Power System Economics: Designing Markets for Electricity / Edition 1

Power System Economics: Designing Markets for Electricity / Edition 1

by Steven Stoft
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Power System Economics: Designing Markets for Electricity / Edition 1

The first systematic presentation of electricity market design-from the basics to the cutting edge. Unique in its breadth and depth. Using examples and focusing on fundamentals, it clarifies long misunderstood issues-such as why today's markets are inherently unstable. The book reveals for the first time how uncoordinated regulatory and engineering policies cause boom-bust investment swings and provides guidance and tools for fixing broken markets. It also takes a provocative look at the operation of pools and power exchanges.

• Part 1 introduces key economic, engineering and market design concepts.

• Part 2 links short-run reliability policies with long-run investment problems.

• Part 3 examines classic designs for day-ahead and real-time markets.

• Part 4 covers market power, and

• Part 5 covers locational pricing, transmission right and pricing losses.
The non-technical introductions to all chapters allow easy access to the most difficult topics. Steering an independent course between ideological extremes, it provides background material for engineers, economists, regulators and lawyers alike. With nearly 250 figures, tables, side bars, and concisely-stated results and fallacies, the 44 chapters cover such essential topics as auctions, fixed-cost recovery from marginal cost, pricing fallacies, real and reactive power flows, Cournot competition, installed capacity markets, HHIs, the Lerner index and price caps.

About the Author
Steven Stoft has a Ph.D. in economics (U.C. Berkeley) as well as a background in physics, math, engineering, and astronomy. He spent a year inside FERC and now consults for PJM, California and private generators. Learn more at www.stoft.com.

Product Details

ISBN-13: 9780471150404
Publisher: Wiley
Publication date: 05/28/2002
Edition description: New Edition
Pages: 496
Product dimensions: 7.30(w) x 9.20(h) x 1.20(d)

Read an Excerpt

Power System Economics

Designing Markets for Electricity
By Steven Stoft

John Wiley & Sons

ISBN: 0-471-15040-1

Chapter One

Why Deregulate?

The propensity to truck, barter, and exchange one thing for another ...is common to all men. Adam Smith The Wealth of Nations 1776

In the beginning there was competition-brutal and inefficient. Between 1887 and 1893, twenty-four central station power companies were established within Chicago alone. With overlapping distribution lines, competition for customers was fierce and costs were high. In 1898, the same year he was elected president of the National Electric Light Association, Samuel Insull solved these problems by acquiring a monopoly over all central-station production in Chicago. In his historic presidential address to NELA, Insull explained not only why the electricity business was a "natural monopoly" but why it should be regulated and why this regulation should be at the state level, not the local level. Insull argued that

exclusive franchises should be coupled with the conditions of public control, requiring all charges for services fixed by public bodies to be based on cost plus a reasonable profit.

These ideas shocked his fellow utility executives but led fairly directly to Regulatory laws passed by New York and Wisconsin in 1907 establishing the first two state utility commissions. Reformers of the Progressive era also lent support to regulation although they were about equally supportive of municipal power companies. Their intention, to hold down monopoly profits, was at odds with Insult's desire to keep profits above the competitive level, but both sides agreed that competition was inefficient and that providing electricity was a natural monopoly.

On the scale of an isolated city, provision of electricity is a natural monopoly and requires regulation or municipal ownership, but as transmission technology developed, it brought new possibilities for trade and competition. The earliest electric companies, for instance Brush's company which lighted New York's Broadway in 1880, integrated generation with distribution, and, in fact, sold light, not electricity. Edison initially did the same, installing the light bulbs in the homes he lit and charging by the number of bulbs installed. Westinghouse introduced highvoltage transmission using alternating current (AC) technology to the United States in 1886, and by 1892 Southern California Edison was operating a 10-kV transmission line 28 miles in length. This, too, was an integrated part of a full-service utility.

