𝑡+1 − 𝛾𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 > 0) (2.3𝑎)
𝜕𝑅𝑡
𝜆𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅𝑡−1 + 𝑤𝑡 − 𝑒𝑡𝐻 − 𝑣𝑡 )
𝛾𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑡 < 𝑅) 𝑡 = 1, … , 𝑇

With 2T first order conditions and 2T reservoir constraints we can make qualitative assumptions
about the optimal production. Through partial equilibrium we observe that the price of electricity
equals the water value accounting for evaporation. 𝜆𝑡 represents the shadow price of stored water.
Assuming that production is positive in all periods (which is a reasonable assumption) the first
condition becomes equal to zero. Then:

𝑝𝑡 (𝑒𝑡𝐻 ) = 𝜆𝑡 , 𝑡 = 1, … 𝑇 (2.4𝑎)

For convenience and showing that when equalizing the water values, at optimum the water value
is equal to the social price of electricity from the first condition and with the second condition in
(2.3a) the water value of period t expresses the value of using water in the following period t + 1
accounting for evaporation. Using these two periods and the optimal solution we can observe the
main features of the solution to the problem.

If we were to introduce a scrap value it would be necessary to have a reservoir level that lies
between zero and the maximum capacity of the reservoir and adding it to the objective function
and the corresponding restriction as 𝑆(𝑅𝑇 ) and 𝑅𝑇 ≥ 𝑅 𝑇 respectively. These constraints will
affect the water value in the terminal period and the water value will rise as maximal production
is reduced. By having a minimum level of water needed at the terminal period T the availability of
water is constrained and by standard demand and supply assumptions its price rises.

For convenience on this topic we will not dwell deeper into scrap values and the mathematics to
maintain simplicity, however, it is important to mention the possibility of introducing this

84
constraint and its effects on the optimal solution. Considering scrap values in the social problem
and obtaining the relevant solutions is mathematically quite straightforward but it does not change
the essence of the optimal price, it just shifts it upwards.

In order to depict the introduction of a reservoir constraint we can use two periods and a bathtub
diagram as used previously. Taking into account two periods we add the inflows to the initial
reservoir level and equalize to hydropower generation with zero spilling in the following equation:

𝑒1𝐻 + 𝑒2𝐻 = 𝑅0 + 𝑤1 + 𝑤2 (2.5𝑎)

If the constraint is not binding, the shadow value of water will be equal in both periods and the
dotted lines represent the maximal storage of the reservoir. The optimum will be where the shadow
prices for both periods are equal to the prices on both periods. This diagram can also be used for
multi-year scenarios taking consecutive periods into account. As a result, the optimum is
represented by M, the inflow in the first period plus the initial reservoir is the line AC and inflow
in the second period is CD. In this first scenario the reservoir constraint is not binding, meaning
that the amount of water in the reservoir plus inflows do not exceed the maximal capacity. Prices
are positive for both periods and in this example generation in the first period is higher than in the
second period.

85
 Figure 2.1a. Two-period bathtub diagram (Non-binding reservoir constraint)
Source: Hydropower Economics, Førsund, 2011, p. 45.

Since the reservoir constraint is not binding we find that from the first-order conditions found in
(2.3a) 𝜆1 = 𝜆2 since 𝛾1 = 0 because 𝑅1 < 𝑅 and then we find that 𝑝1 = 𝜆1 , 𝑝2 = 𝜆2 . In Figure
4.3 the reservoir constraint becomes binding, restricting the amount of available water for
hydropower generation and consequently changing the water value and the prices in the two
periods. Since the demand is not satiated spilling water is not optimal in the first period but it is
optimal to save as much water as possible since the water value is higher in the second period.
Instead of spilling, hydropower is generated and consumed in the first period. As 𝛾1 > 0 then when
the reservoir level in the first period is higher than zero we find that the water value becomes 𝜆1 =
𝜆2 − 𝛾1 where the reservoir constraint multiplier represents the change in the objective function
when the reservoir limit is changed marginally. This could change prices considerably as the
binding reservoir constraint reduces the value of the objective function.

86
 Figure 2.2a. Two-period bathtub diagram (Non-binding reservoir constraint)
Source: Hydropower Economics, Førsund, 2011, p. 46.

Now the amount of hydropower generated will be AB while B’ depicts the optimal solution for
the unconstrained problem. The amount of stored water will be AC in the first period and CD
represents the inflow in the second period. However, the excess generation in the first period leaves
less water available for the second period, increasing the price. The difference is shown by 𝛾1and
the shadowed area shows the reduction in the consumer and producer surplus.

The terminal period and optimal solutions

The main objective is to find the optimal solutions of the dynamic programing problems in discrete
time using Belman’s principle through backward induction from the terminal period T to the first
period. In hydropower there are two options at T, either 𝑅𝑇 = 0 or 𝑅𝑇 > 0. “The latter situation
can be optimal only if the marginal utility of electricity becomes zero before the bottom of the
reservoir is reached” (Førsund, 2011, p. 48).

