ELECTRICITY MARKET DESIGN

William W. Hogan

Mossavar-Rahmani Center for Business and Government

John F. Kennedy School of Government
Harvard University
Cambridge, Massachusetts 02138

ACCC/AER Regulatory Conference 2021

Electricity Market Design Panel
Australia

July 30, 2021

Electricity Market Fundamentals

1
ELECTRICITY MARKET Energy Reform Challenges
A core challenge for all electricity systems is between monopoly provision and market operations.
Electricity market design depends on critical choices. There is no escape from the fundamentals.

Integrated Monopoly Competitive Markets

 Mandated  Voluntary
 Closed Access  Open Access
 Discrimination  Non-discrimination
 Central Planning  Independent Investment
 Few Choices  Many Choices
 Spending Other People’s Money  Spending Your Own Money
 Average Cost Pricing  Marginal Cost Pricing

A Key Market Design Objective

Supporting the Solution: Given the prices and settlement payments, individual optimal behavior is
consistent with the aggregate optimal solution.

2
ELECTRICITY MARKET Reality Tests
A passing reflection on history reinforces the view that there is great uncertainty about energy
technology choices for the future. There are many examples of both bad and good surprises.

TVA's nuclear plant auction set for November U.S. Shale Miracle:
“The Tennessee Valley Authority, in Once the technology crossed the market
apparently a first in the US power industry, threshold, deployment was both large and rapid.
plans to auction its unfinished Bellefonte
nuclear plant in Alabama on November 14 in
what amounts to a "fire sale" of epic
proportions.
Over more than four decades, an estimated
$6 billion was pumped into the project
imagined at a time of far different economic
and electricity projections and expectations.
Bellefonte's minimum asking price — $36.4
million.”
(Megawatt Daily, October 18, 2016, p. 3)

Good wholesale electricity market design is necessary to provide open access with non-
discrimination principles that encourage entry and innovation.

3
ELECTRICITY MARKET Electricity Restructuring
The case of electricity restructuring presents examples of fundamental problems that challenge
regulation of markets.

 Marriage of Engineering and Economics.

o Loop Flow.
o Reliability Requirements.
o Incentives and Equilibrium.

 Devilish Details.
o Retail and Wholesale Electricity Systems.
o Market Power Mitigation.
o Coordination for Competition.

 Jurisdictional Disputes.
o US State vs. Federal Regulators.
o European Subsidiarity Principle.

4
ELECTRICITY MARKET Electricity Restructuring
Electricity restructuring presents twin challenges with a broad theme.

 Create an effective electricity market design with associated transmission access rules.

o An electricity market must be designed.

o The market cannot solve the problem of market design.
o Incentives should drive decisions and innovation.

 Provide compatible market interventions to compensate for market imperfections.

o Market imperfections exist under the best designs.

o Network interactions make the obvious answers wrong or even dangerous.
o Poor market design makes interventions more necessary, more common, and more difficult.

There is a close connection between the twin challenges, and the slippery slope of intervention can
lead to an electricity market that may be worse than the system it was to replace.

If the central planners (or regulators) know what to do, then do it.
But if true, what is the need for electricity restructuring and markets?

5
ELECTRICITY MARKET Electricity Restructuring
The original arguments for greater reliance on markets emphasized the effects of non-utility
generators and the reduction or elimination of the conditions for natural monopoly in generation.

Competitive Wholesale Electricity Market Structure

Generation

Genco Genco ... Genco ... Genco Genco ... Genco

Regional Transmission Organization

Regulated
Transmission

Poolco

Gridco ... Gridco

System Operator
Distribution

Regulated
Disco Disco ... Disco ... Disco Disco ... Disco

Cust. Cust. ... Cust. Cust. Cust. ... Cust.

6
ELECTRICITY MARKET Energy Market Design
The U.S. experience illustrates successful market design and remaining challenges for both theory
and implementation.

 Design Principle: Integrate Market Design

and System Operations
Competitive Wholesale Electricity Market Structure
Provide good short-run operating incentives.
Support forward markets and long-run

Generation
investments. Genco Genco ... Genco ... Genco Genco ... Genco

 Design Framework: Bid-Based, Security Regional Transmission Organization

Constrained Economic Dispatch

Regulated
Transmission
Poolco

Gridco ... Gridco

Locational Marginal Prices (LMP) with System Operator

granularity to match system operations.

