Ensuring Generation Adequacy Through Hedging Obligations

1
Ensuring Generation Adequacy Through Hedging
Obligations

• Shmuel Oren
• University of California at Berkeley
• PUCT Workshop on Planning Reserves Requirements
• Austin, Texas, April 11, 2002

2
What is Reliability

• NERC (North American Electric Reliability
  Council) defines reliability as the degree to
  which the performance of the elements of the
  electrical system results in power being
  delivered to consumers within accepted standards
  and in the amount desired
• Reliability encompasses two concepts
• Security the ability of the system to withstand
  sudden disturbances. This aspect concerns
  short-term operations and is addressed by
  ancillary services which includeVoltage support,
  Congestion relief, Regulation (AGC) capacity,
  Spinning reserves, Nonspinning reserves,
  Replacement reserves.
• Adequacy the ability of the system to supply
  the aggregate electric power and energy
  requirements of the consumers at all times. This
  aspect concerns planning and investment and is
  addressed by Planning reserves, Installed
  capacity, Operable capacity or Available
  capacity.

3
Planning Reserves and Reliability

• Plentiful reserve capacity makes it easier to
  achieve security but is not necessary
• Security can be achieved even with limited
  reserves by curtailing load or by raising prices
  sufficiently to induce demand response and
  investment.
• Generation adequacy is required to insure
  reliable supply at a reasonable price
• In a competitive market obligation to serve is
  obligation to serve at a price
• Reliability is not a product and has no
  meaning unless it is defined in terms of a price
  ceiling on secure energy supply
• Generation adequacy can be interpreted as price
  insurance which in theory is a private good.
  Market participant can decide how much they want
  and at what price according to their risk
  management preferences

4
Achieving generation adequacy in an ideal market

• Inadequate supply leads to high prices which
  attract investment
• Excess capacity will drive competitive prices to
  marginal cost
• Generators on the margin and reserve capacity
  will not cover their fixed costs.
• Exit through early retirement of capacity will
  drive prices up during peak demand leading to
  demand response and scarcity rents
• When capacity is optimal scarcity rents exactly
  covers fixed costs
• Capacity deficiency will drive scarcity rents
  above equilibrium levels resulting in excess
  profits which will attract new investment.
• Forward markets will form that enable consumers
  to lock in prices and avoid price volatility and
  to investor to hedge their investment risk by
  securing long term supply contracts

5
Energy Market With Excess Capacity
Energy Price (/MWh)
Demand at 700 - 800 p.m.
Price at700-800 p.m
Demand at 900 - 1000 a.m.
Price at 900 - 1000 a.m.
Demand at 200 - 300 a.m.
Price at 200 - 300 a.m.
GEN 5
GEN 6
GEN 4
GEN 1
GEN 2
GEN 3
Q1
Q2
Optimal Capacity
Operating level
MW
6
Energy Market With Optimal Capacity
7
Energy price volatility

• Price volatility is an inherent aspect of
  electricity due to its nonstorability and the
  steep supply curve.

WSCC Generation Resource Stack
Electricity On-peak Spot Prices
8
Key questions

• Can we rely on the market to provide investment
  incentives for adequate planning reserves?
• What mechanism will provide an income stream that
  can sustain reserve generation capacity?
• Will capital markets operate efficiently to
  sustain an adequate amount of generation
  investment?
• Is an unrestricted energy market in which
  scarcity rents feed new investment politically
  feasible?
• What mechanism should be used (if any) to
  restrain market power and transfer of wealth
  between producers and consumers while investment
  catches up with scarcity?
• What should be the risk management obligation of
  an LSE

9
What's missing in the theoretical market paradigm?

• Theory does not account for reserve capacity that
  is required on the bench to ensure system
  reliability. When resources are only paid for
  produced energy such reserve capacity will not
  collect sufficient revenues to cover its fixed
  costs and will exit the market
• Steep supply function and uncertainties make
  scarcity rent highly volatile and sensitive to
  market error in determining the optimal capacity
• It is impossible to differentiate legitimate
  scarcity rents from inflated prices due to
  exercise of market power.
• Demand response is limited by technological
  barriers and operational practices
• Very high scarcity rents even if they are
  legitimate are politically unacceptable (reason
  for price caps)
• Low levels of reserves foster collusive behavior
  and market power
• Even suppliers with low market share can become
  pivotal suppliers.
• High prices are sticky
• Capacity shortages cannot be resolved overnight
  and while the entry occurs the persistent
  scarcity rents result in wealth transfers from
  consumers to producers.
• Exposures in the electricity supply chain are not
  properly allocated to insure voluntary, socially
  efficient risk management practices by the market
  participants

10
Alternative Approaches to Ensuring Generation
Adequacy

• Capacity payments (old UK system, Argentina,
  Spain)
• Generators receive capacity payments based on
  availability, technology, VOLL, LOLP to
  incentivize investment and availability.
• Shortcomings
• Payoff to incumbents but does not reassure
  investors
• Results in over investment and too low energy
  prices that reinforce the need for capacity
  payments
• Suppresses demand side response since scarcity
  rents are covered by capacity payments

