December 4, 2000© 2000 Fernando L. Alvarado1 Reliability concepts and market power Fernando L. Alvarado Professor, The University of Wisconsin Invited

December 4, 2000 © 2000 Fernando L. Alvarado 1

Reliability concepts and market power

Fernando L. AlvaradoProfessor, The University of Wisconsin

Invited Seminar at the U. S. Department of EnergyDecember 4, 2000


Outline

• Reliability basics overview

• Some market power issues


Basics overview (assumptions)

• Exactly two technologies– Each technology has a known price

• No market power

• Inelastic demand

• Reliability event occurs when demand exceeds supply


Quantity (power)

Pri

ce

Dem

and

(ine

last

ic)

Available supply

Clearingprice

Maximumavailable

power

Deterministic Demand and Supply, low demand case


Quantity (power)

Pri

ce

Dem

and

(ine

last

ic)

Available supply

Clearingprice

Maximumavailable

power

Deterministic Demand and Supply, high demand case


Probabilistic Demand, high demand case

Outageprobability

Probability of low prices


The piece-wise nature of the supply curve

Gen

erat

or 1

Gen

erat

or 2

Gen

erat

or 3

Gen

erat

or 4 G

ener

ator

5

Gen

erat

or 6


The effect of a generator outage

Outagedgenerator

Oldsupply

limit

Newsupplylimit


Effect of demand uncertainty and generator outage

n-1 secure

insecure

Probabilityp2

Outage probability is p1*p2

Probability p1


System B

System A

Gen

erat

or 1

A

Gen

erat

or 2

A

Gen

erat

or 3

A

Gen

erat

or 4

A

Gen

erat

or 5

A

Gen

erat

or 6

A

Gen

erat

or 1

B

Gen

erat

or 2

B

Gen

erat

or 3

B

Gen

erat

or 4

B

Gen

erat

or 5

B

High pricen-1 insecureLow price

Secure


System B

System AHigh pricen-1 secureLow price

n-1 secure


System B

System ALow pricen-1 secureLow price

n-1 secure

Flow


Temptation: construct a composite supply curve

+

Low pricen-1 secure

unnecessary


Flow

Normal conditions

System B

System ALow pricen-1 insecureLow price

n-1 secure

Situation with line transmission limits

Maxflow

Maxflow

Outagedgenerator

Unableto clear


System B

System AFlow

Maxflow

Use of distributed reserves

Low pricen-1 secureLow price

n-1 secure


Features of the example

• Only two areas (one flowgate)

• Radial

• Demand is inelastic

• Time delays are not an issue

• Generators have no startup/shutdown costs or restrictions or minimum power levels


Observations

• Demand elasticity is important• Locational aspects of reserves matter

– LMP for reserves

• Ramping rates matter• In deregulated markets only units explicitly

committed to reserves are available– In regulated markets and in PJM all units are

• Reliability requires that we increase supply– Standby charges tend to reduce supply (Tim Mount)


Reality

• Many flowgates• Networked sysyem• Demand can be elastic• Time delays important• Generators have fixed

costs and restrictions• Load is uncertain

• Transmission outages exacerbate problems

• If one firm dominates a technology, market power occurs (next)

• If one firm dominates a location, market power results


Market Power?

• The ability to raise prices significantly above the efficient economic equilibrium

• Disclaimer: the slides that follow are not really a market power study but rather they represent a simplified illustration of how higher prices could result as a result of market concentration.


Market Power: Assumptions

• There are exactly two technologies– Each technology has a fixed marginal price availability of the expensive technology– Limited availability of the cheap technology– Cheap technology has fixed costs to recover

• Demand is inelastic– First deterministic, then probabilistic

• All suppliers but a schedule all their cheap power• Supplier a owns P MW in n1 equal-sized generators

– Supplier a can “withhold” one or more generators– Bidding above marginal cost is not allowed, withholding isBidding above marginal cost is not allowed, withholding is


The piece-wise nature of the supply curve revisited

Oth

er s

uppl

iers

Sup

plie

r a

gene

rato

r 1

Dem

and

Clearingprice

If generators bid marginal price,the generators surplus is zero

Sup

plie

r a

gene

rato

r 2


Red generator decides to withhold one generator

Withheldgenerator

Clearingprice

Sur

plus

for

red

supp

lier

Red supplier nowhas large surplus

Of course blue supplierhas even LARGER surplus!

Sur

plus

for

blue

sup

plie

r


If margins are increased

Clearingprice

Now it is not possible for redsupplier to withhold and gain

Raising priceswould requirecollusion

Question: and how are theexpensive technology units

supposed to recover theirfixed costs if they always

clear at their marginal cost?

