The Economics of Electricity Markets
IEEE Press Series

With an accessible and progressive style written in straight-forward language, this book covers everything an engineer or economist needs to know to understand, operate within, plan and design an effective liberalized electricity industry, thus serving as both a useful teaching text and a valuable reference. The book focuses on principles and theory which are independent of any one market design. It outlines where the theory is not implemented in practice, perhaps due to other over-riding concerns. The book covers the basic modelling of electricity markets, including the impact of uncertainty (an integral part of generation investment decisions and transmission cost-benefit analysis). It draws out the parallels to the Nordpool market (an important point of reference for Europe). Written from the perspective of the policy-maker, the first part provides the introductory background knowledge required. This includes an understanding of basic economics concepts such as supply and demand, monopoly, market power and marginal cost. The second part of the book asks how a set of generation, load, and transmission resources should be efficiently operated, and the third part focuses on the generation investment decision. Part 4 addresses the question of the management of risk and Part 5 discusses the question of market power. Any power system must be operated at all times in a manner which can accommodate the next potential contingency. This demands responses by generators and loads on a very short timeframe. Part 6 of the book addresses the question of dispatch in the very short run, introducing the distinction between preventive and corrective actions and why preventive actions are sometimes required. The seventh part deals with pricing issues that arise under a regionally-priced market, such as the Australian NEM. This section introduces the notion of regions and interconnectors and how to formulate constraints for the correct pricing outcomes (the issue of "constraint orientation"). Part 8 addresses the fundamental and difficult issue of efficient transmission investment, and finally Part 9 covers issues that arise in the retail market.

• Bridges the gap between engineering and economics in electricity, covering both the economics and engineering knowledge needed to accurately understand, plan and develop the electricity market
• Comprehensive coverage of all the key topics in the economics of electricity markets
• Covers the latest research and policy issues as well as description of the fundamental concepts and principles that can be applied across all markets globally
• Numerous worked examples and end-of-chapter problems
• Companion website holding solutions to problems set out in the book, also the relevant simulation (GAMS) codes

