Presentation to COMPETE and EPSA Forum:

“Empowering Consumers Through Competitive Markets”

David W. DeRamus, Ph.D.

November 5, 2007

Ensuring Consistent Environmental and Competition Policies in Electricity Markets

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Agenda

• Need for consistent environmental and competition policies

• Demand response in organized markets:

Economic debates and price implications

Policy implications

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Need for consistent environmental and competition policies

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Competitive markets can be effective in achieving environmental objectives

• Roots of U.S. competitive electricity markets lie in federal efforts to improve efficiency and promote renewables Move towards competitive markets not driven by ideological agenda

PURPA (1978) directed at increasing efficiency, as well as promoting cogeneration and renewables

Helped remove barriers to entry faced by competitive suppliers• Further supported by EPACT 1992, Order 888, Order 2000, etc.

Attempted to encourage marginal cost pricing as a conservation measure• Environmental Defense Fund an early advocate of “time-of-day” rates (WI, 1972)

• Policymakers increasingly looking to market institutions to address emissions Positive experience with cap-and-trade programs, e.g. SO2, NOx

Increasing efforts to implement market-based CO2 programs as alternative to traditional “command-and-control” emissions regulation

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Competitive electricity markets are also effective tools for reducing emissions

• Appropriately structured competitive markets can:

Improve system-wide economic dispatch within a given control area

• Dispatch based on economics, not ownership

• Major concern in unrestructured regions is market foreclosure of efficient competing generation by transmission-owning utility

Expand economic dispatch across a wider range of resources by increasing geographic scope of wholesale markets

Improve operating efficiencies and reduce outages at lower-emissions baseload plants, e.g., nuclear facilities

Provide incentives for investment in more efficient and renewable generation

Provide appropriate price signals to guide consumption and investment decisions

Offer customer access to enhanced products, e.g., “green energy” options, time-varying rates using “smart” meters, and direct load control

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Competitive markets prices send appropriate signals regarding the incremental – or marginal – impact of consumer/producer/investor decisions

• Consumer:

At the margin, what is the impact of my consumption decision on the prices I have to pay or the amount of emissions that will be produced?

• Producer:

At the margin, what is the impact of my production decision on the prices that I can charge or the costs that I will incur for emissions?

• Single-plant investor:

How much profit can I expect to earn relative to the marginal price-setting plant if I invest in the most efficient generation technology?

• Portfolio investor:

At the margin, how much incremental risk am I incurring with an additional investment in renewable generation capacity or other “fixed cost” technology?

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Consistent environmental and competition policy is often stymied by other regulatory or legislative efforts

• Policymakers often want to “protect” ratepayers from high electricity prices, even if those prices are the result of competitive markets

• Exposing ratepayers to market prices provides the necessary incentive to curtail consumption

• “Protecting” ratepayers from market signals has negative short-term and long-term consequences

See, e.g. CA 2000-2001 crisis

“Amortizing” current costs of electricity over time does nothing to address the underlying problems: demand-supply imbalances, current fuel costs, etc.

Attempts by policymakers to pursue emissions policies that “protect” ratepayers from increased costs

Focusing on economic incentives can help ensureconsistent environmental and competition policies

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Promoting competitive electricity markets is sound environmental policy

• Exercise of market power can reduce system-wide production efficiency, particularly in non-restructured states

• Horizontal market power is the ability to increase prices above competitive levels Focus is generally on the price effects of withholding one’s own capacity

May lead to production inefficiencies, if less efficient units are dispatched out of merit order

• Vertical market power is the ability to foreclose other suppliers from the market Focus is generally on a monopolist’s ability to exclude equally or more

efficient competitors

Raises significant concerns about production inefficiencies

Of particular concern in regulated industries in which there are some limitations on regulated firms’ ability to increase prices

Foreclosure of competitive generation in unrestructured states should be a significant concern for both competition policy and environmental policy

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Foreclosure result: uneconomic dispatch of a regulated utility’s own higher-cost generation despite competitive supply alternatives

Market foreclosure not only harms competition but also increases energy costs and emissions

q0q1

p0

p1

c1

q1’q0’

Utility’s Power SupplyWholesale Market

Demand

Supply

Wholesale Price

MWh MWh

Utility Cost

 

Efficiency loss

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Demand response in organized markets: economic debates and price implications

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Electricity markets are conducive to demand-side participation

• One purported barrier to competitive electricity markets is inelastic demand

• Actual electricity markets function well under most conditions, i.e., result in competitive prices, even without active demand-side participation

Most concerns with competitive markets are directed towards what happens in periods of tight supply

• Price-elastic demand is not required for robust competitive markets, as long as market structure and auction rules are good

Example: competitive procurement auctions with fixed quantity of demand can still produce highly competitive prices, even with few participants

