Don’t Overemphasize Spot at the Expense of Forward and Real

Time (Macro & Micro)

  Federal Energy Regulatory Commission

  February 26, 2002

  Robert Blohm

  Investment Banker & Economist

  email: rb112@columbia.edu

T O T A LR E V E N U E = MR

TOTALREVENUECURVES

= AR

AR =MRLINEAR :

QUANTITYSOLD

AR : AVERAGE REVENUE

NON-LINEAR

TOTALCOST

TOTALREVENUE

QUANTITYSOLD

TOTALCOST

CURVESMC

=

NON-LINEAR

AC

AC = MC

: SLOPE

OUTSIDE THE PERFECTLY COMPETITIVE TEXTBOOK WORLD OF STRAIGHT LINES ,CURVES ARE NON-LINEAR .

AC : AVERAGE COSTMC : MARGINAL COST

LINEAR :

=MR : MARGINAL REVENUE

: SLOPE

IMPERFECT COMPETITORS PRODUCE THE PROFIT-MAXIMIZINGQUANTITY AND PRICE OFF THE AVERAGE REVENUE CURVE

p pc

q pc

PERFECT COMPETITIONONLY AT A HORIZONTAL SUPPLY AND DEMAND CURVE

WHERE MARGINAL EQUALS AVERAGE

MC

AC

AR

MR

QUANTITY

$ / UNIT

q

p

DEMAND CURVEVALUE CURVE

SUPPLY CURVE

MC: MARGINAL COST

AC: AVERAGE COSTAR: AVERAGE REVENUE

MR: MARGINAL REVENUE

q : PERFECTLY COMPETITIVE QUANTITY pc

p : PERFECTLY COMPETITIVE PRICE pc

: PERFECTLY COMPETITIVE SUPPLY AND DEMAND CURVE

Q

ACTUAL AND PERCEIVEDDEMAND CURVE

IMPERFECT COMPETITION :ONCE THE (PERCEIVED) DEMAND CURVE SLOPES ,

AVERAGE AND MARGINAL REVENUE DIVERGE

ARMR

QUANTITY

$ / UNIT

5/6c

A QUINTOPOLY

1 2/3

1/3

ACTUAL DEMAND CURVE

PERCEIVED DEMAND CURVE

AR

MRQ

$ / UNIT

2/5

4/5c

A QUADROPOLY

1 3/5

AR

MR

1/2

3/4c

A TRIOPOLY

1 1/2

AR

MRQ

2/3

2/3c

A DUOPOLY

1 1/3 1

AR

MR

QUANTITY

1

1/2c

A MONOPOLY

PERCEIVED AGGREGATE DEMAND CURVE STEEPENS AS THE INDUSTRYCOMPRISES FEWER STRATEGIC PLAYERS.

EACH PLAYER IS EFFECTIVELY A SMALL MONOPOLIST, LEAVING ONE-AND-THE-SAME RESIDUAL PORTION OF DEMAND UNSERVED.

p = c

PERFECTCOMPETITION :

FLAT HORIZONTALSUPPLY AND DEMAND

CURVE$ / UNIT

1Q

MR : AGGREGATE PERCEIVED MARGINAL REVENUEAR : AGGREGATE PERCEIVED AVERAGE REVENUE

p

pp

p

p

qq

qq

qq

S

D

Q

MP

AP

SPLITTING THE DIFFERENCE WITH LESS PRICE-SENSITIVE BUYERSGIVES SELLERS A HIGHER (AVERAGE) PRICE .

BILATERALIZATION MEANS MULTIPERIOD PRECOMMITMENT INMULTIPLE FORWARD MARKETS : PRICE-PATH REVELATION MEANS

SMOOTHER, MORE PREDICTABLE PRICE BEHAVIOR .

QUANTITY&

TIME

UNITPRICE

Q : TOTAL QUANTITY BOUGHT / SOLD

A MARKET'S OR AUCTION'SPRICE-DETERMINING MECHANISM

AFFECTSPRICE SIGNALLING .