Preface xv

Nomenclature xvii

PART I INTRODUCTION TO ECONOMIC CONCEPTS 1

1 Introduction to Micro-economics 3

1.1 Economic Objectives 3

1.2 Introduction to Constrained Optimisation 5

1.3 Demand and Consumers’ Surplus 6

1.3.1 The Short-Run Decision of the Customer 7

1.3.2 The Value or Utility Function 7

1.3.3 The Demand Curve for a Price-Taking Customer Facing a Simple Price 7

1.4 Supply and Producers’ Surplus 10

1.4.1 The Cost Function 11

1.4.2 The Supply Curve for a Price-Taking Firm Facing a Simple Price 11

1.5 Achieving Optimal Short-Run Outcomes Using Competitive Markets 14

1.5.1 The Short-Run Welfare Maximum 14

1.5.2 An Autonomous Market Process 15

1.6 Smart Markets 17

1.6.1 Smart Markets and Generic Constraints 17

1.6.2 A Smart Market Process 18

1.7 Longer-Run Decisions by Producers and Consumers 20

1.7.1 Investment in Productive Capacity 20

1.8 Monopoly 22

1.8.1 The Dominant Firm – Competitive Fringe Structure 24

1.8.2 Monopoly and Price Regulation 25

1.9 Oligopoly 26

1.9.1 Cournot Oligopoly 27

1.9.2 Repeated Games 27

1.10 Summary 28

Questions 29

Further Reading 30

PART II INTRODUCTION TO ELECTRICITY NETWORKS AND ELECTRICITY MARKETS 31

2 Introduction to Electric Power Systems 33

2.1 DC Circuit Concepts 33

2.1.1 Energy, Watts and Power 34

2.1.2 Losses 35

2.2 AC Circuit Concepts 36

2.3 Reactive Power 38

2.3.1 Mathematics of Reactive Power 40

2.3.2 Control of Reactive Power 42

2.3.3 Ohm’s Law on AC Circuits 43

2.3.4 Three-Phase Power 44

2.4 The Elements of an Electric Power System 45

2.5 Electricity Generation 46

2.5.1 The Key Characteristics of Electricity Generators 49

2.6 Electricity Transmission and Distribution Networks 52

2.6.1 Transmission Networks 54

2.6.2 Distribution Networks 57

2.6.3 Competition and Regulation 59

2.7 Physical Limits on Networks 60

2.7.1 Thermal Limits 61

2.7.2 Voltage Stability Limits 64

2.7.3 Dynamic and Transient Stability Limits 64

2.8 Electricity Consumption 66

2.9 Does it Make Sense to Distinguish Electricity Producers and Consumers? 67

2.9.1 The Service Provided by the Electric Power Industry 69

2.10 Summary 70

Questions 71

Further Reading 72

3 Electricity Industry Market Structure and Competition 73

3.1 Tasks Performed in an Efficient Electricity Industry 73

3.1.1 Short-Term Tasks 73

3.1.2 Risk-Management Tasks 75

3.1.3 Long-Term Tasks 75

3.2 Electricity Industry Reforms 76

3.2.1 Market-Orientated Reforms of the Late Twentieth Century 77

3.3 Approaches to Reform of the Electricity Industry 79

3.4 Other Key Roles in a Market-Orientated Electric Power System 81

3.5 An Overview of Liberalised Electricity Markets 82

3.6 An Overview of the Australian National Electricity Market 85

3.6.1 Assessment of the NEM 87

3.7 The Pros and Cons of Electricity Market Reform 88

3.8 Summary 89

Questions 90

Further Reading 90

PART III OPTIMAL DISPATCH: THE EFFICIENT USE OF GENERATION, CONSUMPTION AND NETWORK RESOURCES 91

4 Efficient Short-Term Operation of an Electricity Industry with no Network Constraints 93

4.1 The Cost of Generation 93

4.2 Simple Stylised Representation of a Generator 96

4.3 Optimal Dispatch of Generation with Inelastic Demand 97

4.3.1 Optimal Least Cost Dispatch of Generation Resources 98

4.3.2 Least Cost Dispatch for Generators with Constant Variable Cost 99

4.3.3 Example 101

4.4 Optimal Dispatch of Both Generation and Load Assets 102

4.5 Symmetry in the Treatment of Generation and Load 104

4.5.1 Symmetry Between Buyer-Owned Generators and Stand-Alone Generators 104

4.5.2 Symmetry Between Total Surplus Maximisation and Generation Cost Minimisation 105

4.6 The Benefit Function 105

4.7 Nonconvexities in Production: Minimum Operating Levels 106

4.8 Efficient Dispatch of Energy-Limited Resources 108

4.8.1 Example 109

4.9 Efficient Dispatch in the Presence of Ramp-Rate Constraints 110

4.9.1 Example 111

4.10 Startup Costs and the Unit-Commitment Decision 113

4.11 Summary 115

Questions 116

Further Reading 117

5 Achieving Efficient Use of Generation and Load Resources using a Market Mechanism in an Industry with no Network Constraints 119