Integrated utilities remained natural monopolies for many years while expansion of the high-voltage transmission network continued, mainly for purposes of reliability. Eventually the entire Eastern United States and Eastern Canada were united in a single synchronized AC power system. By operating at extremely high voltages, this system is able to move power over great distances with very little loss, often less than three percent in a thousand miles.

Regulated, vertically integrated utilities were well established by the time the transmission system made substantial long-distance trade possible. As a consequence, trade was slow to develop, but the existence of the grid made the de-integration of the electric industry a possibility. Generation could now be split off to form a separate competitive market, while the remaining parts of the utilities remained behind as regulated monopolies. By 1990, encouraged by a general trend toward deregulation, the de-integration trend in electric markets was underway in a number of countries. Today, more than a dozen semi-deregulated electricity markets are operating in at least ten countries, with several operating in the United States.

In spite of this apparent success, many fundamental problems remain. After ten years of operation, the British market has declared itself a failure and replaced all of its market rules. In a single year, the California market managed to cost its customers more than ten years of hoped-for savings. Alberta (Canada) is worried over the results of its recent auction of generation rights that brought in much less revenue than planned. New York saw prices spike to over $6,000/MWh in 2000, and the New England ISO had to close its installed capacity market due to extreme problems with market power. But initial problems do not prove deregulation is doomed; some markets are functioning well. A closer look at fundamental arguments for and against deregulation may help explain why such mixed results might be expected.

Chapter Summary 1-1: Improvements in transmission, rather than changes in generation technology, have removed the natural monopoly character of the wholesale power market in most locations. This makes possible the replacement of regulated generation monopolies with deregulated wholesale power markets. In principle these can be more efficient than the old-style regulation. In practice, California has proven bad deregulation to be worse than mediocre regulation, and England has demonstrated that mediocre deregulation can bring cost-saving efficiencies to a badly regulated generation monopoly.

In the short run, power-market problems tend to be more dramatic than the benefits. The problems are primarily the result of two demand-side flaws: the almost complete failure of customers to respond to relevant price fluctuations, and the customer's ability to take power from the grid without a contract. As fundamental as these are, it is possible to design a workable market around them, but it does require design as well as extensive and clever regulation. Recent U.S. history has shown that there are three impediments to such progress: politics, special interests, and overconfidence. The last is largely due to a dramatic underestimation of the problem.

Section 1: Conditions for Deregulation. Deregulation requires the market not be a strong natural monopoly. One view holds that small efficient gas turbines have overturned the natural monopoly of large coal plants. Yet today's competitive suppliers are far larger than any coal plant, so if the size of a large coal plant were problematic for competition, today's markets would be uncompetitive.

Section 2: Problems with Regulation. Regulation can provide strong Costminimizing incentives and can hold prices down, but it must trade off one against the other. Competition can do both at once. In practice, regulators hold prices down near long-run average costs but leave cost-minimizing incentives too weak. The result is high costs and high prices.

Section 3: The Benefits of Wholesale Competition. Competition provides full strength cost-minimizing incentives and, at the same time, forces average prices down toward their minimum. It may also encourage efficient retail prices.

Section 4: The Benefits of Real-time Pricing. Competition may induce realtime pricing, which will reduce consumption during periods of peak demand. This will reduce the need for installed capacity and, if extensively adopted, should provide a net savings of about 2% of retail price. Although this could be Achieved easily under regulation, competition will provide some additional incentives, but their consequences are still unclear.

Section 5: Problems with Deregulating Electricity. Contemporary electricity markets have inadequate metering. Consequently it does not make sense for load to respond to price fluctuations, and bilateral contracts cannot be physically enforced in real time. As a result demand can and sometimes does exceed supply, and competitive pricing is impossible at crucial times. These flaws result in high prices that must be limited, and they provide ideal conditions for the exercise of market power. Electricity markets are also extremely complex and prone to problems with local market power due to the inadequacies of the transmission system.