𝑝𝑇 (𝑒𝑇𝐻 ) = 𝜆 𝑇 (𝑒𝑇𝐻 > 0)

−𝜆 𝑇 − 𝛾𝑇 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑇 > 0) (2.6𝑎)

87
With the reservoir constraint the situation of scarcity in the last period implies a positive marginal
willingness to pay giving value to the water in the last period. If there is no scarcity then the shadow
price 𝛾𝑇 is zero. Then the second relation implies that 𝜆 𝑇 ≥ 0. Due to no satiation the water value
in period T is also positive. The backward induction to period T-1 then includes periods T and T-
1:

−𝜆 𝑇−1 + 𝜆 𝑇 − 𝛾𝑇−1 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑇−1 > 0) (2.7𝑎)

If a full reservoir is not handed over to T then 𝛾𝑇−1 will be equal to zero. This is more likely in a
multi-period model. If the reservoir is not emptied in T – 1 the equation holds with equality and
the shadow price is equal to the one in T.

There are three different cases: scarcity, threat of overflow, and a case in which we have neither.
In the case of scarcity we find that if the reservoir is emptied in a period that is not the terminal
period we assume that the price is equal to 𝑝𝑇 and the reservoir constraints are not binding, and
the water values are equal to the price. This yields:

𝜆𝑡 = 𝜆𝑡+1 > 0
𝐻 )
𝑝𝑡 (𝑒𝑡𝐻 ) = 𝑝𝑡+1 (𝑒𝑡+1 >0 (2.8𝑎)
𝜆𝑡+1 ≥ 𝜆 𝑇 > 0 (𝑅𝑡+1 = 0)

We assume positive prices due to non-satiation and that the reservoir is emptied at t + 1.

The threat of overflow for a period s where t + 1 is the first scarcity period after s lets us find the
conditions for the periods s and s + 1 (periods with scarcity):

𝑝𝑠 (𝑒𝑠𝐻 ) = 𝜆𝑠 (𝑒𝑠𝐻 > 0)

−𝜆𝑠 + 𝜆𝑠+1 − 𝛾𝑠 ≤ 0 (𝑅𝑠 > 0)
𝐻 ) 𝐻
𝑝𝑠+1 (𝑒𝑠+1 = 𝜆𝑠+1 (𝑒𝑠+1 > 0) (2.9𝑎)
𝜆𝑠+1 ≥ 𝜆𝑡 − 𝛾𝑠+1 (𝑅𝑠+1 ≥ 0)

The important point is that 𝜆𝑠 will equal zero if there is actual overflow since that water cannot be
used for electricity generation as the reservoir cannot store more water in that period. However, if
water is transferred the water value will be positive, but lower than its value at s + 1. This is because
spilling needs to be avoided and the water inflows are saved for the next period. The price of the

88
future has no impact on the period that experiences the treat of overflow so the social planning
problem has to be solved simultaneously.

In the case with neither of these situations the price 𝑝𝑇 will prevail for all the periods and this
situation may arise when the storage capacity is greater than the consumption for the periods taken
into consideration. The two periods analyzed may not represent enough consumption to empty a
multi-year reservoir and, on the other hand, electricity generation increases when the price rises
using saved water in these periods. These situations imply that we never run into scarcity periods
or into periods with threats of overflow. These situations are studied with further detail in
“Hydropower economics” by Finn Førsund. The social planning problem solves for prices
simultaneously and that approach will be used for the Mexican hydropower system.

Price variations occur due to the existence of scarcity and overflow periods and due to changes in
the power generation by uncontrollable resources. Scarcity periods push the price up until the
reservoirs are filled and the scarcity period passes. On the other hand the threats of overflow reduce
the price on electricity since it is common to ramp-up generation in order to avoid water spilling,
increasing output and pushing the price down. In Norway it is common to have rapid changes from
periods of scarcity to periods with threats of overflow due to snow melting but it then translates
into two price changes in a year. On the other hand, hydropower systems in Mexico experience
high inflows from rainy seasons but the reservoirs are filling up constantly during the year. While
the price changes exist also for periods of scarcity and overflow they become milder since there is
no snow melting. The changes from periods of scarcity to overflow do not happen as fast as in the
case of Norway and these conditions allow for a less problematic management of the reservoirs.
The production constraint in Mexico would become binding during the summer, when the
reservoirs are emptied to prepare to the coming rainy season and filling up of the reservoirs.