5.1 Decentralisation, Competition and Market Mechanisms 119

5.2 Achieving Optimal Dispatch Through Competitive Bidding 121

5.3 Variation in Wholesale Market Design 123

5.3.1 Compulsory Gross Pool or Net Pool? 124

5.3.2 Single Price or Pay-as-Bid? 125

5.4 Day-Ahead Versus Real-Time Markets 126

5.4.1 Improving the Quality of Short-Term Price Forecasts 127

5.4.2 Reducing the Exercise of Market Power 129

5.5 Price Controls and Rationing 129

5.5.1 Inadequate Metering and Involuntary Load Shedding 131

5.6 Time-Varying Demand, the Load-Duration Curve and the Price-Duration Curve 133

5.7 Summary 135

Questions 137

Further Reading 137

6 Representing Network Constraints 139

6.1 Representing Networks Mathematically 139

6.2 Net Injections, Power Flows and the DC Load Flow Model 141

6.2.1 The DC Load Flow Model 144

6.3 The Matrix of Power Transfer Distribution Factors 145

6.3.1 Converting between Reference Nodes 146

6.4 Distribution Factors for Radial Networks 146

6.5 Constraint Equations and the Set of Feasible Injections 147

6.6 Summary 151

Questions 152

7 Efficient Dispatch of Generation and Consumption Resources in the Presence of Network Congestion 153

7.1 Optimal Dispatch with Network Constraints 153

7.1.1 Achieving Optimal Dispatch Using a Smart Market 155

7.2 Optimal Dispatch in a Radial Network 156

7.3 Optimal Dispatch in a Two-Node Network 157

7.4 Optimal Dispatch in a Three-Node Meshed Network 159

7.5 Optimal Dispatch in a Four-Node Network 161

7.6 Properties of Nodal Prices with a Single Binding Constraint 162

7.7 How Many Independent Nodal Prices Exist? 163

7.8 The Merchandising Surplus, Settlement Residues and the Congestion Rents 163

7.8.1 Merchandising Surplus and Congestion Rents 163

7.8.2 Settlement Residues 164

7.8.3 Merchandising Surplus in a Three-Node Network 165

7.9 Network Losses 166

7.9.1 Losses, Settlement Residues and Merchandising Surplus 167

7.9.2 Losses and Optimal Dispatch 168

7.10 Summary 169

Questions 170

Further Reading 170

8 Efficient Network Operation 171

8.1 Efficient Operation of DC Interconnectors 171

8.1.1 Entrepreneurial DC Network Operation 173

8.2 Optimal Network Switching 173

8.2.1 Network Switching and Network Contingencies 174

8.2.2 A Worked Example 174

8.2.3 Entrepreneurial Network Switching? 176

8.3 Summary 177

Questions 178

Further Reading 178

PART IV EFFICIENT INVESTMENT IN GENERATION AND CONSUMPTION ASSETS 179

9 Efficient Investment in Generation and Consumption Assets 181

9.1 The Optimal Generation Investment Problem 181

9.2 The Optimal Level of Generation Capacity with Downward Sloping Demand 183

9.2.1 The Case of Inelastic Demand 185

9.3 The Optimal Mix of Generation Capacity with Downward Sloping Demand 186

9.4 The Optimal Mix of Generation with Inelastic Demand 189

9.5 Screening Curve Analysis 191

9.5.1 Using Screening Curves to Assess the Impact of Increased Renewable Penetration 192

9.5.2 Generation Investment in the Presence of Network Constraints 193

9.6 Buyer-Side Investment 193

9.7 Summary 195

Questions 196

Further Reading 197

10 Market-Based Investment in Electricity Generation 199

10.1 Decentralised Generation Investment Decisions 199

10.2 Can We Trust Competitive Markets to Deliver an Efficient Level of Investment in Generation? 201

10.2.1 Episodes of High Prices as an Essential Part of an Energy-Only Market 201

10.2.2 The ‘Missing Money’ Problem 202

10.2.3 Energy-Only Markets and the Investment Boom–Bust Cycle 203

10.3 Price Caps, Reserve Margins and Capacity Payments 203

10.3.1 Reserve Requirements 204

10.3.2 Capacity Markets 205

10.4 Time-Averaging of Network Charges and Generation Investment 206

10.5 Summary 207

Questions 207

PART V HANDLING CONTINGENCIES: EFFICIENT DISPATCH IN THE VERY SHORT RUN 209

11 Efficient Operation of the Power System in the Very Short-Run 211

11.1 Introduction to Contingencies 211

11.2 Efficient Handling of Contingencies 212

11.3 Preventive and Corrective Actions 213

11.4 Satisfactory and Secure Operating States 215

11.5 Optimal Dispatch in the Very Short Run 216

11.6 Operating the Power System Ex Ante as though Certain Contingencies have Already Happened 218

11.7 Examples of Optimal Short-Run Dispatch 219

11.7.1 A Second Example, Ignoring Network Constraints 221

11.7.2 A Further Example with Network Constraints 222