Distribution

Regulated
Financial Transmission Rights (FTRs). Disco Disco ... Disco ... Disco Disco ... Disco

 Design Implementation: Pricing Evolution Cust. Cust. ... Cust. Cust. Cust. ... Cust.

Better scarcity pricing to support resource

adequacy.
Unit commitment and lumpy decisions with coordination, bid guarantees and uplift payments.

 Design Challenge: Infrastructure Investment

Hybrid models to accommodate both market-based and regulated transmission investments.
Beneficiary-pays principle to support integration with rest of the market design.

7
ELECTRICITY MARKET Focus on Balancing Markets First
The solution to open access and non-discrimination inherently involves market design. Good
design begins with the real-time market and works backward. A common failure mode starts with
the forward market, without specifying the rules and prices that would apply in real time.

False Starts for the Electricity Market

Scheduling &
Investment Balancing
Commitment

X
Begin
Design
Here
Operations

Day, Week, Month, ... Real-Time

Ahead Dispatch & Balancing

Rules & Begin

Pricing Design
Here

Market expectations determine incentives. Start at the end.

Work backward, not forward, in setting market design.

8
ELECTRICITY MARKET Pool Dispatch
An efficient short-run electricity market determines a market clearing price based on conditions of
supply and demand balanced in an economic dispatch. Everyone pays or is paid the same price.

SHORT-RUN ELECTRICITY MARKET

Energy Price Short-Run

Marginal
(¢/kWh)
Cost
Price at
7-7:30 p.m.

Demand
7-7:30 p.m.

Price at
9-9:30 a.m.

Price at Demand
2-2:30 a.m. 9-9:30 a.m.

Demand
2-2:30 a.m.

Q1 Q2 Qmax
MW

9
ELECTRICITY MARKET Coordination
The independent system operator provides a dispatch function. Three questions remain. Just say
yes, and the market can decide on the split between bilateral and coordinated exchange.

• Should the system operator be allowed to offer an economic dispatch service for some
plants?

The alternative would be to define a set of administrative procedures and rules for system
balancing that purposely ignore the information about the costs of running particular plants. It seems more
natural that the system operator considers customer bids and provides economic dispatch for some plants.

• Should the system operator apply marginal cost prices for power provided through the
dispatch?

Under an economic dispatch for the flexible plants and loads, it is a straightforward matter to
determine the locational marginal costs of additional power. These marginal costs are also the prices that
would apply in the case of a perfect competitive market at equilibrium. In addition, these locational
marginal cost prices provide the consistent foundation for the design of a comparable transmission tariff.

• Should generators and customers be allowed to participate in the economic dispatch

offered by the system operator?

The natural extension of open access and the principles of choice would suggest that participation
should be voluntary. Market participants can evaluate their own economic situation and make their own
choice about participating in the operator's economic dispatch or finding similar services elsewhere.

10
NETWORK INTERACTIONS Locational Spot Prices
The natural extension of a single price electricity market is to operate a market with locational spot
prices. (Schweppe, Caramanis, Tabors, & Bohn, 1988)

 It is a straightforward matter to compute "Schweppe" spot prices based on marginal costs at each
location.

 Transmission spot prices arise as the difference in the locational prices.

LOCATIONAL SPOT PRICE OF "TRANSMISSION"

Energy Price Short-Run
(¢/kWh) Marginal
Cost

Price differential =
Demand

MW A Pa = 51 Marginal losses
+ Constraint prices
Constraint

B
Pb = 66
Energy Price Short-Run
(¢/kWh) Marginal
Cost

C
Demand

Pc = 55
MW
Energy Price Short-Run
Marginal
(¢/kWh)
Cost

Demand

MW

Price of "Transmission" from A to B = Pb - Pa = 15

Price of "Transmission" from C to A = Pa - Pc = -4

11
NETWORK INTERACTIONS Locational Spot Prices
RTOs operate spot markets with locational prices. For example, PJM updates prices and dispatch
every five minutes for over 12,000 locations. Locational spot prices for electricity exhibit
substantial dynamic variability and persistent long-term average differences.

Minnesota Hub: $131.21/MWh. First Energy Hub:

$-1.57/MWh. March 3, 2008, 9:55am

Missouri MPS -$71.25, Dominion Hub $281.53. May 22, 2013,

12:40pm.