NET DEMAND-IMPATIENCE

IMPLICIT BILATERALIZATION OF POOLS .

SINGLE (MP) PRICE POOL HIDES (AP) PRICE PATH .

AP : AVERAGE PRICE

S : SUPPLY

D : DEMAND

MP : MARGINAL PRICE

: TRANSACTED PRICES

VARIABLE-COST CURVE

VALUE CURVE

S

D

O

BID & OFFER CURVESARE

NOT THE SAME ASTHE VALUE /

VARIABLE-COSTSUPPLY AND

DEMAND CURVES .

UNITPRICE

B

BID & OFFERCURVES START

FROMINVERTEDPOSITIONS

S

DB

SEQUENCE OFTRADE

FROM THE LEFT ASBID CURVE RISES &

OFFER CURVELOWERS .

THE LESS PATIENTTRADE FIRST AS THECURVES INTERSECTON THE PRICE PATH

FROM LEFT TORIGHT .

IMPLICITBILATERALIZATION

OF POOLS

O

S

D

O

B

S

D

O

B

S

D

O

B

QUANTITY&

TIME

RIGHTWARD SEQUENCE OF TRADEAS BID & OFFER CURVES APPROACH VALUE CURVE & VARIABLE-COST CURVE FROM THE LEFT

VALUE CURVE

VARIABLE-COST CURVE

O : OFFER-PRICE CURVEB : BID-PRICE CURVES : SUPPLY CURVED : DEMAND CURVE

UNITPRICE

Q

MP

QUANTITY&

TIME

UNITPRICE

S

D

Q

A MARKET'S OR AUCTION'SPRICE-DETERMINING

MECHANISMAFFECTS

ALLOCATION OF SURPLUS .

SINGLE (MP) PRICE POOLREALLOCATES TO BUYERS

THE EXTRA SURPLUSOTHERWISE GOING TO SELLERS

MORE PRICE-SENSITIVE THAN BUYERS .

NET DEMAND-IMPATIENCE .

AP

VARIABLE COST CURVE

VALUE CURVE

S : SUPPLYD : DEMAND

: SURPLUS TO SELLERS IN ASINGLE (MP) PRICE POOL

: EXTRA SURPLUS TO SELLERS INA BILATERALIZED EXCHANGE

MP : MARGINAL PRICEAP : AVERAGE PRICE

S

D

Q

AP

MP

QUANTITY&

TIME

UNITPRICE

CALIFORNIA UTILITIES WANTED A PERMANENTLYMANDATORY POOL TO BE ABLE TO CAPTURE EXTRA

SURPLUS ,POST RETAIL ACCESS .

WHEN THEY FAILED TO GET IT , THEYDIVESTED GENERATION TO BECOME

NET DEMANDERS .

NET SUPPLY-IMPATIENCE .

: EXTRA SURPLUS TO BUYERS IN A BILATERALIZED EXCHANGE

VALUE CURVE

VARIABLE COST CURVE

S : SUPPLY

D : DEMAND

MP : MARGINAL PRICE

AP : AVERAGE PRICE

S

D

Q

MR

AR

QUANTITY&

TIME

UNITPRICE

VARIABLE COST CURVE

VALUE CURVE

p

NET DEMAND-IMPATIENCE .

MARKET POWER OF SELLERS RELATIVE TO BUYERS .

BILATERALIZATION MEANS SELLERS PRICE OFF THE MARKET'SAVERAGE (TRANSACTION) REVENUE CURVE .

ONE-(MARGINAL-)PRICE POOLS MASK PRICE SIGNALLING OFMARKET POWER ; SO,

UNDER THE MYTH OF PERFECTLY-COMPETITIVE POOL PRICING ,THEY MAY ENCOURAGE SELLERS TO REDUCE QUANTITY .