Answer: you may endup with less capacitythan you thought


If demand is uncertain

The expected surplusgain is: p*(2-1)*P1

Probability p thatwithholding willresult in surplus

2

P1

price 1

Quantity (power)

Pri

ce

Since 1 is cheap unit’s marginalcost, there is no expected surplus loss


Additional observations

• If the margin to the “knee” is Pm, any supplier with a total ownership above Pm may profit from withholding– If more than one supplier meets this conditions,

chances are that someone will withhold


For two generators, surplusis P*(2-1)/2 for demandabove this level

Effect of “granularity”

With only onegenerator, it isimpossible towithhold andbenefit P

Surplus is P*(2-1) fordemand above this level


Effect of “granularity,” three generator case

Surplus is P*(2-1)/3 fordemand above this level

Surplus is 2P*(2-1)/3 fordemand above this level


Effect of “granularity”

Sur

plus

With n=1, there is no surplus

Surplus with n=2

Surplus with n=3

Surplus with n=4

Surplus with n

Demand level


Observations and assumptions

• For “worst case” effect, assume n=• Assume withholding will occur

– Withholding “softens” the supply curve

• High cost periods needed for fixed cost recovery• Demand is probabilistic• Suggestion: market power occurs if expected

surplus exceeds fixed cost recovery– This is also a signal for system expansion

• This means that in the absence of uncertainty, expansion will occur when expected profits exceed long run marginal costs


Effect of number of suppliers on supply curve

One supplier

2 su

pplie

rs3

supp

liers

10 s

uppl

iers

Demand

Pri

ce


Pri

ce

Demand

Period during whichfixed cost recoverycan take place

Effect of demand uncertainty on fixed cost recovery

Withholding increases the period duringwhich surplus accrues but reduces theamount that accrues


Pri

ce

Demand

Period during whichfixed cost recoverycan take place

The effect of demand uncertainty on fixed cost recovery


Numerical studies

• Demand is 60/70/80/90/95% of “knee”

• for demand varies from 0 to 20%

• Demand probability distribution is normal

• Supplier has equal size units available

• There are 3/6/10/15/ suppliers

We illustrate the fixed costs that can be recoveredfor each of the case combinations above accordingto our earlier withholding assumptions


0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.20

50

100

150

200

250

80%

Variance of demand (per unit)

Fixed cost recovery without market power ( suppliers)

Tho

usan

ds p

er y

ear

per

MW

90%

95%

99% Demand level as a percentageof available capacity


0 2 4 6 8 10 12 14 16 18 200

20

40

60

80

100

120

140

160

180

200

Demand Variance (percent)

Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)

suppliers, demand level as a parameter

60%70%80%90%95%

Even for highdemand levels, somedemand varianceis essential forcost recovery


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)

15 suppliers, demand level as a parameter

60%70%80%90%95%

For high enough demand levelscost recovery is possibleeven without demand variance


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)


60%70%80%90%95%

For high demand levelsdemand variance can becomeirrelevant


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300

350

400


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)


60%70%80%90%95%

For low demand levels it isvery difficult to recoverfixed costs


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300

350

400

450


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)


60%70%80%90%95%

For high demand levels, high variancecan even be slightly detrimental to profits


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300

350

400

450


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)


60%70%80%90%95%

With three or less suppliers, it becomes feasibleat high variances to recover fixed costs bywithholding at low demand


0 2 4 6 8 10 12 14 16 18 200

5

10

15

20

25

30

35

40

45

50


Fix

ed

co

st r

eco

very

(th

ou

san

ds

per

MW

-yea

r)

Demand level 60%, number of suppliers as a parameter

suppliers15 suppliers 10 suppliers 6 suppliers 4 suppliers 3 suppliers

At low demand and lowvariance it is impossibleto recover fixed costs


0 2 4 6 8 10 12 14 16 18 200

20

40

60

80

100

120


Fix

ed

co

st

rec

ov

ery

(th

ou

sa

nd

s p

er

MW

-ye

ar)



At higher demand with 3 suppliersit is possible to recovercosts at low variance


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250


Fix

ed

co

st

rec

ov

ery

(th

ou

sa

nd

s p

er

MW

-ye

ar)



0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300

350

400


Fix

ed

co

st

rec

ov

ery

(th

ou

sa

nd

s p

er

MW

-ye

ar)



As demand increases, withholding becomesprofitable even when there are many suppliers


0 2 4 6 8 10 12 14 16 18 200

50

100

150

200

250

300

350

400

450


Fix

ed

co

st

rec

ov

ery

(th

ou

sa

nd

s p

er

MW

-ye

ar)



Only in the caseof infinite suppliers is it

impossible to recover costs


Comments on numeric results• The number of suppliers has a strong influence on cost

recovery– Below a certain number of suppliers, cost recovery by

withholding becomes easier

• There are demand threshold levels beyond which there is a jump in the ability to recover costs

• All studies assume that supplier can adjust level of withholding after learning the demand– Lower returns when this is not true, study underway

• Demand variance has a strong influence on ability to recover costs, sometimes with a threshold level


Final remarks

• Two-technology suppliers can lead to higher than marginal prices as the knee of the supply curve is approached

• Larger number of suppliers reduces this effect• Market power studies should consider fixed

cost recovery issues• We did not even look at congestion or voltage

problems!

Documents

December 4, 2000© 2000 Fernando L. Alvarado1 Reliability concepts and market power Fernando L. Alvarado Professor, The University of Wisconsin Invited