• Electricity markets are also conducive to demand side participation, if customers are exposed to relevant price signals

Some demand side programs require additional investments, e.g. “smart” meters, direct load control technology

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Appropriately compensating demand response is still open to debate

• Arguments against payments to DR as an energy resource:

Savings from foregone consumption should be sufficient compensation

In energy markets, DR is not a distinct product that can be owned and sold

Compensating DR at clearing price is a double payment that distorts the market and creates economic inefficiencies

• Arguments in favor of payments to DR as an energy resource:

“Public good” attributes of DR warrant compensation in energy market

If most load is on a fixed-price tariff, peak demand will be higher than is economically efficient

“Double payment” may still produce a net welfare gain

• In ancillary services markets, DR provides reliability service equivalent to supply resources – so compensation is uncontroversial

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DR programs can provide important reliability benefits

During extreme events, DR can provide high-value reliability benefits

Cost to electricity users of unexpected service interruption – the value of lost load – is much higher than market price caps

As it allows for true user value to be reflected in prices, DR reduces the need for price caps

Peak demand

Supply

Price Cap

Peak demand with DR

Unserved load at price cap

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DR programs can lower market clearing energy prices by moving demand curve down inelastic portion of supply curve

Small amount of DR can have large price effects with tight supply

Benefits to consumers not necessarily a “social welfare” gain: price reduction is a welfare transfer from suppliers to consumers

Price inelasticity may simply be due to fixed-rate tariffs: provide consumers with market signals

Shift to more price-elastic portion of the supply curve reduces potential market power

Peak demand

Supply

Peak demand with DR

P1

P2

Q2 Q1

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Allowing customers to respond to market prices removes inefficiencies with average cost pricing

Peak At average tariff rate

PT, consumption is at QTpeak , above the optimal competitive level QCpeak

Deadweight loss to society of over-consumption is equal to area (a+b)

Off-Peak At average tariff

rate, consumption is at QTOP, below the optimal competitive level QCOP

Deadweight loss to society of under-consumption is equal to area (c)

Tariff Rate

Peak demand

Supply

PT

P*

Efficient peak clearing price

Marginal supply cost at QT

peak

a

b

Off-Peak demand

QTpeakQC

peak

PCpeak

cPC

OP

QCOPQT

OP

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With retail customers under a fixed-rate tariff, demand response payment can improve welfare in peak periods

A DR program to encourage bidding at Pc for quantity (QTpeak - QCpeak) will reduce deadweight loss

Payment to DR is equal to area (b+c+d)

As long as (b+c+d)<(a+b), or rather (c+d)<a, social welfare is improved

Tariff Rate

Peak demand

Supply

PT

P*

Efficient peak clearing price

Marginal supply cost at QT

peak

a

b

QTpeakQC

peak

PCpeak

c

d

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Need to incorporate concept of “residual demand” in order to understand impact of DR on potential exercise of market power

• A critical input to a supplier’s bid decision is an estimate of its residual demand curve

• The residual demand curve is constructed by subtracting the supply of other bidders from aggregate demand

p

q

p0

Aggregate Demand

Aggregate Supply

q0

–

p

q

Supply of others

q-i

p

q

Supply of firm i

Residual Demand

qi

=

• Residual demand curve is more price elastic than aggregate demand, because it includes the response to price of all other suppliers

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Residual demand curve bidding implies that “as-bid” supply curves will deviate from marginal costs in all real markets – in all industries

Price

Quantity

Gain

Loss

As Bid Supply

Residual Demand

Marginal Cost

Real-world, i.e., imperfect, competition in single-price auction

Individual supplier’s “bid functions” based on expectations of demand and of the bids of other suppliers

With some probability of a producer’s bid affecting market-clearing price, bid curve will exceed MC curve

Appropriate for regulator to provide incentives, but not the requirement, for bids to approximate marginal costs

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DR increases elasticity of both demand and as-bid supply curves via its impact on the “residual demand” faced by each supplier

Price

Quantity

S1

MC

DR shifts demand curve down to more price-elastic portion of supply curve*

DR increases elasticity of “residual demand” curve faced by each individual supplier

Increased elasticity of residual demand curve also increases elasticity of as-bid supply curve

Reduces the spread between as-bid supply curve and MC curve

D1

D2

S2

*The figure shows a linear supply curve for simplicity

Effect of D shift

Effect of S shift

p0

p1

p2

q0q2q1

Demand response provides incentives for suppliers to bid closer to marginal costs: a market-based approach to addressing market power concerns

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Demand response: policy implications

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Demand response benefits are not just theoretical – substantial monetary and reliability benefits have already been realized

• Estimated total DR capability nationwide:

37,500 MW – approx. 5% of peak demand1

• RTO/ISOs incorporating DR into centralized markets

Most RTO/ISOs allow DR in energy and capacity markets

ISO-NE, NYISO, CAISO and PJM allow DR in certain A/S markets

DR can bid into ISO-NE forward capacity market

• PJM estimated DR benefits:

$230 million during peak hours on August 2, 2007

$600 million benefit during that week

• CAISO demand reductions of 1000MW+ averted more widespread disruptions over 2007 Labor Day weekend

1 2006; FERC Staff Demand Response Assessment

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Demand response can address remaining market power concerns in organized markets – but policies need to be consistent

• A relatively small amount of DR can have a large impact on market-clearing prices in periods of tight supply

• Peak-period prices still need to be allowed to rise high enough to adequately compensate peak resources

Need prices to periodically rise sufficiently above marginal cost of peaking resource to justify investment

Investment in peak resources needed for reliability, price stability, and to address market power concerns

• Danger of “belts and suspenders” approach to mitigation

“Pre-emptive” market power mitigation – price caps, automated cost-based mitigation – distorts market price signals, increases investor uncertainty, and increases risk of insufficient cost recovery

Price caps limit incentives and effectiveness for “market-based” mitigation – i.e., demand response

Question: How do we know that DR programs will be sufficient to address remaining market power concerns in current organized markets?

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Current wholesale electric markets already function significantly better than simple theoretical models predict – remarkably close to a competitive ideal

Example: Bushnell, Mansur, and Saravia, “Vertical Arrangements, Market Structure, and Competition in Restructured U.S. Electricity Markets”, CSEM WP 126, Feb. 2005

Clearly, something other than industry concentration is already inducing highly competitive supplier bidding behavior

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More complex models of imperfect competition are better predictors of wholesale market performance

Example: Bushnell, Mansur, and Saravia, “Vertical Arrangements, Market Structure, and Competition in Restructured U.S. Electricity Markets”, CSEM WP 126, Feb. 2005

Current institutional arrangements – including forward contracting, as well as specific auction rules – already provide incentives for suppliers to bid close to marginal costs in most hours

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Competitiveness of actual wholesale markets is reflected in bid/cost assessment by PJM Market Monitor1

• Energy market markup analysis Markup calculated as the difference between actual offer and imputed cost for each

actual marginal unit on the system

In 2006 the markup component of LMP was $0.00 or lower in 5,351 hours (61%)

Markup was greater than $25 /MWh in 100 hours (1%)

• Market Monitor conclusions: “Markup on high load days is likely to be the result of appropriate scarcity pricing

rather than market power.”

“Overall results support the conclusion that prices in PJM are set, on average, by marginal units operating at or very close to their marginal costs. This is strong evidence of competitive behavior.”

($/MWh)Load-

weighted Avg LMP

Average Markup

Component

On peak $64.46 +$3.08

Off peak $41.53 -$0.10

1 PJM 2006 State of the Market Report.

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Why are market prices already so close to marginal costs in so many hours of the year?

• Supplier bidding behavior is significantly affected by market expectations and uncertainty – even in uniform-price auctions

• A market participant knows its own costs, but it must estimate:

Opportunity costs – including expectations of prices in other markets

Aggregate demand

Supply bids of other market participants

Financial risks associated with transactions

• Uncertainty of residual demand decreases incentives for bids to deviate too far from marginal costs (risks of not being dispatched when economic)

• Uncertainty of residual demand causes actual market behavior to be closer to competitive ideal than theoretical predictions of simple economic models

• Uncertainty of residual demand is increased by diversity of market participants – and a diversity of strategies

Expanding DR programs will further increase bidder uncertainty regarding residual demand and thus further limit deviation of as-bid supply from MC

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Policymakers need to consider impact of demand response programs on incentives for investment in peaking capacity

• Energy markets do not provide sufficient revenue to support investment in new generation, in part due to administrative price/offer caps

• With demand responsiveness, market-clearing prices better reflect the value users place on uninterrupted service

During periods of binding supply constraints, prices above marginal cost appropriately reflect scarcity value – in the limit, VOLL

• If markets are allowed to value scarcity appropriately, the rationale for price/offer caps disappears

• DR can reduce clearing prices in some hours and can also improve confidence in market outcomes

Elimination/reduction of administrative intervention (price caps) improves supplier confidence in market outcomes

DR supports both short-term and long-term reliability

DR can complement forward locational capacity markets

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Conclusions

• Policymakers should be wary of “protecting” consumers from legitimate market price signals

• Competitive electricity markets promote efficiency and other environmental objectives

• Regulators should consider impact of specific environmental and competition policies on producer and consumer incentives

• Reducing foreclosure of competing suppliers from unrestructured markets can provide important environmental benefits

• Demand response programs can address remaining market power concerns in organized markets

• Implementation of demand response in organized markets should be accompanied by removing price caps and other administrative pricing mechanisms