11
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• ICAP obligation (PJM, New York, New England)
• Central agency (ISO or Regulator) specifies
  requirements for planning reserves based on
  traditional planning tools.
• Load serving entities have to meet a monthly
  prorata ICAP obligation
• ICAP markets allow supplier to trade reserves and
  efficiently reallocate the reserves
  requirements.
• Shortcomings
• Capacity product is too short term to affect
  planning
• Capacity product does not obligate the seller to
  be available for energy production or to provide
  energy at some price
• Capacity prices do not reflect the value of
  producing energy
• Short-term supply and demand for ICAP are
  inelastic so there is either excess (zero price)
  or shortage (infinite price)

12
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• ACAP obligation (Proposed in California)
• ISO specifies requirements for available capacity
  obligation
• Load serving entities have to meet a monthly ACAP
  obligation that is based on their forecasted next
  month peak load plus a fixed percentage
• ACAP obligation can be met through a portfolio of
  generation resources an physical load management
• Resources counted toward ACAP obligation are
  subject to ISO verification at the beginning of
  each month and must be scheduled or offered into
  the ISO operated markets.
• Shortcomings
• Based on the outdated obligation to serve
  paradigm were capacity is a product and
  reliability is a service attribute.
• In a market paradigm, capacity is an option to
  produce energy and reliability is the
  availability of supply at a reasonable price.
• Without an explicit strike price a capacity
  product does not protect customers from price
  spikes and therefore does not provide reliability
• Uncertainty regarding future price caps makes it
  difficult to enter into long term ACAP contracts

13
Alternative Approaches to Ensuring Generation
Adequacy (contd)

• Two year RPRS obligation (Reliant proposal)
• Works like another ancillary service product
• ISO procures two year options on RPRS capacity
  based on forecasted need of replacement reserves
• QSEs assigned obligation based on daily load and
  charged RPRS clearing price for their obligation
• Providers required to offer contracted capacity
  as replacement reserves at contract strike price
  and offer balancing energy at MCPE.
• Contract duration adequate to affect planning
• Shortcomings
• Cost of option not covered by payments.
  Difference must be uplifted or allocated in
  proportion to annual RPRS payment.
• Puts ISO in the position of buying forward and
  selling spot
• Inconsistent with decentralized markets and MIN
  ISO philosophy (sounds like a public power
  solution)

14
Call option approach (strawman)

• load serving entities (LSEs) are required to hold
  at the beginning of each month verifiable hedges
  in the form of forward contracts and/or call
  options totaling 115 of their next month
  forecasted peak load.
• Qualifying hedges must have at least two years
  duration with no less than one year remaining
  life. Strike prices of call option should be at
  or below a maximum level set by the regulator
• Hedging obligation may be multi-tiered with
  different strike prices for example 105 or more
  with strike price of 200/MW, another 5 with
  strike price of 600/MW and another 5 with
  strike price of 1000/MW
• The multi-tiered obligation creates an effective
  demand function for capacity
• Hedging obligations can be met by a portfolio of
  contracts with generators and curtailable load
  contracts.

15
Call option approach (contd)

• Call options may be, self provided, procured
  bilaterally or procured through a voluntary
  auction hosted by ERCOT.
• Generator risk (and consequently the cost of
  options) may be reduced by indexing the strike
  price to fuel cost or by using spark spread
  call options (spark spreadelectricity price -
  heat rate adjusted gas price)
• Call options that are exercised must be able to
  generate the promised power or be liable for the
  price cap or MCPE (whichever is higher) applied
  to the undelivered quantity.
• Self-insurance covered by a financial security
  that will cover the difference between the price
  cap and the regulated strike price for a three
  month worth of the uncovered hedging obligation
  may be allowed on a limited basis.
• ACAP can be viewed as special case were the
  strike price equals to the price cap and physical
  exercise capability is enforced

16
Key aspects of call option approach

• Emphasis on mitigating price volatility rather
  than on steel in the ground which is only one
  of the possible market responses.
• Multiple means of meeting hedging obligation
  ensures balance between investment, demand
  response and risk management
• Hedging products are long term to facilitate new
  investment response by transferring risk from the
  investor to the LSE.
• Enables reserve generation capacity to secure a
  stable income stream for fixed cost recovery in
  exchange for a tangible obligation to produce
  energy at a reasonable price when needed.
• LSE obligations revised monthly to reflect
  changes in customer base
• Secondary market for call options will enable LSE
  to adjust their holdings. Prices will fluctuate
  according to market conditions. (e.g. daily
  fluctuation of long term treasury bond prices)
• As the market matures, individual hedging
  obligation may be relaxed if the market as a
  whole proves to be properly hedged.

17
Summary

• Generation adequacy should be viewed and treated
  as a financial risk management issue rather than
  a reliability issue.
• The ultimate goal of long term reserves policies
  in a competitive electricity market is to
  mitigate price volatility through alternative
  means and not just to promote steel in the
  ground
• Reliability in a competitive market Control of
  price volatility
• Imposing hedging requirements on LSEs is a market
  friendly way of ensuring generation adequacy
• While price caps and reliability standards should
  be subject to regional jurisdictions (RTO, FERC,
  NERC) hedging requirements imposed on LSEs should
  be regulated at the state level (PUC).