REDUCED SUPPLY CURVE IFSINGLE-(VARIABLE-COST-)PRICED POOL

REDUCED QUANTITY IFSINGLE-(VARIABLE-

COST-)PRICED POOL

MR

S : SUPPLYD : DEMAND

AR : AVERAGE REVENUEMR : MARGINAL REVENUE

MR : MARGINAL REVENUE AFTER SUPPLYREDUCTION

consumed at

bought at

t - n . . . t - 2t - 3 t - 1 t

t - n

. . .

t - 3

t - 2

t - 1

t

The physical energy price is the average price of the purchase portfolio.

The financial concept of "term structure" is closely linked to a "purchase portfolio",which is a strongly physical concept.

Row t: (pre)purchase portfolio forconsumption done at time t

Column t-n:

term-structure

ofpurchases

made at time t - n

Table 1

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. . .

. . .

. . .

. . .

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.

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.

.

2 Measures can hurt forward markets

• Operation of spot market by a system operator– Officially designed/operated spot market risks being made the

mandatory market for regulated supply by State regulators

• Lack of physical transmission rights– Hoarding of physical transmission rights is outdone by a

properly designed real-time market• Financial rights can be hoarded too, and at much less cost

– Financial derivatives are always more expensive than the real thing

A spot market is not a real-time market for reliability

• It can be an economic optimization market• The real time-market is the true end-point of the forward market price path.• Real time transactions cannot be done moment-by-moment

deterministically– Time is too short

• Real time performance and value must be measured probabilistically– Classical physics versus quantum mechanics

• Joint indeterminacy of position and momentum• Joint indeterminacy of time and reliability-pricing

– reliability pricing as a time average

Tiered real-time market

• NERC’s Control Performance Standard– targets error performance of Balancing Authorities

relative to system/frequency error performance– individual error is assessed based on whether it hurts or

helps the system/frequency

CPS1

(mHz)+

+

FB i 10

-

MW, or

Control area i's maximum allowed 1-minute average total tie-lineflow (including response) in the direction of the frequency error:

:

:

: One-year target probability density of 1-minuteaverages of frequency error, adjusted for deviation of

the mean from 0

FBi 10

F

F

:

: Probability

"No inadvertent allowedin the direction of

Frequency error when"

F :

On average over the past year:Approximate

0iB :

F

FBT ii

10

1-minute average ofFrequency error

- +F

50-50

Annual standarddeviation of F

Year's Mean of F

Control area i's bias

i iCPSi BBT 102, 5.16

i i

i

BB

BF

10

2

5.16

10

0 iB0B::Bias for other than iSystem bias

F 22

TargetRMS:

• Market made it necessary to price Balancing Authorities’ inadvertent – because they have have commercial interest– must be done in a way compatible with tariffed

pricing of unscheduled energy of exclusively commercial entities

Tiered real-time market (cont.d)

• Market made it necessary to price Balancing Authorities inadvertent (cont.d)– 3 components of inadvertent valuation

• Market value of the energy • Transmission loading component• Frequency control contribution (FCC)

– value of unscheduled is not just energy: it is also quickness of response

» primary (response) and secondary (regulation/AGC, and (operating & replacement/load-following reserves)

» primary is faster and more valuable than secondary

– value is the unscheduled energy’s good or bad contribution to the frequency deviation relative to system/frequency error performance

» compatible with CPS1

Tiered real-time market (cont.d)

Balancing Authority i 's Frequency Control Contribution hi , is the slope of the regression line throughpoints relating hF to iI sampled at different hours h

hF

hi ,

iI

hF

D u a l p r i c i n g o f u n s c h e d u l e d e n e r g yA m b i g u i t y a l o n g t h e d i a g o n a l

R e v e n u e / E x p e n s e

U n s c h e d u l e d p a r t 0 g o o d b a d r e c e i v e

e n e r g y p a r t 0U s o l d pUp e pUp e p a y

b o u g h t pUp e pUp e

Primary Response Stabilizes Frequency Secondary Response Restores Frequency Hz

60

59.925

Seconds15

Inadvertent Interchange and Primary and Secondary Response Very simplified

Numbers in Mw100 100

75 75

100 100

75 25 50 50

25 5075 50

75 25

50

50 50

BalancingAuthority A

BalancingAuthority B

Secondaryresponseof 50

Inadvertentof 25

Outage of 50 inBalancing Authority B

Replacement by 50 from Balancing Authority A

Primary response of50 in load reduction,25 each in A and B

Load

Generation

Tiered real-time market (cont.d)• FCC does not target frequency

• Balancing Authorities must settle their FCC monthly– Since inadvertents sum to zero by definition, Balancing Authorities always

clear

• Balancing Authorities must also comply with CPS frequency targeting, acting as agents subject to NERC penalty– NERC CPS penalty will prompt Balancing Authorities to trade their CPS

rights the way DOE pollution penalties prompted market for pollution rights.