11.8 Optimal Short-Run Dispatch Using a Competitive Market 223

11.8.1 A Simple Example 224

11.8.2 Optimal Short-Run Dispatch through Prices 227

11.8.3 Investment Incentives 228

11.9 Summary 229

Questions 230

Further Reading 230

12 Frequency-Based Dispatch of Balancing Services 231

12.1 The Intradispatch Interval Dispatch Mechanism 231

12.2 Frequency-Based Dispatch of Balancing Services 232

12.3 Implications of Ignoring Network Constraints when Handling Contingencies 233

12.3.1 The Feasible Set of Injections with a Frequency-Based IDIDM 235

12.4 Procurement of Frequency-Based Balancing Services 238

12.4.1 The Volume of Frequency Control Balancing Services Required 238

12.4.2 Procurement of Balancing Services 239

12.4.3 Allocating the Costs of Balancing Services 240

12.5 Summary 241

Questions 242

Further Reading 242

PART VI MANAGING RISK 243

13 Managing Intertemporal Price Risks 245

13.1 Introduction to Forward Markets and Standard Hedge Contracts 245

13.1.1 Instruments for Managing Risk: Swaps, Caps, Collars and Floors 246

13.1.2 Swaps 246

13.1.3 Caps 247

13.1.4 Floors 248

13.1.5 Collars (and Related Instruments) 249

13.2 The Construction of a Perfect Hedge: The Theory 249

13.2.1 The Design of a Perfect Hedge 250

13.3 The Construction of a Perfect Hedge: Specific Cases 252

13.3.1 Hedging by a Generator with no Cost Uncertainty 252

13.3.2 Hedging Cost-Shifting Risks 254

13.4 Hedging by Customers 256

13.4.1 Hedging by a Customer with a Constant Utility Function 257

13.4.2 Hedging Utility-Shifting Risks 258

13.5 The Role of the Trader 259

13.5.1 Risks Facing Individual Traders 261

13.6 Intertemporal Hedging and Generation Investment 263

13.7 Summary 264

Questions 265

14 Managing Interlocational Price Risk 267

14.1 The Role of the Merchandising Surplus in Facilitating Interlocational Hedging 267

14.1.1 Packaging the Merchandising Surplus in a Way that Facilitates Hedging 269

14.2 Interlocational Transmission Rights: CapFTRs 269

14.3 Interlocational Transmission Rights: Fixed-Volume FTRs 271

14.3.1 Revenue Adequacy 271

14.3.2 Are Fixed-Volume FTRs a Useful Hedging Instrument? 273

14.4 Interlocational Hedging and Transmission Investment 273

14.4.1 Infinitesimal Investment in Network Capacity 274

14.4.2 Lumpy Investment in Network Capacity 274

14.5 Summary 276

Questions 277

Further Reading 277

PART VII MARKET POWER 279

15 Market Power in Electricity Markets 281

15.1 An Introduction to Market Power in Electricity Markets 281

15.1.1 Definition of Market Power 281

15.1.2 Market Power in Electricity Markets 282

15.2 How Do Generators Exercise Market Power? Theory 284

15.2.1 The Price–Volume Trade-Off 284

15.2.2 The Profit-Maximising Choice of Rate of Production for a Generator with Market Power 286

15.2.3 The Profit-Maximising Offer Curve 287

15.3 How do Generators Exercise Market Power? Practice 289

15.3.1 Economic and Physical Withholding 289

15.3.2 Pricing Up and the Marginal Generator 291

15.4 The Incentive to Exercise Market Power: The Importance of the Residual Demand Curve 292

15.4.1 The Shape of the Residual Demand Curve 293

15.4.2 The Importance of Peak Versus Off-Peak for the Exercise of Market Power 293

15.4.3 Other Influences on the Shape of the Residual Demand Curve 295

15.5 The Incentive to Exercise Market Power: The Impact of the Hedge Position of a Generator 295

15.5.1 Short-Term Versus Long-Term Hedge Products and the Exercise of Market Power 297

15.5.2 Hedge Contracts and Market Power 297

15.6 The Exercise of Market Power by Loads and Vertical Integration 298

15.6.1 Vertical Integration 299

15.7 Is the Exercise of Market Power Necessary to Stimulate Generation Investment? 300

15.8 The Consequences of the Exercise of Market Power 301

15.8.1 Short-Run Efficiency Impacts of Market Power 301

15.8.2 Longer-Run Efficiency Impacts of Market Power 302

15.8.3 A Worked Example 302

15.9 Summary 304

Questions 306

Further Reading 306

16 Market Power and Network Congestion 307

16.1 The Exercise of Market Power by a Single Generator in a Radial Network 307

16.1.1 The Exercise of Market Power by a Single Generator in a Radial Network: The Theory 308

16.2 The Exercise of Market Power by a Single Generator in a Meshed Network 311

16.3 The Exercise of Market Power by a Portfolio of Generators 313