89
Appendix 3:

Inverse function to determine quantities

Using backward induction and starting at the terminal period T we get that:

𝑒𝑡𝐻 = 𝑅̂𝑇−1 + 𝑤𝑇
𝑘
𝜆 𝑇 (1 − 𝑇) = 𝑝𝑇 (𝑒𝑇𝐻 ) = 𝑝𝑇 (𝑅̂𝑇−1 + 𝑤𝑇 ) (3.1a)

In the case that the capacity constraint for the reservoir is not binding the shadow price related to
this constraint will be equal to zero, and shadow prices for T – 1 and T will be equal. Production
has to be non-negative. Going back to period T – 1 and through the inverse function of the price
we find that the optimal quantity of generated electricity becomes:

𝐻 )
𝑝𝑇−1 (𝑒𝑇−1 = 𝜆 𝑇−1 = 𝜆 𝑇 =>
𝐻
𝑒𝑇−1 −1 (𝜆
= 𝑝𝑇−1 −1 −1 ̂
𝑇−1 ) = 𝑝𝑇−1 (𝜆 𝑇 ) = 𝑝𝑇−1 (𝑝𝑇 (𝑅𝑇−1 + 𝑤𝑇 )), (3.2𝑎)

−1
Where 𝑝𝑇−1 is the mentioned inverse demand function. By backward induction, once the
electricity production is determined in T – 1 then we can also find the solution for the previous
period T – 2. It is necessary to insert the function of water transfer from T – 1 to T:

𝑅𝑇−2 = 𝑅̂𝑇−1 − 𝑤𝑇−1 + 𝑒𝑇−1 = 𝑅̂𝑇−1 − 𝑤𝑇−1 + 𝑝𝑇−1

−1
(𝑝𝑇 (𝑅̂𝑇−1 + 𝑤𝑇 )) (3.3𝑎)

Then in order to solve for the quantity in any period i we substitute following the same backward
induction principle:

𝑒𝑖𝐻 = 𝑝𝑖−1 (𝜆 𝑇 ) = 𝑝𝑖−1 (𝑝𝑇 (𝑅̂𝑇−1 + 𝑤𝑇 )) , 𝑖 = 𝑡 + 2, … , 𝑇 − 1, 𝑇 (3.4𝑎)

If we face a period of scarcity, we know that the water transferred will be zero to the next period
so inflows minus evaporation will be equal to the electricity produced and at the same time equal
to the inverse function of the price. These changes in the reservoir levels can be the reason to
change the amounts of release of water.

90
Appendix 4:

Hveding’s conjecture

The correct management of water in a multi-plant model is crucial in order to avoid actual overflow
and water spilling since this is considered to be a pure waste of resources in a system with perfect
maneuverability.

Hveding’s conjecture establishes that “in the case of many independent hydropower plants with
one limited reservoir each, assuming perfect maneuverability of reservoirs, but plant-specific
inflows, the plants can be regarded as a single aggregate plant and the reservoirs can be regarded
as a single aggregate reservoir when finding the social optimal solution for operating the
hydropower system.” (Førsund, 2011, p. 81).

In order to explain this conjecture, we need to go through different scenarios in which reservoirs
are emptied. It is important to note that we are not considering binding output constraints in the
following cases. The first case will be a threat of overflow in period s in which production implies
that the shadow value of water in period s is equal to the price (and it is positive). Using the shadow
price dynamics we know that −𝜆𝑗𝑠 + 𝜆𝑗,𝑠+1 − 𝛾𝑗𝑠 = 0. If the reservoir is not at its limit in the
following period, then the reservoir constraint is not binding and the shadow price is zero. We can
then imply that the value of the objective function is not affected by single periods with threat of
overflow in a single plant when the price is the same in both periods. It is because of this that a
threat of overflow in a single plant cannot be found but it does not change the value of the objective
function. In other words, the plants that run a full reservoir can cover the demand without spilling.

On the other hand, if the price in the first period is lower than in the following then the situation
may be that all plants that are producing are facing a threat of overflow in the period s. In this case
the reservoir constraint is binding and from the second condition in (4.4) −𝜆𝑗𝑠 + 𝜆𝑗,𝑠+1 − 𝛾𝑗𝑠 = 0
and the equalized water values and prices across plants for each period. We can then substitute the
water values for the prices and we find that 𝛾𝑗𝑠 = 𝑝𝑠+1 (𝑥𝑠+1 ) − 𝑝𝑠 (𝑥𝑠 ) is the shadow price for
all the plants with binding constraints. But then again in the optimal plan it is also possible to have
plants accumulating water and not reaching the reservoir constraint. If the water value is higher
than the price and the reservoir constraint is not binding (𝛾𝑗𝑠 = 0) we find that accumulation can

91
be possible if the water values are equal in the two periods. Nevertheless, the usual case is for
some plants to accumulate and others to produce in order to find the equilibrium between supply
and demand. Accumulation continues until the price is equal to the price in the period before it
started; this price will determine when production starts again if there is no threat of overflow.
There can also exist a case in which the reservoir cannot reach its upper limit in period s, so
accumulation would be optimal from the first period. This usually happens with multi-year
reservoirs that are used as insurance for dry years. The use of these insurance multi-year reservoirs
will happen if the water value and the price for the producing plants are the same.