• To meet their monthly CPS scores, Balancing Authorities will trade their frequency control contributions as an alternative to buying options on frequency support

• FCC is open and scalable to a market below Balancing Authorities– Balancing Authorities can apply FCC to their constituent entities

to incent entities’ self-provision and good performance, thereby minimizing the Balancing Authority’s own local intervention.

• Three tiered market for frequency control– NERC, Balancing Authorities, local entities.

• Frequency is a public good requiring an authority like NERC to drive the frequency-control markets by the threat of penalty.

– This meets both a reliability and a markets objective

Tiered real-time market (cont.d)

Producing unscheduled energy versus producing frequency support (under contract):

Frequency supportProducing without (option)contract

Producing under (option)contract

Affects producer 'j's 'ij Not affects producer 'j's 'ijbecause "scheduled"; so, settled

Secondary

Entitlement to payment for

reversing some system Improves buyer j's ij because

part reversed & settled with 'j

Affects producer _j's _ijPrimary

Entitlement to payment for part

of some entity _j's _ij

Not affects buyer j's ij; rather

j prepays part of ij to _j

4 market operations

Entities j may be indifferent, but BAs i are not indifferent, between

Paying out your ij to another *i , 'j , _j Paying another *i , 'j , _j to reduce your ij

For increasing his _ij

(or *i )

primary by ij

For increasing

his 'ij (or

*i )

secondary by

ij

By increasinghis scheduledBy settling

ij of

his *i ,

_ij or

'ijNo optioncontract

Option contract

By buying ijof his *i ,

_ij

or 'ij

No optioncontract

Optioncontract

Operation 1: Operation 2: Operation 3: Operation 1: Operation 4:

Settlement payout of

ijBuy primary support

ij

Trading

ij

Settlement

payout of ij

Buy secondarysupport

ij

Ancillary services markets

• Ancillary services markets need to be developed as robust options markets– The option price is driven by volatility which is

another way to capture/express Frequency Control Contribution

Possible portfolio of optionsPrice should arbitrage buyer's avoided cost with supplier's opportunity cost

p supply: demand: price:

q in order of size of unscheduled

Puts on generation Calls on generation Calls on loads

I n a c o m p l e t e o p t i o n s m a r k e t f o r f r e q u e n c y r e s p o n s et h e o p t i m a l s c h e d u l i n g p o i n t m i n i m i z e s t h e c o s t o f u n s c h e d u l e d B + C

P e r i o d

O v e r s c h e d u l i n g

A C M O p t i m a l l y w S c h e d u l i n g B D

U n d e r s c h e d u l i n g O r d e r o f s i z e o f u n s c h e d u l e d U n s c h e d u l e d

A B C D O v e r s c h e d u l e d O v e r s c h e d u l e d + U n d e r s c h e d u l e d U n d e r s c h e d u l e d d u e t o o v e r s c h e d u l i n g d u e t o o p t i m a l l y s c h e d u l i n g d u e t o u n d e r s c h e d u l i n g

)](),([)( DValueAValueMinCBMinValue

Conclusion• True price revelation requires specifying spot markets less in order

to leave room for the forward and real-time markets to mature• FERC should not

– over-specify spot markets on the phony pretext that those markets are delivering on their misnamed promise of real-time transactions and reliability,

– nor prompt thereby the migration of transactions from physical forward markets where they belong.

• Forward markets are in desperate need of liquidity development– Spot-opiented merchant generators are capital short