16.4 The Effect of Transmission Rights on Market Power 314

16.5 Summary 315

Questions 315

Further Reading 315

17 Detecting, Modelling and Mitigating Market Power 317

17.1 Approaches to Assessing Market Power 317

17.2 Detecting the Exercise of Market Power Through the Examination of Market Outcomes in the Past 318

17.2.1 Quantity-Withdrawal Studies 319

17.2.2 Price–Cost Margin Studies 321

17.3 Simple Indicators of Market Power 322

17.3.1 Market-Share-Based Measures and the HHI 322

17.3.2 The PSI and RSI Indicators 324

17.3.3 Variants of the PSI and RSI Indicators 326

17.3.4 Measuring the Elasticity of Residual Demand 328

17.4 Modelling of Market Power 330

17.4.1 Modelling of Market Power in Practice 331

17.4.2 Linearisation 332

17.5 Policies to Reduce Market Power 332

17.6 Summary 333

Questions 334

Further Reading 334

PART VIII NETWORK REGULATION AND INVESTMENT 335

18 Efficient Investment in Network Assets 337

18.1 Efficient AC Network Investment 337

18.2 Financial Implications of Network Investment 338

18.2.1 The Two-Node Graphical Representation 339

18.2.2 Financial Indicators of the Benefit of Network Expansion 341

18.3 Efficient Investment in a Radial Network 342

18.4 Efficient Investment in a Two-Node Network 344

18.4.1 Example 345

18.5 Coordination of Generation and Network Investment in Practice 348

18.6 Summary 350

Questions 351

Further Reading 351

PART IX CONTEMPORARY ISSUES 353

19 Regional Pricing and Its Problems 355

19.1 An Introduction to Regional Pricing 355

19.2 Regional Pricing Without Constrained-on and Constrained-off Payments 357

19.2.1 Short-Run Effects of Regional Pricing in a Simple Network 360

19.2.2 Effects of Regional Pricing on the Balance Sheet of the System Operator 361

19.2.3 Long-Run Effects of Regional Pricing on Investment 363

19.3 Regional Pricing with Constrained-on and Constrained-off Payments 364

19.4 Nodal Pricing for Generators/Regional Pricing for Consumers 367

19.4.1 Side Deals and Net Metering 367

19.5 Summary 369

Questions 370

Further Reading 370

20 The Smart Grid and Efficient Pricing of Distribution Networks 371

20.1 Efficient Pricing of Distribution Networks 371

20.1.1 The Smart Grid and Distribution Pricing 373

20.2 Decentralisation of the Dispatch Task 374

20.2.1 Decentralisation in Theory 374

20.3 Retail Tariff Structures and the Incentive to Misrepresent Local Production and Consumption 377

20.3.1 Incentives for Net Metering and the Effective Price 378

20.4 Incentives for Investment in Controllable Embedded Generation 380

20.4.1 Incentives for Investment in Intermittent Solar PV Embedded Generation 384

20.4.2 Retail Tariff Structures and the Death Spiral 385

20.4.3 An Illustration of the Death Spiral 386

20.5 Retail Tariff Structures 388

20.5.1 Retail Tariff Debates 389

20.6 Declining Demand for Network Services and Increasing Returns to Scale 390

20.7 Summary 393

Questions 395

References 397

Index 399

Dr Biggar is Australia’s leading expert on the economics of wholesale electricity markets and the economics of public utility regulation. Since 2002 he has provided economic advice primarily to the Australian Energy Regulator and the Australian Competition and Consumer Commission. He has also provided advice to other government agencies including the Australian Energy Markets Operator, the Australian Energy Markets Commission, and the New Zealand Electricity Authority. He has published a number of papers in academic journals in the economics of electricity markets and the economics of public utility regulation and regularly provides training courses in these areas to government agencies and industry. He has a particular interest in the assessment of market power in wholesale electricity markets and in matters related to wholesale market design.

Dr Hesamzadeh is assistant professor in electric power systems division of the school of electrical engineering at KTH Royal Institute of Technology in Stockholm, Sweden. Dr Hesamzadeh is a world leader in the modelling of market power in wholesale electricity markets, particularly in the context of transmission planning. His special fields of interests include Power Systems Planning and Design, Economics of Wholesale Electricity Markets, and Mathematical Modelling and Computing. Hesamzadeh is currently working towards his Docent degree in Electricity Markets at KTH.