Considering that in a multi-plant model it is not possible for plants to reach the reservoir limits
when there are price increases caused by overflow threats then they are not producing but
accumulating water. But in the case that plant j empties its reservoir in period t + 1 then every plant
has to empty its reservoir in order to follow an optimal path and avoid a contradiction in prices.
The price in the following period for plant j would be higher than in t +1, while it would be equal
in other plants. However, plants may empty reservoirs before others if the water value stays the
same. Aggregation is possible as long as the shadow price is the same and the modeling is
simplified. However individual plants fill up their reservoirs and empty them in the same period
in an optimal case. Also, the individual contributions of the plants may vary in order to meet the
demand at the same time they operate to maximize the value created from the stored water. In
other words, large reservoirs will contribute more in low price periods and smaller reservoirs will
have a higher contribution in high price periods.

Output constraints become relevant for Hveding’s conjecture as it will be necessary to consider
them for the optimal emptying of reservoirs as there is a limit on how much water can be processed
at a time and, thus, prices vary. However, some plants may have binding output constraints while
others may not, then the variations on prices will determine the optimal path to follow by each
plant and this information cannot be obtained from an aggregated model. The market will find the
optimal path for individual plant behavior.

92
Appendix 5:

In this case, the release of water which is equal to the amount of energy generated by an upstream
hydropower plant will become an inflow for the downstream one. This is possible since water and
energy have been measured in kWh since the first sections. In addition to the coupled stations we
have to consider also the independent power plants in the system.

The social planning problem then becomes:

𝑇 𝑥𝑡

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

Subject to

𝑁𝐶 𝑁𝐼 𝐿

𝑥𝑡 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊

𝑗=0 𝑖=1 𝑙=1
𝐻
𝑅0𝑡 ≤ 𝑅0,𝑡−1 + 𝑤0𝑡 − 𝑒0𝑡
𝐻
𝑅𝑗𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑒𝑗−1,𝑡 − 𝑒𝑗𝑡𝐻 , 𝑗 = 1, … , 𝑁 𝐶
𝑅𝑗𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑖𝑡 − 𝑒𝑖𝑡𝐻 , 𝑖 = 1, … , 𝑁 𝐼 (5.1𝑎)

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝐻
𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗 ≥ 0
𝑅𝑗𝑡 , 𝑥𝑡 , 𝑒𝑗𝑡𝐻 , 𝑒𝑙𝑡𝑊 ≥ 0
𝐻
𝑇, 𝑤𝑗𝑡 , 𝑒𝑙𝑡𝑊 , , 𝑒𝑗 , 𝑅𝑗0 , 𝑅𝑗 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒, 𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿, 𝑡 = 1, … , 𝑇

This social problem now includes independent and coupled stations adding up to N plants. Also
since the analysis is being done for the Mexican case it is necessary to include wind power in the
energy balance equation which is treated under the same principles as run-of-the-river energy. The
last restrictions are common for both types of plants. To solve for the first order conditions, we
build the following Lagrangian:

93
 𝐼
∑𝑁 𝐻 𝑁 𝐻 𝐿 𝑊
𝑗=1 𝑒𝑗𝑡 +∑𝑖=1 𝑒𝑖𝑡 +∑𝑙=1 𝑒𝑙𝑡
𝑇

𝐿=∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0
𝑇 𝑁 𝑇 𝑁𝐼

− ∑ ∑ 𝜆𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 ) − ∑ ∑ 𝜆𝑖𝑡 (𝑅𝑖𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑖𝑡 + 𝑒𝑖𝑡𝐻 )
𝑡=1 𝑗=0 𝑡=1 𝑖=1
𝑇 𝑁

− ∑ ∑ 𝛾𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗 )
𝑡=1 𝑗=1
𝑇 𝑁
𝐻
− ∑ ∑ 𝜌𝑗𝑡 (𝑒𝑗𝑡𝐻 − 𝑒𝑗 ) (5.2𝑎)
𝑡=1 𝑗=1

The first-order conditions are:

𝑁 𝑁𝐼 𝐿
𝜕𝐿
= 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 0)
𝜕𝑒𝑗𝑡𝐻
𝑗=0 𝑖=1 𝑙=1

𝜕𝐿 𝑘 𝑘
= −𝜆𝑗𝑡 (1 − ) + 𝜆𝑗,𝑡+1 ( ) − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (5.3𝑎)
𝜕𝑅𝑗𝑡 𝑇 𝑇
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 − 𝑣𝑗𝑡 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗 ), 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁

The conditions for the independent plants will be the same as in (5.4) and all the types of generation
are added in the energy balance to get the total supply of energy. In coupled plants the social price
accounting for evaporation in a period is added to the next downstream plant. The water value for
the last plant is equal to the social price in the period but as we go upstream the water values
become greater than the social price since the water can be reutilized. In mathematical terms, we
get the following prices using the conditions in (5.3a):

𝑁𝐶 𝑁𝐼 𝐿
𝑘
𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) = 𝜆𝑁𝐶 𝑡 (1 − ) (5.4𝑎)
𝑇
𝑗=0 𝑖=1 𝑙=1

And then for the next plant upstream 𝑁 𝐶 − 1:

94
 𝑁𝐶 𝑁𝐼 𝐿
𝑘 𝑘
𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) = 𝜆𝑁𝐶−1,𝑡 ( ) − 𝜆𝑁𝐶 𝑡 (1 − ) =>
𝑇 𝑇
𝑗=0 𝑖=1 𝑙=1

𝑁𝐶 𝑁𝐼 𝐿
𝑇
𝜆𝑁𝐶 −1,𝑡 = 2𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) ( ) (5.5𝑎)
𝑘
𝑗=0 𝑖=1 𝑙=1

Then for plant j the shadow price on water is:

𝑁𝐶 𝑁𝐼 𝐿
𝑇
𝜆𝑗𝑡 = (𝑁 + 1𝐶
− 𝑗)𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑖𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) ( ) (5.6𝑎)
𝑘
𝑗=0 𝑖=1 𝑙=1

If the water releases of the upstream reservoir become the inflows of the coupled hydropower, then
the water value has to be higher than in the other coupled plants to stop production. Shadow prices
in coupled plants are not independent of the social prices but they are linked and water should be
transferred to high price periods. Maneuvering in coupled stations becomes limited by the
production constraints and the release of the upstream plant may create a situation that spilling
would be unavoidable if inflows are too high and the production constraint binds.

Environmental restrictions

The environmental concerns for hydropower plants are the changes on the water flows that may
affect the climate or the fauna in water bodies. Then maximal and minimal amounts of release may
be established to avoid environmental issues. Ramping-up and ramping-down stand for increasing
and decreasing release levels respectively in a hydropower plant. While these constraints are
relevant for coupled systems we will use the independent model to explain them briefly.

𝑇 𝑥𝑡

max ∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧
𝑡=1 𝑧=0

Subject to

𝑁 𝐿

𝑥𝑡 = ∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊
𝑗=1 𝑙=1

𝑅𝑗𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 − 𝑣𝑗𝑡 (5.7𝑎)

𝑅𝑗𝑡 ≤ 𝑅𝑗

95
 𝐻 𝐻
0 ≤ 𝑒𝑗𝑡 ≤ 𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗𝑡 ,
0 ≤ 𝑒𝑗𝑡𝐻 − 𝑒𝑗,𝑡−1
𝐻
≤ 𝑒𝑗𝑡𝑟𝑢 ,
𝐻
0 ≤ 𝑒𝑗,𝑡−1 − 𝑒𝑗𝑡𝐻 ≤ 𝑒𝑗𝑡𝑟𝑑
𝑅𝑗𝑡 , 𝑥𝑡 , 𝑒𝑗𝑡𝐻 , 𝑒𝑙𝑡𝑊 ≥ 0

𝐻 𝐻
𝑇, 𝑤𝑗𝑡 , 𝑒𝑙𝑡𝑊 , 𝑘, 𝑅𝑗0 , 𝑅𝑗 , 𝑒𝑗𝑡 , 𝑒𝑗𝑡 , 𝑒𝑗𝑡𝑟𝑢 , 𝑒𝑗𝑡𝑟𝑑 𝑔𝑖𝑣𝑒𝑛, 𝑅𝑗𝑇 𝑓𝑟𝑒𝑒, 𝑗 = 1, … , 𝑁, 𝑙 = 1, … , 𝐿,
𝑡 = 1, … , 𝑇

To solve for the first order conditions we build the following Lagrangian:

∑𝑁 𝐻 𝐿 𝑊
𝑗=1 𝑒𝑗𝑡 +∑𝑙=1 𝑒𝑙𝑡
𝑇 𝑇 𝑁 𝑇 𝑁

𝐿=∑ ∫ 𝑝𝑡 (𝑧)𝑑𝑧 − ∑ ∑ 𝜆𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝑗𝑡𝐻 + 𝑣𝑗𝑡 ) − ∑ ∑ 𝛾𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗 )
𝑡=1 𝑧=0 𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑁 𝑇 𝑁 𝑇 𝑁
𝐻
− − ∑ ∑ 𝜌𝑗𝑡 (𝑒𝑗𝑡𝐻 − 𝑒𝑗𝑡 ) − ∑ ∑ 𝜌𝑗𝑡 (−𝑒𝑗𝑡𝐻 + 𝑒𝑗𝑡
𝐻 𝑟𝑢 𝐻
) − ∑ ∑ 𝜓𝑗𝑡 𝐻
(𝑒𝑗𝑡 − 𝑒𝑗,𝑡−1 − 𝑒𝑗𝑡𝑟𝑢 )
𝑡=1 𝑗=1 𝑡=1 𝑗=1 𝑡=1 𝑗=1
𝑇 𝑁
𝑟𝑑 𝐻
− ∑ ∑ 𝜓𝑗𝑡 (𝑒𝑗,𝑡−1 − 𝑒𝑗𝑡𝐻 − 𝑒𝑗𝑡𝑟𝑑 ) (5.8𝑎)
𝑡=1 𝑗=1

The first-order conditions are:

𝑁 𝐿
𝜕𝐿
= 𝑝𝑡 (∑ 𝑒𝑗𝑡𝐻 + ∑ 𝑒𝑙𝑡𝑊 ) − 𝜆𝑗𝑡 − 𝜌𝑗𝑡 + 𝜌𝑗𝑡 − 𝜓𝑗𝑡
𝑟𝑢 𝑟𝑑
+ 𝜓𝑗𝑡 𝑟𝑢
+ 𝜓𝑗,𝑡+1 𝑟𝑑
− 𝜓𝑗,𝑡+1 =0
𝜕𝑒𝑗𝑡𝐻
𝑗=1 𝑙=1

𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0) (5.9𝑎)
𝜕𝑅𝑗𝑡
𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 )

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝐻
𝜌𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 < 𝑒𝑗𝑡 )

𝜌𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 > 𝑒𝑗𝑡

𝐻
)
𝑟𝑢
𝜓𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡𝐻 − 𝑒𝑗,𝑡−1
𝐻
< 𝑒𝑗𝑡𝑟𝑢 )
𝑟𝑑 𝐻
𝜓𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗,𝑡−1 − 𝑒𝑗𝑡𝐻 < 𝑒𝑗𝑡𝑟𝑑 ) 𝑡 = 1, … , 𝑇, 𝑗 = 1, … , 𝑁

From the constraints the minimum release of water is constrained to be positive so the first
condition has to hold with equality and only one of the ramping-up or the ramping-down

96
constraints can be binding. In short, the ramping constraint is connected to the upper production
constraint while the ramping-down is connected to the lower production constraint. As previously
discussed we have a situation in which prices vary and now there is a lower limit to water
processing. In the case that prices in two time periods are the same and the lower water-use
constraint is binding then the water value in the first period cannot be higher than the price, and
decreasing the minimum constraint will not influence the objective function at the optimum.

If the social price is higher in and the minimum water release constraint is not binding, then the
assumptions are contradicted since the water value in t is now lower than the price. If the case is
the opposite when there is a lower price in period t compared to the price in t + 1 then the price
formation and the use of water relationship is consistent. The water value in t + 1 is equal to the
price and equal to the water value in t in the second condition of (5.4). In this case the difference
between the price and the water value is not dictated by the minimum release constraint but by the
availability of water to be used in a higher price period. This case is especially relevant for
reservoirs that accumulate water to be used in higher price periods when there is no threat of
overflow and, thus, the minimum water release constraint is binding. The importance of the
ramping constraints comes not from the assumption of constant production but in the optimal
management about production in future periods.

These constraints compromise the validity of Hveding’s conjecture because when production and
ramping constraints are binding then the maneuverability of water is reduced importantly. These
constraints may cause a lock-in of water and as a consequence individual plants will have their
own water values. In a sense, if water values differ then emptying the reservoirs at the same time
may become quite difficult.

97
Appendix 6:

The general model shows implicitly how it is linked to the electricity model when electricity cannot
be transferred through specific transmission lines. We will define G generation nodes, C
consumption nodes and S network links. The net flow will be defined by the variable 𝑏𝑠𝑡 and
generation and consumption at each node influences the net flow:

𝐻 𝐻 ),
𝑏𝑠𝑡 = 𝑏𝑠𝑡 (𝑥1𝑡 , … , 𝑥𝐶𝑡 , 𝑒1𝑡 , … , 𝑒𝐺𝑡 𝑡 = 1, … , 𝑇, 𝑠 = 1, … 𝑆 (6.1𝑎)

In a way that the net flow is a function of the consumption and generation in each node. The energy
𝐿
losses will be defined by 𝑒𝑠𝑡 with the following properties:

𝐿 (𝑏 )
𝐿 𝐿 (𝑏 ),
𝜕𝑒𝑠𝑡 𝑠𝑡 𝜕 2 𝑒𝑠𝑡
𝐿 (𝑏 )
𝑠𝑡
𝑒𝑠𝑡 = 𝑒𝑠𝑡 𝑠𝑡 > 0, >0 (6.2𝑎)
𝜕𝑏𝑠𝑡 𝜕𝑏𝑠𝑡
𝑡 = 1, … , 𝑇, 𝑠 = 1, … 𝑆