Scale economies make it possible for natural monopolies to produce their output more cheaply than a competitive market would. A 1-MW power plant is not very efficient, and there is no way to produce power cheaply on this small a scale. A 10-MW power plant can always do better. Efficiency continues to increase significantly to about the 100-MW level but ever more slowly beyond this level. It used to increase to about 800 MW, and it was once assumed that nuclear plants would be the most economical and their most efficient size would be even greater. If these economies of scale continued, the cheapest way to provide California with power would be to build a 25,000-MW power plant and a few smaller ones to handle load fluctuations. But a large single power plant could not support competition. A competitive market necessarily utilizes smaller plants and would therefore have higher production costs. Consumers would have to pay more if a natural monopoly is forced to operate as a competitive industry with small-scale plants.

Efficiency gains from the operation of multiple plants are another possible source of natural monopoly. Even if very large plants are not more efficient, large generating companies may be. A large company can hire specialists and share parts and repair crews. If multiplant efficiencies continue to large enough scales, a competitive market would again be less efficient than a monopolist.

If a monopolist can produce power at significantly lower cost than the best competitive market, then deregulation makes little sense. The lack of a natural monopoly is a prerequisite to successful deregulation, or at least, the condition of natural monopoly should hold only weakly.

Did Cheap Gas Turbines End the Natural Monopoly?

One popular argument for deregulation claims technical progress has recently nullified the conditions for a natural monopoly in generation. This view assumes generation had previously been a natural monopoly because the most efficient size power plant was approaching 1000 MW, and new technologies have made 100-MW plants almost as efficient.

If this argument were correct, then an 1000-MW supplier must in some sense be a monopolist, and the market must need suppliers that have capacities smaller than 1000 MW to be competitive. But in this case, deregulation must certainly have failed in the United States because every market contains suppliers with capacities exceeding 1000 MW. Yet no one who suggests small efficient plants are a necessary condition for competition seems worried by the presence of huge suppliers in the new markets.

The beliefs that the most efficient size power plant must be quite small, and that competitive suppliers can own many such plants are contradictory. Most likely the former is incorrect, at least in markets with peak loads of over 5000 MW. Fortunately, vast transmission grids have made such large markets the norm. When small efficient plants are necessary for competition, suppliers with total generating capacity greater than the most efficient size plant should be prohibited. Greater threats of natural monopoly conditions come from the economies of multiplant companies and weaknesses in the power grid that effectively isolate "load pockets" during peak load conditions.


The most common argument for deregulation is the inefficiency of regulation. There can be no quarrel about its inefficiency, but it does not follow that Deregulation will be better. Deregulation is not equivalent to perfect competition which is Well known to be efficient. Electricity markets have their own inefficiencies that Need to be compared with the inefficiencies of regulation.

To date, such comparisons have been largely speculative. The most decisive answers inevitably are based on the least information. One side claims regulation is essential because electricity is a basic need. What about housing? That need is even more basic, and housing is 99% deregulated. The other side claims competition provides incentives to reduce costs, while regulation does not. What about the many regulated utilities that have provided reliable power for many years for less than 60/kWh? Do they lack all cost-minimizing incentives? One argument posits that when a regulated utility makes a bad investment, ratepayers pick up the tab; but, when an unregulated supplier makes a bad investment, stockholders pick up the tab. This analysis is myopic. Particular losses fall on the stockholders of particular companies, but the cost of capital takes into account the probability of such mistakes, and every mistake increases the estimated probability. Like all costs, the cost of capital is paid for by consumers. Not only does the cost of capital average in the cost of mistakes, it also adds a risk premium. To the extent stockholders of regulated utilities are sheltered, they demand less of a risk premium than do stockholders of unregulated suppliers. With competition, there may be fewer mistakes, but the mistakes will be paid for by consumers, and a risk premium will be added.