From MISO-PJM Joint and Common Market,

++[Link]

12
ELECTRICITY MARKET A Consistent Framework
The example of successful central coordination, CRT, Regional Transmission Organization (RTO)
Millennium Order (Order 2000) Standard Market Design (SMD) Notice of Proposed Rulemaking
(NOPR), “Successful Market Design” provides a workable market framework that is working in
places like New York, PJM in the Mid-Atlantic Region, New England, the Midwest, California, SPP,
and Texas. This efficient market design is under (constant) attack.

POOLCO
The RTO NOPR Order SMD NOPR "Successful Market Design"
Contains a Consistent Framework
Bilateral Schedules
at Difference in Nodal Prices Poolco…OPCO…ISO…IMO…Transco…RTO…
ITP…WMP…: "A rose by any other name …"
License Plate Access Charges

Coordinated Market-Driven Investment “Locational marginal pricing (LMP) is the

Spot Market electricity spot pricing model that serves as the
Bid-Based, benchmark for market design – the textbook
Security-Constrained, ideal that should be the target for policy
Economic Dispatch
with Nodal Prices makers. A trading arrangement based on LMP
takes all relevant generation and transmission
costs appropriately into account and hence
07/05
Financial Transmission Rights
07/02
supports optimal investments.” (International
(TCCs, FTRs, FCRs, CRRs, ...) 12/99
5/99
Energy Agency, 2007)

This is the only model that can meet the tests of open access and non-discrimination.
Supporting the Solution: Given the prices and settlement payments, individual optimal behavior is
consistent with the aggregate optimal solution. Anything that upsets this design will unravel the wholesale
electricity market. The basic economic dispatch model accommodates the green energy agenda, as in the
expanding Western Energy Imbalance Market (EIM).
13
ELECTRICITY MARKET Path Dependence
The path to successful market design can be circuitous and costly. The FERC “reforms” in Order
890 illustrate “path dependence,” where the path chosen constrains the choices ahead. Early
attempts with contract path, flowgate and zonal models led to design failures in PJM (`97), New
England (`98), California (`99), and Texas (`03). Regional aggregation creates conflicts with system
operations. Successful market design integrates the market with system operations.

Paths to Successful Market Design

SMD
et
a rk CAISO
d M Bilateral Schedules
at Difference in Nodal Prices "Last
i ze Resort" 1999

License Plate Access Charges

an ing

Market-Driven Investment
g 1997
Or nc
Coordinated
Spot Market

l a 1998
Ba ion Bid-Based,

ss
Security-Constrained,
i Economic Dispatch

sm hts
with Nodal Prices

an Rules 2003
Tr Rig Financial Transmission Rights
890
Explode
(TCCs, FTRs, FCRs, CRRs, ...)

C
AT Reform
888
Standardization
Transparency ISO
PX
Contract Zonal
"Simple,
Quick" Path

TLR Flowgate

14
ELECTRICITY MARKET A Consistent Framework
The basic model covers the existing Regional Transmission Organizations in the United States and
is expanding through the Western Energy Imbalance Market. ([Link])
(IRC Council and CAISO maps)

15
Climate and Energy Policy

16
CLIMATE AND ENERGY Clean Energy and Climate Policy
The challenges of climate change present a ‘wicked problem’ that is difficult to solve because of
incomplete, contradictory, and changing requirements. The scale is global, the duration covers
many generations into the future, and the uncertainties can seem overwhelming.

Overview
 The Science helps identify the
Benefits, Costs, Welfare Maximization
challenges and opportunities. and the Social Cost of Carbon

 The Science does not and cannot tell $ Economic Benefits

us what to do.
Social Benefit of Carbon
 There are tradeoffs and this points to
the need for cost-benefit analysis.
Maximum Net Benefits

 One guidepost is the Social Cost of Damages

Carbon that provides a standard for
what to do and how much is enough.
Social Cost of Carbon
 There are many critical uncertainties.
0 Emissions
 A central problem is the continuing
debate about discount rates.

 The climate policy choices will interact with everything else, including the design and
operation of energy markets.