Where the losses increase as the line flow increases. The losses will be calculated by injections
and withdrawals to avoid the complications of specifying the losses from transmission in specific
points. Consumption must be equal to the incoming net flow at equilibrium in general but this will
give us no information about the flows at specific nodes. Then the power flow in the lines will be
part of the energy balance equation and links into consumption nodes must be specified to
determine the amount of electricity delivered into the node. Congestion must also be addressed as
it is a common issue in real life situations where electricity flows both ways from generation nodes,
but consumption nodes only receive it. Loop-flows are created due to the possibility of electricity
travelling through generation nodes to make its way to the consumption nodes. Assuming
capacities are given and all the withdrawals and injections influence the flow in the transmission
lines we have that the flow has to be lower or equal than the capacity of the lines in order to avoid
congestion.

𝐻 𝐻)
𝑏𝑠𝑡 = 𝑏𝑠𝑡 (𝑥1𝑡 , … , 𝑥𝐶𝑡 , 𝑒1𝑡 , … , 𝑒𝐺𝑡 ≤ 𝑏𝑠 , 𝑡 = 1, … , 𝑇, 𝑠 = 1, … 𝑆 (6.3𝑎)

This means there is an upper limit on the line between the generation nodes. This will not capture
loop-flow congestion because even if the capacity is reached there may be other lines below their
physical limits. Voltage and stability will not be included in this analysis of the general model.

The social planning problem taking into account the previous issues becomes:

98
 𝑇 𝐶 𝑥𝑐𝑡

max ∑ ∑ ∫ 𝑝𝑐𝑡 (𝑧)𝑑𝑧

𝑡=1 𝑐=1 𝑧=0

Subject to

𝐶 𝑆
𝐿
∑ 𝑥𝑐𝑡 + ∑ 𝑒𝑠𝑡 = 𝑒𝑗𝑡𝐻
𝑐=1 𝑠=1

𝑅𝑗𝑡 ≤ 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 (6.4𝑎)

𝑅𝑗𝑡 ≤ 𝑅𝑗
𝐿 𝐿 (𝑏 )
𝑒𝑠𝑡 = 𝑒𝑠𝑡 𝑠𝑡
𝐻 𝐻)
𝑏𝑠𝑡 = 𝑏𝑠𝑡 (𝑥1𝑡 , … , 𝑥𝐶𝑡 , 𝑒1𝑡 , … , 𝑒𝐺𝑡
𝑏𝑠𝑡 ≤ 𝑏𝑠
𝑅𝑗𝑡 , 𝑥𝑐𝑡 , 𝑒𝑗𝑡𝐻 , 𝑒𝑠𝑡
𝐿
, 𝑏𝑠𝑡 ≥ 0

𝑇, 𝑤𝑗𝑡 , 𝑅𝑗0 , 𝑅𝑗, 𝑏𝑠 𝑔𝑖𝑣𝑒𝑛, 𝑡 = 1, … , 𝑇, 𝑠 = 1, … , 𝑆, 𝑐 = 1, … , 𝐶, 𝑗 = 1, … , 𝑁

Inserting for the losses the Lagrangian is:

𝑇 𝐶 𝑥𝑐𝑡 𝑇 𝑁

𝐿 = ∑ ∑ ∫ 𝑝𝑐𝑡 (𝑧)𝑑𝑧 − ∑ ∑ 𝜆𝑗𝑡 ( 𝑅𝑗𝑡 − 𝑅𝑗,𝑡−1 − 𝑤𝑗𝑡 + 𝑒𝐻𝑗𝑡 )

𝑡=1 𝑐=1 𝑧=0 𝑡=1 𝑗=1
𝑇 𝑁

− ∑ ∑ 𝛾𝑗𝑡 (𝑅𝑗𝑡 − 𝑅𝑗 )
𝑡=1 𝑗=1

𝑇 𝐶 𝑆 𝑁

− ∑ 𝜏𝑡 (∑ 𝑥𝑐𝑡 + ∑ 𝑒𝐿𝑠𝑡 (𝑏𝑠𝑡 (𝑥1𝑡 , … , 𝑥𝐶𝑡 , 𝑒𝐻1𝑡 , … , 𝑒𝐻𝐺𝑡 )) − ∑ 𝑒𝐻

𝑗𝑡 )
𝑡=1 𝑐=1 𝑠=1 𝑗=1

𝑇 𝑆

− ∑ ∑ 𝜇𝑠𝑡 (𝑏𝑠𝑡 (𝑥1𝑡 , … , 𝑥𝐶𝑡 , 𝑒𝐻 𝐻

1𝑡 , … , 𝑒𝐺𝑡 )) − 𝑏𝑠 ) (6.5𝑎)
𝑡=1 𝑠=1

The necessary first order conditions are:

𝐿 𝑆 𝑆
𝜕𝐿 𝜕𝑒𝑠𝑡 𝜕𝑏𝑠𝑡 𝜕𝑏𝑠𝑡 𝐻
𝐻 = −𝜆𝑗𝑡 − 𝜏𝑡 (1 − ∑ 𝐻 ) − ∑ 𝜇𝑠𝑡 ( 𝐻 ) ≤ 0 (= 0 𝑓𝑜𝑟 𝑒𝑗𝑡 > 0)
𝜕𝑒𝑗𝑡 𝜕𝑏𝑠𝑡 𝜕𝑒𝑗𝑡 𝜕𝑒𝑗𝑡
𝑠=1 𝑠=1
𝜕𝐿
= −𝜆𝑗𝑡 + 𝜆𝑗,𝑡+1 − 𝛾𝑗𝑡 ≤ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 > 0)
𝜕𝑅𝑗𝑡

99
 𝜆𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗,𝑡−1 + 𝑤𝑗𝑡 − 𝑒𝑗𝑡𝐻 ) (6.6𝑎)

𝛾𝑗𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑅𝑗𝑡 < 𝑅𝑗 )

𝜇𝑠𝑡 ≥ 0 (= 0 𝑓𝑜𝑟 𝑏𝑠𝑡 < 𝑏𝑠 )

𝑡 = 1, … , 𝑇, 𝑠 = 1, … 𝑆, 𝑐 = 1, … , 𝐶, 𝑗 = 1, … , 𝑁

The shadow price on the energy balance has a free sign but there may be problems obtaining a
unique optimum due to unclear properties of the flow function. Assuming positive electricity
consumption, the price will be equal to

𝑆 𝐿 𝑆
𝜕𝑒𝑠𝑡 𝜕𝑏𝑠𝑡 𝜕𝑏𝑠𝑡
𝑝𝑐𝑡 (𝑥𝑐𝑡 ) = 𝜏𝑡 + 𝜏𝑡 ∑ 𝐻 + ∑ 𝜇𝑠𝑡 ( 𝐻 ) (6.7𝑎)
𝜕𝑏𝑠𝑡 𝜕𝑒𝑗𝑡 𝜕𝑒𝑗𝑡
𝑠=1 𝑠=1

Interpreting this relationship, we find that the price is equal to the shadow price on the energy
balance plus the opportunity cost of an increase of consumption and the last term on the right-hand
side stands for the marginal losses in the link lines due to the increase in consumption. As the flow
increases on the lines then the losses increase, but flows change whenever consumption increases
marginally. This means that losses can be either positive or negative, which is the same case as
congestion. However, even if the congestion term can be negative, the shadow price on the
congested link out of the region may still be positive. If the loss decreases more than the increase
in consumption the social price could become negative if the loss term outweighs the shadow price
on energy balance and congestion. In this case consumers would be paid to use more electricity,
but this is a very unlikely situation in reality as all the nodes would need to have negative losses.
Thus we can safely assume that the energy balance constraint remains positive despite of the free
sign. The water value then becomes:

𝑆𝐿 𝑆
𝜕𝑒𝑠𝑡 𝜕𝑏𝑠𝑡 𝜕𝑏𝑠𝑡
𝜆𝑗𝑡 = 𝜏𝑡 (1 − ∑ 𝐻 ) − ∑ 𝜇𝑠𝑡 ( 𝐻 ) (6.8𝑎)
𝜕𝑏𝑠𝑡 𝜕𝑒𝑗𝑡 𝜕𝑒𝑗𝑡
𝑠=1 𝑠=1

where the water value equals the shadow price on the energy balance minus the losses created by
the energy injection and the sum of the congestion terms. Then if the system is congested and
losses increase then the water value becomes lower. If the water value has a higher value than the
difference between the value of congestion and the sum of losses and congestion, then production
is zero. In the case of a consumption node the loss term would become negative and the value of

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water of stored water increases. If there are no losses or congestion, the model becomes the same
as described in section 4. The water value in a generator node represents the marginal cost for
hydropower. Compared to the system created without transmission the water values are not
uniform but become node specific for generators nodes coming from the effects of losses and
congestion. Also prices at each node become different. Congestion becomes more important for
spot markets but Hveding’s conjecture does not apply to the aggregate system. This analysis gives
us an idea on how the transmission affects the behavior of a system but as mentioned by Førsund,
the analysis “may be impractical, or too costly, to internalize the full extent of externalities.”
(Førsund, 2011, p. 262). Losses and transmission constraint create important effects on the
interaction of the system and may change the prices and water values at individual nodes, but it
may be unfeasible to include it in an analysis that provides qualitative information about its
behavior.

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