Regulation has two fundamental problems: (1) it cannot provide a strong incentive to suppliers as cheaply as can a competitive market, and (2) regulatory bodies themselves do not have proper incentives. Well-trained regulators could provide much better regulation. But for government to provide competent regulation, the political process would need to change. The first problem, that of incentives provided by regulators, is more susceptible to analysis.

The Regulator's Dilemma

Truly competitive markets do two things at once; they provide full-powered incentives (1) to hold price down to marginal cost, and (2) to minimize cost. Regulation can do one or the other but not both. It must always make a trade-off because suppliers always know the market better than the regulators.

This trade-off is the core idea of modern regulatory theory. Perfect cost-of-service (COS) regulation is at one extreme of the regulatory spectrum. It assures that, no matter what, suppliers will recover all of their costs but no more. This includes a normal rate of return on their investment. Perfect COS regulation Holds prices down to long-run costs but takes away all incentive to minimize cost. If the suppliers make an innovation that saves a dollar of production costs, the regulator takes it away and gives it to the customer.

At the other extreme is perfect price-cap regulation. It sets a cap on the supplier's price according to some formula that takes account of inflation and technical progress, and it never changes the formula. Now every dollar saved is kept by the supplier, so its incentives are just as good as in a competitive market. But it's difficult to pick a price-cap formula that can be fixed for twenty years at a time. A perfect (very-long-term) price cap must always allow prices that are well above long-run cost to avoid accidentally bankrupting suppliers. Consequently, prices will be too high.

The reader unfamiliar with the theory of regulation may be tempted to invent clever ways for the regulator to provide full cost-minimizing incentives while holding prices down to cost, but all will fail. The inevitability of this trade-off has been established repeatedly and with great rigor; however, the trade-off can be improved by improving the regulator's effective knowledge. The main technique for making the trade-off is to adjust the price cap more or less frequently. Constant adjustment produces COS regulation while extremely infrequent adjustment produces pure price-cap regulation. In between, incentives are moderately strong and prices are moderately low. If the regulator has a fair amount of information, this trade-off can be quite satisfactory, but it will never equal perfect competition.

Regulation in Practice

Competition can hold average prices down to long-run costs while putting full strength pressure on cost minimization. At best, regulation does a decent job of both but does neither quite as well as competition. But how does regulation work in practice?


Excerpted from Power System Economics by Steven Stoft Excerpted by permission.
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Table of Contents

List of Results and Fallacies.


Acronyms and Abbreviations.


Part 1: Power Market Fundamentals.


Why Deregulate?

What to Deregulate.

Pricing Power, Energy, and Capacity.

Power Supply and Demand.

What Is Competition?

Marginal Cost in a Power Market.

Market Structure.

Market Architecture.

Designing and Testing Market Rules.

Part 2: Reliability, Price Spikes and Investment.

Reliability and Investment Policy.

Price Spikes Recover Fixed Costs.

Reliability and Generation.

Limiting the Price Spikes.

Value-of-Lost-Load Pricing.

Operating-Reserve Pricing.

Market Dynamics and the Profit Function.

Requirements for Installed Capacity.

Inter-System Competition for Reliability.

Unsolved Problems.

Part 3: Market Architecture.


The Two-Settlement System.

Day-Ahead Market Designs.

Ancillary Services.

The Day-Ahead Market in Theory.

The Real-Time Market in Theory.

The Day-Ahead Market in Practice.

The Real-Time Market in Practice.

The New Unit-Commitment Problem.

The Market for Operating Reserves.

Part 4: Market Power.

Defining Market Power.

Exercising Market Power.

Modeling Market Power.

Designing to Reduce Market Power.

Predicting Market Power.

Monitoring Market Power.

Part 5: Locational Pricing.

Power Transmission and Losses.

Physical Transmission Limits.

Congestion Pricing Fundamentals.

Congestion Pricing Methods.

Congestion Pricing Fallacies.

Refunds and Taxes.

Pricing Losses on Lines.

Pricing Losses at Nodes.

Transmission Rights.




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