17
CLEANER ENERGY Policy Barriers
The National Academy of Sciences identified two main barriers and emphasized two
“overarching recommendations.” (National Academy of Sciences, The Power of Change: Innovation for Development and
Deployment of Increasingly Clean Electric Power Technologies, Washington D.C., 2016, pp.3-4.) (National Academy of Sciences, 2016)

Barriers
“The committee concluded that there are two significant barriers to accelerating greater penetration of
increasingly clean electricity technologies. First, as noted above, the market prices for electricity do not
include “hidden” costs from pollution, stemming mainly from negative impacts on human health,
agriculture, and the environment. Levels of criteria pollutants declined over the past three decades, but
still cause harms. Harms from GHGs are difficult to estimate, but if accounted for in the market, could be
considered by consumers. …

The second barrier is that the scale of the climate change challenge is so large that it necessitates a
significant switch to increasingly clean power sources. In most of the United States, however, even with a
price on pollution, most increasingly clean technologies would lack cost and performance profiles that would
result in the levels of adoption required. In most cases, their levelized costs are higher than those of dirtier
technologies, and there are significant challenges and costs entailed in integrating them into the grid at high
levels. This means that reducing the harmful effects of emissions due to electricity generation will require a
broader range of low-cost, low- and zero-emission energy options than is currently available, as well as
significant changes to the technologies and functionality of the electricity grid and the roles of utilities,
regulators, and third parties. …

…even if the technological and institutional barriers to greater adoption of increasingly clean power
technologies were overcome but their prices were not competitive, an adequate scale of deployment would
require tremendous public outlays, and in many parts of the world would be unlikely to occur. While learning
by doing can lower some costs, deployment incentives are likely to be insufficient as the primary policy
mechanism for achieving timely cost and performance improvements.”

18
CLIMATE AND ENERGY Going Green
The Social Cost of Carbon would define the “appropriate price on pollution.” Too high or too low
would reduce net welfare. Failure to price carbon leads to inefficient policies that impose costs but
may have few benefits.
“Subsidies pose a more general problem in this context. They attempt to discourage carbon-intensive
activities by making other activities more attractive. One difficulty with subsidies is identifying the eligible
low-carbon activities. Why subsidize hybrid cars (which we do) and not biking (which we do not)? Is the
answer to subsidize all low carbon activities? Of course, that is impossible because there are just too
many low-carbon activities, and it would prove astronomically expensive. Another problem is that
subsidies are so uneven in their impact. A recent study by the National Academy of Sciences looked at
the impact of several subsidies on GHG emissions. It found a vast difference in their effectiveness in
terms of CO2 removed per dollar of subsidy. None of the subsidies were efficient; some were horribly
inefficient; and others such as the ethanol subsidy were perverse and actually increased GHG
emissions. The net effect of all the subsidies taken together was effectively zero!”
So in the end, it is much more effective to penalize carbon emissions than to subsidize everything else.”
(Nordhaus, 2013, p. 266)

“Mufson: ExxonMobil has been facing a revolt by shareholders unhappy with the company’s financial
performance and its approach to climate change. Is this part of a wave of efforts to push new and maybe
difficult responsibilities onto corporations?
Nordhaus: It’s just another example of efforts we’re expending that are extremely costly and extremely
divisive. It takes away valuable analyst time from other more fruitful activities such as pricing fossil fuels at
the proper social costs. The movement to have companies measure and disclose their emissions is just an
enormous waste of time. If you had a proper price on carbon, we wouldn’t have to do that any more than we
need companies to do an inventory of their wheat use or silicon use. It’s another example of how we’re
going town a rabbit hole of measures. Even the central banks are getting involved.”
(Steven Mufson Nordhaus Interview, Nobel winner’s evolution from ‘dark realist’ to just plain realist on climate change, Washington Post, June 14, 2021.)

19
CLEAN ENERGY Subsidies and Market Interventions
Subsidies are growing: RPS, RECs, PTCs, ITCs, DR, ZECs and zero emission targets.

“Subsidies are contagious. Competition in the markets could be replaced by competition to

receive subsidies.” (Monitoring Analytics, 2017, p. 2)

20
CLEAN ENERGY Uncertainty and the Social Cost of Carbon
The DICE model is deterministic. Nordhaus examines some of the effects of uncertainty in terms of
the implied SCC today by approximating the impact of uncertainty in the DICE model.

“When uncertainties are accounted for, the expected values of most of the major geophysical variables,
such as temperature, are largely unchanged. However, the social cost of carbon is higher (by about 10
percent) under uncertainty than in the best-guess case because of the asymmetry in the impacts of
uncertainty on the damages from climate change. … the relative uncertainty is much higher for economic
variables than for geophysical variables.” (Nordhaus, 2018, p. 335)

“The ranges of uncertainty for future emissions, concentrations, temperature, and damages are extremely
large. However, this does not reduce the urgency of taking strong climate change policies today. When
taking uncertainties into account, the desirable strength of policy (as measured by the social cost of carbon
or the optimal carbon tax) would increase, not decrease.” (Nordhaus, 2018, p. 335)

“The act-then-learn approach to decisions cannot be fully incorporated into the current DICE uncertainty
structure. … I have undertaken a small test case which examines the impact of learning that is delayed until
2050. …. The results of this simplified example indicate that policies are relatively insensitive to late
learning, although there is substantial value of learning. The optimal carbon price in the act-then-learn
approach is about 6 percent higher than for that of learn-then-act ($36.1/tCO2 rather than $34.2/tCO2 in
2015.” (Nordhaus, 2018, p. 358)

21
CLEAN ENERGY Social Cost of Carbon
The estimates for the Social Cost of Carbon from the DICE optimization, the CLC policy proposal,
and the Net-Zero America cost effective trajectories diverge substantially.

The DICE model computes an optimal trajectory. The Clmate Leadership Council proposal includes a
“Gradually Rising Carbon Fee … Carbon Dividends for All Americans … Significant Regulatory
Simplification … Border Carbon Adjustment.”1 The Princeton Net-Zero America report sets a 2050
emissions target and estimates the implied marginal cost of emission reduction for a range of
trajectories. (Larson et al., 2020, p. 204) The near term estimates are similar, but by 2050 the implied
SCCs diverge from substantially from the DICE optimum. (Gollier, 2020)

1
[Link]

22
Electricity Market Design
And
The Green Agenda

23
ELECTRICITY MARKET Energy Market Design
The expansion of intermittent sources and the rise in special subsidies is seen as a threat to
efficient electricity market design.

“The supply of intermittent wind and solar generation with zero marginal operating cost is increasingly
rapidly in the U.S. These changes are creating challenges for
wholesale markets in two dimensions. Short term energy and
ancillary services markets, built upon mid-20th century models of
optimal pricing and investment, which now work reasonably well,
must accommodate the supply variability and energy market
price impacts associated with intermittent generation at scale.
These developments raise more profound questions about
whether the current market designs can be adapted to provide
good long-term price signals to support investment in an efficient
portfolio of generating capacity and storage consistent with
public policy goals. … Reforms in capacity markets and scarcity
pricing mechanisms are needed if policymakers seek to adapt
the traditional wholesale market designs to accommodate
intermittent generation at scale. However, if the rapid growth of
integrated resource planning, subsidies for some technologies
but not others, mandated long term contracts, and other
expansions of state regulation continues, more fundamental
changes are likely to be required in the institutions that determine
generator and storage entry and exit decisions.” (Joskow, 2019)
(emphasis added)

There are several issues such as system strength (Australian Energy Market Commission, 2020) and
multi-period pricing (Hua, Schiro, Zheng, Baldick, & Litvinov, 2019) (Biggar & Reza Hesamzadeh, 2022).
However, scarcity pricing is a continuing challenge for market design (Hogan, 2013).

24
ELECTRICITY MARKET Pool Dispatch
An efficient short-run electricity market determines a market clearing price based on conditions of
supply and demand balanced in an economic dispatch. Everyone pays or is paid the same price.
The thought experiment of a no-carbon/zero-variable-cost, green energy supply reveals that the
basic efficiency principles still apply. The same principles apply in an electric network. (Schweppe et al.,
1988) Storage will be important, but does not change the basic design analysis. (Korpås & Botterud, 2020)

SHORT-RUN ELECTRICITY MARKET SHORT-RUN ELECTRICITY MARKET

With zero marginal cost renewables
Energy Short-Run
Energy Price Short-Run Price
Marginal (¢/kWh) Marginal
(¢/kWh) Cost
Cost
Price at Price at
7-7:30 p.m. 7-7:30 p.m.

}
Demand Demand
7-7:30 p.m. 7-7:30 p.m.

Price at Scarcity
9-9:30 a.m. Price

Price at Demand Demand

2-2:30 a.m. 9-9:30 a.m. Price at 9-9:30 a.m.
9-9:30 a.m.

Demand Demand
Price at
2-2:30 a.m. 2-2:30 a.m.
2-2:30 a.m.

Q1 Q2 Qmax Q1 Q2 Qmax
MW MW

A key feature would be to increase the importance of scarcity pricing. ERCOT adopted an
Operating Reserve Demand Curve in 2014. (Hogan, 2013) PJM has proposed a series of reforms for
energy price formation, motivated in part by the impact of increased penetration of intermittent
renewable resources. (PJM Interconnection, 2017) (PJM Interconnection, 2019) (Federal Energy Regulatory Commission, 2020)

25
ELECTRICITY MARKET ERCOT Scarcity Pricing
ERCOT launched implementation of the ORDC in in 2014. The summer peak is the most important
period. The first five years of results show recent scarcity of reserves and higher reserve prices.
$10,000

$9,000
5 min SCED ORDC On‐Line Price Adder ($/MWh)

$8,000

$7,000

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

$0
0 1,000 2,000 3,000 4,000 5,000
5 min SCED ORDC On‐Line Reserve (MW)

Jun2014‐Aug 2014 Jun2015‐Aug2015 Jun2016‐Aug2016 Jun2017‐Aug2017

ERCOT ORDC Jun2018 ‐ Aug2018 Jun2019‐24Aug2019

Source: Resmi Surendran, ERCOT, EUCI Presentation, Updated 8/31/2019. The ORDC is illustrative. See also (Hogan & Pope, 2017)

26
ELECTRICITY MARKET ERCOT Scarcity Pricing
After introduction of the ORDC scarcity prices and the contribution to Peaker Net Margin were low
for several years, but this changed in 2019.2 The PNM target level is $80,000-$95,000/MW-Yr.
(Potomac Economics, 2019, p. 112)

2
Beth Garza, “Independent Market Monitor Report,” Potomac Economics, ERCOT Board of Directors Meeting Presentation, October 8,
2019.

27
ELECTRICITY MARKET ERCOT Scarcity Pricing
An ERCOT review of the Summer of 2019 underscored that scarcity pricing was consistent with
performance of the system.3

Notably, high prices occurred at the right time, and were not socialized through capacity market
charges spread over all load.

3
Dan Woodfin and Carrie Bivens, “Summer 2019 Operational Review”, ERCOT Board of Directors Meeting Presentation, October 8, 2019.

28
ELECTRICITY MARKET Augmented ORDC
A conservative assumption addressed at reliability would be to increase the estimate of the loss of
load probability. A shift of one standard deviation would have a material impact on the estimated
scarcity prices. The choice would depend on the margin of safety beyond the economic base.
Texas applied this approach in 2019 and 2020 by implementing 0.25 standard deviations shifts.

29
ELECTRICITY MARKET ERCOT Scarcity Pricing
The February 2021 crisis in ERCOT provided a stunning example of a scarcity event. The scale is
evident in the sustained high prices in $/MWh over four days.4

 A one-in-a-hundred-year (?) weather event

covered Texas and large areas of the Midwest.
 Load increased while natural gas, coal, nuclear
and renewable generators went offline.
 Natural gas pipelines and producing wells froze,
reducing deliveries, including exports to Mexico.
 Electric power lines were down.
 The system operator took out-of-market actions
to reduce demand and increase supply.
 Prices rose to $9000/MWh, for days not just
hours.
 The system operator used the last of line of
defense of rotating blackouts to prevent a total
system collapse.
 A post-mortem will provide many lessons. One
challenge will be to learn the right lessons.
 Was this a reasonably anticipated problem of a
Black Swan that only looks obvious in retrospect?

4
Source: LCG Consulting, Energyonline, [Link]

30
Appendix

31
SPOT MARKET Volatile Spot Prices
The spot price in an electricity market can be highly volatile. A contract for differences offers a
simple financial contract that replicates a fixed price contract. The seller sells to the pool. The
buyer buys from the pool. The CFD provides a means to replicate a bilateral transaction.

"Contracts For Differences" Allow Bilateral Transactions

When SP > CP, Generator paid SP

for sales to market, and
Spot Price (SP) pays SP - CP to customer.

Contract
Price
(CP)

Time
When SP
for sales to market, and
receives CP - SP from customer.

32
SPOT MARKET Volatile Spot Prices
With the contracts for differences, the physical operation of the power pool becomes independent
of the long-term contracts. Importantly, deliverability of the power does not depend on the
contracts. The pool operates a spot market and produces spot prices for settlements.

CONTRACTS CAN HEDGE SPOT PRICES

Long-Term
Power Contracts

Generators Customers

Short-Term Short-Term
Power Sales Power Pool Power Purchases
Pool Price (SP)

Time

33
SPOT MARKET Volatile Spot Prices
For transmission between locations, the transmission opportunity cost is the difference in the
locational prices. This difference of volatile prices will be even more volatile.

NEED "Hedges" FOR LOCATIONAL PRICING

Price
(p/kWh)

A
Pa =

Time

B Price
(p/kWh)

Pb =
C
Time

Price
(p/kWh)

Pc =

Time

Price of "Transmission" from C to B = Pb - Pc = Volatile Price

34
NETWORK INTERACTIONS Loop Flow
Electric transmission network interactions can be large and important.

 Conventional definitions of network "Interface" transfer capacity depend on the assumed

load conditions.

 Transfer capacity cannot be defined or guaranteed over any reasonable horizon.

POWER TRANSFER CAPACITY VARIES WITH LOAD

(WITH IDENTICAL LINKS, TRUE CONSTRAINT ON LINE FROM OLDGEN TO BIGTOWN)

Is The "Interface" Transfer Capacity

900 MW? Or 1800 MW?

OLDGEN OLDGEN
900 MW 600 0 MW 600
=m =m
ax ax
300 MW

INTERFACE

INTERFACE
600 MW
900 MW 1800 MW

BIGTOWN W
BIGTOWN
0 M
30 W 00
0 MW M 1800 MW 12

NEWGEN NEWGEN

35
NETWORK INTERACTIONS Loop Flow
There is a fatal flaw in the old "contract path" model of power moving between locations along a
designated path. The network effects are strong. Power flows across one "interface" can have a
dramatic effect on the capacity of other, distant interfaces.

Transmission Impacts Vary Across the Eastern System

Transfer Capability Impacts
1000 MW from VACAR to BG&E/PEPCO
0.2

Transfer Interface Impact (1000 MW)

Contract Path
0.0
-0.2
Assumption
-0.4
(Impact = 0)
-0.6
-0.8
-1.0
-1.2
-1.4
-1.6
-1.8
-2.0
-2.2
-2.4
-2.6
EC DU MA TV
AR EC KE EC W A N
AC to
to
M AR /C
P& AR to
.E
CA DU YPP
AA to Lt to VP R KE to
C V P oV DU to /C M
P KE OH P& AA
/C L C
P&
L

Interface in Eastern Interconnected System

Source: VEM, Winter Operating Study, December 1993.

36
ELECTRICITY MARKET Transmission Management
Defining and managing transmission usage is a principal challenge in electricity markets.

Transmission Capacity Definitions

Contract Path Flow-Based Paths Point-to-Point

Contract Path Fiction Parallel Flows Flows Implicit

OASIS Schedules Flowgate Rights Financial Transmission

and TLR FGRs Rights
FTRs

37
NETWORK INTERACTIONS Financial Transmission Rights
A mechanism for hedging volatile transmission prices can be established by defining financial
transmission rights to collect the congestion rents inherent in efficient, short-run spot prices.
(Hogan, 1992)

NETWORK TRANSMISSION FINANCIAL RIGHTS

A Pa = 51

Constraint

C Pb = 66

Pc = 55

Price of "Transmission" from A to B = Pb - Pa = 15

Price of "Transmission" from C to A = Pa - Pc = -4

DEFINE TRANSMISSION CONGESTION CONTRACTS BETWEEN LOCATIONS.

FOR SIMPLICITY, TREAT LOSSES AS OPERATING COSTS.
RECEIVE CONGESTION PAYMENTS FROM ACTUAL USERS; MAKE
CONGESTION PAYMENTS TO HOLDERS OF CONGESTION CONTRACTS.
TRANSMISSION CONGESTION CONTRACTS PROVIDE PROTECTION
AGAINST CHANGING LOCATIONAL DIFFERENCES.

38
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William W. Hogan is the Raymond Plank Research Professor of Global Energy Policy, John F. Kennedy School of Government, Harvard
University. This paper draws on research for the Harvard Electricity Policy Group and for the Harvard-Japan Project on Energy and the
Environment. The author is or has been a consultant on electric market reform and transmission issues for Allegheny Electric Global Market,
American Electric Power, American National Power, Aquila, AQUIND Limited, Atlantic Wind Connection, Australian Gas Light Company, Avista
Corporation, Avista Utilities, Avista Energy, Barclays Bank PLC, Brazil Power Exchange Administrator (ASMAE), British National Grid Company,
California Independent Energy Producers Association, California Independent System Operator, California Suppliers Group, Calpine Corporation,
CAM Energy, Canadian Imperial Bank of Commerce, Centerpoint Energy, Central Maine Power Company, Chubu Electric Power Company,
Citigroup, City Power Marketing LLC, Cobalt Capital Management LLC, Comision Reguladora De Energia (CRE, Mexico), Commonwealth Edison
Company, COMPETE Coalition, Conectiv, Constellation Energy, Constellation Energy Commodities Group, Constellation Power Source, Coral
Power, Credit First Suisse Boston, DC Energy, Detroit Edison Company, Deutsche Bank, Deutsche Bank Energy Trading LLC, Duquesne Light
Company, Dyon LLC, Dynegy, Edison Electric Institute, Edison Mission Energy, Electricity Authority New Zealand, Electricity Corporation of New
Zealand, Electric Power Supply Association, El Paso Electric, Energy Endeavors LP, Energy Security Board Australia, Exelon, Financial
Marketers Coalition, FirstEnergy Corporation, FTI Consulting, GenOn Energy, GPU Inc. (and the Supporting Companies of PJM), GPU PowerNet
Pty Ltd., GDF SUEZ Energy Resources NA, Great Bay Energy LLC, GWF Energy, Independent Energy Producers Assn, ISO New England,
Israel Public Utility Authority-Electricity, Koch Energy Trading, Inc., JP Morgan, LECG LLC, Luz del Sur, Maine Public Advocate, Maine Public
Utilities Commission, Merrill Lynch, Midwest ISO, Mirant Corporation, MIT Grid Study, Monterey Enterprises LLC, MPS Merchant Services, Inc.
(f/k/a Aquila Power Corporation), JP Morgan Ventures Energy Corp., Morgan Stanley Capital Group, Morrison & Foerster LLP, National
Independent Energy Producers, New England Power Company, New York Independent System Operator, New York Power Pool, New York
Utilities Collaborative, Niagara Mohawk Corporation, NRG Energy, Inc., Ontario Attorney General, Ontario IMO, Ontario Ministries of Energy and
Infrastructure, Pepco, Pinpoint Power, PJM Office of Interconnection, PJM Power Provider (P3) Group, Powerex Corp., Powhatan Energy Fund
LLC, PPL Corporation, PPL Montana LLC, PPL EnergyPlus LLC, Public Service Company of Colorado, Public Service Electric & Gas Company,
Public Service New Mexico, PSEG Companies, Red Wolf Energy Trading, Reliant Energy, Rhode Island Public Utilities Commission, Round Rock
Energy LP, San Diego Gas & Electric Company, Secretaría de Energía (SENER, Mexico), Sempra Energy, SESCO LLC, Shell Energy North
America (U.S.) L.P., SPP, Texas Genco, Texas Utilities Co, Tokyo Electric Power Company, Toronto Dominion Bank, Transalta, TransAlta
Energy Marketing (California), TransAlta Energy Marketing (U.S.) Inc., Transcanada, TransCanada Energy LTD., TransÉnergie, Transpower of
New Zealand, Tucson Electric Power, Twin Cities Power LLC, Vitol Inc., Westbrook Power, Western Power Trading Forum, Williams Energy
Group, Wisconsin Electric Power Company, and XO Energy. The views presented here are not necessarily attributable to any of those
mentioned, and any remaining errors are solely the responsibility of the author. (Related papers can be found on the web at [Link] ).

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